One-off and recurring taxes on the Sri Lankan telecoms sector as set out in the interim budget proposals on 7 February, raise regulatory risks and would lead to lower profitability and higher financial leverage for Sri Lankan telcos, says Fitch Ratings. The agency has revised its outlook on the sector to negative from stable. If enacted, we believe the proposals may hasten consolidation as two loss-making smaller operators could exit the industry, leaving three remaining.

The interim budget proposes a one-off "super gains" tax of 25% on profit, and a tax of LKR250m (USD1.8m) on each mobile operator. The proposals also shift the burden of a recurring telecom levy of 25% and 10% on prepaid voice and data revenue, respectively, on to telcos from consumers; operators can no longer pass these taxes on to consumers, as changes in retail prices require approval from the telecoms regulator.

A one-off tax of LKR1bn (USD7.5m) is also proposed on companies offering satellite direct-to-home (DTH) TV with more than 50,000 subscribers. The budget proposals, if enacted, will be effective from 1 April 2015.
Should the proposals go ahead, 2015 FFO-adjusted net leverage for Sri Lanka Telecom (SLT, BB-/Stable) and Dialog Axiata (Dialog, AAA(lka)/Stable) is likely to deteriorate to 1.8x and 2.5x, respectively (2014: 1.2x and 1.3x), while the operating EBITDAR margin may narrow by 400bp and 800bp, respectively. Of the two, Dialog will be more affected by the taxes as 38% of its 2014 revenue was from prepaid services, compared with 21% for SLT. Dialog will also pay LKR1bn, as the sole DTH operator with over 50,000 subscribers.

A shift in the burden of the 25% telecom levy from consumers to telcos is likely to incentivise consumers to increase voice and data usage. However, we think that this increase will be only gradual - and insufficient to offset the impact of the absorption of the telecom levy.

Smaller, loss-making telcos including Hutchison Lanka and Bharti Airtel's (BBB-/Stable) fully owned subsidiary, Airtel Lanka, may consider exiting the industry as most of their revenue is pre-paid. We believe that market leaders Dialog and SLT could acquire the smaller operators to reduce price-based competition and consolidate spectrum assets. Sri Lanka's telco market is one of the most overcrowded markets in the world, with five mobile operators serving a population of 21 million.

If the proposals are implemented, Sri Lankan telcos will pay one of the highest taxes as a percentage of revenue among Asia-Pacific telcos. SLT and Dialog will pay about 28% and 36% (2014: 12% and 17%) of their respective 2015 revenue in taxes, fees and levies. This is much higher than the case for India's Bharti Airtel and Indonesia's PT Telekomunikasi Indonesia (BBB-/Stable), which paid about 20% and 17% of their 2014 revenue in similar taxes and levies to their respective governments.