The capital gain tax has been imposed on the sale of securities from the year 2010-2011. After a lapse of almost eight months of its imposition, the Federal Board of Revenue (FBR) was at last able to announce detailed rules for computation of tax liability under this category.
The rules recently announced are comprehensive and provide a guideline to the prospective investors. There are areas that still remain grey, but it is hoped that with the passage of time, these rules will be refined to meet the aspirations of the investing community in order to calculate capital gains tax liability.
Under Rule 13D, Computation of capital gain or loss, arising on the disposal of any security, shall be computed on the basis of First In First Out (FIFO) basis of inventory. No other option like average cost has been provided to investors in this context.
This means that a security that was bought first, would be deemed to be sold first and therefore, the closing inventory remaining unsold during the tax year will be valued on the last purchasing prices. The rule further states that Capital Loss arising on disposal of securities in any tax year shall be set off against capital gain arising from the disposal of securities during the same year to determine the taxable capital gain.
Capital loss arising from the disposal of securities shall not be carried forward in subsequent years. This means that if the computed tax losses are greater than the capital gains, then these would not be carried forward and would be lost forever.
This rule seems to be harsh for the investing community. It may be necessary to mention here that the investing community must plan their realised gains and losses in such a manner that realised losses if any, could be set off against the realised capital gains so that the capital losses do not exceed capital gains in one year, otherwise the remaining capital losses would not be carried forward to next year.
FBR has also disallowed capital losses in certain cases under rule 13F. It states that Capital loss adjustments shall not be admissible in the cases of Wash Sales, Cross sales and Tax swap sales. The rules define adequately this terminology.
Wash sales has been defined as the sale where capital loss realised on disposal of a specific security by an investor is preceded or followed by the purchase of the same security by the same investor within one month period. This means that the investor keeps his portfolio intact in the same manner as it was before.
This disallowance has been made due to the possibility that an investor may sell a particular security at a loss to set off against the realised capital gain to minimise its capital gain tax liability, while repurchasing the same at a lower price without losing the possession of that particular security. The only condition that is attached to this disallowance is the period of one month during which the same security cannot be bought otherwise the loss incurred would not be admissible for setting it off against the realised capital gains.
Similarly, cross trade, where co-ordinated reshuffle of securities between two related accounts of the same investor, between two related accounts of the related investors, between two membership cards of the same broker or between two related brokerage houses is undertaken and securities accumulating unrealised losses are sold to related accounts to artificially realize capital losses in one account, without actually selling the securities to an outsider and the artificial losses so realised in an account are then used to minimise capital gain tax liability on the capital gain realised in the same account are also disallowed. The purpose of this disallowance seems again to disallow realised gains through manipulative trades. Though it appears difficult how these transactions will be detected to identify this practice.
The loss is disallowed in cases of tax swap sales where the investor having realised loss on a particular security does not repurchase the same security but chooses another similar security in the same sector, thus not only minimising or eliminating altogether liability on account of tax on capital gain, but also maintaining the portfolio broadly at the same risk return profile. This seems to be a harsh and unjustified rule.
There are several cases where an investor picks up a security from a sector that does not perform well or it starts losing its value due to several reasons. Therefore, he decides to shift the security within the same sector, why should he not be allowed to claim his capital loss on that security remains arguable. Let us illustrate this principle through an example. An investor buys Bank A that does not perform well due to its huge Non-performing Loans.
As soon as the investor realises his defective choice he decides to sell Bank A at a loss and buys Bank B which he thinks may be a better investment. The loss incurred on the sale of Bank A would be disallowed as the investor has bought BANK B that happens to be in the same sector and therefore, has kept his risk factor the same as it was before. This seems to be unjust, unfair and against a free trade rule that goes against good investment strategy.
It seems to be in the interest of FBR itself to allow this capital loss and treat the purchase of other security in the same sector as a fresh purchase, as he would be paying tax on capital gain if made on the other security that performs well. The present disallowance would be a disincentive for searching a good security that could generate capital gains and increases tax on capital gains subsequently. We have not experienced this type of disallowance in any other tax regime in the developing economies. This rule needs to be reviewed again to make it more investor-friendly.
Rule 13J has enhanced unlimited financial liability of brokers and members of the stock exchanges by making it mandatory for all brokers or stock exchange's members to ask for tax clearance certificate from concerned tax authorities before closing the brokerage account of an investor. In case, the investor disappears from the market without satisfying the tax authorities that he has no tax liabilities outstanding against him, such broker shall be liable to discharge such investor's outstanding tax liabilities to the satisfaction of the tax authorities.
This rule is completely illogical and unpractical. It is our understanding that in the meeting held on 17th January 2011, between a designated Committee of KSE and officials of FBR, the practical difficulties associated with the implementation of this Rule were fully discussed and there was consensus among that the implementation of this rule would not only be injurious for the development of capital markets but would also be difficult to put in practice due to several reasons. These are being reproduced hereunder for the information of the investing community.
Investor-broker's relation comes to an end if a security is bought and sold as soon as payment is affected. Broker has no leverage on an investor once the payment has been made for his sale or the securities have been transferred into his Central Depository Account (CDC). Investor is free to buy securities from Broker A and sell his securities through Broker B. There is freedom of trade and that is an important element of a free market.
There is no method where brokers A or B would be able to know what an investor has done with his securities. Is he keeping the securities as a long term investor or he has sold it through any other broker? Assuming the broker is held responsible for the capital gain, how would the FBR calculate his capital gains tax liability? How would the FBR find out from which broker he has sold his securities and at what price, or if he has incurred a gain or loss?
If the FBR is unable to catch the disappeared culprit, with all legal powers vested with the Board, how could a broker exert influence when he has no legal authority to do so? What if an investor does not ask for closure of his account but keeps it dormant? He would accomplish his objective by keeping his account non active and may shift to other brokers for his active business. This will cause unnecessary levies to be paid to various agencies for an account that remains dormant but is not closed.
With these rules in place, it is feared that brokers would cease the brokerage business as they would be unwilling to accept unlimited tax liability on behalf of their clients. This may result in substantial fall in turnover, slow discovery of pricing and lower capital gains taxes collection.