How Sri Lanka Can Stop Losing Tax Revenue Under OECD Pillar Two

Why Sri Lanka Must Shift from Tax Holidays to Qualified Refundable Tax Credits (QRTCs)

Based on insights shared by Suresh R.H. Perera, Principal – Head of Tax & Regulatory, KPMG Sri Lanka, at the CA Sri Lanka 5th Annual Economic & Tax Symposium.

Introduction

For decades, Sri Lanka has relied on tax holidays and tax exemptions as one of its primary tools to attract Foreign Direct Investment (FDI). The assumption was simple: lower taxes would encourage multinational companies to establish operations in Sri Lanka.

However, the international tax landscape has fundamentally changed.

With the introduction of the OECD/G20 BEPS Pillar Two framework, many of the tax incentives traditionally offered by countries like Sri Lanka are rapidly losing their effectiveness. If Sri Lanka does not modernize its investment incentive regime, it risks losing both foreign investment and tax revenue, while allowing foreign governments to collect taxes that could otherwise remain in Sri Lanka.

The presentation by Suresh R.H. Perera highlighted why Sri Lanka must urgently reconsider its approach.

The Global Tax Landscape Has Changed

According to the presentation, global tax policy is now driven by three major trends:

• Globalization
• Digitalization
• BEPS (Base Erosion and Profit Shifting)

These developments have resulted in the introduction of the OECD Pillar Two Global Minimum Tax, fundamentally changing how multinational enterprises are taxed.

The objective is straightforward:

Every large multinational group should pay at least 15% effective tax wherever it operates.

This effectively eliminates the traditional competition among countries based purely on low tax rates.

Understanding BEPS Pillar Two

The presentation explains that Pillar Two mainly consists of:

• Global Anti-Base Erosion (GloBE) Rules
• Subject-to-Tax Rule (STTR)

Within the GloBE Rules are:

• Qualified Domestic Minimum Top-up Tax (QDMTT)
• Income Inclusion Rule (IIR)
• Undertaxed Profits Rule (UTPR)

Together, these mechanisms ensure that multinational groups ultimately pay a minimum effective tax rate of 15%.

Why Traditional Tax Holidays No Longer Work

One of the most significant messages from the presentation was that tax holidays no longer provide the competitive advantage they once did.

Previously:

• Sri Lanka granted a tax holiday.
• The investor paid little or no tax.
• The investor enjoyed the full benefit.

Under Pillar Two:

• Sri Lanka grants a tax holiday.
• The effective tax rate falls below 15%.
• The investor's home country collects the "Top-up Tax."

As a result:

• Sri Lanka receives no tax revenue.
• The investor receives little or no additional benefit.
• The foreign government collects the tax instead.

This represents a significant leakage of Sri Lanka's tax base.

Everyone Loses Except the Foreign Government

This new international framework creates a situation where:

Sri Lanka loses

because tax revenue leaves the country.

Investors lose

because they no longer receive the intended tax benefit.

Foreign governments benefit

because they collect the top-up tax that Sri Lanka chose not to collect.

This means that maintaining outdated tax holidays may actually disadvantage Sri Lanka without providing any real incentive to investors.

The Importance of Qualified Refundable Tax Credits (QRTCs)

The presentation strongly emphasized the need for Sri Lanka to move toward Qualified Refundable Tax Credits (QRTCs).

Unlike traditional tax holidays, QRTCs are recognised under the OECD Pillar Two framework.

Instead of reducing the effective tax rate below 15%, properly designed refundable tax credits preserve investment incentives while remaining compliant with the global minimum tax rules.

Examples include:

• Refundable investment tax credits
• Research and Development (R&D) tax incentives
• Sustainable and Green investment credits

These incentives encourage investment without causing Sri Lanka to lose tax revenue to another country.

Substance-Based Income Exclusion (SBIE)

Another important concept discussed was the Substance-Based Income Exclusion (SBIE).

Under this mechanism, multinational groups receive exclusions based on genuine economic activity, including:

• Eligible payroll costs
• Eligible tangible assets

Currently, the exclusion equals:

• 5% of eligible payroll costs
• 5% of the carrying value of eligible tangible assets

This encourages companies to establish real operations rather than merely shifting profits.

Why Sri Lanka Must Re-negotiate Existing Tax Holidays

The presentation highlighted that many existing tax holidays should be reviewed.

Countries such as Thailand have already begun replacing traditional tax holidays with Pillar Two-compliant incentives.

Recommended actions include:

• Identify BOI, Port City and other tax holidays applicable to large multinational groups.
• Measure how much revenue is leaking overseas through the top-up tax.
• Replace remaining tax holidays with Qualified Refundable Tax Credits.
• Link incentives to actual investment and employment targets.
• Formalize revised investment agreements.

How BEPS Pillar Two Changes FDI Competition

One of the key conclusions of the presentation is that investment competition is changing.

Previously, countries competed by offering:

• Lower corporate tax rates
• Longer tax holidays

Under Pillar Two, competitiveness increasingly depends on:

• Infrastructure
• Skilled labour
• Regulatory certainty
• Ease of doing business
• Refundable investment incentives
• Cost-based incentives

In other words, countries will increasingly compete based on economic substance, not merely low tax rates.

What Sri Lanka Should Do

The presentation proposed several practical recommendations:

1. Introduce Qualified Refundable Tax Credits (QRTCs)

Replace traditional tax holidays with internationally compliant investment incentives.

2. Use Substance-Based Income Exclusions (SBIEs)

Design incentives linked to real investment, employment and productive assets.

3. Re-negotiate Existing Tax Holidays

Review existing investment agreements to minimise tax leakage.

4. Attract New Foreign Direct Investment

Develop a new investment incentive package aligned with the OECD Pillar Two framework.

5. Endorse Pillar Two

Sri Lanka should consider implementing the framework—starting with the Qualified Domestic Minimum Top-up Tax (QDMTT)—so that any top-up tax is collected domestically rather than by another jurisdiction.

Conclusion

The OECD Pillar Two framework represents one of the most significant changes to international taxation in decades.

For Sri Lanka, the issue is no longer whether tax holidays attract investment. The more important question is who ultimately receives the tax revenue.

If Sri Lanka continues to rely solely on traditional tax holidays, it risks creating a situation where:

• investors receive limited benefit,
• Sri Lanka foregoes valuable revenue, and
• foreign governments collect the tax through the global minimum tax rules.

Moving toward Qualified Refundable Tax Credits (QRTCs) and modern, Pillar Two-compliant investment incentives could allow Sri Lanka to remain competitive while protecting its own tax base.

As highlighted during the symposium, this is an area that deserves serious consideration by policymakers, particularly the Ministry of Finance, as Sri Lanka designs its future investment and tax policy in an increasingly interconnected global economy.