The digital economy is experiencing remarkable growth globally, and Sri Lanka is no exception. Wattegama (2021) valued Sri Lanka’s digital economy at approximately USD 3.47 billion, accounting for 4.37% of its GDP. However, the current tax statutes in Sri Lanka fail to capture the full spectrum of digital transactions that cross borders with ease, as they rely on traditional taxation models based on physical presence. This allows large technology multinationals to sidestep paying taxes, despite deriving revenue and profits from the country.

This has resulted in both lost revenue opportunities as well as an uneven playing field between local and foreign digital service providers.

Let us examine the case of Dilan, who regularly uses ride-hailing services to travel to work. He has to pick between two options – one local and one international. He finds out that the locally incorporated service that has a physical presence in the country, has a larger tax burden than the international one. This has an impact on both the local company’s profits, and the broader economic landscape. The local company must absorb some of the taxes in a way that creates an uneven playing field, while the international one operates without the same financial obligations. This gives the latter the space to offer better promotions in the form of cheaper prices to Dilan, and derive greater profits, which can stifle local competition and make it difficult for local companies to thrive. As digital services continue to expand, there is a pressing need to adapt to this evolving landscape.

Equal application of VAT

Recent discussions have indicated that the government is beginning to recognize this the challenge around digital taxation, with new measures on the horizon to address the implications of the digital economy’s rapid development. The IMF Staff Report released in June 2024 refers to new measures to impose value-added taxes (VAT) on the supply of digital services. The report estimates that this VAT policy could generate between 0.04% and 0.08% of GDP, translating to approximately USD 30 to 60 million based on Sri Lanka’s GDP of USD 74.4 billion in 2022. However, the methodology used to derive these estimates is not explained in the report, nor is the term digital services defined, making it difficult to assess its veracity.

VAT is an example of an indirect tax, while corporate income taxes are an example of direct taxes. While the government should consider reducing the current VAT rate as it adjusts its direct and indirect tax mix, any changes must ensure equal treatment for both local and international service providers to avoid creating unfair advantages or imbalances in the market. If the move results in equal application to local and international providers, it can also level the playing field to create a competitive environment. However, as VAT is an indirect tax, it will likely be passed on to consumers as part of the purchase price. If consumers are highly sensitive to price changes, even a small increase due to VAT could result in a significant drop in service usage, ultimately impacting expected tax revenue.

Navigating implementation challenges

Further, the implementation of VAT on digital services is not without its challenges. For instance, there is a need for a clear legal framework that defines how VAT applies to digital services. Currently, Sri Lankan VAT law does not explicitly mention the supply of digital services by multinational enterprises (MNEs). Policymakers must either update existing legislation or reinterpret current laws to encompass these services adequately. Additionally, operational mechanisms will play a crucial role in the effectiveness of the tax. The government must decide whether the obligation to collect VAT falls on foreign vendors or local financial institutions, which will impact the efficiency of tax collection. Streamlining registration, reporting, and payment processes in line with international standards can help reduce compliance burdens and enhance revenue collection.

Exploring direct taxation methods

While implementing VAT on digital services is a significant step forward, it is not the only solution available. Other policy options, such as Digital Services Taxes (DSTs), a form of direct taxation, can complement the indirect taxation mechanisms being explored. Countries like India, Pakistan and Nepal have successfully employed a combination of direct and indirect taxes to address digital taxation issues. Its specific approach to direct taxation differs, in terms of tax rate, thresholds, and services covered. For example, both India and Nepal have a tax rate of 2%, while Pakistan imposes a rate of 10%. While Pakistan does not have a minimum taxability threshold, India and Nepal do, though the thresholds differ considerably. Furthermore, multilateral solutions proposed by organizations like the OECD aim to establish clear and predictable tax rules that redistribute tax rights based on where sales and users are located. However, achieving global consensus on these matters is often complex and slow, due to the uneven power dynamics of countries. This has prompted many countries to adopt domestic solutions.

Given the changes in the digital economy, it is imperative that the government revises its tax structures accordingly. The use of both direct and indirect measures, applicable services, tax rates, thresholds, and implementation will determine how successful these efforts will be in solving policy challenges.