Investment Company vs Holding Company: How Are Dividends Taxed in Sri Lanka?

Whether a company is classified as an “investment company” or a “holding company” is a critical factor in determining the tax treatment of dividend income. This distinction remains a contentious issue, often giving rise to tax assessments and protracted disputes between taxpayers and the Department of Inland Revenue.

The recent decision of the Court of Appeal of Sri Lanka (“Court of Appeal”) in Colombo Fort Land and Building PLC vs Commissioner General of Inland Revenue (Case No: C.A. (Tax) 21/2022; Tax Appeal Commission No: TAC/IT/106/2017) has provided much needed clarity on this longstanding and contentious tax issue. Although decided under the previous Inland Revenue Act, No. 10 of 2006 (as amended), the Court’s decision remains highly relevant for determining the tax treatment of dividend income under the current law.

In this case, the Department of Inland Revenue took the position that the income tax return of the appellant company could not be accepted on the basis that the company was engaged in the business of investing in shares of other companies. Accordingly, the Department argued that the dividend and interest income of the appellant, being an investment company, should be treated as part of its trading profits in terms of Section 3(a) of the Inland Revenue Act, No. 10 of 2006 (“the Act”).

Two significant issues addressed by the Lordships of the Court of Appeal of Sri Lanka in the aforesaid case are: (1) whether the Commissioner-General and the Tax Appeals Commission erred in law by failing to recognise the Appellant as a “holding company” rather than an “investment company”; and (2) whether the dividends received by the Appellant were assessable as income under Section 3(e) of the Inland Revenue Act, No. 10 of 2006, rather than under Section 3(a) of the Act.

For clarity, under the previous Inland Revenue Act, Section 3(a) covers profits from any trade, business, profession, or vocation, while Section 3(e) covers dividends, interest, and discounts.

Holding Company vs Investment Company

Position of the Tax Authorities

In determining that the appellant company was an “investment company” rather than a “holding company,” the tax authorities relied on the fact that the number of companies in which the appellant had invested changed from year to year and that, among the companies in which it held shares, it owned more than 50% of the shares in only two companies.

Arguments of the Appellant Company

Companies Act Interpretation: The appellant company relied on the interpretation in Section 529 of the Companies Act, No. 7 of 2007 and argued that it qualified as a “holding company”. The relevant statutory provisions are set out below:

“holding company”, a company shall be deemed to be another company’s holding company, if and only if that other company is its subsidiary. For the purpose of this definition “company” includes any body corporate;

“subsidiary”, a company shall be deemed to be a subsidiary of another, if and only if—

(a) that other company either-

1. controls the composition of its board of directors;
2. is in a position to exercise or control the exercise of more than half the maximum number of votes that can be exercised at a meeting of the company;
3. hold more than half of the issued shares of the company, other than shares that carry no right to participate beyond a specified amount in a distribution of profits or capital;
4. is entitled to receive more than half of every dividend paid on shares issued by the company, other than shares that carry no right to participate beyond a specified amount in a distribution of profits or capital; or (b) the first-mentioned company is a subsidiary of any company which is that other company’s subsidiary.

Nature of Investment Companies: The nature of investment companies is such that shares are typically bought and sold within short periods to generate trading profits rather than capital gains. In the present dispute, the appellant company primarily received dividend income and realised capital gains only upon the disposal of shareholdings in its subsidiary companies.

The appellant company relied on the decision in Janashakthi Securities Ltd v Commissioner General of Inland Revenue and argued that the Court had previously recognised a company as an “investment company” where it was incorporated for the purpose of carrying on an investment business and engaged continuously in investing in government securities such as treasury bonds and treasury bills. In that case, approximately 240 transactions of that nature were undertaken during the relevant year, and the income was derived from those trading transactions.

Repetitive Transactions: The appellant company argued that it has not been engaged in investing in the shares of the subsidiary companies on a continuous basis but rather was holding the shares for long durations which resulted in receiving dividend income over a period of time.

In the case of CEI Plastics Limited v Commissioner General of Inland Revenue, the Court emphasised that repetitive and systematic share transactions conducted in an organised manner constituted “business” within the meaning of Section 3(a) of the Inland Revenue Act.

Decision of the Court of Appeal

In this case, the Court of Appeal observed that, unlike in CEI Plastics Limited v. Commissioner General of Inland Revenue, there were no repetitive transactions in shares of the nature required to constitute a “business” under Section 3(a) of the Act. Although dividend income was received on a recurring basis, it did not arise from the principal business activities of the appellant company, specifically, “real estate and property development, management of an investment portfolio, and provision of management services”, and therefore could not be taxed under Section 3(a).

Furthermore, the Court noted that the appellant company exercised control over its subsidiary companies through its shareholdings and directly or indirectly held more than 50% of the shares in those companies within the group structure. In light of these circumstances, the Court concluded that the appellant company functioned as a “holding company” rather than an “investment company”.

Accordingly, the Court of Appeal held that the Commissioner General of Inland Revenue and the Tax Appeals Commission had erred in law by failing to recognise the appellant company as a holding company.

Dividends: Investment Income or Business Income?

Position of the Tax Authorities

The revenue authorities contended that the appellant company’s principal sources of income were dividends and interest, with dividends accounting for approximately 82–87% of its income and argued that exempting dividend income under the Act would leave only a minimal portion of the appellant company’s income liable to tax.

Decision of the Court of Appeal

The Court of Appeal observed that the objective of incorporating the appellant company was “to engage in business in real estate and property development, management of an investment portfolio, and provision of management services,” which did not include investment in shares and earning dividends as a form of business activity.

Given that the appellant company is a “holding company” and having regard to the principal purpose of incorporating the appellant company, the Court of Appeal held that dividend income does not constitute profits or income arising from its business under Section 3(a) of the Act.

Further, the Court of Appeal held that dividend income may be recognised as a separate income from the primary income of the appellant company and that therefore, dividend income should be recognized under Section 3(e) and not under Section 3(a) of the Act.

Why this case matters?

• Whether dividends should be classified as “business income” or “investment income” has been a longstanding dispute, particularly for group companies. Holding companies often earn the majority of their income from dividends, which may be subject to lower withholding taxes or exempt from tax under dividend pass-through exemptions, rather than being taxed at the higher corporate tax rate. The Department of Inland Revenue frequently issues annual assessments to challenge such arrangements.

• The Colombo Fort Land and Building PLC vs Commissioner General of Inland Revenue is a landmark case, as the Court of Appeal held that the company should be treated as a holding company, based on its objects and nature of business, even though the majority of its income was derived from dividends.

• Although the case of Colombo Fort Land and Building PLC vs Commissioner General of Inland Revenue was decided under the previous income tax statute, it remains highly relevant under the current Inland Revenue Act, No. 24 of 2017, as amended.

• Under the Inland Revenue Act, No. 24 of 2017 as amended, the taxable income of a person for a year of assessment shall be equal to the total of the person’s assessable income for the year from each employment, business, investment and other sources.

• Therefore, even under the current income tax law, whether dividends constitute “business income” or “investment income” has critical tax significance, particularly in light of the applicable tax rates.

• The standard income tax rate on gains and profits from business is 30%, whereas, with effect from January 1, 2023, dividends declared by a resident company are subject to a final withholding tax of 15%.

• The Court of Appeal’s decision in Colombo Fort Land and Building PLC serves as an important precedent for the tax treatment of inter-company dividends within group company structures.