Capital gains and the property market

Having reviewed the various comments made on capital gains reform announced in this year's budget, I would like to explain the rationale behind the proposed changes and reply to some of the questions raised.

Will I be taxed if I sell my personal residence?

No, property that is being used for residential purposes is completely out of this debate. I was never taxed under the old regime and the new rules have retained the same exclusions. That is, if you have lived in a property for four years out of the last five years, when one sells the property no tax is liable. There are also a number of exemptions particularly in situations where the sale is forced and therefore capital gains are not likely to have occurred. Such cases include transfer of property or sale due to marital separation and sale of property forced by court order.

How will an inherited property be affected?

For those properties inherited before November 24, 1992 no changes have taken place. That is, when the property is sold, a seven per cent final withholding tax is applicable on the total contract value of the property sold.

For properties inherited after November 24, 1992, the changes made are clearly advantageous.

Under the new system the heirs selling an inherited property will now only pay 12 per cent rather than the maximum 35 per cent under the previous rules. The tax in both cases was and now is applied to the total profit made, that is, on the difference between the sale price and the value declared on the deed of transfer causa mortis or the revision made earlier this year on the inherited value, in line with the scheme announced in last year's budget. This is a clear cut decrease from 35 per cent to 12 per cent, thus reducing considerably the tax payable by heirs of a property.

So where is the controversy?

An element of controversy has emerged on the decision made in this budget to eliminate the previous capital gains regime and to apply instead a 12 per cent final withholding tax on the remaining taxable property.

Allow me to explain the change.

Under the previous regime, when a property is sold a seven per cent provisional tax had to be paid upon signing of the deed on the total value of the property sold. When the annual income tax return falls due, the seller would have to declare the profit made on the transaction, be taxed at a maximum rate of 35 per cent and the additional amount payable is requested and falls due or, in exceptional circumstance, when a loss is made a partial refund may have been due.This system was well understood by property negotiators and contractors but the normal man in the street who sells a second property (not the residential property) once in a lifetime would forget to include the income in his return and three years later receive a hefty bill that not only includes the taxable amount but also a high portion of penalties and interest.

The new system introduces a more simple process where a final withholding tax of 12 per cent is applied on the value of the property sold and paid on signing of the deed. The new system does not require the seller to declare the amount in his income tax return the year after because the dues on those profits would have already been paid. This principle already applies to interest income earners that opt for a 15 per cent withholding tax on interest paid.

How did we come to the established rate of tax at 12 per cent?

From historical data extracted, which comes about from the actual declarations being made, the 12 per cent rate is a reasonable reflection of the profits being declared. This does not mean there have not been any exceptions and, perhaps, a property was sold at a lesser than expected profit. However, the vast majority will merely benefit for the following reasons: For properties that have long been hoarded, the profits being registered once sold are exorbitant and these potential exorbitant profits are either discouraging the sale of the property or encouraging significantly low declarations to try and avoid paying 35 per cent tax which, in effect, in some case means even 30 per cent of the selling price. With the new system, these owners will have a significant reduction in their tax liability, will reduce the interest to under-declare and will bring a new wave of property on the market which could also have the effect of stabilising the market prices. Most people not in the business of trading in property would generally fall in this category, having bought a property possibly for their children or as a long term investment and would now think of putting it on the market.

From the comments I have reviewed the main concerns that have arisen relate to sale transactions that take place in a very short span of time, say, within a year or less. The argument made is that the minimum level of expected profit with a 12 per cent final withholding tax when compared to the old 35 per cent regime is unattainable in such cases.

From the discussions we have had with a number of operators, and judging by declarations made by small and large contractors at large (source data: the same declarations made at the Income Tax Department) a 35 per cent profit is what the vast majority of sellers and contractors today declare, even in such short timeframes. Some have gone as far as admitting that even when this profit is not made they would still declare and pay the tax on that profit just to avoid an investigation by the tax authorities. The new system merely crystallises this situation, simplifies tax collection and provides the necessary peace of mind.

Some examples given in talking points and other articles leave much to be desired and are far from the truth the historical data has to show.

Nobody sells a property worth Lm100,000 to make a mere profit of Lm 5,000, unless it's a forced sale, for which exemption provisions already exist in the act.

The table below shows actual examples.

Just a minor point, these figures assume that the full amounts have been properly declared, ignoring the realties around us, like two contracts for the same sale etc.

Under the new system, there is now a lesser incentive to under-declare because, as can be calculated from the examples given, for every Lm10,000 extra declared in all cases under the capital gains rules a further Lm3,500 would have to be paid (being pure profit under-declared) while under the new rules only Lm1,200 would have to be paid.

Thus, if properly understood and applied, the new system reduces the burden of taxation on the final price and the pressure to under-declare to avoid the tax. Higher declarations mean that the profit on which the present 12 per cent rate is estimated is conservative. This is the main advantage of the system.

The government understands that exceptional circumstances may occur and lower profits are made; the law as submitted in Parliament already contemplates a number of situations where a sale is forced on a businessman or an individual that would require special consideration. We are also studying other circumstances that may be included to avoid over-taxing properties that are sold.

Should the change increase property prices?

I do not believe so for two simple reasons.

First of all the market is not just a price taker; it has the ability to review the market and choose. The release of new property on the market that had been withheld due to the hefty tax liability under the old regime in the case of inherited property or property that has been hoarded for more then three to four years will increase property supply. One should therefore expect property prices to react to this reality and thus stabilise market pressures.

Also, since the vast majority of properties will not be affected, there is no reason why the price should be increased.

Mr Fenech is Parliamentary Secretary at the Ministry of Finance.