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Taxing real estate

Published in Jan-Feb 2017

Why bringing Pakistan's real estate sector under the tax net is such a 'taxing' process.
Illustration by Creative Unit.
Illustration by Creative Unit.

Pakistan’s real estate sector has long been perceived as one of the most lucrative areas of investment, offering Return on Investments (ROIs) of over 100% within a span of a few years – unheard of in any other country in the world. The reasons are quite simple.

There has been almost no government oversight and minimal tax liabilities. As a result, speculative investors with substantial capital have benefited greatly, and for decades, were able to mint massive sums by buying premium real estate in bulk and then selling it a few years later at almost double the price. Added to this, considerable overseas investment in property was witnessed post 9/11, as Pakistani expatriates sought the security of having a home to come back to. This created artificial price hikes and a consequent demand-supply gap.

This scenario changed when the Federal Budget 2016-17 (announced in June last year) redefined the tax regime for the real estate sector. Since 1986, calculating the Collector Rate (the value of immovable property, referred to as the ‘DC rates’) was the prerogative of the District Commissioners (DC) of the Provincial Governments, who relied on fixed valuation tables to estimate the value of a property. This mechanism of valuation did not pose a problem until a gap began to emerge between the DC rates and market prices (see Table 1). The problem which then arose was that the DC rates did not reflect changes in the open market prices. For perspective, over the last 30 years, prices of vacant plots in DHA, Karachi have increased by more than 2,000 times. In 1980, a 2,000 square yard plot was valued at Rs 50,000 (Rs 25 per square yard). In 2015, the same plot was valued at Rs 100 million (Rs 50,000 per square yard).

As the difference between the DC rates and market prices widened, a black (undocumented) economy came into being; all real estate transactions were recorded as per the DC rates, while the actual sum of money exchanged between buyers and sellers was according to the market value. For example, when a 120-square yard plot with a DC rate of Rs 15,000 and a market value of Rs 50,000 was sold, the paperwork (title deeds and sales receipt) reflected the DC value, while the seller received Rs 50,000; a difference of Rs 35,000, became ‘black’ money. As a result, neither the Government of Pakistan, nor the income tax authorities, had any idea of the total income individual sellers and the real estate sector as a whole were generating.

Table 1: Changes in DC rates.
Table 1: Changes in DC rates.

Table 2: Changes in CGT.
Table 2: Changes in CGT.

To correct this imbalance, Section 68 of the Income Tax Ordinance 2001 was amended through the Finance Act 2016, according to which Provincial Governments no longer had the authority to evaluate property prices. Instead, the Federal Board of Revenue (FBR) assumed the responsibility of determining property prices for documentation purposes, with the objective of bringing them at par with actual market values.

This increase in documented property values immediately created a slump in the market. According to most real estate agents, the volume of property transactions decreased by almost 85% post the Budget announcement.

The reason why property transactions severely dipped was due to the fact that all property taxes (introduced by FBR in 2014) increased significantly as the taxes were now calculated on the (substantially higher) FBR rates. Added to this, the FBR raised the tax percentage in the Federal Budget 2016-17, dealing a second blow to the real estate market. Firstly, the Capital Gain Tax (CGT) – essentially a tax on the profit a property owner generates from a sale – schedule was revised. Previously, five percent CGT was applicable on all properties purchased before July 1, 2016, and sold within three years. After the Budget announcement, properties purchased after July 1, 2016 were subject to the CGT schedule as per Table 2. Secondly, the Withholding Tax (WHT) – also known as Advance Tax – payable by buyers was doubled; two percent for income tax filers and four percent for non-filers. Until the 2016-17 Budget, this tax was only applicable on properties valued at three million rupees or more, but the FBR increased this slab to properties worth four million rupees or more.

The reaction from industry stakeholders was unanimous. Builders and developers threatened to stop all construction activity and real estate agents and consultants maintained that these changes would destroy the industry. As the property market came almost to a standstill and foreign direct investment and property tax revenues began to drop, the Government and FBR were forced to reconsider.

The realisation came (if slightly late) that unless the key players were brought on-board, the FBR’s objective of boosting tax revenues and the Government’s goal of rooting out black money from the real estate sector would not be achieved.

What followed were months of negotiations between the Government, FBR, the Association of Builders and Developers (ABAD), Real Estate Association (REA) and the Defence and Clifton Association of Real Estate Agents (DEFCLAREA), Karachi. The result was a tax amnesty scheme, passed by the National Assembly in December 2016.

The consensus was that all DC rates would be increased by 20%, and FBR valuations fixed at approximately 30% of the market for the time being. This implied that provincial taxes (Stamp Duty, Capital Value Tax and Registration Fee) would be collected as per DC values, while federal taxes (CGT and WHT) would be collected as per FBR determined property values.

Perhaps the most important aspect of the amnesty scheme was that individuals who had not paid taxes on their fixed assets earlier were given the opportunity to become filers and ‘legalise’ their undocumented wealth by paying three percent tax on the difference between the DC and FBR rates. What made the scheme controversial was that by paying a nominal amount, individuals who had hoarded property for decades could become documented income tax filers without disclosing their source of income. The Government’s justification was that the tax amnesty would bring almost seven trillion rupees worth of national wealth into the tax net, potentially increasing tax revenues by eight billion rupees.

In my view, the fact that the Government has not specified a deadline for this amnesty will further add to the woes of the regular income tax payers, most of whom are from the salaried classes. Other countries, such as Indonesia, have implemented similar tax amnesty schemes, but their success was made contingent for a specified time frame and a 200% fine was imposed on individuals who missed the given deadline.

The fact that the Government has not specified a deadline for the tax amnesty will further add to the woes of the regular income tax payers, most of whom are from the salaried classes.

The FBR has stated that the three percent tax amnesty will come under review in the Federal Budget 2017-18 and that there are plans to impose a single price for property throughout Pakistan within the next three to five years. It is the opinion of industry players that a system which has been allowed to malfunction for three decades cannot be fixed in three years.

In fact, critics maintain that although there will be a temporary dip in the sector’s profitability, the new tax regime imposed by the FBR should be allowed to continue. Trading activity will decline, and as a result, prices will fall, which will bring a welcome respite for the ‘aam admi’ whose dreams of becoming a homeowner may have a better chance of seeing the light of day.

This game of musical chairs between the Government, the FBR, real estate stakeholders and lobbyists is expected to continue until the announcement of the next budget in June this year.

The writer is Vice Chairman, FPCCI Standing Committee on Real Estate Research & Image Building.