How to handle tax burden on interest

As per the Inland Revenue Act, No.24 of 2017, there is a restriction to deduct interest on borrowings when calculating taxable profit from a business.

The restriction is that,

if the business is a manufacturing entity, maximum interest on borrowings that can be deducted in calculating taxable profit/Loss will be the interest attributable to 3 times of issued share capital & reserves (excluding revaluation reserves).

if the business is other than a manufacturing entity, the interest attributable to 4 times of issued share capital and reserves (excluding revaluation reserves) is deductible.

Accordingly, if interest expense exceeds the above limit as applicable, such interest needs to be added back and taxed accordingly. However, this provision is not applicable to the “financial institutions”.

 Example: Company A is a manufacturing company and its equity consists of share capital of Rs.1,000 & Reserves of Rs.500. Its total debt is Rs.5,000 and Interest on such debt is Rs.1,000.

Accordingly maximum limit of debt  will be restricted to;

3 x (Rs.1,000+500) = Rs.4,500

Therefore, interest applicable to debt of Rs.500 (Rs.5,000-Rs.4,500) is not deductible. Hence, Company A needs to pay tax for Rs.100 (Rs.1,000/5000*500),  since such interest is not deductible when ascertaining the taxable profit.

 This will be severely affected to entities which depend more on debt rather than equity. If a business is highly geared, such business may need to pay taxes for the interest on borrowings subject to above limits.

 How to handle the tax implications on this situation?...

Maintain a track record on borrowings and identify the point at which the entity exceeds the above limit and following options may be considered to mitigate the tax impact.

• The entity could convert such excess amount of debt in to equity.
• Debt Financing where the return on same exceeds relevant finance cost plus the tax expense on disallowance of such finance cost.

 Every Dark Cloud has a silver lining…

If you are a positive entrepreneur, you can plan your business to increase the reserves every month to build up a strong balance sheet. Then you will be able to stand on your own feet rather than depend on borrowings. If this mechanism works, entrepreneurs will not depend on borrowings and they may succeed in their businesses by increasing equity capital which any country wants. Further, this interest restriction directs new entrepreneurs to start businesses with adequate capital and not to depend on borrowings.

If businessmen get this positively, the restriction itself may work to generate more successful entrepreneurs to Sri Lanka.