A shift that expands the net

Sri Lanka’s 2026 Budget introduces a decisive tax reform: the reduction of the Value Added Tax (VAT) and Social Security Contribution Levy (SSCL) registration thresholds from Rs. 60 million to Rs. 36 million per year. The change brings thousands of small and medium enterprises into the VAT regime.

KPMG’s Head of Tax and Regulatory, Suresh Perera, called it a consequential shift for local businesses. The government avoided new taxes but widened the base. Perera noted that broader liability improves VAT effectiveness but accepted the move will be unpopular among smaller operators.

Why the threshold matters

Under the former threshold, only firms exceeding about Rs. 5 million per month had to register. The new level captures businesses from roughly Rs. 3 million per month.

  • Cash flow strain: VAT on taxable sales compresses liquidity for margin-tight SMEs.
  • Administrative load: VAT-compliant invoicing, input-tax records, and digital filings add overheads.
  • Price adjustments: Many will reprice to include VAT, affecting demand and competitiveness.

Fragmented supply chains especially retail distributors and service providers will feel the shift first as VAT inclusion alters pricing across tiers.

The broader fiscal objective

Budget 2026 targets Rs. 5,305 billion in total revenue, with Rs. 4,850 billion from taxes and Rs. 455 billion from non-tax sources. VAT, external-trade duties, and excise taxes remain core. Lowering the threshold captures more domestic activity, supports tax-to-GDP improvements, and aligns with IMF-linked fiscal discipline.

Perera warned that the reform’s success depends on smooth onboarding. If processes are cumbersome, compliance will suffer.

Audits and the risk-based framework

KPMG Partner Hasitha Radella said the budget signals policy maturity but demands stronger enforcement to achieve an 8.5% rise in income-tax revenue and a 3% increase in indirect taxes. From January 2026, the IRD will adopt a risk-based audit framework using analytics via a Risk Management Unit and, if needed, review committees.

Radella welcomed the approach but noted audits in 2024 were costly and time-consuming. Without integrated digital systems and better taxpayer services, adding thousands of VAT registrants risks backlogs.

Sectoral impact

Retail and wholesale trade

Newly liable distributors and suppliers will see tighter margins and possible retail price increases. Consumer purchasing power may face renewed pressure in early 2026.

Professional and creative services

Legal, consulting, advertising, and design firms will bear new compliance work. Many run low-capital, high-turnover models that now meet VAT liability. Expect renegotiated fee structures and tighter billing controls.

Manufacturing and export SMEs

Exporters can claim input VAT, but refund delays can strain cash cycles. Firms serving domestic and export markets will need stronger treasury planning.

Hospitality and tourism

Hotels and travel operators will add reporting obligations. Some may repackage services or adopt tiered pricing to manage incidence.

Compliance as a competitive edge

  • Digital adoption: Cloud accounting and e-invoicing automate VAT and filings.
  • Transparency and bankability: VAT registration signals formality and helps with credit and tenders.
  • Level playing field: Consistent taxation reduces undercutting by informal operators.

For progressive firms, compliance becomes a credibility signal, not just a cost.

Navigating the transition

  1. Audit turnover: Project 12-month revenue against Rs. 36 million; register early if liable.
  2. Implement digital systems: Use software that automates VAT computations and returns.
  3. Update contracts: Standardise VAT-inclusive clauses with suppliers and clients.
  4. Educate staff: Train on invoice formats, input credits, and filing timelines.
  5. Seek advice: Use tax advisors for mixed supplies, exemptions, and refund planning.

Policy outlook

The threshold cut favours collection depth over new levies. Done well, it builds fiscal credibility and reassures partners. Execution risk is high. The IRD must strengthen online services, simplify registration, and communicate clearly. Otherwise, SMEs may see VAT as punitive and drift into informality.

Peer programmes show VAT expansion works when paired with digital transparency, simpler filing, and visible reinvestment that supports SMEs. Sri Lanka can draw on those lessons.

Balancing fiscal goals and business reality

The measure widens the tax base and aims to stabilise revenue. Businesses face tighter margins, more paperwork, and new tech requirements. Success hinges on facilitation digital tools, guidance, and practical support.

Over time, transparent taxation can strengthen both state revenue and private-sector credibility. In the short term, adaptation is key. The message for 2026 is clear: prepare early, modernise systems, and treat compliance as an investment in growth.