Sri Lanka's government seeks changes to legal framework to encourage foreign investment

Since 1994 Sri Lanka has allowed non-resident investment in most sectors of the economy, and its foreign direct investment (FDI) regime was seen for many years as one of the most open in Asia. In the recent past, however, the government has consistently not met its FDI targets, and 2015 saw a marked downturn. The reasons for this declining trend are debatable, but many consider that several important factors include a lack of stability when it came to certain key aspects of the foreign investment climate: namely, the enactment of the Revival of Underperforming Enterprises and Underutilised Assets Act in 2011: the perception of a breakdown in the rule of law; the impeachment of the chief justice; and the implementation since January 2013 of a prohibition on foreign acquisition of land and the subsequent enactment in October 2014 of the Land (Restrictions on Alienation) Act.

The Facts

A report released by the Asian Institute of Management and titled “Foreign Direct Investment in Asia: Lessons of Experience” concluded, “Changes in policies have an asymmetric effect on the location of FDI: changes in the direction of greater openness allow firms to establish themselves in a particular location, but do not guarantee that they will do so. In contrast, changes in the direction of less openness (e.g., nationalisation) will ensure a reduction in FDI.”

Article 157 of Sri Lanka’s constitution offers a guarantee to foreign investments which originate from a country with which Sri Lanka has entered into an investment protection treaty or agreement, where the treaty or agreement has been approved by Parliament with a two-thirds majority as being essential for the development of the national economy. Any such agreement or treaty which has been so approved is declared to have the force of law and, unless in the interests of national security, no written law shall be enacted and no executive or administrative action shall be taken in contravention of the provisions of such a treaty or agreement.

Sri Lanka has also signed bilateral investment protection agreements with 28 countries and most have been approved by parliamentary resolutions. Sri Lanka is also a founding member of the Multilateral Investment Guarantee Agency, an agency of the World Bank. This provides a safeguard against expropriation and non-commercial risks. This legal framework is salutary since it recognises the importance of stability for investors and provides strong legal safeguards for foreign investments.

The Obstacles

However, some challenges to this sense of stability have arisen. The previous government enacted the 2011 Revival of Underperforming Enterprises and Underutilised Assets Act. From the perspective of the security of foreign investment in Sri Lanka, the enactment of this act was quite negative, though the new administration has issued some positive rhetoric.

In his November 2015 policy statement delivered to Parliament, Prime Minister Ranil Wickremesing recognised the issue, as indicated in the following passage: “We also need to revitalise underperforming enterprises within the Underutilised Assets Act and bring the necessary revisions. Many businesses were harassed using this act blatantly while some were taken over. We will not engage in such activities. The government will not take over private enterprises. We will also review the businesses taken over in this manner using the act. The Constitution 14 (G) states the following: ‘Every citizen, as an individual or with others, has the right to engage in a lawful occupation, profession, industry or a business or in an entrepreneurship.’ Also, as per Article 157: ‘We are bound by the international agreements and norms concerning economic development.’ Based on these, we will offer protection for local and global investors and will give them the freedom to engage in business. We will put in place new laws to strengthen this process.”

Another factor that led to a perception of insecurity and that Sri Lanka was not open to foreign investment was the Land Act No. 38 of 2014, which imposed a prohibition on the acquisition of immovable property by foreign individuals and companies with over 50% foreign ownership. Prior to this, foreigners were able to buy land by paying a 100% transfer tax, and firms with over 25% foreign ownership were also subject to the tax.

This also affected foreign investors who had already purchased land in the country and in some cases were now unable to exit from those investments by way of sale to another foreign investor. Exceptions to the law include condominiums above the fourth floor and projects designated as Strategic Development Projects by the Board of Investment (BOI). While the 2014 law did not prohibit 99-year leasehold tenure, the 15% Land Lease Tax, which was imposed on leases in favour of foreigners by the new legislation, effectively deterred many potential investors.

Possible Solutions

The importance of attracting FDI for a developing country has been recognised by the current government of Sri Lanka following its election in January 2015. In his policy statement, Prime Minister Wickremesinghe referred to the need for an economic reconstruction to achieve the medium-term goals of the government and stated, “Under the new measures we will introduce, investments will be encouraged – we will focus more on foreign direct investment.”

It is well-recognised that FDI is a key factor in driving economic growth. FDI and associated capital inflows not only provide capital, but are the means through which know-how and technology transfers take place. Another benefit of FDI is the associated transfer of skills, organisational and managerial practices, and the widening of the host nation’s marketing network. In the prime minister’s policy statement, he also referred to the direct connection between FDI and employment generation. In addition, the 2014 UNCTAD World Investment Report stated that Asia receives the most FDI regionally. Asia draws in nearly 30% of global FDI inflows. Sri Lanka, therefore, has an unprecedented opportunity to emerge as an extremely attractive destination for foreign investors, provided that certain structural adjustments are made. In particular, the increase of the minimum investment requirement to $250,000 has negatively affected smaller investors. In the past the minimum requirement for obtaining BOI approval under Section 16 of the BOI Law was $50,000.

Economic Realities

It is certainly a worthy ambition to pursue large-scale investments, but the reality of foreign investment in Sri Lanka – given the small size of the domestic market and the proximity of its neighbour and economic giant India – is that it is likely to originate from small and medium-sized enterprises (SMEs). Therefore, a lower minimum investment requirement would be appropriate. It is also clear that SME investors would favour a regime of land ownership that would enable them to benefit from an appreciation in land values. In this vein, Prime Minister Wickremesinghe told Parliament, “We will encourage investments that will generate employment. We will also take steps to remove impediments facing such ventures. We understand the obstacles facing investors and businesses generating employment concerning obtaining of land and buildings. We will bring in new laws that will provide ownership of land to registered investors who meet the required criteria, without being affected by the Land Restriction and Alienation Act.”

OBG would like to thank John Wilson Partners for their contribution to THE REPORT Sri Lanka 2016