Sri Lanka Rethinks Thin Capitalisation: SME Warning 📈

The proposed amendment to Section 18(5) of the Inland Revenue Act risks penalizing loss-making businesses by tightening interest deductibility limits. • Overall Impact: The rule, originally designed to prevent multinational corporations from shifting profits, has expanded to all companies. The new amendment proposes including negative retained earnings (accumulated losses) in the definition of "reserves," significantly reducing a firm's equity base for tax calculations. • Sector Breakdown: Small and Medium Enterprises (SMEs): Comprising over 95% of Sri Lankan establishments, SMEs are most vulnerable. Unlike large firms, they rely heavily on debt over equity. Banking & Finance: As SMEs face restricted deductions on loan interest, their ability to service debt and seek further bank financing may weaken. • Key Technical Changes: Current Rule: Interest deductibility is generally restricted when debt exceeds 4x equity. Proposed Change: By deducting losses from equity, a company with a net loss could see its allowable interest deduction fall to zero, potentially creating a taxable profit despite actual financial distress. • Economic Context: Experts warn this shifts the rule from a targeted anti-avoidance measure to a burden on domestic growth. At a time when investment and entrepreneurship are critical for recovery, critics argue tax policy should encourage capital formation rather than penalize struggling sectors.