Is Business Loan Interest Tax Deductible in Sri Lanka?

Your bank takes one number out of your account every month. Rs. 44,063, say. That single figure is doing two completely different jobs, and only one of them reduces your tax.

Part of it is interest, which is the price of borrowing. Part of it is capital, which is you handing back money you were lent. The Inland Revenue Act treats those two halves as opposites. One is a deductible business expense. The other is not a deduction at all, however real the payment feels when it leaves your account.

If you've been claiming the full monthly repayment as a business expense, you've overstated your deduction. If you've been claiming none of it, you've been paying more tax than you owe. Both mistakes are common. Here's how to work out the business loan interest tax deduction you're actually entitled to, and how to prove it if anyone asks.

Is the interest on a business loan tax deductible in Sri Lanka?

Yes, and the rule is narrower than most people assume.

Section 11(1) is the main deduction rule. Expenses are deducted "to the extent they are incurred during the year by the person and in the production of income from the business or investment." Interest then gets its own provision on top of that. Section 12 says the interest you incur under a debt obligation is deemed to be incurred in the production of income "to the extent that" the borrowed money "is used during the year or was used to acquire an asset that is used during the year in the production of income."

Read that twice. Two phrases are doing all the work.

"To the extent that" is the apportionment switch. It means the answer is rarely a clean yes or no. It's usually a percentage.

"Is used during the year" is a timing test. The money, or the asset the money bought, has to be working in your business in the same year you claim the interest.

Section 12 also does something quietly generous. Buying a capital asset is a capital expense, and Section 11(2) bans deductions for expenses of a capital nature. Left alone, that logic would kill the interest on a loan taken to buy business equipment, because the borrowing is tied to a capital purchase. Section 12 overrides that and allows the interest anyway, as long as the asset earns its keep during the year.

Why can't I deduct the capital part of my repayment?

Because repaying capital isn't a cost of earning income. It's the settlement of a debt.

Section 11(2) says no deduction is allowed for "an expense of a capital nature", and Section 11(3) defines that as including "an expense that secures a benefit capable of lasting longer than twelve months". A loan gives your business funding that lasts for years, so paying it back extinguishes a capital liability rather than buying you anything. The Inland Revenue Department's guidance puts it plainly: the capital portion of loan payments is a capital nature expense and is not deductible.

There's a fairness question hiding in that. If you borrowed Rs. 1,500,000 to buy machinery and you can't deduct the repayments, do you get nothing at all for the machine? You do, just through a different door. The cost of a qualifying business asset comes back to you as capital allowances claimed over several years, which is a separate deduction with its own rules.

So a financed asset is two tax stories, not one. The loan gives you an interest deduction. The asset gives you capital allowances. The capital repayment sits between them and gives you neither.

How do I find the interest inside a single monthly repayment?

You don't calculate it yourself. You read it off the schedule your lender already produced.

Every term loan comes with an amortisation schedule showing, for each instalment, how much is interest and how much is capital. The split moves every month. Early on, most of your payment is interest because the outstanding balance is high. Later, most of it is capital. The instalment total stays flat throughout, which is exactly why that single repayment figure tells you nothing useful about your deduction.

Take a working example. Nadeeka runs a small design studio and takes a Rs. 1,500,000 term loan at 18% a year over four years. Her instalment is Rs. 44,063 a month.

Same payment three months running. A different deduction each time.

Across her first full year:

Less than half of what Nadeeka handed her bank is even eligible. Had she claimed the whole Rs. 528,756 as a business expense, she'd have overstated her deduction by Rs. 281,214.

What if the loan was only partly for the business?

This is where the mechanic most often gets misunderstood. The test isn't "what percentage of my life is business". It's "what did the borrowed money actually pay for".

Step 1: Trace what the money paid for

Section 12(a) looks at the use of the funds. A single loan can therefore split into deductible and non-deductible parts depending on where each rupee went. The Inland Revenue Department illustrates this with a business owner who spends loan proceeds across three purposes: constructing an office building, paying staff salaries, and private spending. Interest on the first two is deductible, because those funds are used in producing income. Interest on the private slice is not.

That last part isn't merely unallowed. It's caught by name. Section 10(1)(b)(i) bars a deduction for domestic expenses, Section 197 defines them, and Section 197(3) closes the loop: domestic expenditure "shall include interest incurred with respect to money borrowed that is used in a manner referred to in those subsections". Borrow to renovate your kitchen and the interest on that money is a domestic expense, full stop.

Back to Nadeeka. Her Rs. 1,500,000 went out like this:

80% of the loan is producing income, so 80% of the year's interest is deductible.

• Interest charged for the year: Rs. 247,542
• Deductible business interest (80%): Rs. 198,034
• Disallowed as domestic (20%): Rs. 49,508

Her deduction isn't Rs. 528,756. It isn't Rs. 247,542 either. It's Rs. 198,034.

Step 2: Apportion again if a single asset is mixed-use

Tracing the money gets you most of the way. One further cut applies when the funds bought a single thing you use both for work and personally. A vehicle or a laptop is the usual case.

The same three words govern it. Interest is deductible "to the extent" the asset is used in producing income, so an asset used 60% in the business supports 60% of the interest on the money that bought it. It's the same reasoning that splits a home office electricity bill or a vehicle running cost between business and private use.

The Act doesn't hand you a formula for the interest split. What it does give you, in the proviso to Section 120(1A), is a lawful method where costs are commonly incurred and can't be separately identified: divide them "on a proportionate basis (according to the proportion of turnover or proportion of asset usage)". Pick a basis you can explain, apply it consistently, and write down how you got there.

What if I'm on a lease instead of a loan?

Vehicles and equipment in Sri Lanka are often financed by lease rather than by term loan, and a lease rental looks nothing like a loan repayment. The Act sees straight through the difference.

Section 31(1) says payments under a finance lease, or in acquiring an asset under an instalment sale, "shall be treated as interest and a repayment of capital under a loan made by the lessor or seller to the lessee or buyer". Section 31(3) requires that split to be calculated as if it were a blended loan, with interest compounded six-monthly or over such other period as the Commissioner-General may specify. The Commissioner-General has issued a notice allowing any period accepted under generally accepted accounting principles, which is how monthly schedules work in practice.

So a lease rental is not a rent you deduct in full. It's the same two halves as a loan repayment wearing a different name, and it runs through exactly the same Section 12 tests. Section 31(6) also defines what counts as a finance lease, using tests such as whether ownership transfers at the end of the term and whether the lease term exceeds 75% of the asset's useful life. A genuine short-term operating rental is a different animal and isn't recharacterised this way.

When is business loan interest still not deductible?

Two traps catch people who have got everything else right.

The second trap only bites if you borrowed from someone other than a bank.

Take a loan in conducting your business and you become a withholding agent for the interest you pay. Section 84(3)(b) excludes "payments made by individuals, unless made in conducting a business", which puts business borrowing squarely inside the net. Advance Income Tax on interest runs at 10% with effect from 1 April 2025, up from 5% since January 2023, and Section 86(1) requires you to remit what you deduct within 15 days after the end of the calendar month.

Then comes the exclusion that saves most readers. Section 84(3)(c) takes out "interest paid to a financial institution on the ordinary loans and advances provided by it". Section 195 defines a financial institution as any company or body of persons carrying on banking business, including a licensed specialized bank within the meaning of the Banking Act No. 30 of 1988, a non-banking financial institution regulated in the same way as such a bank, or any other prescribed category.

What records do I need to keep?

The deduction rests entirely on being able to show where the money went and what the interest actually was.

Section 120(1) requires records sufficient to record all transactions and to ascertain the profits or losses from them. Section 120(5) extends that to the source documents behind those records, and Section 120(10) spells out what counts, naming "bank statements" and "contracts" among them. For a loan claim, the practical file is:

• The loan agreement or facility letter, showing the amount, the rate, and the stated purpose
• The amortisation schedule, or an annual interest certificate from the lender
• Bank statements showing the drawdown and where the funds travelled next
• Invoices or receipts for what the money bought, which is what makes your apportionment defensible
• Your own working showing the business-use split and the basis you chose

That fourth item is the one people skip, and it's the one that turns an apportionment from a claim into evidence. If Rs. 900,000 of a loan bought studio equipment, the equipment invoices are what prove it. Watch the payment method too, because a separate rule can disallow a large business payment made in untraceable cash regardless of how well documented it is.

Section 120(6) sets retention at five years from the date of the transaction, and longer if an assessment or related proceedings are still open for a relevant period.

How do I claim the interest on my tax return?

Interest goes into your business income computation as an expense, at the apportioned amount, not as a separate relief you claim later. Nadeeka's Rs. 198,034 sits alongside her other deductible business expenses, reducing her business profit before the personal relief and the tax slabs are applied to what's left.

Three habits keep this clean year after year:

1. Record the purpose at drawdown, not at filing. Reconstructing where a loan went eighteen months later is where honest apportionments quietly turn into guesses.
2. Keep the interest figure separate from the repayment figure in whatever you use for bookkeeping. They're different numbers doing different jobs and merging them is the original error.
3. Revisit the split when the use changes. If the vehicle the loan bought went from 70% business to 40% business, the interest apportionment moves with it.

If your borrowing is complicated, a mixed-purpose facility, a refinancing, or an asset that moved in and out of business use partway through the year, spend an hour with a tax practitioner. The framework above is settled law. Applying it to a messy real-world loan is where the judgement lies, and that's worth paying for.