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CHAPTER 01 INTRODUCTION TO TAXATION OF

CHAPTER CONTENT

1.0 Introduction to Taxation 2.0 Functions of Taxation 3.0 Principles of Taxation 4.0 Direct & Indirect 5.0 Current system in Sri Lanka 6.0 Imposition of 7.0 Residency Rule

1.0 INTRODUCTION TO TAXATION

Tax is a compulsory charge imposed by the Government. Even though it has no direct benefit, there is an indirect benefit to the public at large.

Government collect revenue in the form of taxes, charges or borrowings. As per the central Bank Annual Report 91% of the total revenue represents . That means major portion of is generated by means of taxation.

Taxes are imposed in two forms as direct and indirect taxes. is levied directly on personal & corporate income and profits. Whereas is levied on the price of a good or services.

2.0 FUNCTIONS & PRIMARY OBJECTIVES OF TAXATION

Functions of taxation can be separated into primary function, economic function & social function.

2.1 Primary Function of Taxation

✓ Raising funds for public expenditure. Examples for public expenditures: Free medical services, infrastructure facilities, security & law, free education service

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2.2 Economic Functions of Taxation

✓ Set local & foreign investment direction ✓ Protect local industries from foreign competition

2.3 Social Functions of Taxation

✓ Discourage activities which are undesirable by the society ✓ Encourage activities which are desirable by the society ✓ Reduce income disparity between rich and poor

Question 01 List the functions of taxation with relevant examples.

3.0 PRINCIPLES OF TAXATION

Government collects taxes in order to fund the public expenditure. However, in framing the , the government takes in to account the following basic tax principles.

3.1 Equity

The unique feature of an income tax relative to other forms of taxation is that it is based on a person’s ability to pay.

People should bear the public expenditure in proportion to their respective financial abilities. Tax burden should be more on the rich than on the poor.

3.2 Certainty

The tax to be paid should be certain and not arbitrary. A taxpayer should be able to understand the rules on time of payment, manner of payment, amount to be paid etc.

3.3 Convenience

Tax should be collected by the state in a manner which is convenient to the tax payer. For instance; - Income Tax is collected on installment basis (Quarterly).

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3.4 Simplicity

Income Tax Laws should be clearly understandable to any person. This is the keystone of an efficient tax system. Simplicity leads to more efficient administration, avoiding unnecessary litigation, encourage compliance, and lesser .

3.5 Progressivity

The principle of progressivity means that higher income groups should pay proportionately more than the lower income groups. This is simply called as vertical equity.

3.6 Productivity/Adequacy

The tax system should be productive enough, It should ensure sufficient revenue to the government and encourage productive activity by encouraging the people to work, save and invest.

3.7 Diversity / Broad Base

There should be diversity in the tax system of the country. The burden of tax should be distributed widely on the entire people of the country.

3.8 Stability

An income tax structure once designed with care and long-term objectives in view, must as far as possible be unchanged except for inflation adjustments for a considerable length of time.

3.9 Economy/Efficiency

The minimum possible cost to be spent to collect the tax and the maximum part of the tax collection to be passed on to the Government.

Question 02 List the principles of taxation.

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4.0 DIRECT AND INDIRECT TAXES

Direct tax is a tax paid by a person on whom it is levied. In other words, as far as direct taxes are concerned, the impact and the incidence fall on the same person. It is borne by the same person on whom it is levied and it cannot be passed on to others. In the context of Sri Lanka, income tax is the main direct tax.

In case of indirect taxes, unlike in direct taxes, the impact and incidence fall on different persons. It is not borne by the person on whom it is levied and can be passed on to others. The main indirect tax system prevailing in Sri Lanka is value added tax.

4.1 Differences Between Direct & Indirect Tax

Details Direct Tax Indirect Tax Imposition of payment Direct taxes should be Indirect taxes are paid by taxpayer collected by a person directly to the other than the person on government whom the tax is imposed Shifting of tax burden Tax burden cannot be Tax burden can be shifted shifted to the final consumer Collection Collection cost is high Collection cost is low Tax burden Progressive Regressive Example Income Tax, Custom Value Added Tax ,

Question 03 Differentiate between direct tax and indirect tax by giving applicable taxes in Sri Lanka?

Question 04 Categorize the following taxes as direct & indirect taxes. Income Tax , Value Added Tax, Custom Duty, Stamp Duty, Lottery Tax, Betting Tax

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5.0 CURRENT TAX SYSTEM IN SRI LANKA

5.1 Major Taxes Operates In Sri Lanka & Collecting Authorities

Major taxes that operate in Sri Lanka and collecting authorities are as follows;

Relevant Authority Type of Tax Department of Inland Revenue • Income Tax (IT) • Value Added Tax (VAT) • Stamp Duty (SD) under stamp duty Act No.12 of 2006 Department of • Taxes on imports & Department • Excise Duty on tobacco & liquor Provincial Department of Revenue • Stamp Duty (SD) under stamp duty Act No.43 of 1982 • Betting Tax • Lottery Tax • Mineral Tax

Question 05 List the major taxes that operate in Sri Lanka with the collecting authorities?

5.2 Components Of Law Applicable To Income Tax System In Sri Lanka

5.2.1 The Inland Revenue Act

The main act which is applicable to the imposition of income tax in Sri Lanka is the Inland Revenue Act No.24 of 2017.

5.2.2 Gazette Notifications

From time to time, ministers or administrators issue gazette notifications with regard to the act.

Such gazette notifications would become part of the legal framework for taxation.

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5.2.3 Case Law

Under common law principles, the decision of higher courts become precedent and are considered examples in subsequent matters.

Therefore, previously decided cases on tax matters will also become part of the legal framework for tax. Ex: Mahavitharana Vs CIR , Ramishwara Vs CIR

5.2.4 Rulings

In order to achieve uniformity on continuous issues in administrating the tax system, tax administrators (Department of Inland Revenue) may issue rulings. Ex: Public & private rulings

5.2.5 Notices published in newspapers

Tax administrators may publish notices on certain matters. Such notices form part of the regulatory framework for tax.

Question 06 What are the Components of law applicable to taxation in Sri Lanka.

6.0 IMPOSITION OF INCOME TAX (CHARGING SECTION)

6.1. Applicable Income

Inland Revenue Act No. 10 of 2006 was repealed with Inland Revenue Act No. 24 of 2017. The New Act, effective from 01.04.2018 (From Year of Assessment 2018/2019).

6.2 Applicability of Charging Section (Section 02)

The liability of income tax in Sri Lanka is based on the charging section (section 2) of the “Inland Revenue Act, No. 24 of 2017”.

Under section 2, income tax is payable for each year of assessment by;

(a) A person who has for that year of assessment, or (b) A person who receives a final withholding payment during the year. The income tax payable is equivalent to;

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(a) (Taxable Income x Rate/s*) – tax credits, if any PLUS (b) Final withholding payment x Rate/s*

*The relevant tax rates are given in First Schedule to the Act

It is to be noted that; • a resident person shall pay income tax (IT) on the world income, while • a non-resident person shall pay income tax (IT) on the income that arises in/from Sri Lanka. (Sec. 4)

Question 7 Determine the composition of income tax payable for any year of assessment, according to the Inland Revenue Act No.24 of 2017.

Question 8 Explain the residency rule applicable to any person?

6.3 Interpretations Relevant to Charging Section (Section 195)

(i) Who is liable to pay income tax ? - every person

(ii) How frequently should the tax be computed? - for every year of assessment

(iii) On what should the tax be computed? - in respect of taxable income & final withholding payments

(iv) At what rate should the tax be computed? - at the rates specified in the First Schedule

6.3.1 Who is liable to pay income tax?

Definition of Person (Sec 195)

The word “Person” defined under the Inland Revenue Act as follows.

Person means an individual or an entity and includes a body of persons corporate or unincorporated, an executor, non-governmental organization and charitable institution. (Sec. 195)

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Entity means a company, partnership or trust, but excludes an individual. (Sec.195)

It is to be noted that a “Person” in the previous Act excluded partnerships, but under the new Act partnerships are included under the definition of “Person”.

Body means a company, partnership, trust or other body of persons whether formed in SL or elsewhere.

Charitable Institution means the trustee or trustees of a trust or corporation or an unincorporated body of persons established for a charitable purpose only or engaged solely in carrying out a charitable purpose. (Sec. 195)

Partnership means an association of two or more individuals or corporations carrying on business jointly for the purpose of making profit, irrespective of whether the association is recorded in writing. (Sec. 195).

Trust means an arrangement under which a trustee holds assets. (Sec. 195).

Non-governmental Organizations are also defined in Section 195.

By looking at above definition, the following persons are chargeable with income tax.

✓ an individual ✓ a company ✓ a partnership ✓ a trust ✓ an executor or administrator ✓ a co-operative society ✓ an association, club or society of persons whether corporate or unincorporated ✓ a charitable institution

Question 9 Determine whether “partnership is liable to pay income tax as a “person” under the above provision.

Question 10 Interpret/describe the following wordings with regard to income tax of Sri Lanka? - Person - Entity

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6.3.2 How frequently should the tax be computed?

Period of tax for income tax purpose is a “Year of Assessment”.

“Year of Assessment” means the period of twelve months commencing on the first day of April of any year and ending on the thirty first day of March in the immediately succeeding year.

Year of assessment 2018/2019 refers to the period from April 01, 2018 to March 31, 2019.

Question 11 Describe the wording of Year of Assessment with a relevant example.

6.3.3 On what should the tax be computed?

As per the Charging section income tax shall be payable for each year of assessment by a person who has; - Taxable Income & - Who receives final withholding payments

Tax on Taxable income Assessable Income from Employment xxx Assessable Income from Business xxx Assessable Income from Investment xxx Assessable Income from Other Sources xxx Total Assessable Income xxxx Less : Qualifying Payments & Reliefs ( Sec 52 with 5th schedule) (xxx) (Deductions from taxable income) Taxable Income xxx

Tax on Taxable Income = Taxable Income x Tax Rates = xxxx Less : Any foreign under section 80 (xxx) Any other tax credit allowed under the Act (xxx) Income Tax Payable xxx

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Points to note i. Any tax paid in other country can be deducted as a as per section 80 whether there is any double tax agreement or not with the other country. ii. Tax credit allowed under this Act shall be as per section 89 of the Act. (credit for non-final withholding tax) iii. A person may deduct economic service charge under the ESC Act from income tax payable.

Question 12 As per the IRD Act No.24 of 2017, Determine the composition of Assessable income.

Question 13 A company has following particulars relevant to the year of assessment 2018/2019. • Taxable income of Rs. 30,000,000 which is taxable at the rate of 28% as per first schedule. • Withholding tax on interest received of Rs. 2.800,000. • Economic service charge of Rs. 900,000 which includes the amount brought forward from the year of assessment 2017/2018.

Calculate income tax payable for the year of assessment 2018/2019

Tax on Final withholding payment

Tax on final withholding payment is computed as follows.

Final withholding payment x tax rates as per First Schedule xxxx

Meaning for “final withholding payments” (Sec. 88)

The following shall be the final withholding payments. (a) dividends paid by a resident company to a resident person;

(b) interest paid to or treated as being derived by– - a resident individual (other than such amount of interest paid to a senior citizen falling within the relief threshold in paragraph 2 (d) of the Fifth Schedule to this Act);

- a charitable institution;

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(c) Amounts paid as winnings from a lottery, reward, betting or gambling (other than amounts received in conducting a business consisting of betting and gaming).

(d) Payments made to non-resident persons that are subject to withholding or payments made by individuals not in the course of business to nonresident persons (other than payment derived through a Sri Lankan ).

However above (a) & (b) was not become a final withholding payment from 01.01.2020 onwards.

Question 14 Determine the final withholding payments applicable for individuals from 01.01.2020.

6.3.4 At what rate should the tax be computed?

The persons are liable for income tax at the rates specified in the first schedule to the Act.

7.0 RESIDENCE RULE (SECTION 69)

A person could be categorized as either resident person or non-resident person for income tax purposes. Tax residency is different from general meaning of residency.

If a person including a company is a resident person for income tax purposes, he or it is liable to pay income tax on “income from employment, business, investment or other sources wherever arising”. That means he or it is liable to pay income tax on profits and income which arises in Sri Lanka as well as outside Sri Lanka (global income).

If a person including a company is a non-resident person for income tax purposes, he or it is liable to pay income tax on ““income from employment, business, investment or other sources that arise or derived from Sri Lanka.

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Question 15 Determine whether profits from employment received by a person resident in Sri Lanka by rendering service outside Sri Lanka does fall within the scope of Income Tax in Sri Lanka.

7.1 Residency Rule Applicable to an Individual

An individual shall be a resident in Sri Lanka for a year of assessment if the individual;

- resides in Sri Lanka;

- is present in Sri Lanka during the year and that presence falls within a period or periods amounting in aggregate to one hundred and eighty- three days or more in any twelve-month period that commences or ends during the year;

- is an employee or an official of the and his spouse is posted abroad during the year; or

- is an individual who is employed on a Sri Lanka ship, within the meaning of the Merchant Shipping Act, during the period the individual is so employed.

Question 16

Given below is a summary of the overseas travel details of Mr.Silva, a citizen of Sri Lanka, and determine whether he is a resident person or not for the year of assessment 2018/2019. Date of Departure Date of Arrival 01.04.2018 15.04.2018 01.05.2018 25.06.2018 29.06.2018 15.08.2018 17.08.2018 17.10.2018 24.03.2019 15.04.2019

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7.2 Residency Rule Applicable to a Company

As per the Section 69 of the Act, a Company is deemed to be resident for tax purposes, if; - it is incorporated or formed under the laws of Sri Lanka;

- it is registered or the principal office is in Sri Lanka; or

- at any time during the year the management and control of the affairs of the company are exercised in Sri Lanka.

7.3 Residency Rule Applicable to a Partnership

- formed in Sri Lanka; or

- at any time during the year the management and control of the affairs of the partnership are exercised in Sri Lanka.

Question 17

Determine the tax implication on following scenarios. a). A company resident in Sri Lanka has provided consultancy services outside Sri Lanka for a fee of USD 20,000.

Advise whether the said income falls within the scope of chargeability of income tax. b). A company non-resident in Sri Lanka has carried out business in Sri Lanka and earned profit of USD 150,000 thereon.

Advise whether the said income falls within the scope of chargeability of income tax. c). A non-resident individual has earned a fee of USD 5,500 in providing professional service abroad

Advise whether the said income falls within the scope of chargeability of income tax.

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