SRI LANKA Law and Practice Contributed by: Ayanthi Abeyawickrama, Varners
5.5 Thin Capitalisation Rules and Other Limitations Sri Lanka applies thin capitalisation rules under the Inland Revenue Act, No 24 of 2017 (as amended), which place a cap on the amount of interest expense (financial cost) that a company may deduct for tax purposes. These rules are intended to discourage excessive debt financing and erosion of the tax base through interest deductions. Under the current regime, companies must ensure that the level of debt is reasonable in relation to their capital structure (ie, company’s share capital and reserves). The deductible financial cost is calculated based on: • the value of the financial instruments that gave rise to the cost; and • four times the company’s issued share capital and reserves at year-end (excluding any revaluation reserves). If the company’s actual financial cost exceeds the amount computed under this rule, the excess is dis - allowed as a tax deduction for that year. However, the disallowed portion may be carried forward and deducted in subsequent years, subject to the same limitation. The regime is purpose-built to counter base erosion and profit shifting (BEPS) in line with international best practice. These rules work in tandem with trans - fer pricing regulations, which require all related-party financing arrangements to reflect arm’s length terms and be properly documented. 5.6 Transfer Pricing Sri Lanka has implemented a comprehensive transfer pricing regime under the Inland Revenue Act, No 24 of 2017 (as amended). These provisions require that transactions between associated persons, whether domestic or cross-border, be conducted on an arm’s length basis – that is, under terms and conditions comparable to those that would apply between inde - pendent parties dealing at arm’s length. Transfer pricing rules are designed to prevent profit shifting and erosion of the tax base, and they apply
not only to foreign multinational enterprises but also to domestic groups and BOI-approved entities, where transactions occur between associated persons. The transfer pricing rules apply to transactions involv - ing: • the sale or purchase of goods; • provision of services; • licensing of intellectual property or other intangible assets; • financing arrangements; and • any other transactions that may affect taxable income. Taxpayers are required to: • maintain contemporaneous documentation to jus - tify the method used to determine the arm’s length price; • disclose related-party transactions in the pre - scribed transfer pricing disclosure form, filed together with the annual income tax return; and • submit a transfer pricing certificate confirming compliance, if the value of transactions exceeds specified thresholds. The Commissioner General of Inland Revenue is empowered to adjust the taxpayer’s income where the actual pricing is not consistent with the arm’s length principle. Such adjustments may result in additional tax assessments, interest and penalties. 5.7 Anti-Evasion Rules There is a comprehensive set of anti-evasion and anti- avoidance rules set out in the Inland Revenue Act, No 24 of 2017 (as amended), including: • Section 35 – empowers the Commissioner General to disregard or recharacterise any arrangement entered into primarily to gain a tax advantage, ensuring that tax outcomes reflect the substance over the form; • Section 33 – permits the Commissioner General to recalculate income to align related-party transac - tions with arm’s length standards, thus preventing profit shifting through pricing manipulation; and
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