‘Reserves’ redefined under new IRD bill
Mr. Suresh R.I. Perera
In the delicate balance of Sri Lanka’s economic recovery, fiscal policies must foster growth rather than hinder it. The proposed Inland Revenue (Amendment) Bill of 2026, particularly Clause 4’s revision to Section 18 of the Inland Revenue Act No. 24 of 2017, threatens this equilibrium.
By redefining “reserves” to include negative retained earnings and accumulated losses, the amendment directly challenges the Court of Appeal’s landmark decision in Samson Rajarata Tiles (Pvt) Ltd v. Commissioner General of Inland Revenue (CA/TAX/0008/2015) – decided on May 30, 2023. This move not only risks undermining legal certainty but also imposes undue burdens on businesses at a critical juncture.
Policymakers should heed the judiciary’s wisdom, abandon this regressive change, and prioritise long-term economic health over short-sighted revenue grabs. To appreciate the stakes, let’s revisit the Samson Rajarata case, a beacon of logical statutory interpretation that has guided taxpayers for nearly a decade.
Samson Rajarata Tiles, a Colombo-based manufacturer and exporter of roofing and floor tiles, borrowed short-term loans from its holding company, DSI Samson Group (Pvt) Ltd. For the 2008/2009 tax year, the company claimed interest deductions under Section 25(1)(f) of the Inland Revenue Act No. 10 of 2006, which allowed deductions for expenses incurred in producing income, subject to thin capitalisation limits in Section 26(1)(x).
This provision capped deductible interest at three times (or four times in some cases) the aggregate of issued share capital and reserves.
The Inland Revenue Department disputed the claim, asserting that accumulated losses should count as “negative reserves”, thereby reducing the equity base and limiting deductions. Samson Tiles, having incurred significant losses typical of capital-intensive industries, argued otherwise. The case escalated through appeals, culminating in the Court of Appeal’s ruling on May 30, 2023.
The court, presided over by Justices Dr. Ruwan Fernando and M. Sampath K. B. Wijeratne, posed three key questions of law, two of which centred on the interpretation of the word “reserves”.
In a meticulous analysis, the court adopted a strict literal approach. “Reserves”, it ruled, inherently denote something positive, resources “kept back” or “stored” for future use. A loss or deficit, by contrast, is an absence, not an accumulation.
The Inland Revenue Act did not define “reserves” beyond excluding those from asset revaluations, and the court refused to import broader accounting concepts like “net equity” without explicit legislative intent.
As Justice Wijeratne noted, Section 26(1)(x) specifies “issued share capital and reserves”, not “equity,” which under Sri Lankan Accounting Standards includes retained earnings (positive or negative). Including negatives would erode the capital base arbitrarily, penalising companies for temporary setbacks.
This ruling was a triumph for taxpayers, especially in manufacturing and start-ups where initial losses are inevitable due to high setup costs and market entry barriers. Samson Tiles, with no positive reserves but substantial share capital, could deduct interest based on the full capital amount, preserving its financial viability.
The decision reinforced the doctrine of strict interpretation in tax law, ensuring authorities cannot stretch statutes to disadvantage citizens. It also underscored the evidentiary primacy of statutory records like share registers over vague commercial assertions.
Now, fast-forward to the 2026 Bill, published in the Gazette on February 24, 2026. Clause 4 amends S. 18, the modern equivalent of the old thin capitalisation rules to “improve clarity”. But this “clarity” is a thinly veiled override.
The new subsection (5) explicitly states: “‘reserves’ includes negative retained earnings, accumulated losses or deficits in reserves, but excludes reserves arising from the revaluation of any asset.” It mandates subtracting these negatives when calculating the total issued share capital and reserves, tying deductions strictly to net equity.
Under the current consolidated Inland Revenue Act, S. 18 limits deductible financial costs (interest) using the formula (A/B) x C, where A is the finance cost (interest), B is the value financial instrument (debt value) and C is four times the issued share capital plus reserves (excluding revaluations).
This aligns with the Samson precedent, allowing loss-making firms to maintain deductions based on positive capital elements. Consider a hypothetical loss-making company with Rs.10 million in issued share capital, Rs. 4 million in accumulated losses, Rs. 40 million in debt and Rs. 4 million in interest costs. Under the old rules, it might deduct the full interest by basing C on the Rs. 10 million capital alone, allowing up to Rs. 40 million in deductions. The amendment flips this: for a company with Rs. 10 million in share capital and Rs. 4 million in losses, the base shrinks to Rs. 6 million, capping C at Rs. 24 million instead of Rs. 40 million.
Interest beyond this becomes non-deductible, though carry-forwardable for up to six years if future limits allow. Proponents may argue this prevents abuse, ensuring deductions reflect true financial health and curbing thin capitalisation where debt-heavy structures minimise taxes. But this ignores the broader context.
Sri Lanka’s economy, still reeling from the 2022 crisis, external debt woes, and global uncertainties, relies on resilient businesses to drive exports, jobs, and FDI. Manufacturing entities like Samson Tiles, vital for export-led growth, often face long gestation periods. Penalising them with reduced interest shields during loss phases is counterproductive, raising capital costs when they’re most vulnerable.
Consider the ripple effects. Start-ups, the lifeblood of innovation, routinely show negative retained earnings in early years.
This amendment imposes a “double penalty”: operational losses compounded by higher effective taxes on debt financing. In a high-interest environment, this discourages borrowing for expansion, stifling entrepreneurship.
Broader sectors, from agriculture to tech, could see slowed investments, reduced employment, and diminished future tax revenues as firms falter or relocate. Moreover, this legislative manoeuver erodes foundational legal principles.
The separation of powers demands respect for judicial rulings; overturning Samson Rajarata via amendment is like rewriting the rules after the referee’s call. Legal certainty, a cornerstone for investor confidence, is compromised when rules change retroactively or reactively. Investors, both domestic and foreign, need predictability to commit capital.
By signalling that court victories are fleeting, the Government risks deterring FDI at a time when Sri Lanka aims to attract it through initiatives like the Colombo Port City and Strategic Development Projects. This approach lags behind international best practices. Internationally, interest-limitation rules have moved toward frameworks aligned with the OECD’s Base Erosion and Profit Shifting (BEPS) Action 4, which recommends restricting net interest deductions using a fixed-ratio rule based on a percentage of EBITDA.
Many jurisdictions have modernised their systems accordingly. For example, Malaysia introduced Earnings Stripping Rules effective from July 1, 2019, adopting an EBITDA-based limitation consistent with BEPS Action 4. Singapore, while not implementing an EBITDA-based rule, continues to apply deductibility tests and sector-specific mechanisms rather than rigid thin-capitalisation ratios, reflecting a different but comparatively flexible approach. Sri Lanka, by contrast, is tightening an already archaic system, potentially isolating itself in the global investment landscape.
Abandoning the amendment would preserve the Samson ruling’s integrity, affirming that “reserves” are positive accumulations, not deficits. It would signal a commitment to judicial independence and economic pragmatism. Policymakers could instead explore revenue alternatives: enhancing compliance through digital tools, broadening the tax base without burdening growth sectors, or incentivising R&D deductions as per S. 15 of the Act.
Critics might fear revenue shortfalls, but the math favours patience. Short-term gains from disallowed deductions pale against long-term losses in business activity. A thriving private sector generates sustainable taxes through expanded operations, not squeezed margins. As the court aptly demonstrated, strict interpretation prevents overreach; lawmakers should trust this framework. In conclusion, the 2026 amendment to S. 18 is a misstep that policymakers must retract.
Upholding the Court of Appeal’s ruling in Samson Rajarata Tiles safeguards legal certainty, bolsters economic resilience, and aligns with global trends. Sri Lanka’s future depends on nurturing its “growth engines”, not hamstringing them. Let judicial wisdom prevail, abandon the change, and let businesses build the prosperous economy we all envision.
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