June 15, 2010

Initiating Coverage
Pakistans Premier Financial Web Portal

Capital Gains Tax on Securities Transactions

(A comparative study)
After longstanding debates for years, tax has been imposed on the capital gains
at the local exchanges and securities trading. It is for the very first time that such
tax has been imposed and impact of this tax is widely uncertain. Until now
stocks and shares were specifically exempted from the tax net.
The existing provisions of Sec 37 of the income tax ordinance 2001
states that the capital gains on stock in trade (not being the stocks and shares),
consumable stores or raw material held for the purpose of business, any property
with respect to which a person is entitled to depreciation deduction, any
immovable property and some movable properties are subject to taxes and these
gains are included in the taxable income of the person.
Now it has been proposed that Sec 37 of the income tax ordinance 2001 is to be
amended by introducing Sec 37(A) as under:
37A. Capital gains on sale of securities.
(1) Subject to this Ordinance, a gain arising on the sale of securities shall be
chargeable to tax at the rate specified in Division VII of Part I of the First
Schedule;
Provided that this sub-section shall not apply if the securities are held for a
period of more than twelve months;
Provided further that the provisions shall not apply to a banking company.
(2) In this section securities means shares of a public company, vouchers of
Pakistan Telecommunication Corporation, Modaraba Certificates or
instruments of redeemable capital.
(3) The amount of gain under this section shall be treated as a separate block of
income.
And similarly the division 7 will be as under:
Rate of
S.#
Period
Tax year
tax (%)
1 Holding period is less
2010
10
than 6 months
2011
10
2012
12.5
2013
15
2014
17.5
2 Holding period is more
2010
8
than 6 months but less
2011
8.5
than 12 months
2012
9
2013
9.5
2014
10
The gains subject to capital gain taxes are net of capital losses and expenditure
incurred such as financial charges, brokerage and commission paid and any
expenditure incurred directly in earning such gains and these are treated as
separate block of income.

Capital gain taxes section shall

not apply if the securities are held
for a period of more than twelve
months

Capital gain taxes are net of

capital
losses
and
direct
expenditure incurred

Capital gain taxes shall be

treated as a separate block of
income.

The concept of capital gain taxes on securities transactions is not new to the
financial world as it has been introduced in major financial markets of the world.
In following section we will discuss the treatment of capital gain taxes in India
and US.
Capital Gain Taxes on securities transactions in India
Under Sec 111 (A) of the income tax act 1961 of India, short term capital
gains arising on the transfer of the equity securities or units of equity oriented
mutual funds, on the satisfaction of the conditions, are subject to taxes @ 15%.
If the taxable income without capital gains falls short of the maximum amount
that is not chargeable to tax then the capital gains are reduced by the amount of
difference between maximum amount that is not chargeable to tax and taxable
income without capital gains and the remaining balance of the capital gains are
taxed @ 10%. Whereas capital gain taxes on units purchased in foreign
currency, Bonds and GDR purchased in foreign currency and gains realized by
the foreign institutional investors are generally subject to capital gain tax of
10%.
Capital Gain Taxes on securities transactions in US
In US, in additional to the federal capital gains tax rates, capital gains are
also be subject to state income taxes. Most states do not have separate capital
gains tax rates. Instead, they treat tax capital gains as ordinary income subject to
the state income taxes rates.
Capital gains tax rates are determined by the type of investment asset and the
holding period:
Type of Capital
Holding Period
Tax Rate
Asset
Short-term capital
One year or less
Ordinary income tax rates up
gains (STCG)
to 35%
Long-term capital
More than one year 5% for taxpayers in the 10%
gains (LTCG)
and 15% tax brackets

Short term capital gains arising

on the transfer of the equity
securities are subject to taxes @
15% in India.
Example of adjusting of capital gains in
current income:
Suppose
-Income without CG
Rs. 175,000
-Total CG
Rs. 100,000
-Total taxable income
Rs. 275,000
-Maximum amount not
chargeable to tax
Rs. 200,000
-CG subject to tax @10% Rs. 75,000
-Capital gain tax
Rs. 7,500
CGCapital Gains

Short term capital gains are

treated as ordinary income in US.
Long term capital gains are
subject to tax @ 5% and 15%
depending on the taxpayer tax
bracket.

15% for taxpayers in the 25%,

28%, 33%, and 35% tax
brackets
28% on the gain not excluded

Small Business
More than five
Stock Gains
years
Cost Basis in Calculation of the Capital Gain
Many of the Investors are frequent traders; most of the times securities sold are
neither from single transaction nor is complete holding sold, resulting in
difficulty in measuring the cost basis (purchase price) of the securities for the
purpose of calculating capital gains. Although nothing is provided in the finance
bill regarding this matter but a number of options are available to investors for
determining the cost basis in different jurisdictions around the world. Some of
the options are as under:
Specific Identification method.
This method is applicable when cost of every security can be
specifically identified either through serial number or some other
identification and very same cost is use to determine the capital
gains that are subject to taxes. It is normally very difficult and
costly to determine cost through this method.

Cost Basis is the value assigned

as purchase cost of securities for
the purpose of calculating capital
gains.

First In First Out method (FIFO)

Even if the investor cannot specify particular security to sell, the
actual cost can still be used by keeping track of cost basis for
every lot of securities purchased. When calculating capital gain, it
is assumed that the first securities sold are the first securities
bought.
Last In First Out method (LIFO)
This method is same as FIFO except for it is assumed that the
first securities sold are the last securities bought.
Highest in First Out method (HIFO)
Actual cost is determined by keeping track record of the cost
basis of the every lot purchased, while calculating capital gains, it
is assumed that the first securities sold are those having the
highest purchase price. By using this method the capital gain
taxes can be reduced for a particular year.
Average Cost Method.
The average cost basis is the total purchase price of all securities
divided by the number of securities owned. When some securities
are sold, it is assumed the all securities have same purchase price
i.e. average price.
Tax Loss Harvesting
It is a practice through which investment losses are used to offset the
investment gains by temporarily selling a security that is in loss to realize capital
losses and immediately purchasing the same security in the portfolio, these
realized losses than can be used to offset the capital gains resulting in reduction
of the capital gain taxes payable for the particular period. In Pakistan, in the
proposed amendment capital losses are allowed to offset capital gains but these
losses are limited to amount of capital gains as these gains are treated separate
block of income and it is not included in the total taxable income of the tax
payer and whether these losses can be carried forward to the next period is still
under question mark. In order to benefit from the tax loss harvesting practices it
is crucial to select the timing of realizing losses through appropriate strategy so
that maximum benefit can be achieved. This is true partly due to the reason that
amount paid as taxes will not be reinvested but if the payment of taxes is delayed
then further earning through reinvestment can be achieved, even if taxes are paid
at the end of the holding period the impact of taxes will be lower on the returns
Example of Calculating Capital Gain Tax
Capital Gain Taxes can be calculated through the following formula for
investment:
Selling price
Minus Selling fees, commissions and other expenses
Minus Buying fees, commissions and other expenses
Minus Purchase price or Cost Basis through above mentioned methods
Other Direct Expenses
=Capital Gain (or Loss if negative)
Capital Gain Tax = Capital Gain * Applicable Capital Gain Tax Rate
Capital Gain Taxes in Future Value Formula
If Rs. 1,000,000 is invested in a security for 1 year, pre tax return of 10%
is earned and capital gain tax rate is 8% the net amount after tax will be as
under:

Tax Loss harvesting is the

practice
through
which
investment losses are used to
offset the investment gains by
temporarily selling a security that
is in loss to realize capital losses
to be adjusted against capital
gains.

Investment value in one year:

Capital Gains:
Capital Gain Tax @ 8%
Value after Tax:
Return after Capital Gain Tax:

Rs. 1,100,000
Rs. 100,000
Rs. 8,000
Rs. 1,092,000
9.2%

This value can be calculated through a single formula:

Value after tax = Principal * [(1+R) N (1-TCG) + TCG]
= 1,000,000 * [(1+10%) 1 (1-8%) + 8%]
= 1,092,000
Where
R:
before tax rate of return.
N:
No. of years
TCG:
Capital Gain tax rate
In this way future value can readily be calculated for a number of
investments.
Comparison Table of Capital Gain tax treatment:

Holding period
Distinction
between LT & ST
Capital Losses
Allowed against
Capital Gains

India

US

6 months

12 months

1 Year

Yes

Yes

Yes

No

Carry forward of
Losses

No provision

A no. of issues requires

immediate attention of the
capital market participants:

Pakistan
(Proposed)

Capital Losses
Allowed against
Other Income

Important Issues:

Generally No but in
certain cases reduction in
capital gains is allowed.
Long term Capital losses
are allowed to be adjusted
against short term capital
gains.
Carry forward of losses is
allowed for a period of 8
years

Short term capital gains

are treated as a part of
taxable income and taxed
accordingly

The extent of capital loss

adjustment available to the
investors.
Whether carry forward of the
capital losses will be allowed
Cost
basis
formula
acceptable
to
the
tax
authorities.
Whether tax loss harvesting
practices will be allowed.
Frequency of deposit of
capital gain tax.

Any net capital losses

above $3,000 is allowed
to be carried forward

The information and opinion contained in this report have been compiled by the research department from the sources believed by it to be
reliable and in good faith, but no representation or warranty, expressed or implied, is made as to their accuracy, completeness or correctness.
All opinions and estimates contained in the documents constitute the departments judgment as of the date of this document and are subject to
change without notice an are provided in good faith but without legal responsibility.
Neither the company nor any of its affiliates, nor any other person, accepts any liability whatsoever for any director or consequential loss
arising from any use of this report or the information contained therein.
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Research Team:
Shakeel Ahmad

Abdullah Jamil

Muhammad Haseeb

CMA (Gold medalist),

Research Associate
Research Assistant
ACSI, level 3 candidate of CFA Institute.
abdullah@pkfinance.info
haseeb@pkfinance.info
Research Analyst
0300-9470324
0300-4717347
shakeel@pkfinance.info
0321-8664131
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