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Tuesday, December 22, 2009

Raising revenue via real property gains tax

When the Finance Minister introduced Budget 2010 in October, he surprised many and disappointed some with his tax measures.

Those who were expecting an announcement on a firm date for the implementation of the goods & services tax (GST) were disappointed that the Government has deferred a decision pending further studies on aspects of the tax.

The reintroduction of the real property gains tax (RPGT) came as a surprise to many as it is barely three years since the exemption from the tax was announced.

This is a relatively short time-frame in the context of a structural change in a country’s tax laws. However, we are not in normal times what with the economy still in recovery mode and the Government seeking new ways to reduce its budgetary deficit position.

Both the GST and RPGT are intended to be revenue-generating measures; particularly the GST, which will be broad-based, affecting a significant segment of the community.

It is this feature which makes the tax efficient as it is expected to raise sizeable tax revenue; the very feature which also makes the decision to impose it difficult.

On the other hand, the re-imposed RPGT at a flat rate of 5% is unlikely to result in much tax being collected and there has been speculation that it will not end there and, before long, we will see the scale rates under the previous regime brought back.

These rates applied at 30% to a sale of a property if held for less than two years with a drop in the tax rate for every year longer the property was held.

A property, which was held by an individual for more than five years, was taxed at zero rate. The tax is now 5% regardless of the holding period.

The RPGT is a capital gains tax and it will be useful to understand the characteristics of this form of tax and what other countries are doing in this area.

The RPGT, like all capital gains tax, differs from almost all other forms of taxation in that it is a voluntary tax.

Since the tax is paid only when the property is sold, one can legally avoid paying the tax by holding on to the property.

This phenomenon is known as the “lock-in-effect”. This effect is likely to come into play if the tax is set at a high rate.

This can represent a deliberate policy measure to dampen excessive property speculation.

In fact, the RPGT – which we have today – had its birth in this country as the Land Speculation Tax Act, introduced at a time when real estate speculation was rampant.

It is interesting to note that in September, Vietnam introduced a capital gains tax on property transactions. Every time a property changes hands, the tax is either at 25% of the gain or 2% of the transaction value.

It has been reported that this new tax has “paralysed” the local property market with transactions being reduced by some 80%.

Coincidentally, Malta in its 2010 budget imposed a 12% tax on the transfer value of immovable property with the option of paying tax on the gain at the applicable income tax rate.

So our 5% RPGT rate is somewhat benign in comparison although it has not stopped those who have held their properties for a very long time from being hot under the collar.

This is due to the inherent unfairness of the tax. Unless the capital gains are indexed for inflation, the seller not only pays tax on the real gain in purchasing power but also on the illusory gain attributable to inflation.

The second large inequity of the RPGT, or capital gains tax in general, derive from how economists view it. Land derives its value from the owner’s productive use of it or to sell it to someone who will.

The value of this type of asset is the discounted value of the future stream of income from the use of the asset.

The “gain” that the seller makes would have been reflected in the asset price paid by the buyer and when the buyer derives income from it, he would be taxed on such income when earned.

This is economic double taxation and why many analysts argue that the most equitable rate of tax on capital gains is zero.

Going forward, it would seem that any attempt to use the RPGT to collect more tax by increasing the applicable rate, or rates, would need to consider the inherent paradox that this would bring about.

A higher rate could deter buyers and sellers from entering into property transactions.

This is fine if the intention is to cool down a hot property market. It would then not serve as an effective tax-generating measure.

·Kang Beng Hoe is executive director of Taxand Malaysia Sdn Bhd.

By The Star (by Kang Beng Hoe)

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