Real estate taxation – a blessing or a curse?

The Finance Bill 2016 caught everyone by surprise in the real estate sector, especially persons with black money and short term speculators. For them it is a nightmare that FBR can value the properties at fair market value, which has taxation repercussions regarding source of investment and thereafter can levy Capital Gain Tax (CGT) if the asset is held for less than five years. The whole real estate market is in shock and allegedly, in some major housing entities the business is almost at a halt. There are visible signs that strikes are being arranged in some major cities of Pakistan but so far no defined agenda in terms of demands has been made public especially by any real estate dealers association.

Interestingly, the hearsay is that the two major amendments would discourage foreign remittance to Pakistan. If overseas Pakistanis remit their money through normal banking channels per Income Tax Ordinance 2001, they are exempt from tax and the remitted money is treated as purely “white”. In fact, previously, when an overseas Pakistani with “white” money used to buy an asset and get it registered at Deputy Commission (DC) value he was willingly or unwillingly converting part of his “white” money into “black” money.

As an example, an asset bought for PKR 10 Million and registered at a DC value of PKR 2.5 Million would transform an overseas person’s major chunk of money i.e. PKR 7.5 Million into “black”. This was totally undesirable but he had to follow the market practice by getting the sale purchase agreement registered at the DC value. The beneficiary could be the other party who in most  cases does not have enough “white” money to complete the transaction. Therefore, the concern should be for people who have untaxed money but not the overseas Pakistanis who have, in fact, only “white” money.

Secondly, the government is to levy a 10% capital gains tax on the gain between sale and purchase price if the property is sold within five years of its purchase. This amendment is also geared towards curbing speculative trading which the majority of the overseas Pakistanis do not intend to undertake due to their remoteness and investment strategy. Hence, it barely impacts overseas Pakistanis and even in case a 10% tax is paid on the gain, it should be acceptable considering the high tax rates on capital gains which they are bound to pay in most of the foreign countries of their residence, except for middle east.

The 10% tax slab is rational considering that on other business incomes, the applicable rate is around 35%. Hence the applicable rate is still lower than the tax rate levied on normal business income. Conclusively, the overseas Pakistanis should consider these aforesaid changes in the tax statute a blessing in disguise as it will allow them to properly make their declaration and let their “white” money remain “white” instead of being forced to convert it in to “black” money, under the older system. However, I would advise overseas Pakistanis would be to at least stick to the below:

1) Use normal banking channels to remit their money into their bank accounts from overseas. Keep the relevant documents in their record for future purposes. The documents in order of precedence would proceed thus: realization certificate issued by their Pakistani bank, bank statement from Pakistani bank and remittance receipt of overseas bank.

2) If you intend to purchase the property it should be purchased with “white” money. The sale-purchase agreement should be on the fair market value of the property and not the DC vale. The agreement has to be signed by both parties and should not be left blank. If you are a filer, you can declare it, or else keep it in safe record for future use.

3) In case you intend to sell a property, hold on to it until the dust has settled and the issue of capital gain is cleared. Else, the maximum you have to pay is 10% of the gain between fair market value and purchase price.

Federal Board of Revenue (FBR) remained helpless especially during the last five years and was made to accept DC values owing to FBR’s own circulars wherein the aforesaid were binding. FBR tried to suggest changes in the statutes which included desperate measures including proposing to the government that FBR could acquire the property at 25% additional price compared to the registered price. But government rightly struck down these proposals as it could have created panic in the market. However, the recent amendment regarding fair market valuation and levying of capital gain if an asset exchanges hand within five years of its purchase merited consideration which the government approved through legislature. The implications of these two amendments are far reaching:

Fair Market Value: If the transactions would be registered at Fair Market Value, the seller would have to pay CGT (within five years of its purchase) and purchaser would have to produce “white” money to complete the transaction which will be an uphill task. Else, the tax implications, including levy of evasion penalties and additional tax, could eat up a major portion of the market value of the asset under transaction. The measure would definitely discourage “black” money holders who were hiding their wealth in real assets.

Capital Gain Tax (CGT): The levy of CGT withholding period less than five years is an attempt to discourage speculative trading. Currently, speculative trading had resulted in creating artificial hike in prices, making the possibility of building their own home an unattainable dream for ordinary Pakistanis.

Surprisingly, the real estate dealer associations have not yet come up with their official demand of charter. I wonder, what could a rational set of demands even be? Do away with fair market value or abolish the holding period of capital gains tax? Both of these do not hold merit for serious consideration in view of the fact that the provisions have been included to check “black” money and speculative trading. Hence, what could be the options at hand and what could be the possible outcomes?

1) Stay from Higher Courts: Apparently, there is no cogent reason as the bill has been passed by the National Assembly and the intention of legislature is clear – discourage black money holders and curtail speculative trading

2) Street Protests and Hold Off: Unless there is a genuine and rational agenda, it will be difficult to muster support from ordinary citizens, apart from the stakeholders which will be represented by real estate agents. The government may not be pressed for revenue loss due to halt in business considering their long term goal. Per Daily Express clipping by Shahabaz Rana dated July 14, 2016 Naveed Zafar Ashfaq Jaffery & Co, a chartered accountancy firm has revealed that there is PKR 7,000 Billion of “black money” in the real estate sector. If taxed properly, there could be one time wind fall tax collection and recurring thereafter.

3) Negotiation with the Government: Apparently, this will be the desirable and best route forward. FBR is in a strong position and it is expected it will not budge with undue demands. There could be number of suggestions but I would suggest the following:

a) Tax Amnesty: Government has announced tax amnesty schemes a number of times in the past,  the most recent one, for traders, being introduced just a few months back, but the response has always been lukewarm. However, here the situation is different wherein noose is around the neck of tax evaders and it will primarily be at their request with only available and acceptable solution. It is expected that FBR will take advantage of the situation and will not offer amnesty at any rate lower than 10% of the amount to be made white. The aforesaid is the rate which FBR has normally used as a benchmark rate for amnesties declared in the past two decades and even as recently as few months ago for traders. The impact of this would be enormous for the economy wherein huge amounts of tax will be collected once and then perennial collection would continue based on the market value. If we agree with the number quoted by Express Tribune then 10% of PKR 7,000 Billion would translate into PKR 700 Billion tax collection. It is important to mention that the current year collection of FBR was PKR 3,104 Billion and hence it would translate into 22.6% of the tax collection for current year and even FBR would not have any issue in meeting Fiscal Year 2016-17 target, which is fixed at PKR 3,621 Billion.

b) Capital Gain: Reducing the holding period from five to three years would be reasonable and acceptable to all the parties. Earlier, it was two years wherein after this period there would not be any liability under capital gains tax.

c) Giving Powers to FBR to Inquire the source of Foreign Remittance: The Protection of Economic Reforms Act 1992 debars FBR from requesting foreign exchange remitters to disclose the source i.e. who remitted the money and whether that person had the financial health to remit that money. The lack of these powers has in fact caused more damage to the FBR than any other restriction as it has robbed Pakistan of trillion of rupees in terms of tax collection ever since the act came into effect. Practically, all sophisticated investors who are fully conversant with legal implications send their untaxed money through “hawala” abroad and get it remitted to Pakistan statedly at less than 5%. This is a big loop hole in the system and has to be plugged immediately. After all, if the remitter is genuine then he should not have any issue if his financial health is probed. But apparently, due to known reasons to everyone in terms of beneficiaries, no government has ever shown willingness to give this power to FBR. In this case, if this power is not granted, even if amnesty scheme is declared and implemented, it will not meet set objectives. Just consider, if the rate for amnesty is 10% all sophisticated investors will be inclined to whiten their money at a reduced rate and hence exchequer will be robbed of the requisite revenue.

Conclusively, the changes in tax statute regarding real estate taxation is a blessing in disguise for the overseas Pakistanis who can do transactions with their “white” money freely and without any hassle. However, these measures are a nightmare for “black” money holders and speculative traders who had become used to enjoying unprecedented gains in short time frames. The government and FBR has got a golden opportunity to set things right, and with the assistance of stakeholders, they can come up with a viable solution of which a tax amnesty may be one. However, it is equally important to make amendments in the Protection of Economic Reforms Act 1992 by giving the FBR power to probe the source of remittance to distinguish between genuine and “hawala” transactions