What Investors and Fund Managers Must Know

Unit trusts have become an increasingly popular investment vehicle in Sri Lanka, allowing individuals to pool funds and access diversified investment opportunities such as equities, bonds, deposits, and property.

With the introduction of the Inland Revenue Bill 2026, several important clarifications and compliance requirements have been proposed regarding how these unit trusts will be taxed.

However, it is critical to note: These provisions are currently at the Bill stage and will only become law once passed by Parliament and certified by the Hon. Speaker.

Understanding How Unit Trusts Work

A unit trust is structured around three key parties:

• Unit Holders (Investors) – who invest money into the fund

• Trustee – who holds the assets on behalf of investors

• Fund Manager – who manages the investment decisions

The pooled funds are invested in multiple asset classes such as:

• Shares (equities)

• Bonds and deposits

• Properties

• Commodities

The returns generated from these investments are distributed to investors in the form of:

• Regular income distributions (dividends)

• Capital gains

Current Tax Treatment – The Pass-Through Concept

Sri Lanka follows a pass-through taxation model for unit trusts that qualify under the law.

This means:

• The unit trust itself is not taxed

• Instead, tax is payable by the unit holders based on their share of income

This treatment applies where the unit trust is engaged in what is defined as an:

“Eligible Investment Business” (Section 195)

A business qualifies if it predominantly (80% or more) involves:

• Investment in capital assets

• Financial instruments

• Similar investment-related activities

How Income is Taxed

Under this model, taxation follows three key principles:

1. Tax at Investor Level

Each unit holder is taxed on their share of income, not the trust.

2. Income Retains Its Character

Income is taxed based on its nature:

• Interest → taxed as interest

• Dividends → taxed as dividends

• Capital gains → taxed as capital gains

3. Proportionate Allocation

Income is allocated based on the number of units held.

Importantly, tax applies based on legal entitlement, even if cash is not yet received.

What Happens if the Trust is NOT Eligible?

If a unit trust does not meet the 80% eligibility threshold:

• It will be treated as a company

• Subject to corporate income tax (e.g., 30%)

• Distributions will be treated as dividends

This significantly changes the tax outcome.

Key Changes Proposed in Inland Revenue Bill 2026

The 2026 Bill does not fundamentally change the pass-through concept, but it introduces critical compliance enhancements.

1. Mandatory Income Certificate to Unit Holders

Unit trusts (or mutual funds) will be required to issue a detailed certificate to each investor, including:

• Total income allocated

• Exempt amounts

• Withholding tax deducted

• Other prescribed details

Deadline: On or before 31 August following the year of assessment

Why This Matters

• Improves transparency

• Helps investors file accurate tax returns

• Strengthens reporting discipline

2. Strict Consequence for Non-Compliance

This is the most significant proposal in the Bill.

If the unit trust fails to issue the required certificate:

• The trust will be deemed a company

• Pass-through treatment will be denied

• The trust must pay income tax at corporate rates

Tax Payment Deadline: On or before 30 September

Implication

A simple compliance failure could result in full taxation at entity level, creating a major financial impact.

3. Reinforcement of Pass-Through Mechanism

The Bill further clarifies that:

• Income earned by the trust is treated as earned by the investor

• The trust acts merely as a vehicle for allocation and reporting

This aligns Sri Lanka with international taxation practices for collective investment schemes.

Practical Impact

For Investors

✔ Better clarity on taxable income
✔ Easier tax return preparation
✔ Visibility of withholding taxes

However:

•  Responsibility increases to correctly report income

For Fund Managers

Increased compliance obligations:

• Accurate tracking of investor-level income

• Timely issuance of certificates

• Strong internal systems required

Risk of losing pass-through status if compliance fails

For the Tax System

✔ Improved transparency
✔ Reduced tax leakage
✔ Stronger enforcement framework

Key Risk Areas

Professionals and businesses should pay attention to:

• Misclassification of “eligible investment business”

• Failure to issue certificates on time

• Incorrect allocation of income

• Misidentification of income type (interest vs capital gain)

Final Thoughts

The Inland Revenue Bill 2026 signals a clear shift:

Not a change in taxation principles, but a tightening of compliance and enforcement

For investors, this means more transparency.
For fund managers, this means greater accountability.

Important Reminder

All provisions discussed above are proposed under the Inland Revenue Bill 2026 and will:

Only become effective once passed by Parliament and certified by the Hon. Speaker

As per the Bill proposed Effective Date : 01 April 2025