UPDATE | APRIL 2017: The 15% lease tax is now completely removed as of January 2017.

UPDATE | FEBRUARY 2016: As this post is one of the highest read on this blog, I felt it was important to provide a brief update upfront in order to set this original note (from October 2014) in current context. In the Budget 2016 speech (announced in November 2015), the Finance Minister (Ravi Karunanayake) stated that the policies adopted by the previous regime regarding foreign ownership of land will be reversed. Specifically, the restrictions on land ownership by foreign nationals will be lifted,  including the complete removal of the 15% tax on land leases and associated stipulations. The FM also announced that on a case-by-case basis, the government will be willing to sell land to foreign nationals (based on some criteria of FDI inflow, purpose, etc.) Subsequently, the FM somewhat backtracked on this and stated that outright sale will continue to be prohibited and only long leases (up to 99 years) will be granted. The removal of the lease tax would still hold, and foreigners would have overall easier access to land. Yet, although announced in November last year, as of the 23rd of February 2016 these changes to the law have not been made. (Many tax proposals contained in Budget 2016 have not been given effect yet either.) The lifting of the legal bar on sale of land, or the changing of the lease tax regulation requires legislative changes and/or passing of new gazettes.

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“Whereas in furtherance of the development policies being promoted by the Government in the backdrop of a globally integrated environment, it is deemed expedient and necessary to ensure the prudent use of land which is a limited resource, in a manner that preserves the national interest”

This is the opening section of the new Land (Restrictions on Alienation) Bill that the government presented to Parliament this month. There has been a lot of debate on this piece of legislation for some months now. It was first mentioned as far back as November 2012, in the Budget 2013 speech. I, too, did some work on it a few months ago together with the private sector to look at what kind of a fallout it would have on Foreign Direct Investment (FDI) and what revisions ought to be considered to avoid such a fallout. Most did not dispute that land is a matter of strategic national interest and that having stronger controls can be justified. But not seeing beyond this, to the implications for business and investment, is what was troubling. Yet, despite best efforts by many, it was passed early this week (subject to some minor Amendments).

Let me recap here some of the key features of the forthcoming Act.

7 Features

1. Foreigners are no longer be permitted to buy land in Sri Lanka. Prior to this, foreigners (individuals or companies with foreign shareholding of 50% or more) could purchase land but with a huge transfer tax (100%). Under the new Act, this too will be prohibited. Foreigners can only lease land for up to even 99 years, but paying a lease tax (more on that in a bit)

2. If you are a company with less than 50% foreign shareholding (i.e., you are a domestic company) and you buy some land, the shareholding mix of your company cannot change for at least the next 20 years. If and when it does (and foreign ownership edges up above 50%) your land purchase becomes null and void.

3. Some persons/institutions are exempt from the new law. Diplomatic missions; International, Multilateral, Bilateral organisations; and Condominium parcels situation on or above the 4th floor. Additionally, based on complete discretion by certain subject Ministers and the Cabinet, certain projects deemed as Strategic Development Projects (under the SDP Act of 2008) particularly in sectors like banking, financial, insurance, maritime, aviation, advanced technology, infrastructure development, or relocating of global and regional commercial HQs. It also exempts land transfers made to next of kin who are foreigners, gifts, etc, and also land bought by dual citizens.

4. Foreigners can’t buy land, but they can lease it….with a hefty new lease tax. The lease tax is 15% on the total rent payable for the entire duration of the lease (1 year, 33 years, 99 years, whatever). (There are some exemptions – for instance a lower 7.5% rate if you’re located in a BOI zone, a designation Tourism Development Area, etc). But the real whopper is that it is payable up front for the entire duration of the lease period.

5. This new Act will come in to effect from 1st January 2013 – a full 22 months retroactively.

At the reading of the Bill this week, the Deputy Finance Minister moved some amendments. After those are incorporated, here are some additional features:

6. If a domestic company buys some land, and subsequently sees an increase in foreign shareholding above 50%, then a new clause kicks in. If that company is listed on the Colombo Stock Exchange, the company has to “take steps to reduce its foreign shareholding to less than 50% within a period of 12 months”. If not listed on the CSE, it has just 6 months in which to do it. 

7. If you’re a company that has been in active operation for a period of more than 10 consecutive years in Sri Lanka, the new Act does not becomes applicable on 1st January 2013 but on the date the speaker endorses the Act. Although there is no expressed clause on the reverse of this, it is implicit then that if you have been around for less than 10 years, then the Act becomes effective on 1st January 2013.

(These are just 7 selected areas, there are a whole host of other elements in the Act, including the standard ‘legalese’ relating to definitions, dispute resolution, etc.)

7 Reasons to Worry

So, here are some initial thoughts stemming from this. These are not based on rigorous research, they are simply put forward as food for thought, to stimulate some discussion, and strictly my personal views.

1. At the heart of it, the new Act is aimed at restricting the access to land for foreigners, first by prohibiting the sale of land to foreigners and secondly by making the payable tax on leases prohibitively expensive. But it provides for a fair amount of discretion by politicians and government officials as to which projects can gain exemption from the Act, because the provision for such discretion is expressly written out in the Act. I believe that allowing for so much discretion is at the heart of what economists call ‘rent-seeking’ (i.e., corruption/unofficial payments/graft/campaign contributions etc)

2. Any Act that is retroactive is highly undesirable as it severely hurts the business climate, creates a lot of policy uncertainty, and further solidifies investor worries that economic policies in Sri Lanka are subject to too many ad-hoc changes. IPS Executive Director Dr. Saman Kelegama shared similar sentiments here, asserting that “We have to give predictable and consistent signals without policy backtracking”.

3. Sri Lanka is struggling to get any impressive increase in FDI, post-war. As I argued here, the only notable increase in FDI has come in the property/mixed development/real estate sector (evidenced by Altair Tower, JKH Waterfront, etc). As a government minister himself observed recently, FDI targets have been falling sharply short of targets. The targets are already fairly conservative in my view, considering Sri Lanka is a post-war economy with plenty of greenfield opportunity. FDI has been below target by over US$ 700 million over 2012 and 2013. Seeing this, the BOI dropped its 2014 FDI target by a full US$ 500 million. The ‘good’ FDI that Sri Lanka desperately needs – not non-starters like the Krishh project or fly-by-night investors, but rather FDI that is here with technology, FDI that helps boost Sri Lanka’s exports, FDI that links Sri Lanka to new markets – that type of FDI has not really come to post-war Sri Lanka. But this is exactly the type of FDI that will be put off by ad-hoc implementation of protectionist laws like the new land Act.

4. Certainly, Sri Lanka has an impressive post-war growth story to tell – benign macroeconomic fundamentals, impressive infrastructure drive, new connective infrastructure like ports and airports, reduced tax rates (from 35% to 28%), eased capital controls, etc. Huge new commercial opportunities lie in store for investors who are interested. Prospects are bright. But prospects are also bright in many other countries, particularly in South East Asia like Vietnam, Cambodia, Indonesia, Philippines, etc. ‘Good’ FDI often has a choice of many destinations to locate in. Every little bit of policy signalling matters in attracting them to our shores. We must be wary of any and every negative signal we send out. As I asserted in this Reuters interview,

Though it is not unprecedented to restrict foreign ownership, Sri Lanka has just given a red light to foreign investors, specially at a time the country is trying to attract long term foreign investments

5. Yes, its not unprecedented for countries to prohibit foreign ownership of land. A review of international evidence regarding foreign land ownership practices reveals that while many Western countries (Germany, France, UK, Netherlands) and some Asian countries (Malaysia, Singapore, Bangladesh, Japan and Mauritius) permit foreign land ownership in order to spur inward FDI, many others impose tighter restrictions on outright sale to foreigners. India, Philippines, Thailand, Vietnam, Indonesia, Cambodia, and Laos have restrictions in place for foreigners in purchasing property, but leases and other tenancy agreements are allowed. Practices in some of Asia’s preferred FDI destinations including Philippines, Thailand and Singapore, suggest that a tiered approach to taxes on lease agreements is widely adopted, as opposed to a blanket “minimum” rate. Yet, the distinction to be made here is that many of those policy regimes appear transparent and objective in their design as well as implementation. For instance, even though prior authorization from government bodies plays a key role in determining foreign ownership of property in many countries, exemptions provided by government officials on the basis of ‘national interest’ and other subjective measures is rare.

6. The feature of the new Act that forces companies to reduce their foreign shareholding to below 50% in the event they have bought land and see an increase in foreign ownership is an extremely intrusive imposition on an enterprise. It could lead to substantial distortion of investment behaviour in the stock market. If a listed company that had bought land saw an increase in foreign purchases of its shares (which is often beyond their control) and it tips over 50%, it will be forced to go around asking domestic shareholders to up their ownership, and go around asking the foreign shareholders to sell their shares. It will skew pricing in the market, with the foreign shareholder then able to command an artificially much higher price from domestic shareholders in return for selling off. It then raises some important strategic questions. For instance, would people be encouraged to open an off-shore company purely for the sake of buying shares of a listed company, trigger the 50% clause, and then command an artificially high price from domestic shareholders, because the company is compelled to reduce the foreign shareholding within 12 months as stipulated by the Act? To what extent would this distort the core purpose of the stock market – which is to facilitate natural entry and exit of investors into equity of companies? The new Act then not only impinges on land decisions, but also directly on investment decisions and impinges on the operation of the stock market? (A securities expert would be able to tell us more on this…)

7. I guess its safe to say that what’s done is done, the Act will come into effect in a couple of weeks, and there is little point pontificating on what could have been. But what is troubling is that little consultation the government had with the groups of stakeholders who are likely to be impacted by the new law, and how little interest the authorities seemed to have for even hearing about the potential fallout. Chambers of Commerce, lawyers, investment advisors, independent economists, all failed in making a bigger dent in this decision. It calls to question the whole process of policymaking in this country and the role that key stakeholders play in it. The Ceylon Chamber had made some very practical and well thought out recommendations on amendments to the law when it was in Bill form, including a reduction in the lease tax from 15% to 5%. Mid-level government officials tasked with attracting investors and boosting FDI inflows will now have to face the challenge of doing so amidst yet another encumbrance.

Concluding Thoughts

Going forward, Sri Lanka must find a balance between what the state perceives as ‘doing things in the national interest’, while also remembering that ‘the national interest’ should also be about growing the economy, generating more good jobs, promoting exports, and enhancing our economic standing in the world. Good FDI is at the heart of this. My sincere hope is that I am proven wrong about this law being a ‘red signal’ to foreign investors, and the substantial boost in good FDI that the country desperately needs will not be discouraged.

Sri Lanka is now undoubtedly a hot destination for emerging markets investors. But we are not the only hot destination. The sooner we realise that, become humbled by it, and re-focus our efforts on promoting investment more strategically (like what Penang in Malaysia did for instance) the faster Sri Lanka could realise its economic development goals.

Notes & Disclaimer: The latest version of the Bill is available here. Contact the Parliament library to request a copy of the Amendments moved by Deputy Finance Minister on Monday 20th October. I am told that the changes are being incorporated by the Legal Draftsman’s Office, and the final Act will be signed by the speaker in the coming weeks. Consult with an investment advisor and/or corporate lawyer for further details on the implementation of this new Act. This is only a personal opinion article.