How to Start an Overseas Business in Sri Lanka | Business Impact of Foreign Exchange and Tax Regulations on Business Expansion from Sri Lanka to Overseas Markets

This article delves into the foreign exchange regulations and tax policies that affect the expansion efforts of Overseas Businesses in Sri Lanka. in overseas markets. It focuses on resident investors and does not cover investments made by entities other than private limited companies or alternative forms of foreign exchange transactions.

Foreign Exchange Regulations

Under the Foreign Exchange Act, eligible resident investors are permitted to establish and maintain overseas offices, branches, or projects (referred to as overseas offices) in foreign countries.

Limits on Outward Investments

Capital transactions for outward remittances must be conducted through an Outward Investment Account (OIA), which is opened and maintained by the eligible resident investor through an authorized dealer or a restricted dealer. These transactions are subject to limits specified in issued directions and the provisions of the Foreign Exchange Act.

For companies or partnerships investing in overseas offices/branches, the limit is set at USD 300,000 per calendar year or an equivalent amount in other designated foreign currencies. However, the usage of outward investment accounts for payments has been suspended since June 2022, following a gazette notification by the finance minister at that time.

Additionally, the gazette order imposes a maximum limit of USD 20,000 or its equivalent in other designated foreign currencies for outward remittances on capital transactions made through Business Foreign Currency Accounts or Personal Foreign Currency Accounts held by resident individuals in Sri Lanka, during the effective period of the notification.

Repatriation of Income and Liquidation Proceeds

Any income and capital proceeds from investments must be brought back to Sri Lanka through the same outward investment account used for the initial investment, within three months from the date of receipt.

Incentives for Resident Investors

Eligible resident investors are allowed to utilize funds up to fifty per cent (50%) of the value of capital gains from previous outward investments credited to their outward investment account, without being subjected to the permitted limits. However, this incentive has also been restricted by the aforementioned gazette notification since June 2022.

Other Terms, Conditions, and Reporting Requirements for Foreign Investments

1. Prior to each outward remittance, the investor must obtain a clearance letter from the Head of the Department of Foreign Exchange through an authorized dealer or a restricted dealer. Investors planning subsequent foreign investments must provide a certificate obtained from a Fellow member of the Institute of Chartered Accountants of Sri Lanka or a Charter holder of the Chartered Financial Analyst (CFA) Institute, outlining the progress and status of their previous investments, along with supporting documents. The Head of the Department of Foreign Exchange will issue the clearance letter upon being satisfied with the progress of the previous investments.
2. The Board of Directors of an investment company that has invested in an unlisted company outside Sri Lanka must evaluate the progress of such investment annually and submit a report to the Head of the Department of Foreign Exchange, including details on the investee's profit or loss, dividends declared by the investee, or dividends received by the investor. This report must be submitted on or before March 31 of the following year or as specified by the Head of the Department of Foreign Exchange for a particular investment.
3. In order to be eligible for permitted investments under foreign exchange regulations, investors must maintain a sound financial position and performance. They must also provide a recommendation from a Fellow member of the Institute of Chartered Accountants or a Charter holder of the Chartered Financial Analyst Institute, in line with the directions issued by the Central Bank. Additionally, the feasibility of the proposed investment must be demonstrated to the Head of the Department of Foreign Exchange.

Tax Regulations

Determining Applicable Taxes for Foreign Subsidiaries/Branches

To ascertain the applicable taxes for foreign investments, companies must submit relevant agreements, business details, business process details, and organizational charts in writing to the tax policy unit of the Inland Revenue Department. Subsequently, the tax policy unit will consult with the interpretation committee and provide details regarding the taxes applicable to the specific foreign investment.

Tax Clearance Requirements for Outward Remittances in Foreign Currency

For foreign currency remittances, a tax clearance must be obtained from the Inland Revenue Department (IRD), except in cases mentioned in the negative list under the Inland Revenue Act. The tax clearance certificate issued by the IRD must then be submitted to the bank to initiate the remittance process.

Due to the Withholding Tax (WHT) imposed on payments received by non-residents, the company must submit a tax clearance certificate issued by the IRD to the bank in order to process outward remittances. The WHT rate will be determined based on the provisions of the Inland Revenue Act but will be subject to the provisions of double tax avoidance agreements.

Payments to resident individuals will be subject to the Advance Personal Income Tax (PAYE/WHT) as per the provisions of the Inland Revenue Act. Invoices and related agreements must be submitted to both the IRD and the bank in all the aforementioned circumstances.

Note: The above information is based on the current regulations and should be verified with the relevant authorities for any updates or changes.

Exchange Rate and Currency Depreciation with Reasons in Sri Lanka (1977 to up to date)

Introduction

The exchange rate is a rate of exchanging a unit of foreign currency with the domestic currency unit.  Depreciation and devaluation are two different concepts. Depreciation is the adjustment of the exchange rate so that more of yours currency is needed to exchange for a unit of foreign currency (Bandara, 2007) Devaluation is the different concept from depreciation. Devaluation is decreased the value of the particular currency under the fixed exchange rate. The Opposite side of the devaluation is considered as revaluation
Managed floating rate system
Managed floating is a concept that lies between fixed exchange rate system and floating exchange rate system. It avoids both appreciation and depreciation of the exchange rate by selling and buying the domestic currencies in foreign exchange market to control the fluctuations in the exchange rate. It is not the clean float and basically it is decided based on the control of the central bank in foreign market unless demand and supply of the market. It is a combination of favorable features of both fixed exchange rate system and free floating system. According to that, central bank intervenes to control the fluctuation of exchange rate in the short run, while it is decided based on the demand and supply in the long run. It is implemented from 1977 to 2001.

Free-floating rate system

On 23 of January 2001, Sri Lanka shifted from managed floating system to free-floating exchange system. According to this central bank avoids from preannouncing the exchange rate. Instead of that CB intervenes in foreign exchange market by selling and buying foreign currency at or near market prices due to the strong need of maintaining a large stock of foreign reserves.

Evaluation of Sri Lankan Foreign Exchange rates after 1977

Managed floating exchange regime (1977-2000)

The dual exchange rate system was abolished in November 1977, and both rates, namely the official rate and premium rate, were unified at Rs 16 per US dollar. Unification of the exchange rate on November 16, 1977, resulted in a devaluation of the rupee by 44.6% against the US dollar and 45.5% against the pound with the purpose of export competitiveness. The rupee was devalued from 8.41 rupees per US dollar in 1977 to 15.61 rupees per US dollar in 1978. The massive devaluation of the rupee resulted in a sharp increase in the remittances sent by Sri Lankans living abroad. (Athukorala and Jayasuriya, 1994).The worker remittances increased from 190 million rupees in 1977 to 610 million rupees in 1978.
1977 introduced a managed floating system, and Central bank made a discussion with all other commercial banks and determines the future buying and selling rate based on the demand and supply of the foreign exchange rate. According to that decision, the exchange rates of six main currencies (Dollar, Pound, Mark, Frank, and Indian Rupees) and commercial bank have right to decide the exchange rate of other currencies based on the cross exchange rate. In November 1982, the Central bank made significant changes regarding the exchange rate. Such as cancelling the meeting which decided the buying and selling rate of exchange rate at the central bank and determined the buying and selling rate of only Dollars, Central bank limited the use of Dollar when in foreign transactions with the Commercial bank, commercial bank received right to determine the foreign exchange rate based on the demand and supply of the foreign currency. Purpose of the Central bank for the above changes is limited to intervention in the foreign exchange market. In 1990 Central bank of Sri Lanka stopped the preannouncing of buying and selling rate of US dollars. Instead of that, they introduced a daily system for deciding buying and selling rate at the beginning of transactions. Aims of presenting conventional operation are protecting the competitiveness of domestic export in the foreign market and giving a stable position for international trade. After July in 1997, there was some financial crisis, especially in the East Asian countries due that an unstable condition in foreign exchange market prevailed in those countries. Sri Lankan rupee is depreciated against US $ by   7.5% because of the impact to the price of the rubber production of Sri Lanka and industries like the garment industry and commodity export industries the revenue fell far below the expected targets. Also, financial hardship faced by South Korea, Malaysia, and Hong Kong a fall in foreign investment in Sri Lanka too, is expected. Depreciation of Sri Lankan rupee is relatively low when compared with the domestic currency of some of the countries in that region depreciated against the US Dollar. However as a south Asian country Sri Lanka was less affected during that period due to Capital transactions were limited since restrictions were imposed against the operations of capital account in balance of payment, favorable aspects of foreign assets, ability to bear the foreign debts and continuous depreciation of Sri Lankan Rupee under the managed floating rate system. Due to the above reasons, Sri Lanka was able to avoid the unfavorable effects from the decline of competitiveness of export and save a considerable amount of outflow of capital temporarily resulted for lower depreciation against US Dollar. In 2000, due to the rapid rises in petroleum prices and military expenditure resulted in increasing the deficit of the balance of payment and decline of foreign assets. (Appendix 1) Therefore Central bank had to amend the margin in exchange rate frequently. From 30 th June 2000, the margin of exchange rate extended from 2% to 5% and devalued the average amount by 4% to give flexibility to Sri Lankan rupee in the foreign exchange market. The margin of the exchange rate is extended in all time when depreciates the rupee value. It is difficult to maintain the managed floating exchange rate system since the continuous increase of the deficit of the balance of payment and further expectation of depreciation of Sri Lankan rupee. The balance of the payment problem of the country was not entirely solved by the rupee depreciation in 2000. Therefore there is a need for a new exchange rate system.

Floating exchange rate regime (2001- up to now)

With the introduced of the floating exchange rate system has led to minimization of the probability of outflow of official foreign reserves. If the central bank followed the crawling band system further, it would have led to an unstable situation in exchange and financial market by out flowing the official foreign reserves. Because of the introduced of the free-floating exchange rate rupee is depreciated by 11.3% against the US dollar, by 8.8% against the sterling pound and 6.7% against Euro. Due to the introduction of the free-floating exchange system, there was a huge fluctuation in the financial market of Sri Lanka. Within few hours buying price of Dollar has moved from Rs 84.75 to Rs 85 and selling price of dollar shifted from Rs 85.25 to Rs 89. As a result of  right of commercial bank to decide the exchange rate based on demand and supply there were a number of exchange rates for dollars and Sri Lankan Rupee at the same time. (Appendix 2).However Sri Lankan rupee has depreciated in few amounts when compare with the other countries. For Instance, in January 1999, there was a 40% of depreciation in Riyal on the first day of free-floating exchange. There was a 16% of depreciation in Indian rupees at the first day of floating exchange system. 31% for Korean won in 1997 and 28% for Sweden corner in 1992. (Ramasinghe, 2007). Even though there is depreciation in Sri Lankan Rupee in first two days after implementing the floating exchange system instantly it has appreciated in the third day. Reasons for the settlement of instability after introducing the floating exchange system are the following actions taken by the central bank. The beginning of the December in 2004, there was a huge fluctuation in exchange rate because of massive amount of deficit in the balance of payment. The exchange rate depreciated up to the rupee 105.47 per US dollar in 17th December. However due the expectation regarding the foreign aids receiving because of tsunami the exchange rate appreciate up to Rs 104.61 per US dollar in 31st December. In 2005 exchange rate is revalued up to the certain extent due to the foreign aids received because of tsunami. Country got the large no of foreign currency inflows and received the debt moratorium from the lenders. In 2010 the exchange rate was appreciated due the  .The budget 2012 proposed to devalue the exchange rate by 3% bypassing the mandate of the Central bank of Sri Lanka. Soon after the CBSL stopped intervention to foreign exchange market and subsequently depreciated by 12% during the year 2012.

Replacing the fixed exchange rate with a managed floating exchange rate with the purpose of export-led growth in 1977. But that did not happen due to the two main reasons namely reasons related with exports and reasons related with budget deficit. Excessive budget deficit contracted domestic saving and ultimately it is impact for the balance of payment. When compare the Sri Lankan export with few South Asian and East Asian countries it can be noticed that there is a significant improvement in Bangladesh and Vietnam. (Appendix 3). Sri Lankan export sector has continued to rely on low value-added exports mainly garments. However, when compared with East Asian countries, they have utilized the export-led growth with the high-income category including technology, innovation, and science. They have changed their export commodity from agricultural product to human-computer interaction product. Also Sri Lanka missed the opportunity to engage in global product sharing. The main export of the Sri Lanka is textile and garment. When compare the clothing exports from 1980 to 2010 from South Asian countries in 1980 clothing exports contribution from Bangladesh  and Sri Lanka was US $ 2 million  and  US $ 109 million respectively. However the Sri Lankan clothing exports in 2010 is lower than the Bangladesh. (Appendix4). When compare the textile export from 1980 to 2010 from south Asian countries it can be noticed that there is a considerable difference between Sri Lanka and Bangladesh.(Appendix 5). Bangladesh has become one of the leading exporters in the textile and garment industry shifting from non-value added (textile) to value-added exports (garment).these economic conditions resulted in expansion of trade deficits which necessitated continuous depreciation of the rupee.
Conclusion
There are two main exchanged regimes after 1977, namely managed floating exchange rate system and free-floating exchange rate system. Because of the various reasons most of the time rupee value is depreciated rather than appreciation. Even though there is a continuous depreciation of Sri Lankan rupee with the intention of export-led growth exports of Sri Lanka is still backward when compared with other South Asian and East Asian countries.