By Indika Hettiarachchi
Sri Lanka is a capital staved nation urgently in need to boost private investment to catalyze economic development. In such background it is rather an unusual move for Sri Lanka to increase Capital Gain Tax (“CGT”) to 30% from 10%. This will place Sri Lanka among countries with highest CGT applicable for private market investment, and is expected to have a dampening effect on investment activities in the country. This will not only discourage local corporate investment but also likely to reduce Foreign Direct Investment (“FDI”).
Sri Lanka’s Colombo Stock Exchange has less than 300 listed companies out of total over 22,000 registered companies and represent a very small share of the overall economy. CGT will impact all investment and divestment activities relating to all unlisted companies in the country ranging from small single shareholder businesses generating less than million rupee revenue to larger exporters generating over billion dollars in revenue.
Impact on entrepreneurial ecosystem
Different types of private market investors are an essential part of any efficient entrepreneurial eco-system, and Sri Lanka’s entrepreneurial eco-system is still at very early stage of development. Private Market investors like venture capital and private equity funds, and corporate investors form essential part of this eco-system. High CGT is likely to discourage private market investment activity and raise cost of capital for new ventures/projects. For example this move is likely to discourage large corporates from engaging in corporate venture and investment programs which have gained popularity during last decade. Such programs play an important role in catalyzing innovation and economic diversification. Moreover high CGT will discourage re-investment of capital back into the economy (in the form of new investment).
Due to high risk of undertaking private market investment (especially new ventures), it is natural that investors expect high capital appreciation from such investment. Taxing such capital gains at high rate will increase the required returns thus increasing cost of capital for new venture/projects.
Impact on FDI?
When we analyze Sri Lanka’s historic FDI trends, it is clear that Sri Lanka attracts majority of productive and high impact FDI through M&A (Mergers and Acquisition) path compared to Greenfield path. In order to create more M&A driven FDI opportunities in the future, it is essential that Sri Lanka has a conducive environment for private market investment and a healthy entrepreneurial ecosystem. High CGT is likely to make capital available for private market investment more expensive and scarce thus reducing future FDI opportunities through M&A path.
Impact on the development of Capital Market
Sri Lanka’s capital market eco-system is showing signs of deepening with increase in fund raising and M&A activity involving private/ unlisted businesses. This is a very healthy sign to strengthen the entrepreneurial ecosystem. However with the imposition of high CGT such private market investment activity are likely to see a decline impacting overall decline in capital market activity.
Impact of Inflation?
Historically Sri Lanka experienced volatile and high inflation. Inflation diminish real value of assets including investment in companies. Although current monetary policy framework targets to maintain 5% inflation, Sri Lanka’s uncertain growth in foreign inflows (relative to growth in nominal GDP) is likely to perpetuate cyclical currency depreciation and associated high inflation. In such scenario, the investors in private market investment are likely to face higher CGT (inflation effect) reducing real returns. Hence government should at least consider allowing use of an inflation index in calculating CGT as done in some countries.
Indika Hettiarachchi, a Private Equity investment professional and Managing Partner of Mycelium SME Fund, Sri Lanka and Bangladesh focused SME fund. He can be contacted on Indika.h@jupitercapitalpartners.com.