SRI LANKA’S CONSTRUCTION INDUSTRY IN CRISIS
In any country, the performance of the construction industry is often considered as a barometer of economic development. At present, our construction industry is plagued by low construction volume, skilled worker shortage, high construction costs and unequal competition from foreign contractors.
A clear indication on low construction volume is the 7 percent drop in cement consumption in 2018, compared to 2017. The construction industry contributes about 9 percent to gross domestic product (GDP) employing about 600,000. In recent years, the total annual construction turnover is about Rs.800 billion, which is expected to increase if the investments planned by the government materialize.
To overcome the present foreign exchange crisis, one of the most viable solutions will be to attract many export-oriented industries through foreign direct investments (FDIS), capitalizing on our strategic location. But our high construction cost, which will increase the setting up costs of an industrial venture, could act as a disincentive to attract FDIS needed to spur economic growth.
From a comparison given below on the construction of middle-class housing, it is evident that our unit cost of construction is the highest in the region, second only to Singapore (which is a well-developed country with a very high per capita GDP). See Table 1.
The following are some measures that can be taken to reduce the construction cost.
NBT on construction contracts
Earlier, the Nation Building Tax (NBT) was not applicable to construction contracts. It was introduced by the budget for 2017. The introduction of NBT on construction contracts has a cascading effect due to the nature of the construction projects, which have several layers of subcontractors and specialist contractors (e.g. piling, air conditioning, electrical, lifts installations, etc., which will be constituent components of a main contract).
Also, with the present operation of NBT, there is a tax on tax situation as Value-added Tax (VAT) is charged on the NBT as well. Considering the above, it may be prudent to completely withdraw the NBT on construction contracts, which was the practice up to 2017.
WHT on construction sector services
With the introduction of the Withholding Tax (WHT), with effect from April 1, 2018, 5 percent WHT is to be deducted from work subcontractors and other small service providers, if the monthly payment exceeds Rs.50,000. But for employed persons, the pay as you earn tax is applicable only when the monthly gross salary exceeds Rs.100,000.
As these small-scale sub-contractors are not registered with the Inland Revenue Department, this WHT cannot be recovered by them and as such become an additional cost on the main contractors in the end. Therefore, it is proposed to increase the threshold of Rs.50,000 to Rs.200,000 for 5 percent WHT.
High cost of imported materials
As stated before, our unit construction cost is the highest in the South Asian region.
A main reason is the five different taxes imposed on many imported construction materials. The aggregate effect of these five taxes for ceramic tiles amounts to 107.6 percent of the CIF value. As the majority of the construction materials are imported with the application of such taxes, it is no wonder that our construction cost is the highest.
These taxes applicable to ceramic tiles and sanitary ware are described in Table 2, for a CIF value of Rs.100.00. On top of these, the importers have to pay the port charges as well.
It defies any logic that the NBT and VAT are charged even on the other three taxes, viz. Customs Duty, Cess and Port and Airport Development Levy (PAL).
Reducing construction cost
To reduce the construction cost and rationalize the tax calculations, following is proposed on import of construction materials.
Limit Cess Levy to 15 percent on all imported construction materials and charge only on the CIF value.
Withdraw the PAL and NBT completely on all imported construction materials.
Compute the VAT wherever applicable only on the CIF value to avoid tax on tax.
With the above proposals, the total taxes will reduce to 60 percent as against the present 107.62 percent. We consider the margin of 45 percent (60 percent - VAT) is sufficient to protect the local manufacturers.
Supply of sand for construction work
The government has very correctly imposed restrictions on mining river sand and transporting it, due to the massive environment damage caused due to the excessive mining. The total annual requirement of sand is estimated at 21 million cubic meters (MCM).
The alternatives to river sand are the mechanically washed and sieved offshore sea sand and manufactured sand by crushing rock. The annual supply of offshore sea sand and manufactured sand is not more than 3 MCM. As such, 18 MCM is still obtained from river beds. Out of this 18 MCM, nearly 30 percent or 5.0 MCM of river sand are transported illegally without permits.
The price of river sand in Colombo is Rs.18,000 per cube (2.83 CM), whereas washed and sieved offshore sea sand price is Rs.10,300/ cube in Nawala.
The only way to curb illicit river sand mining and transport is by making the cheaper sea sand available abundantly to meet the construction demand. This will reduce the demand for river sand and at the same time reduce construction costs.
At present, offshore sea sand is pumped only at Muthurajawela by Sri Lanka Land Reclamation and Development Corporation (SLLRDC). But their present maximum annual supply capacity is only 350,000 CM. Even with the expected addition of a second washing plant at Muthurajawela, the supply capacity will increase only to 1,300,000 CM. But to make an impact on the market to reduce price, the annual supply of sea sand should be targeted at minimum of 5,000,000 CM.
As such in parallel to SLLRDC supply at Muthurajawela, there should be another two supply points to pump sand from deep sea. One of the biggest constraints to pump sea sand, wash and sieve is the large extent of land needed closer to the beach and a fresh water source. As pumping has to be done during a short period of one to two months, due to the high cost and need to avoid rough weather during monsoons, to undertake the supply of 2,000,000 CM of sea sand annually will need a land in extent of 25 ha.
The government should make available a land in extent of 25 ha near Chilaw closer to the beach on a concessionary lease with a 10-year tax holiday to set up an operation to pump sand from deep sea, stockpile and supply after washing and sieving. For this purpose, even the former VOA land at Iranawila will be suitable.
The other alternative to reduce the demand for river sand is to promote the manufacture of rock sand. There are few companies that have set up manufacturing plants to produce rock sand. But when selling this sand to house builders and small contractors, the producers are at a disadvantage. This is as the manufactured sand is liable to VAT, whereas offshore sand and river sand are not liable. As such, it is proposed to exempt manufactured sand also from VAT.
Competition to local companies
The local construction companies are at a tremendous disadvantage when competing with some of the foreign contractors, due to various incentives provided by the foreign governments to them with cheaper import of materials and access to concessionary working capital.
In addition, some of these companies continue to use construction machinery imported on a duty free basis in the past for foreign funded projects, on new projects for which such facilities are not available. As a result, in some recent tenders, the foreign contractors, especially Chinese, were found to be 30 percent cheaper than the lowest local tenderer.
It is reported that already there are 95 Chinese companies undertaking work, whereas there are only about 70 local construction companies in the Construction Industry Development Authority (CIDA) grades C 2 and above. If no corrective action is taken to support the local construction industry, very soon many local construction companies will collapse.
Of the over 2000 construction companies, first to collapse will be the small and medium companies, which comprise the majority of our construction landscape. Reportedly, Chinese construction companies have access to cheaper working capital at approximately LIBOR + 2 percent when needed by them. Such facilities are not available to local companies.
To support the local construction industry, which contributes about 10 percent to GDP and employs 600,000 direct, following measures are proposed.
Support to local construction companies
Restrict projects without majority foreign funding exclusively to local construction companies. Foreign companies could be considered for these projects only after tendering with local companies have failed and with the approval of the CIDA. This could be ensured by a suitable amendment to the Construction Industry Development Act, No. 33 of 2014.
Allocate US $ 200 million to a special fund to be disbursed through the approved banks to support local construction companies in the following manner.
-To mitigate the adverse impact due to high interest rates at 16 percent on working capital needs to execute a contract undertaken and also unequal competition by foreign contractors, banks to provide term loans at 8 percent interest repayable over eight years. The amount given could be limited to 15 percent of the average annual construction turnover of a company during the last three years.
As per the Inland Revenue Act, a foreign construction contractor operating in Sri Lanka for a single project without a local company registration, can pre-declare its profits and thereby pay only 20 percent tax instead of the 28 percent, which the local contractors are liable to pay (present status quo is no equal playing field for local construction contractors). As such, this 20 percent rate should be increased to 28 percent.
Foreign consultants
We can have no objection to the foreign consultants and foreign contractors undertaking projects with majority foreign funding. If it is a foreign loan-funded project through ERD, then competitive bids should be called from eligible foreign consultants and contractors rather than awarding on a single bid proposal.
In all instances, foreign consultancy and construction companies will be compulsorily required to form joint ventures with the local counterparts, sharing at least 40 percent of the project scope.
This is one of the objectives of the national policy on construction adopted by this government to ensure the better compliance to local regulations and standards and also to facilitate technology transfer. Such requirements are prevalent in many developing countries to protect and develop the local companies.
Equal treatment to local steel manufactures
Another proposal is that all the steel manufacturers should be given the same concessions when importing steel billets for the production of reinforcing and structural steel. At present, the exemption on the PAL, which is charged at 7.5 percent, is allowed for the import of steel billets to only one manufacturer.
As proposed in the section titled ‘Reducing construction cost’ above, if the PAL is withdrawn on the import of all construction materials, then this anomaly will be automatically removed. Now there is no Customs Duty on import of steel billets by all manufacturers. If concessions are to be given to any manufacturer because of the magnitude of investment, then it should be as a concession on corporate tax and not on the taxes charged on import of raw materials.
Liberalizing cement industry by removing MRP
On cement, the government has imposed a maximum retail price (MRP), which is hindering further investment on cement manufacture. This has also led to much corruption. This is at much variance to the other major construction material, reinforcing steel, on which there is no price control.
Presently, there is sufficient competition on cement supply with two cement manufactures, five bulk cement importers and 40 bag cement importers. With this competition, there is no justification to impose an MRP on cement when there is no MRP on reinforcing steel. The removal of this will encourage more investment on cement manufacturing and thus even more competition.
Removing restrictions on bitumen imports
A few years back, import of bitumen was a monopoly of Ceylon Petroleum Corporation (CPC). But since 2016, several private suppliers were allowed to import in addition to CPC and IOC. As a result, the quantity of bitumen imported by CPC has dropped to 1.2 percent in 2018.
But the present practice is for the Petroleum Resources Development Ministry to issue letters of recommendation to import bitumen. This has caused much delay and could be a source of corruption. Bitumen being a non-hazardous material should be allowed to be imported according to market demand, subject only to quality control. This will allow timely supply of bitumen for road development work.
Threat to local roofing products manufacturers
By 2014 budget, the import of roof and ceiling sheets on a duty free basis under the India-sri Lanka Free Trade Agreement had been gazetted. Relevant HS Codes are 6811.81 and 6811.82. This is against the policy of the government to provide protection to local manufactures. We have to be very careful when importing roof, ceiling and partition boards due to the substandard quality and potential fire risk.
Even in the Grenfell Tower fire disaster in London, which killed 71 persons, the main cause was the partition boards, which were inflammable. As such, these materials should be quality controlled and should not be imported free under FTAS. There should be a reasonable duty imposed.
Income tax on trade chambers
The trade chambers and professional institutes, which are formed by Acts of Parliament and as companies by guarantee, where no profits or dividends are distributed among the members/ shareholders, play a very important role to nurture the domestic industry and uplift the professional services.
Without any financial support from the government, these chambers and professional institutes have managed to raise funds in an exemplary manner to extend their services in spite of many difficulties. Some of them were exempted from income tax payments up to 2017. But now all of them are subject to 28 percent income tax. This will adversely impact their services.
As such, it is proposed that the trade chambers, which are either formed by Acts of Parliament or as companies by guarantee with no profits distributed among shareholders/members, be either exempted from income tax or only subject to 14 percent concessionary tax rate.
Similarly, even the professional institutes, which have become members of any one of above chambers and formed by Acts of Parliament, should be allowed the above concession. Policy professional institutes should be encouraged to be part of the relevant trade chamber so that they could function in unison with the industry.
Promoting export of construction services
Export of construction services played a major role in the development strategy of South Korea in 1980s. As Sri Lanka has many well-developed construction companies, with suitable incentives, export of construction services can be promoted as a major source of foreign exchange earnings. Already there are few companies which have ventured out amidst many difficulties. Following are proposed to encourage export of construction services.
a) Bank facilities
To get an award for a construction contract it is necessary to get bank guarantees from a bank registered in that country. As our companies are not known to these banks, this is possible only by our banks facilitating guarantees through a bank in the country concerned on a back to back basis.
This is the practice adopted even by the foreign contractors when undertaking work here. Consequently, it is proposed that the government should make arrangements through the Central Bank for our banks to issue back-toback guarantees to our construction companies to undertake work in SAARC countries, GCC countries and countries such as Kenya, Uganda, Tanzania, Zambia, Ruwanda, Tonga, Benin, Ghana, Ivory Coast, Ethiopia, Madagascar, Seychelles, Mauritius, Australia, Fiji, Malaysia and Indonesia through correspondent banks in these countries.
When tendering, it is necessary to have the guarantees within a short period of about two weeks and as such, it is essential to have standing arrangements made beforehand.
b) Facilitating key company executives
When undertaking construction services abroad, it is necessary for the key executives of companies to travel to destinations such as Bangkok, Hong Kong, Kuala Lumpur and Manila to attend business and progress meetings at short notice. But now visas to these destinations take over two weeks. In addition to explore work possibilities, it is necessary to travel to many countries where economies are expanding.
Our company executives face many difficulties when obtaining visas to travel for business purpose to several of these countries. Company executives from China, Singapore, India, Malaysia, Japan and Korea have no such difficulties.
As such, the following measures are proposed: Issue TPNS by the Foreign Ministry to embassies based in Colombo for business travel of senior construction and consultancy company executives when recommended by the Chamber of Construction Industry Sri Lanka; such TPNS to be issued within two days.
For the directors of major construction and consultancy companies, who undertake work abroad, issue an official passport with an endorsement as ‘Commercially Important Person’ (CIP). This will facilitate to get visas without much delay and also easy passage through airports.
At our airport, have separate immigration channels for business/first class travellers and foreign passport holders. Now with only one common channel there is a long queue.
c) Export of construction services
Even though several companies have undertaken overseas contracts for consultancy and construction, this is yet to be considered formally as an ‘export’ qualifying for concessions given to other exporters. This should be corrected immediately.
In addition, since 2017, earnings from export of construction services are taxed, whereas these earnings were exempted from tax before. For companies with export income on construction services over 80 percent the tax rate is 14 percent and for other companies it is 28 percent. But only one company is engaged totally on the construction work overseas, thus qualifying for 14 percent. This is discouraging our construction and consultancy companies to venture overseas. As such, it is proposed to exempt from tax as before, earnings from overseas operations of these companies.
Establishing BIM Centre
The contribution of construction industry to GDP is about 9 percent during last year. This is expected to reach 15 percent within the next two years if the expected FDI become reality. Increasing productivity, timely completion and avoidance of disputes in the construction industry are essential pre-requisites for a healthy economic growth.
Building Information Modelling (BIM) is a new system widely practiced in developed countries to achieve the above objectives. The USA commenced using this system from 2003 and now more than 70 percent of construction and consultancy companies use BIM.
In the UK, use of BIM is mandatory. Norway, Denmark, Finland, Sweden and Germany are European countries heavily using BIM. In Singapore, BIM is mandatory for project approval. Hong Kong and Malaysia are two other Asian countries, where BIM is widely used.
However, in Sri Lanka most architects, engineers and quantity surveyors are still not using this system.
This is partly due to the very high cost of BIM software and partly due to the reason that most of our architects, engineers and quantity surveyors are not trained in this system. Even our universities are not providing training on the BIM system. Already, for all building projects in Colombo Port City, use of BIM is made compulsory. This will be the trend with all the new buildings with FDIS.
As such, there is an urgent need to establish a BIM Centre to provide training to industry professionals and also to make available its facilities to be used by the consultancy and construction companies on a reasonable payment.
The government should seriously consider to facilitate establishing a BIM Centre with minimum 25 workstations by extending a financial grant of Rs.150 million.
The establishment of this BIM Centre will make our construction industry more competitive by reducing costs and will be a step forward to the future.
REITS under CSE
Globally, the real estate investment trusts (REITS) have become an integral part of the investment portfolio, accepted by individual and institutional investors, providing greater access to real estate projects. Sri Lanka can also benefit significantly by the introduction of same.
It can provide a platform for the much-needed FDI without transferring the ownership of real estate asset to the foreign investor. Asian REITS market is now valued at approximately US $ 180 billion. Singapore, Hong Kong, Taiwan, Japan, South Korea, Malaysia and Thailand are the market leaders. Now even Indonesia, the Philippines, Pakistan and India have introduced these. Necessary legislation should be enacted to introduce REITS in Sri Lanka soon, which was a budget proposal announced earlier.