May 22, 2006	Monday	Rabi-us-Sani 23, 1427

THE federal budget 2006-07 would impact bourses in a number of direct and indirect ways. However, market reaction to the budget could largely be determined by decisions on four taxes, (i) capital gains tax, (ii) capital value tax (CVT) and other taxes specific to brokerage business (iii) tax on dividends and (iv) income tax rate for listed companies.

Experienced market participants understand that budgetary decisions on taxes would be driven primarily by political pragmatism rather than economic rationale.

It may have little capacity to put taxpayer’s money to good use but there is no satisfying the government’s appetite for taxes. When tax managers would deliberate a change in taxes for stock market, the question they would ask themselves is: can we get away with it? If the answer is “yes,” it is likely that the tax burden would be increased.

Few market players are hoping for budgetary concessions due to elections in 2007 as it wasn’t a popular vote that brought the present regime to power and nor can votes be expected to sustain it. Besides, there aren’t many votes to be had from the stock market which, as they say, relies on its “nuisance value” for bargaining. Keeping these ground realities in mind, let’s discuss expectations about each of these four taxes.

The most important tax pertains to capital gains. Share trading is exempt from capital gains tax till June 2007. This exemption in place since 1974 and it has been consistently renewed by different governments. Due to predominance of speculation in the market, a sustained bull run, and limited participation of individual investors, some quarters are demanding imposition of capital gains tax. The government, however, is ill-placed to make any move towards it.

Leading brokers have been publicly warning that they would strongly resist capital gains tax and it would trigger a large decline in stock prices.

Market is given extensive media coverage and government officials have been touting the rise in KSE-100 as evidence of their successful economic policies. Already under pressure due to inflation and sugar crisis, the government would not like another ugly situation in the stock market. It can decide to extend this tax exemption beyond 2007 or postpone the decision till next budget.

Since the latter could also affect investor sentiment, an extension would be a safer choice. However, such an extension would probably not go beyond June 2008 as tax managers would prefer not to loose the political power that comes with annual extensions.

The second critical tax is CVT. The government had introduced it at 0.1 per cent on purchase of shares in 2004 but under pressure from stock brokers, it was reduced to 0.01 per cent. In addition to CVT, there is also a 0.005 per cent withholding tax on sale of shares; 0.005 per cent withholding tax on brokerage commission on sale and purchase; and 10 per cent withholding tax on CFS premium.

Brokers have to absorb these taxes on proprietary dealing but while dealing for clients they can pass on CVT, withholding tax on sale and withholding tax on CFS premium. In 2005, it was perhaps fear of renewed controversies that these taxes were left unchanged.

In 2004-05, KSE is said to have collected about Rs3 billion on account of these taxes and this year the collection is expected to be higher. In spite of these taxes, turnover is increasing. In 2005, which was marred by the March crisis, average daily turnover at KSE was 365 million shares per day up six per cent from 2004 which in turn was up 11 per cent compared to 2003.

Unlike capital gains tax, CVT is in place for two years and many participants are prepared for an increase, even if they are unwilling to admit it. Due to market scandals and stories about mega riches of large brokers, there are elements in government who would like to see some sort of tax being slammed upon them. Tax managers would probably take the view that they can get away with a moderate increase in the rate of CVT.

Key Taxes for Stock Market Capital gains tax on shares Exemption for all investors till June 2007, regardless of any holding period CVT on purchase of shares 0.01%; final tax liability; deducted by stock exchanges Withholding tax on sale of shares 0.005% on sale; adjustable; deducted by stock exchanges Withholding tax on brokerage commission 0.005% on sale/purchase; final tax liability; deducted by stock exchanges Withholding tax on Badla/CFS premium 10%; adjustable; deducted by stock exchanges Withholding tax on dividends of listed companies 10% for individuals, 5% for public companies; final tax liability; deducted at source Corporate income tax rate From July 2007, public companies, listed or unlisted, would be taxed @ 35% Note: Mutual funds are exempt from CVT and withholding taxes if they distribute 90% of their profits

The third is withholding tax on dividends of listed companies. Market participants would like to see it eliminated. They argue that dividends are paid by companies out of post-tax profits therefore taxing shareholders for dividends is double-taxation.

Successive governments, including this one, have continued to ignore the economic rationale against double taxation of dividends. Due to large inter-corporate holdings and limited participation of individual investors, by removing tax on dividends, the government may be seen as giving “relief” to large market players, which makes this move unlikely.

There is however some room for concession. At present dividends are being taxed at different rates for different types of investors. For instance, dividends for individuals are taxed at 10 per cent compared to five per cent for public and insurance companies.

Government could introduce a slab system for individuals with no tax on dividends for small investors. This would be a politically correct move and one that would not cause significant loss in revenue. Else it could reduce the rate for all to five per cent, which would also appease high net worth investors.

The fourth is income tax for listed companies. Till 2002, unlisted public companies were taxed at 45 compared to 35 per cent for listed public companies. Since 2003-04, the government has been narrowing this differential at two points per annum so that by July 2007 both listed and unlisted companies would be taxed at 35 per cent.

Market participants want lower tax rate for listed companies to encourage new listings and to compensate listed companies for the cost incurred in complying with the Code of Corporate Governance. Not every one is convinced. Others argue that whether or not a company decides to list or de-list should be based on its capital requirements rather than tax advantages and to be rewarded for better governance, companies should look towards market forces and not to the government.

Moreover, potential candidates for listings also stay away from exchanges fearing that their shares could be targeted for “satta.” But even if there were convincing economic rationale for giving a lower tax rate to listed companies, the government was unlikely to concede.

Corporate profits have been rapidly growing and by giving a concession to already-listed companies that include leading tax payers, the government could lose large tax revenue without any significant political or economic gain.

In sum, one set of expectations from the coming budget is (a) one year extension of capital gains tax exemption (b) moderate increase in rate of CVT (c) reduction in tax rate on dividends for individuals and (d) no change in policy on income tax rate for public companies.