Last week I discussed in these columns the primary changes in the procedure of determination of fair value with respect to transactions relating to immovable property. That article touched upon the subject of taxing right, by federation or the provinces, on gains arising out of disposal of immovable property. However, it is a legal issue that needs to be dilated finally by courts. The objective of this second article of the series is to understand the implications of Income Tax Ordinance, 2001 which arise on account of this major change in law. During the course of time, between the Finance Act, 2016 and to date we have seen many amateurish comments and suggestions.
Let us first understand the issue under consideration. The first ground reality is that at the moment in case of property transactions there are two documents. One document is for the value which is reflected on documented economy side, be it provincial stamp duty or to Income Tax Ordinance, 2001's wealth statement. That value is almost 1/10th of the fair value of property in certain areas in Karachi. The other document, usually also a bank document, in the shape of pay-order, for the difference between the first value and the actual transaction. This is always the fair value if it is a transaction between two independent persons. In that situation notwithstanding the issue of right of taxation, the difference is definitely subject to a particular provision of law being Section 111 of the Income Tax Ordinance, 2001 being undisclosed or concealed income, if the buyer cannot substantiate the sources of funding. Nevertheless, the existence of these two documents, is itself a testament of concealed or undisclosed income. The difference is accordingly taxable at the normal rate of up to 35 percent, including penalty and prosecution, which flow with such an action. What we had done in the past by way of a circular issued in 1993 is to stop the taxation officer to invoke Section 111 in such situations. That action was never a part of law; and it cannot be. It was effectively an illegal action as no government can provide an immunity from an action by way of a circular when facts are apparent. It is for this reason that many caveats are placed in such circulars. The other side of the picture was rightful fear of harassment and abuse of power. As stated earlier, a balance was required which unfortunately tilted too much in favour of tax evaders.
The aforesaid description confirms fears and the basis for the same. People dealing in properties and engaging in this double documentation, including almost all of us, are fully aware of a clear legal position. However, as a system, we do not want to face the challenge and change the comfortable status quo. This suits upper class with a boom in housing market. The situation has reached such a level that continuation of present system is not desirable, where the position is entirely different from those that prevailed in 1993.
Notwithstanding the other aspects, it is to be clearly appreciated that this is not a matter of manner of valuation, persons who will value etc. Those are trivial matters and aberrations. It is a simple fact apparent to us that a substantial portion of property transactions is made with the money which is not identified with the source and is therefore subject to direct application of Section 111 of the Income Tax Ordinance for the buyer. This would therefore mean that challenging the right of the Federal Government to tax or otherwise will not remove the sword hanging on the persons engaged in such transactions.
There is another important fact involved in this case. A substantial number of transactions are made by persons who are not in the taxation system. These persons in our terminology are called 'non-filers'. In theory such persons should not be worried as their transactions are not on the radar of tax department and there is no bar for them to continue doing what they had been doing in the past. This aspect is true in theory. However in practice, they are the real persons agitating against the revised position for the reason as there is a clear indication, and rightly so, by the government that records of all transactions at the registrar level will be examined and over time will be open to public scrutiny. Once such records are made available, exposure to Section 111 and other consequences cannot be avoided. This aspect should not escape the eyes of policymakers.
The aforesaid description is sufficient to highlight that the issue identified is genuine and I reiterate that this is a step in right direction. Now the question will be whether our fragile fiscal policies will be able to bear the burden of pressure that will be placed on them from all relevant and irrelevant sides, because large stakes are involved. There will be threats of decrease in foreign investment, etc. It is so as the quantum is too big, over US $300 billion. Without prejudice to the above and the fact that a level playing field be provided to all sectors of economy on fiscal matters, there has to be a transition in the system that provides some solace/space to the whole sector that remained outside the documented system on account of inaction of the government. In this situation the following transitional measures may be suggested with respect to application of Section 111 of the Ordinance and determination of capital gain on disposal of immovable property:
1. Whilst invoking provisions of Section 111 or capital gain on disposal in such cases, there should be 'two' valuations. The cost of buyer will be adjusted/indexed upward to the fair value at the time of acquisition and provision relating to gain on sale and Section 111 shall only be applicable on the difference between the first and the second value. This is effectively a sort of amnesty for the past transactions and acceptance of validity of the circular issued to a particular extent. This will effectively be a blessing in disguise for the cases where such properties have been placed as collateral, as by closing our eyes, we accepted that the documented value of property is much lower than the one at which such property has been mortgaged for the purpose of loan. The banking sector especially Pakistan Banks' Association should support the government to remove an inherent weakness from the system;
2. Throughout the world there is a special mode of taxation of capital gains especially on immovable property. Such assets are not taxed like ordinary income. It is therefore suggested that a concept of 'indexation' of cost be introduced with respect to determination of cost of property. In India this concept has been introduced for certain kinds of shares. The purpose of indexation is to relieve the owner or seller from undue burden as capital gain on immovable property, whether taxed by federal or provincial government is totally different in character from ordinary income. The purpose is essentially documentation; it is not collection of revenue.
The aforesaid two measures are essential for the smooth transition of system. There can be other solutions also; however, we have to agree on a simple principle that if equity is to be introduced in the taxation system then such 'islands' for parking untaxed money have to brought within the four corners of a civilized taxation system applicable for other sectors specially organised manufacturing, services and salary income. Any delay in the process, including reversals to archaic system, will be suicidal for the country.