Noticed all those ads for housing societies on city outskirts across Pakistan? If you’ve felt as if the construction business has been booming recently, you haven’t been wrong. It has been looking up since 2000 and improved 11%, according to the the economic survey of 2015-16.
Construction is a powerhouse for economic growth and development. It provides jobs to millions of unskilled, semi-skilled and skilled people and pumps money into both the formal and informal sectors. Trading in construction material and engineering services works wonders for foreign exchange earnings as well.
Given that this area of the economy was doing so well, the government decided to make builders and developers pay taxes on it. The boom in the development of infrastructure and housing across the country was fuelling the economy but was not contributing enough to the national exchequer. The decision to do this is not new. In fact, every year changes are made to the tax laws after the budget is released. The government does this to align the law with the trends in the economy. In the past, a large part of the construction sector was untaxed. The most recent changes, however, seek to rope these areas in. The Friday Times walks you through some of these basic changes in this two-part series. Part two will follow next week.
For builders and developers
The Finance Act of 2016, has introduced new fixed taxes on builders and developers (sections 7C and 7D of the Income Tax Ordinance, 2001). The intent of these laws is to match the level of investment in the construction industry with its profits. Until now contributions were only being made in terms of taxes on the sale or transfer and purchase or transfer of immoveable property and through rental income. There were no taxes specifically for developers and builders. The difference between them, to put it in a nutshell, is that developers ‘develop’ and builders ‘build’. Developers are like film producers and builders are more like film directors. Developers lay the foundation but do not necessarily get their hands dirty. On the other hand, builders actually produce the results.
Developers take raw land and develop it. They get the paperwork done for permits and create building lots, put in place sewers, water and electric lines, and even streets. After these foundations are laid, the builders enter to erect the building/house etc. It’s the developer who buys large tracts of property, subdivides it, changes zones, and makes it more valuable. Then, he probably sells it off. (A builder can also be a developer, by the way.)
The tax on builders and developers is a form of fixed tax—a tax that is set at certain amount and does not vary according to the value of the item being taxed.
Under the new law, any person or business doing construction, or selling residential, commercial and other buildings, and those involved in the development and sale of these plots must now pay a tax according to the area. For this purpose, cities have been categorized into three groups according to sizes and the value or demand of property in them: (A) Karachi, Lahore, and Islamabad; (B) Hyderabad, Sukkur, Multan, Faisalabad, Rawalpindi, Gujranwala, Sahiwal, Peshawar, Mardan, Abbottabad, and Quetta; (C) Urban areas not specified under A and B.
Suppose Fargo is a company that constructs commercial buildings in Islamabad and sells them. Let’s say the construction costs Rs50 million and it sells for Rs75 million. We know that the company has made a profit on this sale, therefore tax is leviable. However, the tax shall not be levied on the amount of profit (Rs25 million), in this case. It has to be calculated by applying rate of tax to the area of the building. Let’s suppose, the area of the building is 2,000 square feet, valued at Rs210 per square feet. In this case, then you calculate tax by this formula: Rs210 x 2,000 square feet = Rs420,000. So the tax is based not on the value of property but on the area it covers.
If you have an empty plot, you do not have to pay a tax. You pay tax if you are a developer or a builder under this law, and only if, as a developer or a builder, you sell the plot or property for profit. This new tax applies to deals struck or signed after July 1, 2016. The idea behind it is to give people incentive to record the actual value of properties. Before this, there was no way the government could record the values of real estate according to the area they covered.
Given that this area of the economy was doing so well, the government decided to make builders and developers pay for taxes on it. The boom in the development of infrastructure and housing across the country was fuelling the economy but was not contributing enough to the national exchequer
Valuing immoveable property
To make assessing the value of property more practical, the government has made changes to the principle of Fair Market Value (under section 68). Fair market value (FMV) is an estimate of the market value of a property, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market. The tax is imposed on capital gain when a capital asset is acquired under certain conditions. Under the 2002 rules, the FMV was determined by the provincial revenue authorities, also known as the District Collector rates (DC rates). Taxing capital gain is a federal subject. The rates varied but were considerably lower than the actual value. In fact, they were around 80% lower than the market rates.
Take for example, the official collector rates in Defence, Karachi, at Rs1,650 per square yard while the FBR has unearthed transactions carried out at a whopping Rs155,000 per square yard rate. The rates so determined were binding on the Commissioner Inland Revenue (FBR). The Finance Bill, 2016 proposed, however, that the powers of the Commissioner be withdrawn and handed to a panel of approved valuers of the State Bank of Pakistan (SBP). The real estate lobby strongly opposed this change. After long deliberations, it was changed to hand this over to the FBR, which would determine the values of the immoveable property. Similarly, the binding nature of the value determined by the provincial revenue authorities (so they could collect stamp duty) has also been withdrawn. The FBR recently issued the rates for the cities in categories A and B, as mentioned above. The rates are given in tables that list the major areas in each city. Separate tables have been made for residential flats and apartments and commercial and industrial areas.
(As an aside, it is fair to mention that this was done because the DC rates did not correspond with the actual values, which is why the changes in the law ignore the FMV fixed by the provincial authorities. The provincial authorities will still, however, determine the values for provincial taxes through DC rates for stamp duty. Their powers are still intact. By determining the FMV, the FBR has not in any way robbed them of the power of the provincial authorities. The provincial authorities are not and were never authorized to impose taxes on capital gain.)
So, how do you determine value for immoveable property under the FBR’s new rates? Suppose Fargo Co. is building residential buildings in sector E-11, Islamabad. After constructing a house, it sells it. Let the construction cost be Rs50 million and the house sell for Rs75 million. We know that the company has made a profit on this sale, therefore it has to pay tax. However, the tax won’t be taken on the profit (Rs25 million), in this case. It is calculated by the rate of tax for the area of the house. Let’s suppose, the house is 2,000 square yards and the FBR’s rate for this neighbourhood is Rs26,000 per 500 sq yds. Thus we calculate the tax to by Rs26,000 x 4 = Rs104,000.
The author is the Deputy Commissioner (Inland Revenue), Large Taxpayers’ Unit, Islamabad and also runs her own blog. She can be reached at email@example.com @amnatariqshah