With effect from July 1, 2010, the Pakistani authorities withdrew the capital gains tax exemption by introducing 10% capital gains tax on a holding period of less than 6 months and 7.5% on a holding period 6 to 12 months on the capital gains made on shares, bonds and mutual funds.
In an effort to control or stop the possible evasion from this new tax, the FBR has introduced some desperate measures, which have resulted in very low capital gains tax during its first year of implementation. Once again, the policy makers failed to take into account the ground realities and came out with such measures which could not yield any positive results as far as generating higher tax revenues is concerned. In fact, it has resulted in dwindling trading volumes on the stock exchanges, with majority brokerage houses and asset management companies struggling for survival, as retail and high net worth clients have preferred to stay away from the market, given the impractical working of CGT collection, its calculation and filling.
The Pakistani tax authority has gone a few steps ahead of the world by forcing on asset management companies (mutual funds) into collecting capital gains at the time of redemptions as a withholding tax. Nowhere in the world is the CGT deducted at source by an asset management company on the gains made by investors in its mutual funds. The CGT calculation is worked out on net capital gains made by individual or corporate investors on all buy and sell transactions involving capital gains and losses in all financial investments (equities and mutual funds) made during a tax year. Since capital gain working is worked out from diverse sources of financial investments, which could involve various brokerage houses and mutual funds, it is impractical to force AMCs to be the CGT collecting agents. By doing so, the FBR has actually made people go away from financial investments and provided them more incentive to invest in National Saving Schemes, where the state is providing guaranteed higher comparable returns.
To illustrate, an individual who has two accounts with as many brokerage houses and who has also invested in two different mutual funds (having two different accounts) managed by two different AMCs, will have to go through a series of steps involving getting the proof of capital gains tax already deducted by AMCs and then adjusting the same against his other accounts. The major problem is encountered when the deducted capital gains tax by an AMC is more than his actual capital gains tax liabilities, where he will have to file for refund at the time of filing his tax returns. This is too much for any retail investors to handle. We need to be practical in implementing the CGT. There is no withholding of the CGT by mutual funds anywhere in the world for the simple reason that it can't be in the form of a withholding tax. The CGT is deposited by the taxpayer by the stipulated time period and they are responsible for providing and keeping all such records.
Another major lacuna is the carry forward of losses. The FBR has disallowed carry forward of capital losses for calculating of CGT in subsequent years and has so far refused to listen to the rational for not having such a clause. This is also unique for Pakistan; nowhere in the world could one find such arbitrary harsh measures. If an investor succumbs to heavy losses in one particular year, say Rs 1 million, there will not be any incidence of CGT in that particular year. However, if that same investment made some recovery and the investor has managed to book capital gains of Rs 500,000 in next year, he will be subjected to Rs 50,000 CGT, nevertheless, he is still carrying losses of Rs 500,000 (1,000,000 previous year's loss -500,000 this year's gain). In most countries, capital losses are allowed to be carried forward for 3 to 5 years. Similar, provisions need to be made in Pakistan as well to make equity investments attractive.
Besides the above issues, there are other major factors, which need to be taken into consideration regarding the capital gains tax in Pakistan. First is the size of total capital gains generated in the economy from financial instruments. Pakistan has an extremely narrow base of equity investments. The total number of investors as registered with the Central Depository Company (CDC) is around 53,000 with additional clients of 200,000 operating through sub-accounts with brokerage houses. At the same time, the total size of open-end mutual funds is Rs 200 billion (with Rs 50 billion in equity funds and the remaining in fixed income funds) with the investors' base not exceeding 100,000. The total size of Pakistani equity market was around $32 billion as of June end 2010, with a free float of around 20% (currently over $36 billion). This means that potentially if the whole of free float of $6 billion (Rs 500 billion) has changed hands during the FY 2011, with gains of around 20% (Rs 100 billion profits from capital gains); the government could have potentially generated Rs 10 billion in capital gains. Similarly on mutual funds, with the assumption of 15% average total return, a maximum of Rs 3 billion could have potentially been generated had all the unit holders booked their profits during the year. Hence, maximum possible realisable capital gains tax could be Rs 13 billion provided every investor books profits once at a maximum high value during the year. In actual, since most of the investments in equities and mutual funds don't change hands, the total CGT collection will be much lower than what the FBR was contemplating earlier. In its initial assessments, the FBR had reportedly projected very high capital gains tax for the year 2011. Given the above mentioned facts, most of those projections done by the FBR were unrealistic. In fact, what has happened is quite opposite to what FBR has been hoping for and it has done more harm to the capital markets in Pakistan by pushing investors away from making investments in equities and mutual funds.
Second, we need to understand why so many other countries in the world have not yet introduced the capital gains tax. This list includes countries such as Malaysia, Hong Kong, Sri-Lanka, Bangladesh, UAE, Egypt, Turkey, Thailand, Singapore and many more. Most of these countries are not even considering the introduction of capital gains tax at this stage, as they believe that attracting new investments is more important rather placing barriers such as the capital gains tax. Pakistan is much worse than most of the countries on all macroeconomic parameters which don't have the capital gains tax. The focus should be on making things move on the economic front, where a vibrant economy should generate enough taxes, instead of making steps which will thwart the progress. The introduction of capital gains tax and accompanying cumbersome provisions are having serious negative consequences on the working of market participants such as mutual funds, brokers and investors in general. There is a common but misplaced conception that stock brokers and equity investors have been making unusually big money and more taxes should be extracted from all those who are involved in investments. Notwithstanding this mindset, policy matters should not be left at the whims of those individuals who don't have the required know-how. In case of the CGT imposition, policymakers have failed to see the consequences of their actions and they have remained adamant on keeping things as they had initially implemented. We need to realise the importance of the functioning and vibrant capital markets for the Pakistani economy. This country is starving for capital and if policymaking is just aiming to extract more taxes rather than facilitating growth in businesses, attracting new investments and achieving higher rate of economic growth will remain a distant dream.
We need to realise that financial investments in equities and mutual funds are at a very rudimentary stage in Pakistan. We have not reached the stage where income from capital gains has reached the level where any sizeable taxes could be collected. Quite the contrary, the introduction of the capital gains tax in the present manner is a hindrance in the development of capital markets in Pakistan. Nonetheless, it is quite understandable that the government will find it hard to revert back by removing the CGT. What is needed is to make the process of CGT collection simple and practical like the rest of the world. Let people pay their own CGT and if the FBR thinks that Pakistanis can't be trusted to deposit their CGT returns to the government, then it more reason for them not to imposing a tax which they can't collect. Under such a scenario, instead of their capital gains tax, the best available option would be to impose a securities transaction tax (STT), which is payable whether you buy or sell a share. This is what other countries have done to circumvent the tax avoidance of capital gains tax. No investor can escape this transaction-related tax, which will be collected at source and will help FBR in generating sizeable tax revenues.