Exploring tax impact of IMF’s second review under Extended Fund Facility

• The IRIT will be charged on the income of individuals (rather than the value of the property itself), on owner-occupied and vacant residential properties, as a substitute to property tax

The International Monetary Fund (IMF) Executive Board recently concluded the 2024 Article IV Consultation with Sri Lanka and completed the second review under the Extended Fund Facility (EFF) programme. Under Article IV of its Articles of Agreement, the IMF holds bilateral discussions with the members, usually every year. 

A staff team gathers economic and financial data and engages in discussions with the officials regarding the country’s economic progress and policies. Upon returning to the headquarters, the staff compiles a report that serves as the foundation for discussions by the Executive Board. 

The recently conducted Article IV Consultation focused on wide-ranging reforms to restore macroeconomic stability and debt sustainability, maintain price and financial stability, rebuild external buffers and implement growth-oriented structural reforms, including strengthening of governance. 

One of the key findings of the review was that Sri Lanka has made significant strides in implementing structural reforms to improve its fiscal consolidation and public financial management. The government has taken steps to rationalise expenditures, strengthen revenue administration and enhance debt management practices. These efforts have helped stabilise the economy and reduce vulnerabilities, paving the way for the country to receive the third tranche of around US $ 330 million.

Proposed tax reforms 

KPMG Academy’s virtual assembly hosted by Principal and Head of Tax Suresh Perera, Principal Rifka Ziyard and Associate Director Mirani Ratnarajah offered invaluable insights into several new proposed tax measures agreed upon during the IMF’s second review under the EFF programme, including the following: 

•Imputed rental income tax on income of individuals from owner-occupied and vacant residential properties from April 2025
•Removal of exemption from corporate income tax for export of services
•Increase in corporate income tax rate for sectors like betting, gaming, tobacco and liquor from 40 percent to 45 percent
•Replacement of special commodity levy on certain items with 18 percent Value Added Tax (VAT)
•VAT on digital services
•Phased out lifting of import restrictions on motor vehicles and other imports
•Repeal of simplified VAT by April 2025 and replacement with VAT refund system
•Increase in stamp duty on land leases

What is imputed rental income tax?

The primary change is the introduction of an imputed rental income tax (IRIT). This tax targets the notional income that the homeowners could earn, if they rented out their homes. The IRIT will be charged on the income of individuals (rather than the value of the property itself), on owner-occupied and vacant residential properties, as a substitute to property tax. 

As per the IMF report, the IRIT is expected to be implemented with effect from April 1, 2025, with the exemption thresholds and a graduated tax rate schedule, to ensure progressivity (although information about exemptions and rates have not been revealed yet). 

The Finance, Economic Stabilisation and National Policies Ministry released a press statement on June 16, 2024, providing clarifications on the planned IRIT in Sri Lanka. This press release states that the goal of the IRIT is to tax affluent individuals rather than those with average incomes. To accomplish this, a suitable tax-free threshold will be set to guarantee that the tax is aimed at very high-value properties or multiple properties owned by the wealthy members of society. 

The implementation of the IRIT is expected be subjected to the regular legal process. According to the IMF report, the Cabinet approval has already been obtained. Subsequently, the bill was scheduled to be presented to Parliament by the end of June 2024, with the parliamentary approval expected by the end of July 2024 and the tax is projected to be fully operational by April 2025.

Administrative measures 

In order to implement the IRIT effectively, it is essential for the government to obtain the necessary data regarding the estimated current market value of properties – including the property type, annual value and the latest assessment date. To ensure accurate property value assessments, this database will consist of digitised records and a nationwide digital Sales Price and Rents Register (SPRR). 

Several implementation deadlines will underpin these new tax policies, including initiating the implementation of a provisional SPRR and property valuation database by August 2024 and establishing a comprehensive property valuation database by December 2024. 

These records will be accessible to the Inland Revenue Department, Government Valuation Department, Land Registry as well as the public. The data collated will not only be utilised for levying the IRIT but also as the key source for property values when raising assessments in relation to Income Tax, Capital Gains Tax, stamp duty and local recurrent property taxes. 

An amendment to the Notaries Act is also anticipated to ensure all notaries automatically update the SPRR with comprehensive information on notarised property contracts to facilitate the establishment of these databases.

Housing policy vs tax policy 

The objective of the National Housing Policy of Sri Lanka is to chart the course towards achieving the goal of ‘Shelter for All by the Year 2025’ through a nationwide people’s housing movement with active participation and action of all stakeholders. Recognising that adequate shelter is a fundamental right of its citizens, the government’s aim through the housing policy is to facilitate those in need to attain sustainable housing.

Meanwhile, with the newly suggested reforms, a tax is to be imposed on the potential income the homeowners could earn, if they rented their property, instead of living in it. Up until the year 2011, interest on housing loans was allowed as a deduction against income. However, this was later abolished and currently no tax deduction is allowed for the same. The homeowners are now facing a situation where they must pay taxes as if they had earned an additional rental income, all the while being unable to lower their taxable income through deductions related to homeownership. This directly conflicts with the nation’s housing policy.

IRIT in other jurisdictions 

Although rare, the IRIT is not a new concept and has been in operation in other jurisdictions. Countries that have Iimputed the rental income taxes include Denmark, Greece, the Netherlands and Switzerland. The methods and rates vary but the goal is to balance the tax burden between the homeowners and renters. 

The rationale for the IRIT is that it creates tax parity between the renters and homeowners. In the above jurisdictions, the renters cannot deduct their rent from the taxable income whereas the homeowners have a tax advantage because they save money by not paying rent and can deduct mortgage interest and maintenance costs causing significant disparity between the two parties. 

The imputed rental value was proposed as a countermeasure in the above countries to prevent this potential tax advantage. Although logical in theory, this approach has often been criticised for its complexity and perceived as ‘fictitious’ income by the owners. Switzerland, known for its fiscal prudence and stable economy, is currently in discussions about abolishing the imputed rental value, with the government and public showing openness to reform. 

Taking into account the varying tax structures in different jurisdictions, the IMF report lacks clarity on the strategy for achieving tax neutrality through the implementation of the IRIT system in Sri Lanka. As mentioned earlier, the decision to disallow housing loan interest and maintenance costs as deductible expenses and implement an IRIT will lead to a disparity that may discourage the homeowners from residing in their own properties. An adjustment to the Inland Revenue Act would be necessary to align this new reform with Switzerland’s practices. This adjustment should permit the deduction of interest on housing loans and maintenance costs to prevent the imposition of an income tax without allowing the corresponding deductions.

The residential property held outside Sri Lanka will also fall under the purview of the IRIT since tax is imposed on the income of individual rather than the real property value itself. In relation to a resident of Sri Lanka, worldwide income is liable for tax, not only the income derived within the country. As such, when computing the income of resident individuals, the imputed rent should be imposed, irrespective of the location of the property. The other jurisdictions that have the IRIT in their tax system also consider the rental value of immovable property abroad when determining the rate of tax. 

Other salient points 

The IMF is of the view that a similar tax previously included in Inland Revenue Act No. 10 of 2006 (under which the primary residences were exempt and assessed values for rating purposes were used to determine the base) generated hardly any revenue for the government, due to the broad scope of the exemption and use of antiquated and downward biased annual values. Given this precedent, no reference has been made in the IMF report to the exemption granted on principal place of residence.

In the past, there was a comparable tax referred to as the ‘mansion tax’. This tax was applicable to residential buildings completed on or after April 1, 2000, was levied on large homes valued at more than Rs.150 million or with a floor space of at least 10,000 square feet and was proposed in the 2015 budget. Nonetheless, the impracticality of enacting such a tax led to its abolishment. If the purpose of the new tax reform is not to tax property but the high-net-worth individuals, then a simple measure to be taken would be to revive mansion tax, preventing the administrative hassle involved in the implementation of the IRIT. 

Similar measures have been adopted in Greece – where a tax on luxury living is imposed on the amount of annual imputed income arising from the ownership or use of private cars with large engine power, airplanes, helicopters, swimming pools and so on. 

While the IMF’s second review underscores the importance of the IRIT in sustaining Sri Lanka’s revenue mobilisation efforts, the proposed new tax raises several questions. Meanwhile, a number of other changes representing a significant shift in Sri Lanka’s taxation policy are due to be implemented and will be discussed in an upcoming feature.