Pakistan’s stock market has lost 2.3% or 1764 points in the last seven sessions amidst fear of increased Capital Gain Tax (CGT) or dividend tax. Further, there is a rumour that the government may also mull changing the treatment of these taxes from full and final tax to normal tax for a few investors. We already highlighted this concern in our Pre-Budget Report released on June 01, 2024, titled Pakistan Federal Pre-Budget FY25—Strict measures needed to get IMF loan: “To meet high tax target, the government may increase tax on dividend, capital gain, and interest income. This, along with any change in the status of these taxes from full and final to normal tax, will affect the net returns of the stock market investors. ”
Our analysis of past budget changes in CGT and dividend taxes (FY15, FY16, and FY18) reveals that the market’s response was generally muted, with the exception of FY18. In this year, the market experienced a 6% decline post-budget announcement, which coincided with MSCI reclassification from the frontier to emerging markets. This reclassification led to a net outflow of US$133mn in May and Jun 2017, significantly impacting the market. The specific market impacts of changes in capital gain and dividend tax are detailed below.
FY15 – CGT increased by 250bps to 12.5% and no change in dividend: Post announcement of increase in CGT by 250 bps to 12.5%, the stock market fell by 0.61% in 10 sessions (intra 10 day low: -1.7%).
FY16 – Increase in CGT and dividend tax by 250bps: In FY16 budget, taxes on dividend and CGT increased by 250bps, however, market ended up with return of 1.5% in 10 days after announcement of budget after falling 1.71% during intra 10 days.
FY18 – Introduction of single tier CGT and increase in dividend tax by 250bps: In FY18 budget, Government removed 3 tier structure of CGT and introduce single flat tax of 15% for tax filers and 20% for non tax filers. Dividend tax was increased to 15%, up 250bps. In that year market fell 5.9% in 10 sessions after budget. This decline can not be wholly attributed to budget measures as MSCI rebalancing/reclassification also coincided with these dates and market witnessed outflow of US$133mn in May and Jun 2017 (Budget announcement: Jun 09, 2017), as discussed above.
How change in tax treatment will impact stock market and Investors?
Individuals: Currently, over 70% of the market turnover (Rs) is generated by individuals, which are taxed at CGT of 15% and dividend tax of 15% (assuming tax filer status).
Currently, CGT and dividend tax of these individuals is considered as full and final. However, reportedly, there is a proposal that government may consider changing treatment of this tax status from full and final to normal tax regime.
Post this amendment (if happens), the capital gain and dividend income both will be added to the whole normal income of the individuals (for example, salary, income from business etc.) and tax rate will be applied based on the applicable tax rate according to income slab (check side table).
Currently, banks and insurance companies are paying normal tax on dividend income, capital gain and interest income. However, these companies are allowed to deduct their business expenses from this income, which effectively helps them manage their tax rates.
However, in case of individuals, if this happens, will create a disparity and put extra burden on individuals since expenses are not deducted from income of individuals, or in other words, individuals pay taxes on their turnover (salary, dividends, interest income etc.).
We believe, practically this will not work in case of Ultra high net worth individuals (HNIs), who have dominated share in trading volume as they will divert their trading to corporate accounts, where tax rates will be managed by deducting expenses.
This will be negative for small investors who may end up paying higher taxes on dividends and capital gain.
Companies (including Brokers): Companies (including brokers) contribute approx. 20% to the trading activity at PSX.
This investor category at PSX is also under the final tax regime or in other words paying 15% tax on dividends and capital gain.
Theoretically, If this treatment changes to normal tax (if happens), this will increase their tax liability in our view at the time of filing returns as difference between corporate tax and dividend/capital gain withholding tax will be paid/adjusted.
However, companies with lower profits/higher expenses or companies in loss can effectively benefit from this; the tax liability based on corporate tax rate of 29% may fall lower in this case compared to 15% direct withholding tax on interest and dividend income. In this case, companies may have to file refund claim with FBR, if CGT and dividend tax is not classified as minimum tax.
Banks and insurance: Banks and Insurance companies contributes 4-5% to the trading activity at PSX and currently their capital gain and dividend income is treated as normal income, hence their will be no impact of this development (if happens) on this category of investors.
Courtesy -Topline Research
