Sri Lanka will tax capital gains made within 10 years of purchase of real estate assets at 10%, according to the finance minister. The proposed rate is far lower than that charged on income. The only other tax charged on real estate transactions is 4% stamp duty when registering a deed of ownership.
Around the world, capital gains are taxed at various levels. There is no uniform formula, however, plenty of practical and good practices are easy to identify.
WHAT IS CAPITAL GAINS TAX?
Capital gains taxes are paid when assets like shares, property or even unconventional investment assets like paintings are sold. They are levied on the difference between the purchase price and the sales price.
However, Sri Lanka will only tax capital gains on real estate. The 2017 budget estimates to raise Rs5 billion or the equivalent of 0.27% of the government’s tax revenue in 2017 by this measure.
WHY NOT TAX GAINS ON OTHER ASSET CLASSES?
Capital markets, especially those for listed shares, were excluded from the tax after capital market regulator the SEC joined the industry in lobbying against its imposition. Taxing gains on listed share transactions is simpler because trading and settlement is electronic and the taxes on gains can be easily collected.
While capital gains are not taxed, share transactions are charged a 0.3% levy from both the buyer and the seller on the turnover of every share trade at the Colombo Stock Exchange.
WHAT ARE THE DRAWBACKS OF TAXING CAPITAL GAINS?
This tax can distort investment. In the case of Sri Lanka, real estate investors will hold out for longer than a decade from purchased to sell assets to avoid paying tax on the gain. This will leave capital locked up in less productive assets. Investing in real estate has been a way of storing wealth and avoiding the corrosive impact of inflation in the past. In the future, investors will seek other safe havens like stocks instead of real estate.
While gains on listed shares are not being taxed, if they were to be in the future, it can result in double taxation. Companies are taxed on their profits. Firms may distribute some of the profits as dividends, but often retain most of the earnings. Retained earnings increase the value of the shares, and when a stockholder sells the shares, the added value of retained earnings is taxed again.
WHY IS THE PROPOSAL TO INTRODUCE THE TAX ON REAL ESTATE CRUDE?
In the UK, for instance, only gains on investment property are taxed, and the primary residence of a family is excluded. Often, families sell the house they live in only to buy another. Families don’t view their home as an investment asset. By taxing gains on the primary residence, the government erodes the ability of people to upgrade a home.
WHAT ABOUT THE IMPACT OF INFLATION ON ASSET PRICES?
If a real estate investor earns a 100% gain over a period in which inflation has been 100% (prices of goods and services have doubled), the investor’s real return is zero. When the nominal gain is then taxed, he/she receives a negative real return. This means the effective rate on capital gains can be extremely high.
In the UK, for instance, companies are allowed an indexation allowance and individuals taper relief to offset the gains due to inflation. In the US, such inflation offsets are unavailable. In high inflation countries – without an indexation allowance – real estate will be a high-risk asset class for storing wealth.
Capital losses are allowed to be carried forward to be set off against future gains in most jurisdictions.