For Small and Medium Enterprises (SMEs) and corporate entities operating in Sri Lanka, maximizing profitability requires a deep operational understanding of business income taxation under Part III of the Inland Revenue Act. The tax system works on a simple core principle: your gross business receipts minus allowable business deductions equal your taxable income.

However, adjusting your accounting profit to match your taxable profit requires careful navigation of statutory deductions and capital allowance schedules.

Part 1: Defining Business Income & General Deductibility

Q1: What constitutes “Business Income” under the Inland Revenue Act No. 24 of 2017?

A: Business income is the net profit derived from conducting any form of trade, commerce, business, profession, vocation, or strategic undertaking.

Q2: What accounting method is mandatory for recognizing business income?

A: Income must generally be recognized on an accrual basis (when earned, not when cash is received). However, small businesses with low turnover may be permitted to utilize a cash basis.

Q3: What is the foundational rule governing the deductibility of an expense against business income?

A: Under Section 14, an expense must be revenue in nature (not capital expenditure) and must be incurred “wholly and exclusively” in the direct production of that business income.

Q4: Are salaries and wages paid to employees fully deductible by a business?

A: Yes, provided the salary payments are genuine, commercially realistic, and supported by proper internal documentation.

Q5: Can a sole proprietor deduct a salary paid to themselves from their shop’s business income?

A: No. A sole proprietor cannot be an employee of their own business. Any salary drawn by the owner is classified as a personal drawing and is disallowed for tax deductions.

Q6: Are business entertainment expenses fully deductible?

A: No. The Inland Revenue Act imposes a strict restriction, allowing businesses to deduct only 50% of their actual documented business entertainment expenses.

Q7: Can a business deduct statutory fines, late penalties, or legal bribes?

A: No. Section 14 explicitly excludes all fines, statutory interest penalties, and illegal payments from being claimed as deductible business expenses.

Q8: Is income tax paid to the IRD considered a deductible expense for the business?

A: No. Income tax charged on profits is a distribution of earnings, not an expense incurred to generate income, and is completely non-deductible.

Q9: Under what specific conditions can a business write off bad debts as a tax deduction?

A: The bad debt must have been previously included as part of the business’s taxable revenue, and the company must provide documentation proving that the debt is genuinely unrecoverable.

Q10: Are loan repayments for a commercial business vehicle fully deductible?

A: No. The capital repayment portion of a loan is a capital outflow and cannot be deducted. However, the interest component of a business loan is fully deductible.

Part 2: Capital Allowances (Tax Depreciation)

Q11: What is a “Capital Allowance” under the Fifth Schedule?

A: Because the full cost of a capital asset cannot be deducted in the year of purchase, the law allows businesses to deduct the asset’s cost spread over its useful life using straight-line percentages.

Q12: What is the annual tax capital allowance rate for computers and IT equipment?

A: Computers and IT software are written off at a rate of 25% per annum over a 4-year period using the straight-line method.

Q13: How fast can a business write off office furniture and general equipment?

A: Office furniture and general equipment are depreciated at a rate of 10% per annum over a 10-year period.

Q14: What are the capital allowance write-off rates for heavy plant and industrial machinery?

A: General plant and machinery qualify for a straight-line write-off rate of 12.5% per annum over an 8-year operational span.

Q15: Over what period can a company claim capital allowances on an industrial building?

A: Industrial and commercial buildings can be claimed at a rate of 5% per annum over a 20-year period.

Q16: What is the capital allowance rate for commercial vehicles versus private passenger motor cars?

A: Both commercial and private motor vehicles are written off at 20% per annum over a 5-year period under the Fifth Schedule.

Q17: If an SME buys a laptop for LKR 200,000, how is the deduction calculated in Year 1?

A: Applying the 25% rate, the business claims a capital allowance deduction of LKR 50,000 for the first Year of Assessment, repeating this deduction for the next three years.

Part 3: Business Losses & Corporate Tax Rates

Q18: What are the statutory regulations regarding carrying forward business losses under Section 36?

A: Business losses can be carried forward to be set off against future business profits for up to a maximum of 6 years.

Q19: Can a current business loss be carried backward to claim refunds on prior tax years?

A: No. The IRA 2017 does not allow business losses to be carried back to previous Years of Assessment.

Q20: What are the “ring-fencing” rules regarding tax losses?

A: Ring-fencing means that losses from one specific business source can generally only reduce future income from the same or a highly similar business activity.

Q21: What is the standard corporate tax rate versus the concessionary SME rate?

A: The standard corporate tax rate is 30%. However, qualifying Small and Medium Enterprises enjoy a concessionary corporate tax rate of 14%.

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