Advance Income Tax on interest

By adopting a thoughtful approach, the Government can support senior citizens while preserving the integrity and sustainability of the tax framework

While making the 10% AIT a final tax for senior citizens above 70 years is a compassionate and practical policy, it requires careful design to address revenue, equity, and administrative concerns. By limiting the scope to those with modest incomes and implementing strong verification and monitoring mechanisms, policymakers could strike a balance between social responsibility and fiscal prudence. This approach would demonstrate a commitment to supporting an aging population while maintaining the integrity of the tax system

The current Advance Income Tax (AIT) rate of 5% on interest is increased to 10%. Direction mechanism is to be introduced to prevent interest income below the personal relief to be paid without being subject to deduction. Currently, the AIT on interest is not a final tax. No changes to this status have been proposed. (w.e.f. 1 April 2025).

The increase in the Advance Income Tax (AIT) on interest from 5% to 10% in Sri Lanka will have various implications for taxpayers, depending on their financial situation and the nature of their income. Here’s an analysis:

1. Impact on individual taxpayers

• Reduced disposable income: Taxpayers who earn interest income will experience a reduction in their net earnings as a higher percentage of their gross interest is withheld as AIT. For those reliant on interest income (e.g., retirees or individuals with significant fixed deposits), this could significantly reduce their cash flow.
• Increased administrative burden for refunds: Taxpayers whose overall income falls below the taxable threshold may need to claim refunds for the excess AIT withheld. The increased rate means larger sums to claim, leading to additional administrative work.
• Possible tax planning adjustments: Taxpayers may reconsider investment choices, potentially shifting from interest-bearing accounts to tax-efficient alternatives, such as equity investments or tax-exempt instruments.

2. Impact on high-income earners

• Advance tax credits: High-income earners who pay income tax at a rate higher than 10% may utilise the increased AIT as an advance tax credit against their final tax liability. However, this change would not increase their overall tax burden but may affect their cash flow during the tax year.
• Reduced savings incentives: With higher upfront taxes on interest, some high-income individuals may be discouraged from saving in fixed deposits or similar instruments, which could impact their financial strategies.

3. Impact on non-residents

• Increased withholding tax: Non-residents earning interest from Sri Lankan sources will also face the higher withholding tax, potentially making Sri Lankan interest-bearing investments less attractive.
• Double taxation treaties: Non-residents from countries with double taxation treaties may need to ensure that the excess withholding aligns with treaty terms, increasing compliance work.

4. Broader economic implications

• Shift in investment behaviour: As interest on savings becomes less attractive due to higher tax withholding, individuals and institutions may move towards alternative investments like stocks, real estate, or other financial instruments.
• Impact on the banking sector: Banks may see reduced deposits in interest-bearing accounts as customers seek better post-tax returns, potentially impacting liquidity and lending capacity.
• Increased government revenue: The higher rate will increase government revenue in the short term, contributing to fiscal consolidation efforts.

5. Equity considerations

• Burden on low-income savers: Individuals in lower income brackets who rely on interest as a primary source of income will face a disproportionately higher financial strain, as the AIT is withheld upfront regardless of their overall tax liability.
• Need for refund mechanisms: It is crucial for the tax authorities to streamline refund mechanisms for those not subject to income tax to ensure fairness and minimise hardships.

Mitigation strategies for taxpayers

• Tax planning: Seek professional advice to optimise investment portfolios to minimise tax burdens. Explore tax-exempt or tax-efficient investment options where possible.
• Claiming refunds: Ensure proper documentation and timely filing of tax returns to claim refunds if the effective tax rate is lower than the withheld AIT.
• Adjusting financial plans: Reassess savings and investment strategies to account for the reduced net returns on interest income.

The increase in AIT on interest is a significant measure that will impact taxpayers’ cash flows, investment choices, and overall financial planning. While it supports government revenue objectives, its success depends on how well the tax system addresses refund claims and minimises the compliance burden.

Tax direction mechanism

Introducing a direction mechanism to exempt interest income below the personal relief threshold from Advance Income Tax deduction could bring several advantages and challenges, especially for senior citizens who rely solely on interest income. Here’s a detailed analysis:

Advantages of the direction mechanism

1. Protection for low-income earners

• Avoidance of upfront tax deduction: Senior citizens and other individuals earning interest below the personal relief threshold would not have to suffer unnecessary deductions, ensuring they receive their full income upfront. This is particularly beneficial for those whose sole income is interest and who rely on it for day-to-day expenses.
• Equity in taxation: The mechanism aligns with the principle of progressive taxation, ensuring that individuals with incomes below the taxable limit are not burdened by an upfront tax.

2. Simplified compliance

• Reduced need for refund claims: By preventing deductions at the source for non-taxable individuals, the mechanism minimises the administrative burden of filing tax returns solely for refund claims, which can be complex and time-consuming for senior citizens.
• Ease of administration: Banks and financial institutions would have clear instructions to identify eligible taxpayers, streamlining the process and avoiding disputes over unnecessary deductions.

3. Financial relief for senior citizens

• Preserving cash flow: Senior citizens often rely on interest income for basic needs. Ensuring their income is exempt from deduction below the threshold would help them maintain liquidity and financial stability.
• Encouragement to save: Knowing their interest income won’t be reduced by AIT, low-income earners and senior citizens might be more inclined to save in interest-bearing accounts.

Difficulties and challenges

1. Implementation complexity

• Verification of eligibility: Financial institutions would need a robust mechanism to verify whether a depositor’s total income, including interest, is below the personal relief threshold. This could involve: 
•  Submission of declarations or affidavits.
• Cross-verification with tax authorities.
• Administrative burden: Setting up the system to identify and exempt eligible accounts could impose significant costs and operational challenges on banks and other financial institutions.

2. Risk of misuse

• False declarations: Some individuals may falsely declare that their income is below the personal relief threshold to avoid AIT deductions, leading to potential revenue loss for the government.
• Monitoring and enforcement: The tax authorities will need to monitor compliance closely, requiring additional resources for audits and checks.

3. Limited awareness

• Educational barriers: Many senior citizens might not be aware of the procedure to claim exemptions or may find it cumbersome, leading to exclusion despite their eligibility.
• Complexity of documentation: The requirement to file forms, declarations, or obtain certificates from tax authorities might deter eligible individuals from availing themselves of the exemption.

4. Equity and fairness issues

• Perceived inequity for non-exempt individuals: Higher-income earners who are subject to AIT might perceive the exemption as unfair, leading to calls for broader reforms or adjustments in the AIT structure.

Suggestions to address challenges

1. Automated verification: Integrate financial institutions with the tax authority’s database to automatically verify eligibility based on prior tax returns or income declarations.

2. Simplified declaration process: Introduce a one-time declaration system for senior citizens to certify their eligibility, reducing the need for annual paperwork.

3. Awareness campaigns: Launch targeted education programs to inform senior citizens about their rights and the steps to claim exemptions.

4. Technology solutions: Leverage digital banking and tax platforms to streamline the exemption process, making it accessible even for those with limited technical skills.

5. Audits and penalties: Implement safeguards against false declarations, including periodic audits and penalties for non-compliance.

Conclusion: A direction mechanism to prevent AIT deductions on interest income below the personal relief threshold is a fair and equitable solution that can greatly benefit senior citizens. However, its success depends on addressing implementation complexities, minimising administrative burdens, and ensuring widespread awareness and compliance. By striking the right balance, this initiative can enhance taxpayer satisfaction while maintaining the integrity of the tax system.

Recommendation: Making the 10% Advance Income Tax (AIT) on interest a final tax for senior citizens above the age of 70 years could be an equitable and administratively efficient policy. However, policymakers might hesitate to adopt this approach due to certain challenges and considerations. Let’s explore the rationale behind the hesitation and the potential benefits if implemented.

Potential advantages of making 10% AIT a final tax for senior citizens

1. Simplifies the tax system for senior citizens: Eliminates the need for filing annual tax returns, as the tax deducted at source would be the final liability. Reduces the administrative burden on senior citizens, many of whom may struggle with the complexities of the tax system.

2. Equity and social justice: Senior citizens often have fixed or limited sources of income, such as savings and fixed deposits. Treating AIT as a final tax acknowledges their financial vulnerability and ensures fairness.

3. Predictability and certainty: Provides a clear and predictable tax liability, allowing senior citizens to plan their finances better. Ensures they are not subjected to surprise tax liabilities or refunds, which can disrupt financial stability.

4. Encourages savings: A final tax mechanism might motivate senior citizens to continue investing in interest-bearing instruments, supporting the financial system and promoting a savings culture.

5. Administrative efficiency: Reduces the workload for tax authorities by limiting the need for refunds or additional assessments for senior citizens. Simplifies tax compliance processes for banks and financial institutions by standardising deductions for eligible individuals.

Reasons policymakers might hesitate to adopt this approach

1. Revenue considerations: A final tax may result in lower revenue collection for the Government, especially if senior citizens have other sources of taxable income that would otherwise be subject to further taxation. It could create a perception that senior citizens are being exempted from their fair share of taxes.

2. Complexity in defining eligibility: Verifying age and determining whether a taxpayer qualifies as a “senior citizen” might require additional administrative steps, particularly for taxpayers with multiple accounts or income sources.

3. Risk of abuse: Non-eligible taxpayers might try to exploit the system by misrepresenting their age or residency status, leading to revenue leakages. Senior citizens with high net worth or substantial interest income may benefit disproportionately, undermining the principle of progressive taxation.

4. Equity across age groups: Other taxpayers, especially middle-income earners below 70, might perceive this as an unfair advantage for senior citizens, leading to demands for similar exemptions.

5. Policy consistency: Introducing age-specific taxation rules may complicate the broader tax framework, making it less consistent and harder to administer across demographics.

6. International precedents: Policymakers may avoid this approach if other jurisdictions with similar tax systems do not adopt such age-based final tax policies, considering it unconventional or inefficient.

Mitigation strategies to address policymaker concerns

1. Revenue-neutral threshold: Limit the final tax treatment to interest income below a specific annual threshold (e.g., Rs. 1 million), ensuring that only low to moderate earners benefit from the policy.

2. Verification mechanisms: Require banks to validate age eligibility using Government-issued identification and report interest income to tax authorities for monitoring.

3. Targeted applicability: Restrict the policy to individuals with no other significant income sources, ensuring that the benefit is directed towards truly vulnerable senior citizens.

4. Awareness and transparency: Communicate the policy’s intent clearly to the public, emphasising its role in social welfare and support for an aging population.

5. Cap on benefits: Impose a cap on the total interest income eligible for the final tax treatment to prevent high-income senior citizens from disproportionate benefits.

While making the 10% AIT a final tax for senior citizens above 70 years is a compassionate and practical policy, it requires careful design to address revenue, equity, and administrative concerns. By limiting the scope to those with modest incomes and implementing strong verification and monitoring mechanisms, policymakers could strike a balance between social responsibility and fiscal prudence. This approach would demonstrate a commitment to supporting an aging population while maintaining the integrity of the tax system.

Overall conclusion: The increase in the AIT on interest from 5% to 10%, while intended to boost Government revenue, has significant implications for taxpayers, particularly senior citizens who rely solely on interest income. Addressing the equity and administrative challenges of this policy is crucial. Introducing mechanisms to exempt low-income earners or treating the 10% AIT as a final tax for senior citizens above 70 years could alleviate undue burdens, simplify compliance, and promote fairness.

However, policymakers must strike a balance between revenue generation and the financial well-being of vulnerable groups. Clear eligibility criteria, robust verification systems, and targeted relief measures can ensure that the tax system remains both equitable and efficient. By adopting a thoughtful approach, the Government can support senior citizens while preserving the integrity and sustainability of the tax framework. This would not only enhance taxpayer satisfaction but also reinforce public trust in the fairness of the nation’s fiscal policies.

(The writer holds an MBA (UK), FCA (SL), FCMA (UK), FCPA (Aust.), CMA (Aust.), FCMA (SL), MCPM (SL), CGMA (GLOBAL). He is Managing Partner at A. G. Sarma (Chartered Accountants) – since 1971, and Chartered Accountant, Tax and Management Consultant. He can be reached via: [email protected] | www.agsarma.com.)