Does serving a prison sentence absolve a defaulter from unpaid taxes?

Under Section 43(1) of the VAT Act, VAT default is not classified as a criminal offense warranting direct imprisonment. Instead, it is an offense punishable by a fine equivalent to the unpaid tax. The court may impose imprisonment only if the defaulter fails to pay the fine. This is governed by Section 291(1) of the Code of Criminal Procedure Act No. 15 of 1979, which sets imprisonment terms based on the fine amount

A recent court decision in Sri Lanka has sparked widespread debate and confusion. Four months ago, a company director was sentenced to six months in prison for failing to remit Value Added Tax (VAT) payments owed by the company. The case drew attention not only due to the rarity of such a sentence but also because of the prominence of the convicted individual.

The director’s release last week, after serving the prison term, has further fuelled public discourse. Many are questioning whether serving a prison sentence effectively absolves a tax defaulter from paying outstanding taxes amounting to billions of rupees. This widespread concern stems from a lack of understanding of the legal framework governing tax recovery in Sri Lanka.

Legal framework for recovering VAT defaults

The VAT Act No. 14 of 2002 outlines several mechanisms for recovering unpaid VAT, including:

• Seizing and selling movable property
• Initiating legal proceedings through the courts
• Freezing bank accounts
• Issuing notices to debtors
• Preventing the defaulter from leaving the country

The Commissioner General of Inland Revenue (CGIR) has the authority to initiate one or more of these recovery actions simultaneously.

Conditions for recovery action by the CGIR

Before taking recovery action, the CGIR must fulfil certain legal requirements as per the VAT Act:

• Issuance of a Charge Sheet: A notice of assessment must be issued under Chapter V (Assessment of Tax) of the VAT Act.
• Appeal Resolution: If the taxpayer appeals the assessment, it must be resolved under Chapter VI.(Appeal) of the VAT Act.
• Finality of Assessment: The tax assessment must become final under Chapter VII (Finality of Assessment) of the VAT Act.
• Notice of Default and Recovery Action: The defaulter must be informed of the outstanding tax and the intended recovery measures.
• Objection Rights: If the defaulter has not appealed the assessment, they may still object to the CGIR’s notice.

If recovery actions are taken before completing these steps, they are deemed invalid. Typically, it takes at least three years to complete this process, ensuring fairness and adherence to the rule of law.

Public criticism and misunderstanding

The Inland Revenue Department (IRD) often faces criticism for delays in recovering tax arrears. However, much of this criticism arises from a misunderstanding of the legal obligations and taxpayer rights enshrined in the VAT Act.

Imprisonment for VAT default: Legal interpretation

The said ruling by the Colombo Magistrate sentencing the VAT defaulter of Rs. 3.5 billion to six months’ imprisonment had generated public debate. Many questioned whether the six-month sentence was appropriate for such a large evasion, and whether the defaulter could simply serve this time and avoid full payment.

The VAT Act, however, does not classify VAT default as a criminal offense punishable by imprisonment. Under Section 43(1), non-payment of VAT is an offense punishable by a fine equivalent to the unpaid tax. The court can only impose imprisonment if the defaulter fails to pay the fine, in accordance with Section 291(1) of the Code of Criminal Procedure Act No. 15 of 1979, which specifies imprisonment periods based on the quantum of the fine. Thus, the court’s discretion is limited to what the law allows.

Section 43(1) of the VAT Act is very clear on this issue.

“The Magistrate shall thereupon summon such defaulter before him to show cause why further proceedings for the recovery of the tax should not be taken against him, and in default of sufficient cause being shown, the tax in default shall be deemed to be a fine imposed by a sentence of the Magistrate on such defaulter for an offence punishable with fine only or not punishable with imprisonment and the provisions of subsection (1) of section 291 (except paragraphs (a), (d) and (i) thereof), of the Code of Criminal Procedure Act, No. 15 of 1979, relating to default of payment of a fine imposed for such an offence shall thereupon apply, and the Magistrate may make any direction which, by the provisions of that subsection, he could have made at the time of imposing such sentence:” (Emphasis added)

The court’s discretionary power to set the imprisonment term is controlled by the fine amount, as outlined in the Code of Criminal Procedure Act.

Section 291(1) (f) of the Code of Criminal Procedure Act, No. 15 of 1979 reads as follows: 

“(f) if the offence is not punishable with imprisonment the terms for which the court directs the offender to be imprisoned in default of payment of fine shall not exceed the following scale, that is to say: 

i. for a term of seven days where the amount of the fine exceeds ten rupees but does not exceed twenty-five rupees;

ii. for any term not exceeding fourteen days where the amount of the fine exceeds twenty five rupees but does not exceed fifty rupees;

iii. for any term not exceeding three –months where the amount of the fine exceeds fifty rupees but does not exceed one hundred rupees;

iv. for any term not exceeding six months where the amount of the fine exceeds –one hundred rupees;” (Emphasis added)

Thus, the Colombo Magistrate’s Court sentenced the VAT defaulter to six months in prison for failing to pay Rs. 3.5 billion in taxes. 

Under Section 43(1) of the VAT Act, VAT default is not classified as a criminal offense warranting direct imprisonment. Instead, it is an offense punishable by a fine equivalent to the unpaid tax. The court may impose imprisonment only if the defaulter fails to pay the fine. This is governed by Section 291(1) of the Code of Criminal Procedure Act No. 15 of 1979, which sets imprisonment terms based on the fine amount.

Maximum sentence under the law

On looking at the provisions of the VAT Act and of the Code of Criminal Procedure Act it is obvious that the Colombo Magistrate’s Court had imposed the maximum possible sentence of six months for defaulting VAT payment as allowed by the law. 

Accordingly, the Code of Criminal Act limits inter alia the term of imprisonment to maximum six months in the case the fine (the default tax) exceeding Rs. 100. Thus, the defaulted tax that was imposed as fine by a magistrate, if exceeded Rs. 100, the maximum term of imprisonment is six months, irrespective of the exceeded amount.  

It is needless to emphasise that the Code of Criminal Procedure Act dealing with imposition of fines and resultant imprisonments, was passed 45 years ago. Conversely, the Act badly needs urgent and timely amendments to the outdated provisions.

Does serving a prison sentence cancel a tax debt?

While the court proceedings to recover the defaulted taxes conclude once the defaulter completes the prison term, the liability to pay the taxes remains.

This does not mean that the defaulter’s responsibility of making the payment of and liability to the default does not end with the imprisonment. The CGIR is still legally obligated to pursue recovery of the outstanding taxes through various measures outlined in Chapter VII of the VAT Act. These include seizing and selling movable property, freezing bank accounts, notifying debtors, and preventing the defaulter from leaving the country.

Nature of VAT default in question

In my view, this article would be incomplete—and fail to do justice—if not discussed the nature of the taxes in default that led to the court proceedings.

I have been reliably informed, though subject to verification by the relevant parties, that the lion share of these taxes were not those taxes collected and declared by the company in its VAT returns (not on return taxes). Rather, they were estimated and issued by tax officials. The company, it seems, was unable to file timely appeals due to the internal turmoil caused by the bond scam fiasco. Consequently, the estimated assessments became final and conclusive, prompting the Commissioner General of Inland Revenue (CGIR) to initiate recovery actions, including court proceedings.

The necessity for this article would not have arisen if the company had been able to file its appeal within the stipulated time.

Conclusion

The recent case has highlighted the need for greater public awareness of tax laws and the legal process surrounding tax in default in general and VAT defaults in particular. While imprisonment is a punitive measure for non-payment, it does not erase the debt. Legislative reforms may be necessary to address outdated legal provisions and enhance tax enforcement mechanisms in Sri Lanka.

(The writer is a retired Deputy Commissioner General of Inland Revenue. He can be reached via [email protected].)