Reforming interest deductibility in Sri Lanka’s tax policy
Ms. Charmaine Tillekeratne
Sri Lanka’s economy stands at a crossroad, recovering from a profound crisis that exposed vulnerabilities in fiscal management, external debt, and growth strategies. Amid these challenges, one often-overlooked aspect of tax policy is the limitation on interest deductibility under Section 18 of the Inland Revenue Act No. 24 of 2017. This has emerged as a significant barrier to business expansion and overall economic vitality. This provision, which caps the tax-deductible interest on loans, including those from independent financial institutions, was not a deliberate creation of local policymakers but an unintended import from international templates during reforms in 2018. While aimed at curbing tax avoidance, it has inadvertently created a disincentive for borrowing, stifling investment and innovation at a time when Sri Lankan enterprises need them most.
This article argues that removing these restrictions on interest paid to unrelated banks and financial institutions would align tax policy with economic growth objectives, empowering entrepreneurs, small and medium-sized enterprises (SMEs), and larger companies to access capital more affordably. By doing so Sri Lanka can foster a more dynamic business environment, boost job creation, and accelerate recovery. The case is clear: tax policy should support, not hinder, the nation’s entrepreneurial spirit.
From Flexibility to Restriction
Under the previous Inland Revenue Act (No. 10 of 2006), interest deductibility was more straightforward and business-friendly. Section 25(1)(f) allowed deductions for interest expenses incurred in producing income, provided the borrowed funds were used for income-generating assets or activities. Critically, this applied without broad quantitative limits to loans from independent third parties, such as banks. Restrictions were primarily targetted at intra-group loans to prevent profit-shifting within related entities, under section 26(1)(x) &(y), a common concern in multinational operations.
This was changed with the enactment of the new Inland Revenue Act in 2017, effective from April 2018. Section 12 allows the interest but with a restriction in section 18 which introduced a formula-based cap on deductible financial costs, often referred to as thin capitalisation rules. For non-manufacturing entities, deductible interest is limited to four times the sum of issued share capital and reserves; for manufacturing firms, it’s three times. This ratio was changed subsequently, and now it is four times irrespective of whether he is a manufacturer or non-manufacturer. Excess interest can be carried forward for up to six years but remains subject to the same cap. This rule applies universally to financial instruments, encompassing not only related-party debt but also arm’s-length loans from banks and other independent lenders.
The origins of this shift trace back to Sri Lanka’s engagement with the International Monetary Fund (IMF). In 2016, Sri Lanka secured a three-year Extended Fund Facility from the IMF to address balance-of-payments issues and fiscal imbalances. As part of the programme, the government committed to revenue mobilisation and tax reforms to broaden the tax base and improve collection efficiency. The new Act drew heavily from IMF-recommended templates, which emphasise anti-avoidance measures like thin capitalisation to combat base erosion and profit-shifting (BEPS). However, these templates, designed largely for advanced economies or multinational-heavy contexts, were adopted without sufficient customisation to Sri Lanka’s domestic realities. IMF missions in 2018 praised the reforms for enhancing fiscal consolidation but did not anticipate the drag on local borrowing.
What was intended as a safeguard against abusive practices has thus become a broad-brush policy that penalises legitimate business financing. Unlike the old regime, which encouraged prudent leveraging for growth, the current rules treat all debt similarly, regardless of the lender’s independence.
Mechanics of the Restriction and its Business Impact
To understand the issue, consider the formula in action: Suppose a Sri Lankan company has Rs. 100 million in share capital and reserves. Under Section 18, a manufacture or non-manufacturing entity could deduct interest on up to Rs. 400 million in debt (4x multiplier). If actual borrowing exceeds this—say, Rs. 500 million—the interest on the excess Rs. 100 million becomes non-deductible, increasing the effective tax burden. For a company taxed at 30 per cent, this means paying tax on non-deductible interest as if it were profit, effectively raising the cost of borrowing.
This is particularly burdensome for SMEs and start-ups, which often rely on bank loans to scale operations. In Sri Lanka, where access to equity financing is limited due to underdeveloped capital markets, debt is the lifeblood of growth.
Entrepreneurs might need loans to purchase machinery, expand inventory, or enter new markets. Yet, the cap discourages such moves by making debt more expensive after-tax. A business that could previously deduct full interest on a Rs. 200 million bank loan now faces partial disallowance if it exceeds the equity-based threshold, eroding profitability and cash flow.
Larger companies fare no better. In sectors like manufacturing, where capital-intensive investments are essential, the 4x multiplier exacerbates the problem. Firms might delay expansions or opt for suboptimal financing, such as high-cost short-term debt, to stay within limits. This not only hampers individual businesses but also reduces overall investment in the economy. Data from the Central Bank indicates that private sector credit growth has been sluggish post-crisis, in recent years—far below the double-digit rates needed for robust recovery. In essence, Section 18 pits tax compliance against business pragmatism, forcing firms to choose between growth and fiscal efficiency.
Broader Economic Consequences: A Drag on National Progress
The ripple effects extend beyond individual enterprises to the national economy. Sri Lanka’s GDP growth, which rebounded to around 5 per cent in 2025 after the 2022 crisis, remains fragile amid global uncertainties. Restricting interest deductibility undermines key drivers like investment and employment. Businesses hesitant to borrow invest less in productive assets, leading to slower job creation and reduced consumer spending. SMEs, which account for over 50 per cent of employment in Sri Lanka, are hit hardest, perpetuating inequality and regional disparities.
This misalignment between tax and growth policies is stark. While the government promotes initiatives like export diversification and digital transformation, the tax code inadvertently counters them by raising the cost of capital.
Countries like Vietnam and Indonesia, with more flexible interest deductibility for third-party debt, have seen stronger post-pandemic recoveries through credit-fuelled investments. In contrast, Sri Lanka’s approach mirrors overly rigid BEPS rules better suited to high-income nations, not an emerging economy reliant on domestic borrowing.
The 2022 crisis, exacerbated by low tax revenues (below 10 per cent of GDP), underscores the need for balanced reforms. While IMF-driven changes aimed to boost collections, they overlooked growth-friendly adjustments. Ultimately, a policy that discourages borrowing slows economic velocity, lowers tax revenues in the long run, and hampers Sri Lanka’s ambition to become an upper-middle-income nation.
The Case for Reform: Prioritising Independent Loans
The solution is straightforward and urgent. Amend Section 18 to exclude interest on loans from independent financial institutions from the cap. Retain restrictions for related-party debt to prevent abuse, but liberate arm’s-length borrowing to encourage responsible leveraging. This would lower the after-tax cost of debt, making bank loans more attractive and channeling funds into productive uses.
Benefits would be immediate and widespread. Entrepreneurs could expand without tax penalties, fostering innovation in sectors like tourism, agriculture, and IT. SMEs, often equity-poor, would gain better access to formal credit, reducing reliance on high-cost alternatives. Overall, increased investment could add to annual GDP growth, based on economic models from similar reforms elsewhere. Moreover, this aligns with IMF’s evolving focus on growth-oriented policies, as seen in recent programmes emphasising revenue without stifling private sector dynamism.
Critics might argue that easing deductions could erode revenues. However, the dynamic effects—higher business profits, more jobs, and expanded tax bases—would likely offset short-term losses. Carry-forward provisions could be retained for transitional relief, ensuring fairness.
Conclusion
Sri Lanka’s tax policymakers must act decisively to resolve the conflict between fiscal caution and economic ambition. By eliminating restrictions on interest deductibility for independent loans, the government can transform Section 18 from a growth inhibitor into a neutral facilitator. This reform, rooted in local needs rather than imported templates, would empower businesses, invigorate the economy, and pave the way for sustainable prosperity. The time for change is now—let tax policy be a partner in progress, not an adversary.
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