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Diplomacy in Action

2012 Investment Climate Statement - Sri Lanka


2012 Investment Climate Statement
Bureau of Economic and Business Affairs
June 2012
Report
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OPENNESS TO, AND RESTRICTIONS UPON, FOREIGN INVESTMENT

The end of Sri Lanka's long-running civil war in May 2009 has opened a new era of economic opportunities and rebounding economic growth. The Government of Sri Lanka (GSL) has set very ambitious goals for economic development, aspiring to GDP growth rates over 8%, and developing economic hubs in ports, aviation, commercial, knowledge and energy. Sri Lanka also provides very strong prospects in tourism and infrastructure. Sri Lanka’s strong prospects for economic growth have attracted the interest of foreign investors. Sri Lanka can still be a difficult place to do business, however, with an unpredictable policy environment, cumbersome bureaucracy, and a recent asset seizure bill that has created business uncertainty. Further, the government has increased control of the economy recently and is a concern for private investors. Nonetheless, compared to other South Asian countries, Sri Lanka is relatively open to foreign investment. It offers a relatively open financial system, moderately good infrastructure, and generally capable workers. Some U.S. and other foreign investors have realized worthwhile returns on investment in Sri Lanka while others have tried and departed frustrated.

The Government of Sri Lanka (GSL) has created concerns with several economic policies. In November 2011 the GSL rushed through parliament, under an urgent mechanism, a law to seize 37 underperforming companies and assets. Although most of these companies were defunct enterprises, several were operating. The GSL stated that these companies had violated the terms of their land leases with the government. The GSL has promised that this was an “one off” measure, but the GSL subsequently announced plans to seize 37,000 hectares of allegedly unused tea plantation land. Although the assets seized were not American businesses, the new law, and its passage after one day of debate in Parliament, have created business uncertainty. In another area, stockbrokers criticized laws promulgated by the Securities and Exchange Commission (SEC) to impose price bands and limit credit offered by stockbrokers to their clients. The chairwoman of the Securities and Exchange Commission resigned on principle, and a month earlier the SEC Director General had been transferred to a new position outside the SEC. Although a new SEC chairman has been appointed, there are concerns on the regulation of the stock market.

Strong Economic Growth

Sri Lanka is poised for strong economic growth. Despite the 1983-2009 civil war, GDP growth averaged around 5% from 2000-2008. Due to the global recession and escalation of fighting during the final stages of the war, GDP growth slowed to 3.5% in 2009 and foreign reserves fell sharply. Economic activity rebounded strongly with the end of the war and an IMF agreement resulting in two straight years of 8% growth in 2010 and 2011. Sri Lanka is now a lower-middle income developing nation with a gross domestic product of about $59 billion. This translates into a per capita income of about $2,800, among the highest in the region. There are significant regional disparities with the western province contributing to about 45% of GDP. The contribution of former conflict affected northern and eastern provinces is 3.4% and 5.9% respectively.

There are many bright spots for the Sri Lankan economy, although there are concerns with a large trade deficit and the exchange rate. The economic re-integration of northern and eastern provinces, where the war was fought, has boosted agriculture and fisheries. Reconstruction in the north and east, and infrastructure development throughout the country including new ports and roads, are also fuelling growth. Tourism rebounded strongly and arrivals reached record levels. Inflation, which had reached double digit levels in the war years, was around 6% in 2011. External trade remained strong, but a widening current account deficit is a concern. Sri Lanka’s exports grew by about 23% in 2011. Imports grew even more strongly by about 50% resulting in a massive trade deficit of $9 billion, up from $5.2 billion in 2010. Contrary to expectations, the loss of GSP Plus trade benefit to EU did not dent export demand. Remittances from migrant workers, at around $5 billion, are Sri Lanka’s largest source of foreign exchange and helped to partially offset the trade deficit. Sri Lanka also receives multilateral and bilateral financial support. While China has emerged as the largest lender, traditional donors such as the IMF, World Bank, ADB, and Japan as well as neighboring India continue to provide significant funds to Sri Lanka. In 2009, Sri Lanka received IMF assistance to overcome a balance of payments crisis. The fund has so far disbursed $1.7 billion to Sri Lanka under its $2.6 billion loan program, but the IMF program is under indefinite review. Increased foreign commercial borrowings including a $1 billion Eurobond have also helped external reserves, which reached $6 billion (4 months of imports) in 2011. The IMF has cautioned Sri Lanka about the declining non borrowed reserves. Despite the widening current account deficit, the Central Bank of Sri Lanka intervened in the foreign exchange markets throughout 2011 to keep the rupee stable until it was depreciated 3% in November. Some analysts believe that the rupee is still overvalued.

The Central Bank expects the economy to continue to grow by 8% in 2012 aided by growth in all sectors of the economy. Sri Lanka’s growth prospects could be affected due to economic problems in the U.S. and EU, the key export markets. The Central Bank forecasts inflation to remain at single digit levels. Government fiscal control has improved, but the losses of state controlled companies are a major concern. The budget deficit reached 8% in 2010, and is forecast to fall to around 7% in 2011 and 6.2% in 2012. The public debt has at times reached close to 100% of GDP, but due to declining budget deficits and strong economic growth it has declined to 78% of GDP in 2011.

FDI has increased since the end of the war but remains relatively low. Sri Lanka continues to struggle to attract FDI as the government sends mixed signals to the investor community. One exception is the tourism sector. For the first time, several regional and international hotel chains have expressed a strong interest in developing properties in Sri Lanka. Investor interest in other sectors has been limited. Sri Lanka expects FDI to reach $1 billion in 2011, its highest level ever.

Stable Political Situation

Sri Lanka is a stable parliamentary democracy. In 1978, it shifted away from a socialist orientation and opened to foreign investment, although changes in government have often been accompanied by reversals in economic policy. Of the two major parties, the more pro-business United National Party has been in opposition in recent years. When it last held power, from 2002 to 2004, it pursued privatization and regulatory reform welcomed by domestic and foreign investors.

In January 2010, President Rajapaksa was re-elected for a second six year term, which commenced in November 2010. President Rajapaksa’s Sri Lanka Freedom Party-led government also won Parliamentary elections in May 2010, and holds a two-third majority, giving President Rajapaksa control of the legislative branch.

Statist Economic Policy

The GSL follows a rather statist economic policy, guided by Mahinda Chintana ("Mahinda's Thoughts"). Mahinda Chintana seeks to reduce poverty by steering investment to disadvantaged areas; developing small and medium enterprises; promoting agriculture; and expanding the already enormous civil service. The Rajapaksa government has halted privatization – reversing several previous privatizations – and advocates state control of what it deems "strategic" enterprises such as state-owned banks, airports, and electrical utilities. The government has increased its control of the banking sector utilizing government controlled funds and companies to take majority control of leading private banks. The Sri Lankan military is also slowly becoming engaged in activities traditionally reserved for the private sector including air and sea transport and tourism. The government has adopted import substitution strategies. Taxes on imports remain high although the government removed taxes on certain intermediate imports to make the country a trading hub. The Mahinda Chintana plan aims to double Sri Lanka’s per capita income to $4,000 within six years. To do so, Sri Lanka requires GDP growth well over 8%, and the investment rate needs to rise from 27% of GDP to 35% of GDP. The majority of investment is expected from private investment as public investment is expected to remain around 6.5%. Mahinda Chintana seeks to develop Sri Lanka as a regional hub for air and sea transportation, trading, energy, and knowledge based services.

While the state is a major player in many economic sectors, there is a strong private sector that plays a key role across the economy including in finance, exports, tea, apparel, IT and tourism. However, both local and multinational companies complain that increasing government role in business is harming the investment climate. Though many multinational companies perform better than the local private sector, international MNCs and SMEs feel the government is blatantly biased towards local companies. Some investors are concerned, that Sri Lanka is becoming a highly nationalistic environment where the government is prone to blame foreigners for its economic and social ills.

Sri Lanka has established strong economic ties with Asian countries such as China and India. China has increased its political influence and is a major player in infrastructure development, building ports, power stations and roads. Several GSL leaders believe that Asia is their future, although Sri Lanka’s exports still are primarily destined for Western markets.

Despite the generally bright prospects, there are still significant impediments to investment in Sri Lanka, such as inconsistent economic policies, bias towards state control of the economy, the workers' declining English language skills, inflexible labor laws, overburdened infrastructure (although the GSL is moving to improve roads and ports), and an unreliable court system. Sri Lanka boasts a 90% literacy rate in the local Sinhala and Tamil languages, but English, which was once widely spoken, is now less prevalent. The government has launched a drive to increase English proficiency. Sri Lanka's labor laws include many model protections, but can make it nearly impossible for companies to lay off workers even when market conditions fully warrant doing so. The cost of dismissing an employee in Sri Lanka is, percentage-wise, one of the highest in the world. Until recently Sri Lanka has not invested in infrastructure to keep pace with its growth. Its roads are narrow and congested. With the conclusion of the war, Sri Lanka is renovating and constructing roads in the North and East. Multi-year projects to expand the ports in Colombo and Hambantota are underway.

Sri Lanka's electricity supply is generally reliable but can fail to meet peak demand in years of low rainfall. Electricity costs are priced higher than in other Asian countries. Businesses in Sri Lanka also face high interest rates, although rates have come down in the past few years. Sri Lanka's courts cannot be relied upon to uphold the sanctity of contracts. The courts are not practical for resolving disputes or obtaining remediation, because their procedures make it possible for one side in a dispute to prolong cases indefinitely. Aggrieved investors (especially those dealing with the government on projects) have frequently pursued out-of-court settlements, in hopes of speedier resolution. In late 2008, the Supreme Court, in an interim order, halted payments to five international and local banks involved in oil hedge contracts with the government. One of the involved banks is American. The record on international arbitration is mixed, as one bank won its case, the government won one case (against the American bank), and there has not been a decision in the third case.

Trade

According to preliminary data for 2011, Sri Lanka's exports (mainly apparel, tea, rubber, gems and jewelry) were $10.5 billion and imports (mainly oil, textiles, food, and machinery) were $20.0 billion. Although Sri Lanka has a $9 billion trade deficit with the world (primarily India and China), the United States has a large trade deficit with Sri Lanka. Exports to the United States, Sri Lanka's second largest market, are projected to be $2 billion in 2011, or 19% of total exports. The United States is Sri Lanka's second biggest market for garments, taking about 40% of total garment exports. The United States' exports to Sri Lanka are projected at $250 million in 2011. U.S. exports consist primarily of wheat as well as industrial machinery, medical instruments, aircraft parts, lentils, paper, specialized fabrics and textiles for use in the garment industry, fruits and pharmaceuticals. United States investors have invested approximately $200 million in foreign direct investment. U.S. investors are much more significant in portfolio investment; for example, U.S. investors purchased a little over 40% of a $1 billion sovereign bond fund in 2011.

Board of Investment

The Board of Investment (BOI) (www.investsrilanka.com), an autonomous statutory agency, is the primary government authority responsible for investment, with a focus on foreign investment. The BOI recently underwent a major restructuring process in order to improve its ability to capture foreign direct investment. BOI promotes the following sectors as priority sectors for FDI: Tourism and leisure, infrastructure, knowledge services, utilities, apparel, export manufacturing, export services, agriculture and education. Specialized divisions representing these sectors strive to provide services to foreign investors through the entire investment process.

Large investment projects, both local and foreign, identified as strategic development projects are handled by the Treasury and a special Cabinet Review Committee, outside of the BOI. These projects require approval from the full cabinet, a process which is not transparent and which can politicize even the most urgently needed investments. Parliamentary approval is also needed for these projects.

The BOI manages a number of export processing zones which feature business-friendly regulations and improved infrastructure for foreign investors. The BOI is intended to provide "one-stop" service for foreign investors, with duties including approving projects, granting incentives, and arranging services such as water, power, waste treatment, and telecommunications. It also assists in obtaining resident visas for expatriate personnel, and facilitates import and export clearances.

BOI incentives are attractive and real, but the BOI is not the "one stop shop" it aspires to be. Although it is relatively effective in assisting investors who want to establish operations within its industrial processing zones, it is less effective in facilitating and servicing large investments outside these zones. Sri Lanka's large, inefficient, and dated bureaucracy often works at cross-purposes with BOI authorities and commitments. Registration of foreign company branch offices in Sri Lanka can be cumbersome as well.

Even with incentives and BOI facilitation, foreign investors face difficulties operating in Sri Lanka. Problems range from difficulty clearing equipment and supplies through customs speedily to difficulty obtaining a factory site. Legal challenges to environmentally sensitive projects have been burdensome, even when objections are unfounded. Slow and indecisive application of bureaucratic requirements has also obstructed investment. In part to avoid these delays, and to overcome land allocation problems, the BOI encourages investors to locate their operations in BOI-established industrial processing zones. Investors locating in industrial zones also get access to relatively better infrastructure facilities such as reliable power, telecommunications and water supplies.

Laws Affecting Investment

The principal law governing foreign investment is Law No. 4, created in 1978 (known as the BOI Act), as amended in 1980, 1983 and 1992, along with implementation regulations established under the Act. The BOI Act provides for two types of investment approvals. Under Section 17 of the Act, the BOI is empowered to recommend concessions to companies satisfying certain eligibility criteria on minimum investment. Such companies are eligible for generous investment concessions granted under the Inland Revenue Act Section 17(A). Investment approval under Section 16 of the BOI Act permits companies to operate under the "normal" laws of the country and applies to investments that do not satisfy eligibility criteria for BOI incentives. Strategic Development Project Act of 2008 (SDPA) provides generous tax incentives for large projects identified by the Cabinet of Ministers as Strategic Development Projects. The government has recently granted incentives to Shangri-La hotels for hotel projects and to Cairn Lanka Ltd for oil exploration under the SDPA. Other laws affecting foreign investment are the Securities and Exchange Commission Act of 1987 as amended in 1991 and 2003, and the Takeovers and Mergers Code of 1995 revised in 2003. A new Companies Act came into effect in 2007, replacing the Companies Act of 1982. The new law aims to improve trade and commerce as well as corporate governance in the business sector. It features simplified regulations concerning company formation; provisions specifying the duties of company directors; provisions to prevent the abuse of powers by directors; provisions to protect creditors; and a dispute board to settle disputes among directors. Various labor laws and regulations also affect investors. See sections below.

Foreign Equity Shares by Sector

The government allows 100% foreign investment in any commercial, trading, or industrial activity other than a few specified sectors mentioned below.

The following sectors are regulated and subject to approval by various government agencies or the BOI: Air transportation, coastal shipping, large scale mechanized mining of gems, lotteries and manufacture of military hardware, military vehicles and aircraft, dangerous drugs, alcohol, toxic, hazardous or carcinogenic materials, currency and security documents.

Foreign investments in the areas listed below will be limited to 40% of foreign equity. Foreign ownership in excess of 40% will be approved on a case by case basis by the BOI: The production for export of goods subject to international quotas, growing and primary processing of tea, rubber, coconut, timber based industries using local timber, deep sea fishing, mass communications, education, freight forwarding, travel agency and shipping agency business. The GSL is considering opening higher education to foreign investment.

Foreign investment is not permitted in the following businesses: non-bank money lending; pawn-brokering; retail trade with a capital investment of less than $1 million and coastal fishing.

Privatization Halted

The GSL has halted privatizations, preferring to maintain state-owned enterprises, and has even reversed several privatizations. In 2008, the Supreme Court cancelled a privatization of a government-owned bunkering company, done in 2002, stating that it was illegal. In 2009, the Supreme Court cancelled a 2003 sale of a government-owned large insurance company. In 2010, the government bought back shares of two privatized companies when their owners sought to exit the companies. In one instance, the government bought shares of Sri Lankan Airlines, the national carrier, from Emirates Airlines of UAE. The government also bought shares of Shell Gas Lanka held by Royal Dutch Shell Company.

Labor unions in state-owned enterprises are often opposed to privatization and restructuring and seem particularly averse to foreign ownership. In the past, this made the privatization of government entities problematic for new foreign owners.

Sri Lanka ranks 89th out of 183 countries in the World Bank's Doing Business 2012 Index, ahead of its South Asian neighbors except Maldives (87). Within the index, Sri Lanka ranked at 38th in terms of starting a business, 42nd in resolving insolvency and 46th in protecting investors. The country ranked lower at 173rd in paying taxes, 161st in registering property, 136th in enforcing contracts, 111th in dealing with construction permits, 95th in getting electricity and 78th in getting credit. The GSL is trying to improve Sri Lanka’s ranking in the index.

INTERNATIONAL BUSINESS RANKINGS

Measure

Year

Index/Ranking

TI Corruption Index

2011

3.3/86

Heritage Economic Freedom

2011

57.1/107

World Bank Doing Business

2011

N.A./89

MCC Gov’t Effectiveness

2010

0.30/72%

MCC Rule of Law

2010

0.39/72%

MCC Control of Corruption

2010

0.05/52%

MCC Fiscal Policy

2010

-8.3/8%

MCC Trade Policy

2011

77.1/64%

MCC Regulatory Quality

2010

0.34/72%

MCC Business Start Up

2011

0.97/63%

MCC Land Rights Access

2011

0.64/32%

MCC Natural Resource Mgmt

2011

94/79%

CONVERSION AND TRANSFER POLICIES

In accordance with its Article VIII obligations as a member of the International Monetary Fund (http://www.imf.org/external/pubs/ft/aa/aa08.htm), Sri Lanka has liberalized exchange controls on current account transactions. In 2010, Sri Lanka relaxed exchange controls on several categories of capital account transactions. When the GSL experiences balance of payments difficulties (such as in 2009), the government tends to impose controls on foreign exchange transactions, but now the GSL has loosened the rules on transactions.

Exporters must repatriate export proceeds within 120 days to settle export credit facilities. Other export proceeds can be retained abroad in a local bank's correspondent bank. Currently, contracts for forward bookings of foreign exchange are permitted for a maximum period of 360 days for the purposes of payments in trade.

There are no barriers, legal or otherwise, to the expeditious remittance of corporate profits and dividends for foreign enterprises doing business in Sri Lanka. The average delay period for remitting investment returns, interest and principal on private foreign debt, lease payments, royalties and management fees through normal, legal channels is in the range of 1 to 4 weeks. All stock market investments can be remitted without prior approval of the Central Bank through a special bank account. Investment returns can be remitted in any convertible currency at the legal market rate.

Foreigners are now permitted to invest in Sri Lankan debt instruments, both government and corporate debt. The Central Bank’s dollar-denominated bond issues in the local market are also open to foreign investors.

Both foreign and local companies are permitted to borrow from foreign sources.

EXPROPRIATION AND COMPENSATION

Since economic liberalization policies began in 1978, the Sri Lankan Government has not expropriated a foreign investment. The last expropriation dispute was resolved in 1998. The GSL is currently involved in several major disputes with foreign companies, as detailed in the section on disputes involving U.S. companies.

On November 9, 2011 the Government of Sri Lanka approved a new law entitled the Revival of Underperforming Enterprises and Underutilized Assets Act that allows expropriation of assets belonging to 37 companies the government considers as underperforming. These companies had leased land from the government, and the government states that the companies were not meeting conditions of the lease. Although many of the 37 companies were defunct, several were operating businesses. The Bill was passed under an urgent mechanism that limited Parliamentary debate to one day. The Central Bank stated that the Act was an “one off” measure, but the government has subsequently announced plans to retake 37,000 hectares of tea plantation land, which the government said was not being fully utilized. The law increases investor uncertainty regarding property rights in Sri Lanka and will likely be a significant barrier to foreign direct investment.

DISPUTE SETTLEMENT RULES

Sri Lanka's legal system reflects diverse cultural influences. Criminal law is fundamentally British. Basic civil law is Roman-Dutch. Laws pertaining to marriage, divorce, and inheritance are communal. Sri Lankan commercial law is almost entirely statutory. The law was codified before independence in 1948 and reflects the letter and spirit of British law of that era. Its amendments have, by and large, kept pace with subsequent legal changes in the U.K. Several important legislative enactments regulate commercial matters: the Board of Investment Law, the Intellectual Property Act, the Companies Act, the Securities and Exchange Commission Act, the Banking Act, the Industrial Promotion Act and Consumer Affairs Authority Act. Most of these laws were revised recently.

Sri Lanka's court system consists of the Supreme Court, the Court of Appeal, Provincial High Courts and the Courts of First Instance viz. district courts (with general civil jurisdiction) and magistrate courts (with criminal jurisdiction). The provincial high courts have original, appellate and reversionary criminal jurisdiction. The Court of Appeal sits as the intermediate appellate court with a limited right of appeal to the Supreme Court. The Supreme Court exercises final appellate jurisdiction for all criminal and civil cases. Citizens may apply directly to the Supreme Court for protection if they believe any government or administrative action has violated their fundamental human rights.

All commercial matters exceeding the value of Rs 3 million (approximately $26,000) fall within the jurisdiction of the Commercial High Court of Colombo. There are also a number of tribunals which exercise judicial functions, such as the Labor Tribunals to hear cases brought by workers against their employers. Until recently, the court system was largely free from government interference. There are allegations that the judiciary is sometimes subject to political influence, but this has not been evident in commercial litigation to this point. Litigation can be slow and unproductive, though. Monetary judgments are usually made in local currency. Procedures exist for enforcing foreign judgments.

Bankruptcy Laws

The Companies Act and the Insolvency Ordinance provide for dissolution of insolvent companies, but there is no mechanism to facilitate the re-organization of financially-troubled companies. Other laws make it difficult to keep a struggling company solvent. The Termination of Employment of Workmen Act (TEA), for example, makes it difficult to fire or lay off workers who have been employed more than six months for any reason other than serious, well-documented disciplinary problems. The Labor Commissioner's approval or the affected employee's consent is required to fire workers. The government has introduced a standard compensation formula under the TEA to facilitate termination for other than disciplinary reasons. Employers protest that compensation is excessive compared to similar formulae in the Asian region, with terms in Sri Lanka about twice as generous as the East Asian average. (See section on "Labor" for further details.)

In the absence of proper bankruptcy laws, extra-judicial powers granted by law to financial institutions protect the rights of creditors. When a company cannot meet the demands of a creditor for a sum exceeding Rs 50,000 (approximately $440) the creditor may petition for the company to be dissolved by the court. Lenders are also able to enforce financial contracts through powers that allow them to foreclose on loan collateral without the intervention of courts. However, loans below Rs 5 million ($435,000) are exempt from the application of the law. Additionally, a judgment ruled that these powers would not apply with respect to collateral provided by guarantors to a loan. These two moves have weakened creditors' rights. Financial institutions also face other legal challenges as defaulters obtain restraining orders on frivolous grounds due to technical defects in the recovery laws. Also, for default cases filed in courts, the judicial process is extremely slow.

The Companies Act of 2007 introduced a "solvency test" to determine the financial health of a company. There are provisions relating to the responsibilities of a company's directors in cases of serious loss of capital. The solvency test is intended to prevent companies without sufficient assets from obtaining loans and to protect rights of creditors.

The Companies Act does not provide for the revival of struggling companies. However, as in the past, it is expected that the courts would take a liberal attitude towards any restructuring plans that may be of benefit to a company.

Investment Protection

The government has entered into 24 investment protection agreements with foreign governments (including the United States) and is a founding member of the Multilateral Investment Guarantee Agency (MIGA) of the World Bank. Under Article 157 of the Constitution of Sri Lanka, investment protection agreements enjoy the force of law and no legislative, executive or administrative action can be taken to contravene them. The government has ratified the Convention on Settlement of Investment Disputes, which provides the mechanism and facilities for international arbitration through the World Bank’s International Center for the Settlement of Investment Disputes (ICSID).

The U.S. Sri Lanka Bilateral Investment Treaty (BIT) was ratified by both governments in 1993 (www.state.gov/documents/organization/43588.pdf). The United States and Sri Lanka hold annual government to government Trade and Investment Framework Agreement (TIFA) talks, which is a forum to seek to resolve trade disputes.

Arbitration

The Arbitration Act of 1995 gives recognition to the New York Convention on Recognition and Enforcement of Foreign Arbitral Awards. Arbitral awards made abroad are now enforceable in Sri Lanka. Similarly, awards made in Sri Lanka are enforceable abroad. A center for arbitration known as the Institute for the Development of Commercial Law and Practice (ICLP) (www.iclparbitrationcentre.com) has been established in Colombo for the expeditious, economical, and private settlement of commercial disputes. However, the ICLP appears unlikely to become involved in disputes involving the Sri Lankan Government, which is often a party to disputes involving foreign investors.

The Labor Department has a process involving labor tribunals for settling industrial disputes with workers or unions, and arbitration is required when attempts to reconcile industrial disputes fail. The Labor Commissioner typically becomes involved in labor-management mediation. Other senior officials, including the Labor Minister, and the President, have intervened in particularly difficult cases.

The government record in handling investment disputes is problematic. Disputes often become politicized, causing the government to put political interests ahead of its respect for the sanctity of contracts.

Investment Disputes Involving U.S. Companies

U.S. companies have experienced problems with payment of valid contracts; implementation of agreements with the government; and inexplicable failure to secure contracts, despite demonstrated superior performance, high value, and competitive bids. In practice, it may be advisable to seek to include provisions for international arbitration.

A U.S. power company producing electricity in Colombo has experienced several difficulties, including late payments by the state owned enterprise, failure to provide required letters of credit, and a retroactive law which requires partial government ownership. The USG has raised this issue in meetings with the GSL but the issue has not been resolved, although the GSL is now current on its payments.

The Ceylon Petroleum Company (CPC) entered into a contract in 2008 with five banks on an oil hedging contract. Although the CPC made money on the contract at first, once the international price of oil declined substantially, the CPC and GSL refused to honor the oil hedging contracts. One American bank is involved. The banks filed for international arbitration. One arbitration decision was in favor of the GSL position, while another arbitration held the GSL has violated contracts.

PERFORMANCE REQUIREMENTS AND INCENTIVES

The Board of Investment specifies certain minimum investment amounts for both local and foreign investors to qualify for incentives. Firms enjoying preferential incentives in the manufacturing sector in most cases are required to export 80% of production, while those in the service sector must earn at least 70% of income in foreign exchange. Sri Lanka complies with WTO Trade Related Investment Measures (TRIMS) obligations.

Sri Lanka encourages both local and foreign investment in tourism and leisure, infrastructure development, knowledge services (including information technology), utilities, apparel, export manufacturing, export services, agriculture and education. Foreign investors are generally not expected to reduce their equity over time, nor are they expected to transfer technology within a specified period of time, except for build-own-transfer or other such projects in which the terms are specified within pertinent contracts.

Foreign investors who remit at least $250,000 can qualify for a one-year resident visa, which can be renewed. Employment of foreign personnel is permitted when there is a demonstrated shortage of qualified local labor. Technical and managerial personnel are in short supply, and this shortage is likely to continue in the near future. Foreign employees in the commercial sector do not experience significant problems in obtaining work or residence permits.

Investment Incentives

INCENTIVES FOR STRATEGIC DEVELOPMENT PROJECTS

Strategic Development Project Act of 2008 provides for tax incentives for large projects identified by the Cabinet of Ministers as Strategic Development Projects (SDP). SDPs are defined as investments which are in the national interest, likely to bring economic and social benefits to the country and change the landscape of the country through the provision of goods and services, substantial inflow of foreign currency, generation of employment and income, and transfer of technology. Information regarding projects selected as SDPs and incentives are published in the government gazette and needs to be approved by the cabinet and the parliament. The incentives become operational upon parliamentary approval. Projects approved under this law are exempted from taxes for up to 25 years. The exempted taxes include corporate income tax, Value Added Tax, Economic Service Charge, Debit Tax, Customs Import and Export taxes, Port and Airport Tax and the Nation Building Tax.

INCENTIVES UNDER SECTION 17 OF THE BOARD OF INVESTMENT (BOI) ACT AND SECTION 17 (A) OF THE INLAND REVENUE ACT

Qualifying Industries and Incentives:

Agriculture, animal husbandry, nontraditional manufacturing exports, specified manufacturing activities for the local market, services, infrastructure projects and any other project considered of having economic benefit to the country and approved by the Ministry of Finance.

Minimum investment of $3 million; 5 year tax holiday
Minimum investment of $5 million: 6 year tax holiday
Minimum investment of $7 million: 7 year tax holiday

Other Incentives: Industries exporting more than 90% of goods or services qualify for duty-free imports of capital goods and raw materials. Other companies qualify for duty free imports of capital goods and construction material during the project implementation period. They will also qualify for free repatriation of profits and dividends and free transferability of shares. An Economic Service Charge (ESC) at 0.25% of income applies to all companies including BOI-approved companies with tax holidays.

INCENTIVES UNDER SECTION 16A AND 16 B OF THE INLAND REVENUE ACT

Qualifying Industries and Incentives:

Fish processing - 5 year tax holiday
Producing and primary processing of agriculture seeds or planting materials - 5 year tax holiday

INCENTIVES UNDER SECTION 16C OF THE INLAND REVENUE ACT

Qualifying Industries and Incentives:

Any manufacturing activity (*) - 3 year tax holiday
Minimum Investment of Rs 50 million ($439,000)
(*) excluding tobacco and tobacco products

PROPOSED INCENTIVE PROGRAMS

The 2012 Government of Sri Lanka budget proposed to extend tax holidays to various industries as follows. The GSL has not yet announced the date of implementation of these proposals, so investors are advised to consult the BOI websites for updates:

Small Scale Enterprises

A 4 year tax holiday for small scale enterprises in agriculture, animal husbandry, fisheries, and creative work, including art work and information technology; Minimum investment of Rs 25 million ($219,000).

Medium Scale Enterprises

A 4 to 6 year tax holiday for medium scale enterprises in manufacturing, agriculture, agro processing, animal husbandry, fisheries, fish processing, IT, Business/Knowledge Process Outsourcing (BPO/KPO), health care, education, beauty care, cold rooms/storages, tourism, sports and fitness centers and creative work including art work; Minimum investment of Rs 50 million to Rs 200 million ($439,000 to $1.75 million).

Large Scale Enterprises

A 6 to 12 year tax holiday for large scale enterprises in agriculture or forestry; manufacturing or processing of non-traditional goods for exports; manufacturing of boats, pharmaceuticals, tires, tubes, motor spare parts, furniture, ceramics, glass ware or other mineral based products, rubber based products, cosmetic products, edible products, construction materials; services provided to a person or partnership outside Sri Lanka; tourism or tourism related projects; infrastructure projects including construction of commercial buildings, internal waterways, related transport (passenger or freight), renewable energy, industrial estates or knowledge cities, urban housing or town centres, sanitation or waste management systems, water services, hospitals and health care services; maintenance of maritime vessels/ aircrafts; sporting services; software development; light or heavy engineering industry; artificial insemination for cattle (dairy development); higher education/skills development/adult education. Minimum investment of Rs 300 million to over Rs 2.5 billion ($2.6 million to over $21.9 million).

Import Replacement Industries

A 5 year tax holiday followed by a concessionary tax rate of 12% for strategic import replacement industries. i.e. cement, steel, pharmaceuticals, fabric, and milk powder; Minimum investment levels apply.

For further information on investment incentives and other investment-related issues, potential investors are encouraged to contact the Board of Investment directly. The BOI can be found at www.investsrilanka.com or reached via e-mail at info@boi.lk. The BOI has introduced an investor matchmaking service via the BOI website. Information regarding this service can be found at www.investsrilanka.com/online_resources/partnership.

Trade Agreements Enhance Market Access To South Asia And Europe

The Indo-Lanka Free Trade Agreement (ILFTA) (www.doc.gov.lk) between Sri Lanka and India, has been in effect since 2000. Under this agreement, most products manufactured in Sri Lanka with at least 35% domestic value addition (if raw materials are imported from India, domestic value addition required is only 25%), qualify for duty free entry to the Indian market. Tariff concessions for Sri Lankan products include zero tariffs on 4,235 items; 50 to 100% reduction for tea and garments under quota; 25% reduction for 553 textile items; and no reduction for 431 items on India's "negative list." Discussions are underway to reduce the negative lists of both countries. Exporters to India have still faced a variety of non tariff barriers which has reduced the effectiveness of the FTA. The two countries are also discussing services sector liberalization, under a proposed Comprehensive Economic Partnership Agreement (CEPA). Other areas potentially covered by the CEPA are investment and economic cooperation. Because production constitutes a portion of value addition, ILFTA and the proposed CEPA enables foreign firms operating in Sri Lanka to gain preferential entry into the Indian market. The CEPA negotiations have stalled, however, and it is not clear that Sri Lanka is interested in finalizing the deal.

The American Chamber of Commerce in Sri Lanka, in a study on the ILFTA, identified agro-processing, food preparation, tea, rubber products, coconut products, spices, furniture, ceramic and confectionary as having growth potential in India. The study also found vehicles and vehicle parts, aircraft parts and motorcycles to be possible attractive sectors for U.S. manufacturers under the Indo-Lanka Agreement.

The 2005 Sri Lanka-Pakistan Free Trade Agreement (SLPKFTA) (www.doc.gov.lk) provides duty-free entry into Pakistan for almost all Sri Lankan exports except those on the negative list. Pakistan’s negative list contains 541 items with no duty concessions. Sri Lanka's Board of Investment promotes the following product sectors under SLPKFTA: spices, coconut based products, animal or vegetable oils, confectionary, processed food, rubber products, ceramics, jewelry, iron and steel, copper and aluminum articles machinery and mechanical appliances, electronics and electrical appliances, medical instruments, and automobiles and spare parts.

Sri Lanka and six other South Asian nations belonging to the South Asian Association for Regional Cooperation (SAARC) agreed in 2004 to establish a South Asian Free Trade Area (SAFTA) (http://www.saarc-sec.org/main.php), which began operation on July 1, 2006. SAFTA offers regionalized tariff reductions for imports from member countries. Stated goals of SAARC members under SAFTA are to reduce duties for imports from member countries to between zero and 5% over a period of 7-10 years. The SAARC trade talks have had limited effect to date on trade and investments.

These agreements could help make Sri Lanka a gateway to South Asia for foreign investors. To date, however, inter-regional trade remains quite low.

Sri Lanka lost duty free privileges for exports to the European Union (EU) enjoyed under the "EU GSP-Plus" incentive agreement in mid 2010 because of the GSL's claimed failure to implement three human rights conventions (the International Covenant on Civil and Political Rights, the Convention against Torture, and the Convention on the Rights of the Child). Under this program, 7,200 Sri Lankan products meeting rules-of-origin criteria had entered the EU duty free.

Many Sri Lankan exports to United States enter duty free under the U.S. Generalized System of Preferences (GSP) program. In 2010 the United States decided to accept for review a petition filed by the AFL-CIO alleging that Sri Lanka was not meeting internationally recognized labor standards. The USG has had a productive dialogue with the GSL. GSP benefits continue throughout the GSP review process.

RIGHT TO PRIVATE OWNERSHIP AND ESTABLISHMENT

Private entities are free to establish, acquire, and dispose of interests in business enterprises. Private enterprises enjoy benefits similar to those granted to public enterprises, and there are no known limitations to access to markets, credit, or licenses. Foreign ownership is allowed in most sectors. Private land ownership is limited to fifty acres per person. The government owns about 80% of the land in Sri Lanka, including the land housing most tea, rubber, and coconut plantations. The government has leased most of these plantations to the private sector on 50-year terms. Although state land for industrial use is usually allotted on a 50-year lease, 99-year leases may also be approved on a case-by-case basis, depending on the nature of the project. There are also substantial land disputes arising from the end of the war, as the government regains control of areas after many years of war. During the war, many records were lost, and with the LTTE (declared a terrorist group by the USG) formerly in control of some areas for up to 20 years, there are likely to be significant disputes on property ownership.

While foreign investors can purchase land from private sellers, the government has imposed a 100% tax on land transfers to foreigners. For this purpose, Sri Lanka has defined foreign investment to involve as little as 25% foreign ownership – a definition that can be particularly difficult for companies listed on the Colombo Stock Exchange since on any particular day, their ownership characteristics may vary. Apartments above the third floor of condominium buildings, land for the development of large housing schemes, hospitals and hotels with a minimum investment of $10 million, exporting companies with a minimum investment of $1 million, and large infrastructure projects with a minimum investment of $50 million are exempted from the tax. Regulations regarding these exceptions were published in Gazette No 1386/18 dated March 30, 2005.

PROTECTION OF PROPERTY RIGHTS

Secured interests in property are recognized and enforced. The legal system is nondiscriminatory and protects and facilitates acquisition and disposition of property rights by foreigners, although it has recently become subject to political influence. A fairly reliable registration system exists for recording private property including land, buildings and mortgages although there are problems due to fraud and forged documents. There are likely to be difficult land disputes in the recently freed northern and eastern regions of the country, following the end of the war.

Intellectual Property Rights Protection

Sri Lanka is a party to major intellectual property agreements including the Bern Convention for the Protection of Literary and Artistic Works, the Paris Convention for the Protection of Industrial Property, the Madrid Agreement for the Repression of False or Deceptive Indication of Source on Goods, the Nairobi Treaty, the Patent Co-operation Treaty, the Universal Copyright Convention, and the Convention establishing the World Intellectual Property Organization (WIPO). Sri Lanka and the United States in 1991 signed a Bilateral Agreement for the Protection of Intellectual Property Rights. Sri Lanka, a WTO member, is also a party to the Trade Related Intellectual Property Rights (TRIPS) agreement in the World Trade Organization. Sri Lanka has not acceded to the WIPO Performances and Phonograms Treaty (WPPT); the WIPO Copyright Treaty (WCT); or the WTO Information Technology Agreement.

Sri Lanka adopted an intellectual property law in 2003 that was intended to meet both U.S.-Sri Lanka bilateral IPR agreement and TRIPS obligations to a great extent. The law governs copyrights and related rights, industrial designs, patents, trademarks and service marks, trade names, layout designs of integrated circuits, geographical indications, unfair competition, databases, computer programs, and undisclosed information. All trademarks, designs, industrial designs and patents must be registered with the Director General of Intellectual Property. Sri Lanka introduced regulations to regulate the commercial use of local creations in 2008.

Infringement of intellectual property rights (IPR) is a punishable offense under the law. Intellectual property rights come under both criminal and civil jurisdiction. Recourse available to owners includes injunctive relief, seizure and destruction of infringing goods and plates or implements used for the making of infringing copies, and prohibition of imports and exports. Penalties for the first offence include a prison sentence of 6 months or a fine of up to Rs 500,000 ($4,425), but smaller penalties are the norm. Penalties can be doubled for a second offense. Aggrieved parties can seek redress for any IPR violations through the courts, though this can be a frustrating and time-consuming process.

Since the passage of the 2003 IPR law, Sri Lanka has slowly begun enforcing its provisions. In 2010, a separate Anti Piracy Unit was created in the Criminal Investigations Division of the Sri Lanka Police. Sri Lanka Customs also created a trade mark database and a separate Intellectual Property Unit within the Social Protection Division, although neither the database nor the Unit is fully functional yet. It is rare for the police to act without a formal complaint and assistance from an aggrieved party. Several offenders have been charged or convicted by courts. However, the minimal damages and suspended sentences imposed suggest that the court system still fails to recognize the significance of intellectual property rights.

Counterfeit goods continue to be widely available in Sri Lanka. Local agents of well-known U.S. and other international companies representing recording, software, movie, clothing and consumer product industries continue to complain that lack of IPR protection is damaging their businesses. Piracy of sound recordings and software is widespread, making it difficult for the legitimate industries to protect their market and realize their potential in Sri Lanka. Software companies complain of the lack of IPR enforcement within government institutions. In December 2009, the government of Sri Lanka approved a new Information Technology (IT) policy for the government sector which includes rules on hardware and software procurement. Both proprietary software and open source software are permitted in government departments. The U.S. Embassy, the United States Patent and Trademarks Office (USPTO), and the American Chamber of Commerce of Sri Lanka are working to pursue more aggressive enforcement and enhance public awareness, including sponsoring IPR workshops for police, judges and senior GSL officials. The police have conducted some raids to seize counterfeit goods.

Patents, Copyrights and Trademarks

Patents are valid for 20 years from the date of application but must be renewed annually. Patents are granted for inventions, with the following exceptions: discoveries, scientific theories and mathematical methods, plant or animal varieties (other than micro biological processes) and essential biological processes for the production of plants and animals (other than non-biological and microbiological processes), business rules and methods, methods of treatment by surgery or therapy, and diagnostic methods practiced on a human or animal body. The law also permits compulsory licensing and parallel imports of pharmaceutical products. Compulsory licensing will allow the government to grant licenses to manufacture certain patented drugs, overruling patent licenses in a national emergency. The parallel imports will allow the import of a branded drug from an alternative source.

Copyrights are not registered. A work is protected automatically by operation of law. Original literary, artistic, and scientific works including computer programs and databases are protected under the new law. There are enforcement limitations applying to copyrights, including software.

Sri Lanka recognizes both trademarks and service marks. The exclusive right to a mark is acquired by registration. A mark may consist of words, slogans, designs, etc. Protection also is available to well known marks not registered in Sri Lanka. Registered trademarks are valid for ten years and renewable. The law also recognizes both certification marks and collective marks.

TRANSPARENCY OF REGULATORY SYSTEM

The Board of Investment strives to inform potential investors about laws and regulations that may affect operations in Sri Lanka. Laws are in place pertaining to tax, labor and labor standards, exchange controls, customs, environmental norms, and building and construction standards. However, some of the laws and regulations are difficult to access.

Foreign and domestic investors often complain that the regulatory system is unpredictable due to outdated regulations, rigid administrative procedures, and excessive leeway for bureaucratic discretion. Effective enforcement mechanisms are sometimes lacking, and coordination problems between the BOI and relevant line agencies frequently emerge. Lethargy and indifference on the part of mid- and lower-level public servants compound transparency problems. Lack of sufficient technical capacity within the government to review financial proposals for private infrastructure projects also creates problems during tendering. An example of weakness in regulations occurred in mid-2006, when police and government agencies closed two satellite television broadcasting stations for not possessing required licenses. The two stations remained closed for over five months, before various government agencies reauthorized their operations.

The Sri Lankan cabinet can approve strategic projects. During the past few years, the Government awarded several key infrastructure projects to Chinese companies outside the tender process. They included a 300 megawatt coal power project, a fuel bunkering project, a large port construction project and an airport project in the southern district of Hambantota, and several road construction projects. In addition, the Government has promised oil exploration rights to India and China outside the tender process. Similarly, in 2008, the government-owned Ceylon Petroleum Corporation signed an agreement with the government of Iran to finance the expansion of the country’s oil refinery. The government had previously signed a Memorandum of Understanding with an American company to negotiate an agreement for the same project. Despite the purported agreement with Iran, the refinery project is still on hold, and it now appears that the Iranian oil refinery project will not go forward. The GSL has been considering other proposals, including by American companies, to build a new oil refinery.

Although many foreign investors, including U.S. firms, have had positive experiences in Sri Lanka, some have encountered significant problems with government practices and regulations. Some multinational firms have experienced extensive unexplained delays in trying to reach agreement on investment projects. Others have had contracts arbitrarily canceled without compensation, even though the Sri Lankan Cabinet had approved those contracts.

Proposed laws and regulations are generally made available for public comment. However, occasionally they are published without public discussion.

EFFICIENT CAPITAL MARKETS AND PORTFOLIO INVESTMENT

Retained profits finance about 70% of private investment, with short term borrowing financing a further 20% of investment. Local companies are allowed to borrow from foreign sources. With the end of the war and rebounding economic activities, opportunities to raise capital through the capital market have expanded. Contrary to expectations, however, the stock market was not used extensively to raise new capital in 2011. The government permitted foreign investments in corporate debentures in December 2011

Foreign direct investment (FDI) finances about 4% of overall investment. Foreign investors are allowed to access credit on the local market. They are also free to raise foreign currency loans..

The state consumes over 50% of the country's domestic financial resources and has a virtual monopoly on the management and use of long-term savings in the country. This inhibits the free flow of financial resources to product and factor markets. For 2012, the government's net borrowing from the local market is forecast to be Rs 270 billion ($2.3 billion). Inflation was brought down to single digit levels in 2010-2011. With the decline in the rate of inflation, the Central Bank reduced key interest rates. Consequently, lending rates for blue chip companies was around 10% in December 2011 compared to over 20% in December 2008. Other companies including SME's face higher rates.

Credit Instruments

Commercial banks are the principal source of bank finance. Bank loans are the most widely used credit instrument for the private sector. Financial institutions also raise syndicated bank loans to fund large-scale investment projects undertaken by the private sector.

The domestic debt market in Sri Lanka is still at a nascent stage. The first credit rating agency in Sri Lanka was Fitch Rating Lanka (www.fitchratings.lk), which opened an office in Colombo in 1999. Fitch Ratings Lanka is a joint venture between Fitch Ratings Inc, International Finance Corporation (IFC), the Central Bank of Sri Lanka, and several leading local financial institutions. Credit ratings are now mandatory for all deposit-taking institutions and for all varieties of debt instruments and have helped numerous Sri Lankan companies raise funds through debt markets.

Sri Lanka received its first sovereign credit ratings in December 2005, with a "BB-minus" from Fitch Ratings and a "B-Plus" from Standard and Poor's (S&P). Current ratings stand at "BB-Minus" with a stable outlook (Fitch), "B-Plus" with a positive outlook (S&P) and “B1” with a positive outlook (Moody’s).

Accounting Standards

There is an active and fairly competent accounting profession, based on the British model. The source of accounting standards is the Institute of Chartered Accountants of Sri Lanka (ICASL), and standards are constantly updated to reflect current international accounting and audit standards adopted by the International Accounting Standards Board (IASB). In addition, Sri Lanka is following the worldwide move to adopt International Financial Reporting Standards (IFRS) for financial reporting purposes set by the IASB. The proposed full convergence is expected for financial periods on or after January 1, 2012. A significant change is expected with full convergence. Due to the lack of an adequate enforcement mechanism, problems with the quality and reliability of financial statements still exist.

Sri Lankan accounting standards are applicable for all banks, stock exchange listed companies and all other large and medium-sized companies in Sri Lanka. Accounts of such business enterprises are required to be audited by professionally qualified auditors holding ICASL membership. ICASL has published accounting standards for small companies as well. The Accounting Standards and Monitoring Board (ASMB) is responsible for monitoring compliance with Sri Lankan accounting and auditing standards. British professional accounting bodies are quite active in Sri Lanka. The Chartered Institute of Management Accountants (CIMA), a leading professional accounting body based in the UK and spread over the Commonwealth, has its largest overseas presence in Sri Lanka.

Securities and Exchange Commission

The Securities and Exchange Commission (SEC) regulates the securities market in Sri Lanka. The SEC covers stock exchanges, unit trusts, stock brokers, listed public companies, margin traders, underwriters, investment managers, credit rating agencies and securities depositories.

Foreign investors can purchase up to 100% of equity in Sri Lankan companies in numerous permitted sectors. In order to facilitate portfolio investments, country funds and regional funds may obtain SEC approval to invest in Sri Lanka's stock market. These funds make transactions through share investment external Rupee accounts maintained in commercial banks.

In a bid to control speculative trade in the Colombo Stock Exchange, the SEC introduced new rules which limited broker credit in 2011, as well as price bands to limit stock volatility. The SEC also started to investigate insider dealing, market manipulation and fraud, but came under pressure from powerful market players who argued that these regulations were depressing stock values. The Chairwoman of the SEC resigned in December 2011 “on principle”, apparently because of these pressures, and the SEC Director General had been transferred one month prior. A new SEC Chairman has been appointed, but concerns exist about the strength of the SEC’s regulations.

Colombo Stock Exchange

The Colombo Stock Exchange (CSE) has fully automated trading, clearing and settlement systems. The CSE maintains a rolling settlement period of 3 days. Twenty-three local and foreign joint venture brokers currently operate at the CSE. Foreign stockbrokers are permitted to hold up to 100% equity in stock brokerage firms operating at the CSE. The SEC has a settlement guarantee fund with an initial capital of Rs 100 million ($877,000), which aims to guarantee the settlement of trades between clearing members of the exchange.

There are 267 companies listed on the stock exchange with the top ten positions by market capitalization held by conglomerates, telecommunication companies, banks, and food and beverage companies. The CSE declined by about 9% in 2011. It was the world’s second best performing stock market in 2009-2010 on post war economic optimism. Excessive speculative investment is blamed for the market downturn. There were 13 new listings in the CSE in 2011. Some of these IPOs saw their share price slump below the issue price immediately after listing in the market. For longer term growth, Sri Lanka’s stock market needs to improve regulation and monitoring and increase liquidity.

Improvements are also needed in corporate governance, accountability, and public disclosure. The Accounting and Auditing Standards Monitoring Board, the Ceylon Chamber of Commerce, the Colombo Stock Exchange, and professional accounting bodies are taking initiatives in these areas.

Acquisition of companies through mergers and acquisitions is governed by the Takeovers and Mergers Code of 1995 made under the Securities and Exchange Commission of Sri Lanka Act. This law applies only to companies listed on the Colombo Stock Exchange. It is modeled on the lines of the London City Code on Takeovers and Mergers. Acquisition of more than a 30% stake of a listed company requires the buyer to make an offer to all other shareholders. The articles of association of a few listed companies restrict foreign equity to certain levels.

Banking System

Sri Lanka has a fairly well diversified banking system. There are 22 commercial banks – eleven local and eleven foreign. In addition, there are 9 local specialized banks. Citibank NA is the only U.S. bank operating in Sri Lanka. Several domestic private commercial banks now have substantial government equity acquired through investment agencies controlled by the government.

The Central Bank is responsible for supervision of all banking institutions. It has driven improvements in banking regulations, provisioning, and public disclosure of banking sector performance. Credit ratings are mandatory for all banks operating in Sri Lanka. The Central Bank has accepted the Basel II standardized approach framework. The Central Bank has also developed a road map for the implementation of International Accounting Standards on Financial Instruments for banks by January 1, 2012. Nevertheless, the Central Bank still suffers from lack of autonomous authority, especially with regard to the large state-owned banks.

Sri Lanka has enacted laws to deal with money laundering and terrorist financing. These laws were amended in 2011. The amendments sought to address shortcomings identified by international and regional bodies. According to the Central Bank of Sri Lanka, with the amendments Sri Lanka’s Anti Money Laundering (AML) and Countering Financing Terrorism (CFT) regimes are now fully compliant with the international standards.

The Bank Supervision Department of the Central Bank supervises and examines financial institutions for compliance with anti-money laundering and terrorist financing regulations. A Financial Intelligence Unit (FIU) was created in 2006, and operates under the Central Bank. The Financial Intelligence Unit has issued instructions to banks, finance and insurance companies, and the securities industry regarding anti-money laundering and terrorist financing regulations. The FIU has also issued rules on "know your customer" and "customer due diligence" to these entities.

In late 2008, the Central Bank dissolved the board of directors of a private local bank, Seylan Bank, following a financial scandal at a non-regulated large finance company connected to the bank. Since then, the Seylan Bank has been restructured with equity from new shareholders. The bank has returned to normal business activity with a board of directors appointed by the new shareholders.

The Central Bank also took control of several non-bank finance companies connected to the failed finance company. These companies are being restructured through mergers. Weaknesses in smaller finance and leasing companies exposed to real estate remain a concern.

An international credit rating agency has recently expressed concerns about Sri Lanka’s financial system due to rapid credit growth and rising asset prices.

State-Owned Banks

Total assets of commercial banks stood at Rs 2,969 ($27 billion) as of December 31, 2010. The fully two state-owned commercial banks, Bank of Ceylon and People’s Bank, with assets of Rs 715 billion ($6.5 billion) and Rs 548 billion ($5.0 billion) respectively, are still important players, accounting for over 40% of all assets.

The two state banks are inefficient. Both these banks have significant exposure to the state and state-owned companies, which are treated as performing loans. However, as these banks are implicitly guaranteed by the state, their problems have not harmed the credibility of the rest of the banking system. Non-performing loan ratio was 3.3% at Bank of Ceylon and 5.6% at People’s Bank.

Private Commercial Banks and Foreign Banks

Private commercial banks and foreign banks operating in Sri Lanka generally follow more prudent credit policies and, as a group, are in better financial shape. Foreign banks tend to make provisions in line with international best practices, as most foreign bank branches are subject to host country supervision in addition to that of the Central Bank of Sri Lanka.

Non-performing loans of the banking sector, which increased in 2008-2009, declined to 4.3% in 2011.

Capital Adequacy

Sri Lanka adopted capital adequacy standards set by the Basel Committee on banking regulations and supervisory practices in 1993. The minimum capital adequacy ratio required by the Central Bank is 5% for core capital (Tier I) and 10% for risk weighted assets (Tier I and Tier II). The Central Bank adopted Pillar 1 of Basel II capital adequacy standard for all banks in 2008.

Capital adequacy in the banking sector was 14% in 2011. The Bank of Ceylon's capital adequacy ratio is well within Central Bank requirements. Following issuance of debentures in 2008-2009, People's Bank reported CAR ratio of 12.8% in 2010, which is within Central Bank requirements.

COMPETITION FROM STATE-OWNED ENTERPRISES (SOE)

SOE's are active in transport (bus and railways, ports and airport managements, air line operations), utilities such as electricity, petroleum imports and retail, water supply, banking and telecommunications, TV and Radio broadcasting, newspaper publishing, banking and insurance. In recent months, Sri Lankan armed forces have entered commercial activities crowding out some private investment. They operate air services, shipping services, tourist resorts and farms for civilian purposes.

Directors of SOE's are appointed by the cabinet or a line Ministry. They report to line Ministries. The board seats are allocated to both senior government officials and politically-affiliated individuals. Senior management positions such as the post of CEO are most often allocated to politically-affiliated individuals.

Sri Lanka does not currently have a sovereign wealth fund (SWF).

CORPORATE SOCIAL RESPONSIBILITY (CSR)

Leading companies in Sri Lanka are actively promoting CSR. Some SME companies have also started to promote CSR. The Ceylon Chamber of Commerce (CCC), the largest business chamber in Sri Lanka, has a CSR section promoting CSR among its membership. CCC also has an annual "Best Corporate Citizens" award to encourage CSR activities. In addition, a professional accounting body has a program to promote sustainability reporting. Internationally, some of Sri Lanka's leading companies have joined the UN Global Compact initiative. The apparel industry, Sri Lanka’s largest export industry, has a specially designated CSR program for the industry under the title "Garments without Guilt" (www.garmentswithoutguilt.com). The ethical sourcing and sustainable development practices under the program aim to empower women and their communities through poverty alleviation and opportunities for education and personal growth. In addition, the program endeavors to promote sustainable eco-friendly manufacturing practices in the apparel industry. Firms who pursue CSR are viewed favorably by Sri Lanka’s business sector, resulting in positive media attention.

POLITICAL VIOLENCE

The Sri Lankan government's military campaign against the Liberation Tigers of Tamil Eelam (LTTE) ended in May 2009 with the defeat of the LTTE. During the war, the LTTE had a history of attacks against civilians, though none were directed against U.S. citizens. There have been no terrorist attacks since the end of the conflict, and the government has authority throughout the island.

During the two and half decades of war, foreign tourists and foreign business representatives were not LTTE targets, but they were injured in attacks on other targets. In 2001, the LTTE attacked Colombo's international airport and destroyed commercial and military aircraft. Sri Lankan Airlines lost several commercial aircraft in the attack. Prior to 2001 the LTTE attacked several foreign-flagged commercial ships in the waters off the north and east of the country. The LTTE also bombed Colombo’s financial and business districts, causing numerous casualties and extensive damage to property.

In 1997, the United States designated the LTTE as a Foreign Terrorist Organization (FTO). The LTTE remains on the U.S. list of designated terrorist organizations. In 2007, the United States froze the assets of, and blocked transactions with, the Tamils Rehabilitation Organization (TRO), a U.S.-registered non-profit group, on the grounds that it provided support for the LTTE.

In May 2011, workers at the Katunayake Export Processing Zone, the country’s largest EPZ, held a massive protest demanding the withdrawal of a proposed new pension plan covering all private sector employees. The government had bypassed the tripartite labor consultations with workers and employers and submitted the proposal to parliament with little notice. The protest led to a violent clash between the workers and the police. The clashes resulted in the death of one EPZ worker and injuries to a number of protestors and police officers, and damage to several factories. One worker died, while several hundred were injured. The GSL closed the EPZ for two days as a precautionary measure. Following the clash, the government withdrew the pension bill, and the head of the police resigned.

Spontaneous demonstrations take place in Sri Lanka from time to time in response to world events or local developments. Demonstrations near Western embassies are not uncommon, although in many cases they are protests aimed at the GSL, and are near the embassies due to the vicinity of GSL buildings.

CORRUPTION

Corruption in Sri Lanka

Public sector corruption, including bribery of public officials, remains a significant challenge for U.S. firms operating in Sri Lanka. While the country has generally adequate laws and regulations to combat corruption, enforcement is weak and inconsistent. U.S. firms identify corruption as a constraint on foreign investment, but, by and large, it is not a major threat to operating in Sri Lanka – at least once a contract has been won. Corruption appears to have the greatest effect on investors in large projects and on those pursuing government procurement contracts.

There is a consensus that corruption is rampant in Sri Lanka. In Transparency International's Corruption Perception Index for 2011 Sri Lanka ranks 86th with a score of 3.3 out of a possible 10 points, a slight improvement from a score of 3.2 in 2009 and 2010. The World Bank Control of Corruption Index, which ranges from -2.5 to +2.5, has deteriorated to -0.36 in 2009 from -0.16 in 2004. In a 2006 USAID Democracy and Governance assessment, anecdotal evidence from the private sector indicated that the percentage of a public sector contract paid in bribes nearly tripled. According to Transparency International, corruption is a serious problem threatening democratic and economic development in Sri Lanka. Corruption exists in all spheres of society, in the public, private and not for profit sectors alike. High tolerance of corruption, non-sanctioning of corrupt behavior and a culture that tends not to question authority all provide an environment in which corruption can flourish. Transparency International identifies corruption as a systemic problem.

Sri Lanka ratified the UN Anti-Corruption Convention in 2004. Sri Lanka has signed but not ratified the UN Convention against Transnational Organized Crime. Sri Lanka became a signatory to the OECD-ADB Anti-Corruption Regional Plan in May 2006.

Bribery Commission Not Effective

The Bribery Commission, the main body responsible for investigating allegations of bribery and corruption, was reconstituted in May 2011. It was rendered inactive for over a year after the expiry of the term of office of the previous commissioners. In early 2011 the GSL also transferred 56 police officers assigned to the Bribery Commission, and appointed 56 new officers who have not been screened or trained in anti-corruption work.

The function of the Commission, under Act No 19 of 1994, is to investigate allegations brought to its attention and to institute proceedings against responsible individuals in the appropriate court. The law states that a public official's offer or acceptance of a bribe constitutes a criminal offense and carries a maximum sentence of seven years imprisonment and a fine at the discretion of the courts. A bribe by a local company to a foreign official is not covered by the Bribery Act.

The Bribery Commission has recently investigated corruption charges involving junior and mid level public officers. Large scale corruption is not investigated.

Several other government entities try to address corruption, the most important being the Auditor General's Department. However, there is confusion regarding mandates, with these institutions frequently interpreting their mandates narrowly and thus inhibiting their effectiveness.

BILATERAL INVESTMENT AGREEMENTS

The Government of Sri Lanka has signed investment protection agreements with the United States (which came into force in May 1993) and with the following other countries:

1. Belgium
2. People's Republic of China
3. Denmark
4. Egypt
5. Finland
6. France
7. Germany
8. Indonesia
9. India
10. Iran
11. Italy
12. Japan
13. Korea
14. Luxembourg
15. Malaysia
16. Netherlands
17. Norway
18. Romania
19. Singapore
20. Sweden
21. Switzerland
22. Thailand
23. United Kingdom

Taxation

A bilateral treaty between Sri Lanka and the United States to avoid double taxation was ratified and entered into force on June 12, 2004.

Foreign investors not qualifying for Board of Investment incentives such as tax and exchange control exemptions or concessions are liable to pay taxes on corporate profits, dividends, and remittances of profits. They are also liable to pay a Value Added Tax on goods and services.

An Economic Service Charge (ESC) at 0.25% of income applies to BOI-approved companies enjoying tax holidays. The Embassy encourages prospective U.S. investors to contact an international auditing firm operating in Sri Lanka to assess their tax liability.

OPIC AND OTHER INVESTMENT INSURANCE PROGRAMS

The United States and Sri Lanka concluded in 1966 (and renewed in 1993) an agreement that allows the Overseas Private Investment Corporation (OPIC) to provide investment insurance guarantees for U.S. investors. OPIC currently provides coverage to banking and power sector investments in Sri Lanka. Sri Lanka's membership in the Multilateral Investment Guarantee Agency (MIGA) offers the opportunity for insurance against non commercial risks.

The U.S. Embassy and other U.S. Government institutions spend tens of millions annually in Sri Lanka. This amount can potentially be utilized by OPIC to honor an inconvertibility claim; however, no such claims have been made to date in Sri Lanka. The Embassy purchases local currency at the financial rate.

LABOR FORCE

Sri Lanka's labor force is literate (particularly in local languages) and trainable, although weak in certain technical skills and the English language. The average worker has eight years of schooling. Two-thirds of the labor force is male.

In 2011, 7.5 million Sri Lankans were employed, with 43% in services, 24% in industry and 34% in agriculture jobs. Overall, 43% of the workforce is in the private sector and 14% in the government. Self employed workers constitute 31% of all employed while another 11% were unpaid family workers. About 61% of the employed are in the informal sector.

The unemployment rate has declined in recent years to around 5%. The rate of unemployment among women and high school and college graduates, however, has been proportionally higher than the rate for less-educated workers. Youth and entry-level unemployment and underemployment remain a problem. Unemployment rates are lower in part due to a large outflow of Sri Lankan migrant labor. A significant proportion of unemployed people seek "white collar" jobs, often preferring government jobs. However, most sectors seeking employees offer manual or semi-skilled jobs or require technical or professional skills such as management, marketing, information technology, accountancy and finance, and English language proficiency. The construction, plantation and apparel industries report a shortage of workers. Some investors have faced problems in finding sufficient employees with the requisite skills.

The government has initiated educational reforms it hopes will lead to better preparation of students and better matches between graduates and jobs. More computer, accounting and business skills training programs and English language programs are becoming available. But the demand for these skills still outpaces supply.

Migrant Workers Abroad

There are an estimated 1.7 million Sri Lankan workers abroad. Remittances from migrant workers, at $5 billion, are Sri Lanka’s largest source of foreign exchange. The majority of this labor force is unskilled (housemaids and factory laborers) and located primarily in the Middle East, but Sri Lanka is also losing many of its technically and professionally qualified workers to more lucrative jobs abroad. Despite the global slowdown, remittances from migrant workers abroad increased substantially in 2009-2011.

Wages and Holidays

Labor is available at relatively low cost, though it is priced higher than in some other South Asian countries. Productivity lags behind other countries in Asia. Child labor is prohibited and is virtually nonexistent in the organized sector, although child labor occurs in informal sectors. The minimum legal age for employment is set at 14. Most permanent full time workers are covered by laws pertaining to maximum hours of work, minimum wage, leave, the right of association, and safety and health standards.

Many believe that Sri Lanka's labor laws and its numerous official holidays dampen productivity. The full moon day of each month (sacred in the Buddhist faith), if it falls on a weekday, is a paid holiday. There are eight other public holidays. The public sector and banks enjoy additional holidays. These statutory holidays are in addition to 21 days of annual/casual leave and approximately 21 days of sick leave (the number of days for sick leave is at the discretion of the management). Further, female employees are entitled to 84 days fully paid maternity leave for the first two pregnancies. Female workers are permitted 60 hours of overtime work per month.

Termination Laws

The Termination of Employment of Workmen Act (TEA) makes it difficult to fire or lay off workers who have been employed more than six months for any reason other than serious, well-documented disciplinary problems. Disputes over dismissals can be brought to a labor tribunal administered by the Ministry of Justice. The labor tribunals have large backlogs of unresolved cases. Certain labor disputes founded upon fundamental rights (allegations of termination/transfers based upon discrimination, etc.) can be brought directly to the Supreme Court. Recent amendments to the Industrial Disputes Act (IDA) include labor dispute resolution rules to expedite the dispute process.

The government has introduced a standard compensation formula under the TEA to facilitate termination. The compensation formula takes into account the number of years of service and offers 2.5 months salary as compensation for 1 year of service, 12.5 months salary for 5 years of service; 38 months for 20 years and up to a maximum of 48 months salary for 34 years service. According to the World Bank's Doing Business 2009 report, Sri Lanka's firing cost is among the highest in the world. For example, Sri Lanka's firing cost for 20 years of service, at 38 months, compares with Pakistan and Nepal's 22.5 months, India's 19.6 months, Malaysia's 18.5 months, China's 13.2 months and Bangladesh's 11.7 months. The Labor Commissioner's approval or the affected employee's consent is required to fire workers. The Labor Commissioner's approval is often subject to delays of around 6-7 months. Employers complain that the package is excessive, especially compared to international norms. They have also pointed out that higher compensation could adversely affect companies requiring restructuring, and discourage investment.

Trade Unions

About 20% of the 7.5 million-strong work force is unionized, but union membership is declining. There are more than 1,900 registered trade unions (many of which have 50 or fewer members), and 19 federations. About 15% of labor in the industry and service sector is unionized. Most of the major trade unions are affiliated with political parties, creating a highly politicized labor environment. In many cases several unions, affiliated with different political parties, work together at state-owned enterprises. This is not the case for private companies, which only have one union or perhaps a workers' council to represent the employees. Several trade unions with affiliations to major political parties have formed themselves into an organized group, the National Association for Trade Union Research and Education (NATURE), to promote education and training among trade unionists.

All workers, other than police, armed forces, prison service, and those in essential services, have the right to strike. By law, workers may lodge complaints to protect their rights with the commissioner of labor, a labor tribunal, or the Supreme Court. The president retains the power to designate any industry as an essential service.

Unions represented workers in many large private firms, but workers in small-scale agriculture and small businesses usually did not belong to unions. The tea industry, however, is highly unionized. Public sector employees were unionized at very high rates. Labor in export processing zone enterprises tends to be represented by non-union worker councils.

Many private companies in the export processing zones have worker’s councils, although there are also unions in the EPZs. These worker councils have functioned well in some companies in providing for worker welfare. The BOI has requested that companies recognize trade unions, allow union access to export processing zones, and accept the right to collective bargaining. The BOI has issued guidelines for the formation and operation of employee councils, giving powers to employee councils to negotiate binding collective agreements. According to the BOI, where both a recognized trade union with bargaining power and a non-union worker council exist in an enterprise, the trade union will represent the employees in collective bargaining.

Unions have complained that the Board of Investment and some employers, especially in the BOI-run export processing zones, prohibit union access and do not register unions on a timely basis. Employers allege that the JVP, a Marxist political party opposed to private enterprise, could provoke labor to strike under the pretense of trade union activity. Due to the JVP's violent past, employers are generally not in favor of it or its trade union arm, the Inter-Company Trade Union. There are also a number of independent unions.

The International Labor Organization's (ILO) Freedom of Association Committee has observed that Sri Lankan trade unions and employee councils can co-exist, but advises that there should not be any discrimination against those employees choosing to join a union. The right of employee councils to engage in collective bargaining has been held as valid by the ILO.

In 2010, the United States government accepted to review a petition submitted by the American Federation of Labor and Congress of Industrial Organizations (AFL-CIO) to the United States Trade Representative seeking suspension of Generalized System of Preferences (GSP) benefits for Sri Lanka due to alleged labor rights violations in some factories in the export processing zones. Following the acceptance of the petition, the governments of the United States and Sri Lanka have entered into consultations.

The government issued new rules on union elections in 2011. Further, the BOI established “facilitation centers” for unions to meet members and other workers in the three largest EPZs.

Collective Bargaining

Collective bargaining exists but is not universal. Employers' Federation of Ceylon, the apex employers association in Sri Lanka, assists its member companies to negotiate with unions and sign collective bargaining agreements. While about a quarter of the 533 members of the Employers' Federation of Ceylon are unionized, 120 of these companies (including a number of foreign-owned firms) are bound by collective agreements. A further 24 have signed Memorandums of Understanding with trade unions. As of January 2010, there were only four collective bargaining agreements signed in companies located in export processing zones.

Labor-Management Relations

Formerly confrontational labor-management relations have improved in the last few years as employers have worked harder to motivate and care for workers. Work stoppages and strikes in the private sector are on the decline, and there were few strikes in 2011. While labor-management relations vary from organization to organization, managers who emphasize communication with workers and offer training opportunities generally experience fewer difficulties. U.S. investors in Sri Lanka (including U.S. garment buyers) generally promote good labor management relations and labor conditions that exceed local standards.

ILO Conventions

Sri Lanka is a member of the International Labor Organization (ILO) and has ratified 31 international labor conventions. The labor laws of Sri Lanka are laid out in almost 50 different statutes. The Ministry of Labor has published a Labor Code, consolidating important labor legislation. Sri Lanka has ratified all eight of the core labor conventions included in the 1998 ILO Declaration on Fundamental Principles and Rights at Work. ILO Convention 138 on minimum age for admission to employment and Convention 182 on worst forms of child labor were ratified during 2000-2001. Sri Lanka ratified ILO convention 105 on Forced Labor in 2003. The ILO and the Employers' Federation of Ceylon are working to improve awareness of core labor standards. The ILO also promotes its Decent Work Agenda program in Sri Lanka.

FREE TRADE ZONES

Sri Lanka has 10 free trade zones, also called export-processing zones, administered by the BOI. The oldest, the Katunayake and Biyagama Zones, located north of Colombo near the Bandaranaike International Airport, are fully occupied. The third zone is located at Koggala on the southern coast. Several mini export-processing zones are located in provinces. There are nearly 200 foreign export processing enterprises operating in all of these zones. There are also two industrial parks that have both export-oriented and non-export oriented factories. In addition, a large private apparel company opened Sri Lanka's first privately run fabric park in 2007. The company invites local and foreign companies to set up fabric and apparel factories in this eco-friendly park.

In the past, firms preferred to locate their factories near Colombo harbor or airport to reduce transport time and cost. However, excessive concentration of industries around Colombo has caused heavy traffic, higher real estate prices, environmental pollution, and scarcity of labor. The BOI and the government now encourage export-oriented factories to set up in industrial zones farther from Colombo. However, Sri Lanka's poor roads make these outlying zones more challenging. There are now two garment factories established in eastern Sri Lanka, for example, which provide additional sources of workers. The government has embarked on a substantial plan to improve road infrastructure island wide, including a new road from Colombo to the airport.

FOREIGN DIRECT INVESTMENT TRENDS

From 2006-2010, foreign direct investment (FDI) flows to Sri Lanka averaged only about $500 million per year. Although final statistics have not been released, there are indications that there was $1 billion in 2011, mainly for ports and tourism projects.

U.S. Investments

Total cumulative U.S. investment in Sri Lanka is estimated to be in the range of $200 million. Major U.S. investors include: Energizer Battery, Mast Industries, Smart Shirts (a subsidiary of Kellwood Industries), Chevron, Citibank, 3M, Coca-Cola, Pepsi Co, Fitch Ratings, AES Corporation, AIG/Chartis Insurance, American Liquid Packaging Systems USA, Virtusa, Avery Denison, North Sails, Motorola Solutions, Amsafe Bridport, RR Donnelly and Revlon (through its Indian subsidiary). Several Sri Lankan-Americans have started IT and BPO companies in Sri Lanka serving the US market. In addition, IBM, NCR, Procter & Gamble, Sun Microsystems, Microsoft, Intel, Oracle, DuPont, Bates Strategic Alliance, McCann-Erickson, Pricewaterhouse Coopers, Ernst and Young, and KPMG all have branches, affiliated offices or local distributors/ representatives. Kentucky Fried Chicken, Pizza Hut, Federal Express, UPS, and McDonald's are represented in Sri Lanka through franchises. Numerous other American brands and products are represented by local agents.

Non-U.S. Investments

Leading sources of foreign direct investment in Sri Lanka are Malaysia, the United Kingdom, the United States, Singapore, India, China, the UAE, and Korea. Major non-U.S. investors include: Unilever, Nestle, British American Tobacco Company, Mitsui, Pacific Dunlop/Ansell, Prima, FDK, Telekom Malaysia Bhd, S.P. Tao, HSBC, the Indian Oil Corporation and Bharathi Airtel of India. In 2011, Shangri La signed agreements to build hotels in Sri Lanka. Leading U.S. and foreign investors that have acquired significant stakes in privatized companies include Chevron, Hanjung Steel of Korea, Mitsubishi Corporation and C. Itoh (A.K.A. Itochu) of Japan, and the Indian Oil Corporation.

Web Resources

Board of Investment of Sri Lanka: www.boi.lk or www.investsrilanka.com
International Monetary Fund (IMF) Sri Lanka country information: www.imf.org/external/country/LKA/index.htm
Article VIII obligations of the International Monetary Fund: www.imf.org/external/pubs/ft/aa/aa08.htm
U.S. Sri Lanka Bilateral Investment Treaty: www.state.gov/documents/organization/43588.pdf
Institute for the Development of Commercial Law and Practice: www.iclparbitrationcentre.com
Indo-Lanka Free Trade Agreement: www.doc.gov.lk
South Asian Free Trade Area: www.saarc-sec.org/main.php
Fitch Ratings Lanka: www.fitchratings.lk
Garments without Guilt program of the apparel industry: www.garmentswithoutguilt.com
Transparency International Sri Lanka: http://www.tisrilanka.org/
Doing Business 2012, World Bank: http://www.doingbusiness.org/



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