All you need to know about the new capital gains tax from April 2018

• Tax expert Suresh R.I. Perera, LLB, Attorney at Law, FCMA (UK), shares with the Daily FT salient points of the new Capital Gains Tax which comes into force April 2018 and its impacts

Q: Why is Sri Lanka imposing capital gains tax from 1 April 2018? 

A: This measure to tax ‘gains’ in addition to current status of collection of income tax from profits and income stems from the fact Sri Lanka’s ‘Tax to GDP’ ratio is very low and the Government needs revenue to meet the state expenditure. As we all know Sri Lanka has heavily borrowed from foreign sources and in order to stabilise its sources of funds, more funding should be generated from taxation to meet its expenditure as opposed to debt funding. It’s common knowledge that Sri Lanka’s Direct Tax to Indirect Tax ratio is an inequitable 19:81 hence the source for additional tax required to the State’s Coffers should not be from indirect taxes. 

The imposition of income tax on Gains is a form of ‘direct taxation’. That I believe is the logic behind the policy maker’s move for re-introduction of Tax on capital gains which was abolished in 2002 from Sri Lanka’s tax system. There was also a thinking before the budget speech, that one segment of the society is deriving benefits from the appreciation of real estate in Sri Lanka, including land and condominium properties, therefore it would be equitable to collect taxes from this segment of the society. I think that was the thinking behind the budget proposal to impose 10% tax on capital gains from immovable property, but restricted to transactions where holding period was less than 10 years.  

Q: How would the Capital Gains Tax operate from April? 

A: First and foremost it’s not correct to say capital gains tax is being introduced from April. From 1 April the new Inland Revenue Act No. 24 of 2017 is applicable and chapter 1V of the new Act imposes “Gains from realisation of assets and liabilities” with income tax. Therefore there is no new tax called Capital Gains Tax adding to the numerous taxes in Sri Lanka. 

The budget speech 2017 proposed to introduce Capital Gains Tax at the rate of 10% on immovable property. But the concept that has been legislated in the new Inland Revenue Act is far wider than that. The income tax on gains introduced is not restricted to mere land but extends to all types of assets; immovable, movable, tangible, intangible etc. 

Therefore, gains from unlisted shares, financial assets, leases, share options and all other types of assets will be liable. The tax is applicable on gains from liabilities in addition to assets also. Therefore debts, loans, etc. will also be impacted from April when being released, satisfied, etc.  

Q: Would the introduction of the tax on gains impact the Stock Exchange and Capital Market of Sri Lanka? 

A: The income tax free status applicable on sale proceeds of listed shares will continue under the new Inland Revenue Act too. Therefore, irrespective of whether it’s trading profit, the capital gain that would accrue on it would not attract income tax including income tax on realisation of an asset. 

This is keeping in trend in some of the other countries in the region too. Countries such as Philippines, India have specifically excluded listed shares from being subject to Capital Gains Tax. At present, India imposes a 15 per cent tax on short term capital gains made from the sale of shares within a year of purchase. However, gains made after a year of purchase is exempt from the levy. However, in recent Budget 2018-19 read by Finance Minister of India, Arun Jaitley announced that the long term capital gains will be introduced on sale of listed shares from 1/4/2018. Long-term capital gains exceeding Rs. 1 lakh from sales of shares made on after 1 April 2018, will be taxed at 10%. However, the cost is indexed up to 31 January 2018 hence there will be no tax on gains accrued up to 31 January 2018. Referring back to the tax on gains in Sri Lanka, if a party realises a capital gain from listed debentures, such gain would attract income tax. Though not linked to tax on realisation of assets/liabilities , “profits” from trading in listed debentures also would attract income tax under the new Inland Revenue Act. 

Unit Trust Industry as well as transactions involving Government Treasury Bills & Bonds would also have repercussions stemming from the new change couched at the Chapter 1V of the Act. 

Q: How much revenue would the Government receive by taxing the gains?

A: Administration of all forms of Direct taxes are comparatively difficult and pose a challenge to tax administrations in every jurisdictions specifically so in developing countries. Indirect taxes and border taxes are comparatively easy to administer. Therefore there is a tendency in countries with less developed tax administrations for heavy reliance on indirect and border taxes. Sri Lanka’s direct tax to indirect tax ratio is not only a result of the Tax Policy Deign but also a weak and inefficient administration country’s main form of direct tax, the income tax. The border taxes or the taxes, duties and levies collected at the point of importation in Sri Lanka constitute almost 42% of the total tax revenue. 

Due to the difficulty inherent to the administration it’s doubtful whether this measure would generate any significant quantum of revenue. On the other hand IRD may not be in a position to measure the exact impact as only tax from tax on gains from realisation of investment assets that may be recorded in the system as opposed to tax on gains from capital assets which would be part of the annual income tax return. 

On the other hand it could be observed in the countries like India, the tax generated from tax on capital gains is not that great. So I expect a similar trend to be witnessed in Sri Lanka also.  

Q: Do you think capital gains tax would lead tax payers to curtail their transactions and overall result being slowing down of the economy? 

A: The reason for abolition of tax on capital gains in 2002 was to promote formation of capital for the development of the economy on one hand and the insignificant revenue that was generated due to the difficulty in administration. Abolition of tax on capital gains has the effect of ‘un - locking of capital’ for new investments. This spurs economic growth. 

It is widely believe that a tax on capital gain leads to slow down of the economy. On the other hand it is also seen as a tool to reduce the gap between rich and the poor. 

Q: What is the impact of so called capital gains tax would have on ordinary individuals? 

A: Well, this issue pertaining to individuals could be analysed from two fronts. Those individuals entering into business transactions in the course of carrying on a business on one front and individuals not engaged in a business but deriving investment gains on the other. Let’s consider the latter category as ordinary individuals.  

The impact would be felt not only by individuals selling land, building and unlisted shares but those entering into transactions in the nature of gift and exchange. The legal term for triggering the tax point is the concept of “Realisation” not just sale as widely believed. In addition to the commonly known parting of ownership, the concept of ‘realisation’ includes change in status of asset, ceasing to exist which could mean liquidation for a company and death for an individual, point of recouping the investment though the title continues with the person, change in the status of residence, write off of bad debt, etc.

There is a special relief couched in the Act in relation to the principal residential house of a person. The sale of principal residential of house of a person continuously owned for at least 3 years immediately before transfer by the person would not attract the tax provided the person has been living there for at least two years. This relief is restricted to houses fulfilling the above criteria and cannot be used for any other house. 

Further in relation to a resident individual where a gain from realisation of an investment asset is less than Rs. 50,000 a month or Rs. 600,000 per annum will not be liable to the tax on realisation.

In addition to general rules there are special rules enacted in the Act to address special situations. Therefore certain gifts by individuals may not attract the tax when the donor transfers it to specified donees but the cost base of the donor may be included in computation of the cost base of the donee at the point of sale or realisation by the donee. Donations by individuals to charitable institutions do not expose the donor for tax on gains. Likewise transfer of land or building by parents to their children is another category where patents would be excluded from the tax but the cost base of the donating parent would get aggregated to the cost base of the child for purpose of ascertaining tax on gains of the child when he realises the asset.  

Q: What is the reason for difficulty in administration of Capital Gains Tax? 

A: The ascertaining the cost base with evidence is a challenge. The law provides for certain adjustments to be made to the cost as well as the “consideration” received for the asset. Costs include Legal fees, advertising expenditure, repair cost, etc. however evidence for these adjustments would also pose a challenge. In addition, tracing and investigating isolated transactions giving rise to gains is a challenge if there is no voluntary compliance by the tax payers. 

Another important point is that from the perspective of policy to tax “Gains from assets & liabilities” it’s nothing but equitable that only the Gains or Appreciations occurring after the introduction of the new law should be taxed. Appreciations occurring and attributable to holding period before the introduction of the law should not be taxed. 

The policy makers seem to have attempted to achieve this equitable status by embedding s. 203(4) into the Act. But due to an oversight in the use of the language in drafting, it seems the intention has been achieved only partially. 

The historical capital appreciation attributable to the holding period prior to the Act has been excluded only in relation to “Investment assets” and not the other types of assets. Due to this omission, in relation to all other types of assets including land and building used in a business, the difference between original cost and consideration will be exposed to tax. Whilst this leads to inequitable status of capital appreciation prior to the Act too being exposed to tax, as business income, it also gives rise to impractical situation of ascertainment of original cost and adjustments to the cost where evidence may not be available.  

Q: Is there a return to be filed for Capital Gains?

A: Yes, a return should be filed within a month after the realisation in relation investment assets. Tax on realisation of investment assets should also be paid within a 30 day period. However in relation to capital assets used in the business it seems the gain/loss will be part of the annual income tax return. The manner and the procedure relating to the payment of tax on the gain from realisation of an asset should be specified by the Commissioner-General as per the IRA law.