EXTRACTS FROM THE SPEECH BY THE HON. TONIO FENECH, PARLIAMENTARY SECRETARY AT THE MINISTRY OF FINANCE, ON THE ‘REVISED CAPITAL GAINS AND PROPERTY SALES TAX’

There were a number of reasons why Government felt that a number of changes where necessary to the way profits on the sale of property should be taxed.

Firstly, we wanted to encourage long-hoarded property to re enter into the market, potentially increasing supply and thus possibly assist in stabilising price trends in the property market. We also sought to address a number of anomalies that where caused with the changes that had been made in way inherited property was being taxed, where-by in most instances Government was proving to have a too large a share from the same selling price, we also wanted to give a fairer and more equitable treatment to individuals who inherited property.

We also felt the need to need to simply taxation procedures for those who are not in the business of buying and selling property and thus simplifying the mechanism for the assessment and payment of the tax and on whom we also felt we should reduce the undue burden of taxation.

Undue tax burden

When tax on capital gains was introduced in 1992, it was incorporated in the mainstream income tax system. This meant that the profits on the transfer of property were considered as part of the income of the seller for the year in which the transfer was made, even if they were derived from a one-off transaction and even though they would have accrued over a number of years. This created a distortion in the system of personal taxation because it meant that in practice capital gains were fully taxed at 35%.

The persons who were worst hit by the old system were persons who were not speculators or traders in property, but persons who had owned the property for a long period. For these people, selling property meant losing one-third of their accrued wealth and they were therefore reluctant to part with their property.

What we have sought to do through the recent changes as announced in the budget speech and as subsequently adjusted was to make a more clear delineation as to what is deemed to be a sale of property of a capital nature and a sale of property of a trading nature.

Today the delineation is quite clear for all, and also applies a very simple logic, a trader is one who buys and sells within a short span of time, an individual that holds on a property beyond a reasonable time frame is one who is looking for the capital appreciation of the property and thus is not a trader but merely a user or potentially a long term investor.

We have thus retained the old regime for genuine trading activity, acknowledging that within this time-frame profits higher then 30% may not be always realisable and thus could have had the opposite impact of increasing prices to merely to absorb the added burden. The recent amendments in Parliament thus give the option to the trader as to which regime one would like the property being sold to be taxed in. May I clarify that the 5 year window does not start ticking from the day the amendments have been passed but from the day the property has been purchased. Thus if one buys a property in 2 years time the five year window starts ticking from the date of purchase.

May I also point out that if a property forms part of a development project the option is subject to a condition: it has to be exercised on the first sale – and, once exercised, the option will apply for all sales within that 5-year period. The reason for this condition is obvious. If a person takes the option, he would be allowed to calculate his tax on the profit after deducting the costs of the development. But the allocation of costs to different units within the same project is not always a straightforward exercise and cannot always be controlled properly. If different methods of taxation are applied to different sales within the same project, the results could be distorted. When a developer makes the first sale he must therefore decide which system will apply to all the sales of the units within that project throughout the 5-year period. Once the 5 year period ends, any further sales will be taxed under the final tax system.

It is important to note that profits made from properties that have been sold by companies under the Final Withholding Tax regime, are not taxable in the hands of the shareholder once a dividend is distributed. On the other had since beyond the 5 year period any gains made are deemed to be of a capital nature those gains cannot be offset against losses made from other group companies. This benefit has been allowed within the five year time frame because these are deemed to be trading income and thus should not be treated differently from other trading income. However I must emphasis that as a principle gains of a capital nature where never transferable against trading losses in our tax system.

We believe that this system will discourage the hording property on two grounds:-

1. Property that has been long held can now avail itself of a lower tax rate and be induced to re-enter the market;
2. On the other hand the five year window discourages traders to keep holding on property beyond a reasonable time unless they deciding to keep it for other trading activities such as renting.

For people who do not trade in property but buy a home for their personal use or as a longer term investment the new regime compares very favourably with the tax that was previously chargeable. The 12% rate on the transfer value corresponds roughly to 35% on a gain of about 34%, but it is a known fact that property prices increase fairly rapidly by higher percentages over a long span of time, thus making the burden of taxation no longer prohibitive, while in the case of property that is sold within the first 5 years they will too have the right to avail themselves of the capital gains provisions.

Inherited property and property acquired by donation

The changes that have been made are surely highly beneficial to people who have inherited property. In the case the present rate to tax has been lowered to 12% from the 35% that had previously been introduced. In such a case the 12% is not charged on the transfer value but on the margin of the transfer value over the value declared on the inheritance. May I bring to your attention the fact that for those persons who availed themselves of the scheme that was introduced last year and increased the declared value of inherited property, the increased amount will also be deductible. Property inherited before the 25th November 1992 will continue to be taxed at the flat rate of 7%.

This beneficial treatment is extended to donated property: the transfer of property that had been acquired by donation will also be taxed on the margin as long as it is made more than 5 years after the donation.

The right to opt out of the scheme

Sales of property within special designated areas

The option is available also to the sale of property situated within a special designated area, but in this case the option is not limited by any period of time. The reason for this special concession was the magnitude of these projects and therefore the longer time-development factor in such projects.
Again, however, certain conditions apply. Firstly, the option can only be exercised on the first sale that is made on or after the 1 March and it will then apply to all subsequent sales of property within the designated area in question. Secondly, the option is available only to the original developer. Once the original developer sells property, the second owner will fall back into the mainstream regime i.e. having the right to exercise the option within 5 years from purchase.

Options in other cases

The final version of the law provides for other cases where the person transferring the property can opt out of the system. One of these other exceptions applies to engaged couples who buy property jointly to use it as their residence, and who then break their engagement. In such situations one of the co-owners would usually agree to sell his or her share to the other. But it is not likely that he or she would derive the profit that a normal sale would produce, and the law therefore grants the option also in this case.

Another situation where the option is available is the sale of property by non-residents. This is meant to ensure that non-residents do not lose the benefit of double taxation relief in their home country. The sale of property to the Government following expropriation is also subject to the option if the Presidential order had been issued, or if Government had actually taken possession of the property, before November. And finally, the option can be exercised by companies that wish to claim roll-over relief. The roll-over relief provisions that applied under the old system will therefore remain available.

Sales by judicial auction and sales during a winding up of a company by the court are not subject to the final tax regime and will continue to be taxed under the old system.

Exemptions

The new system safeguards all the exemptions that were previously available. It reproduces all the exemptions that are contained under the provisions relating to capital gains, and it also contains a sweeping clause that provides that all transfers that were previously exempt will not be taxed under the new system.

In the case of a transfer of one's own residence, the exemption has even been widened and in certain cases it may now be claimed even though the transferor may have owned the property for less than three years.

The exemptions include an exemption on intra-group transfers. Transfers between companies within the same group will not qualify merely for a tax deferral but for outright exemption. And this will apply not only to transfers that produce a capital gain but to all intra-group transfers. The law enables the Minister to make rules to change the conditions for this exemption. These powers will be used if it is considered that the exemption is being abused.

Simplification

Another important advantage of the new system is the simplicity in its administration. Under the previous system, when a person transferred property he had first to pay provisional tax at 7% of the transfer price. Taxpayers who felt that the 7% rate would exceed their tax liability could ask for a reduced rate and the Inland Revenue Department had to deal with a number of requests for reductions based on estimates and provisional calculations. The transferor was then required to prepare a computation of the gains and declare them in his annual tax return. The tax finally chargeable depended on the allowable deductions and on the taxpayer's other income. Investigations of declarations under the old system often revealed incorrect capital gains computations, or claims for expenses that were not supported by receipts. This system created complications both for the taxpayer and the administration.

The final tax system does away with these procedures and, as a rule, the tax due will now be determined by means of a simple calculation and settled at the time of the contract.

The Commissioner of Inland Revenue will of course have the power to control that the correct amount of tax has been paid. The basis of the system is the correct declaration of the transfer value and additional tax may be imposed in those cases where a low transfer value is stated in the deed. But even in this respect, the law provides for a fair and swift mechanism and certain procedures have for this purpose been borrowed from the Duty on Documents and Transfers Act. If the Commissioner is advised that the market value is higher than that declared on the deed, he may raise an assessment but he can do so only within 12 months from the notification of the sale. No assessment will be raised if the variation is not more than 15%. The Commissioner's decision will be subject to objection and appeal in the normal way, but if the taxpayer agrees to settle the assessed amount within a short period he will automatically qualify for a reduction of the penalties.

Conclusion

We believe that the final tax system provides advantages to property owners without creating disadvantages to property dealers and property developers. We are confident that the measures that we have introduced will produce positive trends in the property market, and this should, in turn, prove beneficial to the economy as a whole.