I will not be posting much about tax compliance anymore. I have decided to redirect my efforts towards analysing the taxes that government, through URA, does not collect.
It is interesting that in spite of the desperate efforts by Government to raise tax revenues, the very same government routinely foregoes huge amounts of tax revenues by granting various tax incentives to taxpayers and even exempting specific groups from paying taxes.
These measures are called tax expenditures and it would be expected that for purposes of transparency and political debate, tax expenditure reports ought to be made public and should provide reliable information about estimates of foregone revenue at the level of individual provisions.
The estimates would then be used to perform cost-benefit evaluations and assess the effectiveness and efficiency of these tax incentive provisions. Ideally, the estimates of foregone revenue should be linked to the budget.
Unfortunately, government does not report tax expenditures and the public therefore, cannot discuss whether these tax incentive mechanisms make sense or if they achieve their stated goals.
Academicians cannot assess their impact in terms of distribution, investment or market distortions; and our Parliamentarians cannot decide whether to get rid of those tax expenditures that clearly fail to generate the desired effect. This will be a discussion for another day.
Today I will shed light on a proposed incentive in the Income Tax (Amendment) Bill, 2021 that touches on taxation of capital gains. NB: This is an extract from an update in my book “Domestic and International Taxation in Uganda”.
CAPITAL GAINS AND INDEXATION
Profits or gains that arise from disposal or transfer of a capital asset are called “Capital Gains” and are charged to tax under the head “Business income”.
In other words, if a taxpayer sells an asset, tax must be paid on the profit earned from the disposal. The profit is called Capital Gains and is taxed as ordinary business income. Conversely, if a taxpayer makes a loss on the disposal of as asset, they incur a capital loss which is deductible.
The Income Tax (Amendment) Bill,2021 contains a provision that will reduce the effective tax burden on long term capital gains that a taxpayer earns.
The proposed tax law provides for inflation adjustments (i.e. indexation), by allowing a taxpayer to index their tax cost for purposes of determining a gain or loss on an asset disposal or transfer transaction.
In other words, the provision allows a taxpayer to increase the purchase price (cost base) of the asset that they have sold. This helps to reduce the net taxable profit and thus lower the tax payable on the capital gains.
The idea behind this is inflation which reduces asset value over a period of time. This benefit provided by the proposed law is called ‘Indexation’.
With indexation, a taxpayer is allowed by law to inflate the cost of their disposed asset by a government notified inflation factor. This factor is called the ‘Consumer Price Index’, from which the term ‘Indexation’ is derived.
This inflation index is used to artificially inflate the taxpayer’s asset price, and thus help to counter erosion of value in the price of an asset and brings the value of an asset at par with prevailing market prices. Moreover, indexation provides a more accurate measure of economic gain than an unindexed transaction.
Under the proposed law, the benefit of indexation will be available only to long-term capital assets. By way of definition, indexation is a process by which the cost of acquiring an asset is adjusted for, against inflationary rise in the value of the asset.
Taxing nominal gains without adjusting for inflation could result in high taxes on what are small or no economic gains, and perhaps even real economic losses.
The introduction of indexation now categorises capital assets into short term assets and long term assets. Any capital asset sold by a taxpayer within 12 months from the date of purchase can be categorised as a short-term capital asset; and any capital asset sold after 12 months from the date of purchase can be categorised as a long-term capital asset.
The indexation method proposed for calculating a capital gain applies if:
1. A capital gains tax (CGT) event occurs for an asset acquired by a taxpayer; and
2. The taxpayer owned the asset for 12 months or more before disposal.
Under this indexation method, the taxpayer disposing the asset increases each amount of cost or expense included in an element of the cost base of the asset by an indexation factor which is worked out using the consumer price index (CPI).
The elements of the cost base can be indexed from the month prior to incurring the relevant element of cost or expense, up to the month the asset is sold. The indexation factor is calculated by dividing the CPI for the month in which the asset is sold, with the CPI for the month prior to the purchase of the sold asset.
This index is then multiplied by the original cost of the asset so as to arrive at an adjusted inflated cost. The adjusted inflated cost is then deducted from the selling price.
Without indexation, capital gains on disposal of short-term assets is calculated by deducting the original cost of purchase (cost base) from the selling price.
Assume a piece of land was purchased in June 2010 for shs.10,000,000 and sold in January 2011 for shs.25,000,000. The Consumer Price Index for 2010 is 153.25 and for 2011 is 181.67
In this case, the indexed cost of acquisition would be
10,000,000 x 181.67/153.25 = 11,854,486
So, the taxable capital gain would be 25,000,000 – 11,854,486 = 13,145,514 and tax at 30% would be shs.3,943,654.
If the land was purchased and sold within 12 months from the date of the purchase, the capital gains would be computed by deducting the original purchase price (cost base) from the selling price.
So, the taxable capital gain would be 25,000,000 – 10,000,000 = 15,000,000 and tax at 30% would be shs.4,500,000.
Therefore, indexation creates a tax saving of shs.556,346.
The writer is the director and team lead of Tax & Regulatory Services at Libra Advocates and Consultants