Capital Gains Tax (CGT)- Tax on the tree that bears fruits
In an era where capital gains tax is the object of the attention, appreciating the distinction between capital and income receipts is fundamental. Justice Pitney used the metaphor of the tree that bears the fruit (capital) and the fruit (income) to draw the distinction between the two concepts.
CGT would be applicable on “capital gains” and not on “trading or business profits”. Hence the prerequisite would be to ascertain whether a particular receipt stems from a capital transaction or a revenue transaction. The former would be exposed to CGT, subject to rules to be enacted and the latter would continue to be governed by the rules pertaining to income tax. Some countries levy CGT via an enactment of a distinct Statute whereas some include “capital gains” as a source of income in the same Statute charging income tax. Sri Lanka in the past adopted the second approach above. One has to keep the fingers crossed to observe the approach to be followed by the legal drafters to implement the decision of the policy makers to implement CGT in the future.
Capital vs Income Receipts
In order to make the distinction between income and capital receipts, the famous test “badges of trade” is used by the analysts. The ‘motive’ at the time of acquisition, whether to hold in the long run or to trade is a key criteria whilst other factors such as an actual long holding period which indicates that the cash flow being capital in nature, frequency of the activity, subject matter, etc are important.
History of CGT in Sri Lanka
CGT is far away from being novel to Sri Lanka’s tax net. It has a track record of approximately 40 years of gathering taxes to the State and its absence was only during the last 13 years from the Statute Book. Sri Lanka is not the only country that suspended and is reintroducing the CGT in order to increase the tax base. Kenya which adopted CGT in the 1970s scrapped it in 1985 and reintroduced it in 2014.
Distinction between disposal of capital assets and stocks
Sale of stocks in the ordinary course of the business would not attract CGT on the vendor. For instance a property developer engaged in sale of condominium units or land plots would not have to be concerned about CGT as the stream of cash flow that the property developer receives would be trading/ business income as opposed to capital gains. The property developer would be called upon to pay income tax and not CGT. An investor who is in the ‘business of buying and selling’ apartments would also be liable for income tax on his profit margin and not CGT.
This same logic would hold true in relation to other traders such as motor vehicle import traders, primary dealers engaged in sale of treasury bills and treasury bonds etc.
Types of capital gains
The incidence of capital gains would not be restricted to only in the case of transactions of sale of a property. It could extend to incidences such as transactions involving intangible rights, intellectual property, redemption of shares, dissolution or amalgamation of business etc. depending on the definition to be enacted.
Exemptions
In formulating the new CGT policy exclusions from the CGT would have to be considered. The earlier law that was repealed in early 2000 provided for exemptions for first sale of residential house, travelling vehicles where tax depreciation has not been claimed, household and personal items (other than jewellery), transfers from trustee to the beneficiary, inherited property, gifts, conversion of a sole proprietorship or partnership to a limited liability company, sale of listed shares and listed debt in the stock exchange, sale of shares by unit trusts, sale of treasury bills in the secondary market, and any property where the holding period was more than 25 years. Whilst some of these exemptions could be assessed in enacting the new law, merits of other categories to be exempted should be assessed on a case by case basis within the context of the quantum of the targeted revenue collection.
Rates
The rate or rates to be used for calculation of CGT is a key determination that policy makers would be called upon to make. Should it be a single flat rate or multiple rates? Though a single rate may not result in the complexity that may stem from multiple rates, a single rate may not be equitable from the point of view of taxpayers. Most of the other countries follow multiple rates depending on the holding period; where the holding period is long, lower rates and where the holding period is short, higher rates is the global norm.
For instance India, in order to apply the rates, categorise capital gains as short term and long term. The multiple rates of India vary from 10 per cent to 40 per cent inclusive of exemptions. The four band rate in Malaysia, range from 5 per cent to 30 per cent, depending on the holding period.
The law that prevailed in Sri Lanka levied CGT using multiple rates linked to the holding period.
Complexities of CGT
Economists point out that CGT introduces a “lock-in effect” to the economy. This refers to slowing down the business activities due to owners of capital asset postponing or reducing the economic activity. Challenges for implementation would include specifying a valuation mechanism to be adopted to prevent under and overvaluation, addressing the issue of non-availability of records to ascertain the historical purchase cost of the capital asset, collection of taxes, etc.
Stock market
The concerns of many at present is with regard to the impact of reintroduction of CGT on the stock market which is already in a bear market status. Due to the law that prevailed prior to the November budget, trading profit from listed shares were exempt from income tax on account of imposition of share transaction levy (STL). However STL was administratively removed in January (though the Finance Act has not been amended) in order to provide further relief for the stock market. The critics have been quick to point out that the imposition of CGT on share trading, is contrary to the policy of furthering the stock market activities extending tax relief to the stock market. A difficult decision lies in the hands of the policy makers with regard to subjecting listed shares for CGT. However one must appreciate that the vendors who engage in the “share trading as a business” would not be exposed to CGT as the stream of cash flow in their hands constitute trading profits as opposed to capital gains. Most of the institutional investors including banks, finance companies, insurance companies, and some individuals may fall within this category depending upon the tax statutes.
Policy with regard to unit trust and mutual funds should be specially considered in formulating policies. Impact on unlisted shares including impact on private equity providers, and venture capital companies should also be borne in mind.
What should be the overall policy regarding the stock market activities? Should trading profit from the stock market continue to be exempt from income tax while capital gains to be taxed? This warrants a comprehensive analysis on the part of the policy makers to ensure no unintended consequences befall the stock market.
It is noteworthy that Taiwan repealed CGT rules that were in the statute book with effect from January 2016 to ensure the CGT would not be a barrier to the flourishing of the stock market. Whereas in India, the long term capital gains from listed shares where Securities Transaction Tax is levied is exempt from capital gains.
It is also crucial that a clear definition is provided with regard to trading profits and capital gains on stock market activities if two tax policies are adopted with regard to income tax and capital gains tax, as an ambiguity would lead to unsettling the market.
Conclusion
Policymakers may justify the reintroduction of CGT for many valid reasons including widening the tax base, rectifying the tax to GDP ratio, overdependence on trade taxes, redistribution of the wealth and reducing the dependency by the State on debt to meet its expenditure, etc. However, it is apt to take cognizance of the maxim of Publilius Syrus (1st century BC), “what is done hastily cannot be done prudently”.
Decisive policies have to be made with regard to exemptions, rate or rates to be applied, valuation and collection mechanism (i.e. self-assessment payments/ withholding at source/ collection by stock brokers). In the final analysis the failure or the success of the policy would be revealed in the future by the quantum of the additional taxes collected by the State and the overall impact on the economy and the taxpayers of the country.