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AN INVESTOR’S GUIDE TO THE CONSTRUCTION BOOM
It is hard to forget, even for a few moments, that we are living in unprecedented times. From journalists to politicians, to your uncle passing idle lockdown hours by forwarding unverified ‘news’ on WhatsApp, there is no shortage of people reminding us of the present moment’s uncertainty. Not that we need the reminders. With Covid-19 forcefully bringing routine life to a standstill and countries around the world reeling from the economic impact of government-imposed lockdowns and business closures, it is clear for anyone to see that we are experiencing history in the making.
Governments in developed countries have tried to step up, announcing various protection schemes to help businesses and people adversely affected by the crisis. But the problem is more acute in countries such as Pakistan, where governments do not have the fiscal space to launch wide-ranging social protection programmes. Nonetheless, in an effort to offer some relief, the government of Pakistan has decided on incentivising construction activity to offset the negative impact of Covid-19 on the economy.
The incentive package was introduced by the President of Pakistan by promulgating the Tax Laws (Amendment) Ordinance 2020 on April 17, 2020. What is novel about this package is that it grants amnesty in exchange for investing money in construction, thus using the money to create employment and generate economic activity. However, one need not have undeclared wealth to benefit from the package. The fixed low rate of tax incentivises anyone with capital to engage in construction activity.
Former US President Ronald Reagan had once quipped, “the government is the problem… if [the economy] moves, tax it. If it keeps moving, regulate it…” Apparently realising the same, the government of Pakistan has designed the construction package as an amnesty scheme to spur the private sector into construction by almost eliminating taxation, minimising regulation and reducing the role of the government. The government hopes that the package will have the intended effect on the value chain and employment.
There are some good reasons to think this. The construction industry, due to its linkages with manufacturing, warehousing, transportation, retail and rental, along with maintenance and servicing of constructed property, has a far-reaching impact on the general economy. The number of industries associated with the construction value chain can range from 23 to 80, depending on which government minister is making the statement. The impact of the construction industry on employment cannot be overstated. The construction of 100,000 flats annually in Karachi alone puts 360,000 labourers to work, according to a piece published on Karandaaz Pakistan’s online blog. In addition, the sector employs engineers, architects, contractors and other service providers who are directly related to construction activity.
In the aftermath of the Great Depression, the US government adopted the National Housing Act 1934 to spur construction. President Roosevelt said the act’s aims were, “First, to return many of the unemployed to useful and gainful occupation; second, to produce tangible, useful wealth in a form for which there is great social and economic need.” The Pakistan Tehreek-i-Insaf (PTI) government has similar objectives for introducing the construction incentive package.
But this article will not calculate the economic activity that will be created by this ordinance, leaving that to economists. Neither will it do a clause by clause analysis of the ordinance. It will, instead, focus on the ordinance’s urban residential construction section, and may serve as an introductory guide for the readers of this newspaper and small investors on how they can maximise the benefits from the package.
Since the package has been announced, many have asked who will benefit from it. One obvious answer is big builders and investors.
But are these large developers the only ones who can benefit from the package? Encouragingly, the short answer is no (of course, the longer answer is more complicated). Undoubtedly, the real winners will be builders and investors with big money, but even relatively smaller investors can benefit from the incentives.
So, let’s see how to get the most out of the potential construction boom in Naya Pakistan. If you have the money, that is.
QUALIFYING A PROJECT
For a project to qualify for the incentives, it has to be registered with the Federal Board of Revenue (FBR) before December 31, 2020. The projects that were already under construction before the promulgation of the ordinance, are referred to as ‘existing’ projects. The projects that will commence after the promulgation of the ordinance, are referred to as ‘new’ projects.
To qualify as a new project, the construction should commence before December 31, 2020. Both new projects and existing projects should be completed before September 30, 2022 to avail the benefits under this ordinance.
A building project will be deemed complete when the map-approving authority, or the National Engineering Services Pakistan (Nespak), has certified that the grey structure is complete, and the roof of the top floor has been laid on or before September 30, 2022. Hereinafter, any reference to existing or new projects in this article will refer to projects that have been registered with FBR under the ordinance.
Comment: A completion date of September 30, 2022, which is 2.5 years from now and will be less than 2 years from the last date of registering the project with FBR, provides a very short time for seeking approvals and construction of the new building. If the already announced incentive packages weren’t enough to spur growth, the President of Pakistan has recently promulgated the Companies (Amendment) Ordinance 2020, that now allows real estate companies to launch projects and receive deposits from prospective buyers without no objection certificates (NOCs) from relevant authorities, which may help real estate companies to complete projects in this short period of time.
This free-for-all should really kick-start the construction activity.
Budding investors wanting to play it safe should consider investing in the construction of existing projects, which have all the approvals. This will be less risky, as such projects have a higher likelihood of being completed in such a short time.
EXEMPTION FROM SECTION 111 OF INCOME TAX ORDINANCE 2001 FOR BUILDERS
Section 111 empowers tax authorities to inquire about the sources of a person’s assets or cash. Under the ordinance, Section 111 has been made inapplicable in case of new projects i.e., tax authorities cannot inquire about the source of the capital invested by the builder to construct the project.
Comment: The builders of existing projects will not be exempt from Section 111. If a builder of an existing project has wealth that he wants to declare, he can either start a new project or, as we shall see next, use the wealth to purchase completed units in new or existing projects. Thus, if a risk-averse investor wants to invest in the construction of an existing project, he/she should only do so if he/she doesn’t intend to seek exemption from Section 111.
CAPITAL INVESTMENT IN THE NEW PROJECT
If building a new project, the association of persons (AOP) or company building it should be registered under the Partnership Act 1932 or the Companies Act 2017, after the promulgation of the ordinance and before December 31, 2020. A new bank account is to be opened and money deposited through a crossed cheque before December 31, 2020. Any investment towards purchase of the land should also be made before December 31, 2020 and the payment for the purchase of the land should have been made in full through a crossed cheque.
Comment: All the capital that is required to build the project should be deposited in the bank account before December 31, 2020. Builders may be tempted to use less of their own money and raise the debt or use purchasers’ deposits to complete the project. However, if the builders want to maximise the exemption under Section 111, they should try to complete the project with as much of their own funds as possible. This means the builder will have significant capital tied into the project and can only realise his profit and recover the capital if the project is designed to be sold out quickly.
EXEMPTION FROM SECTION 111 OF INCOME TAX ORDINANCE 2001 ON PURCHASING A UNIT IN THE PROJECT
The purchase of a unit in a new project or existing qualifying project will be exempt from Section 111 for the original purchaser of the unit, provided that the full payment of the unit is made through a crossed cheque, before September 30, 2022.
Comment: The ordinance does not restrict a buyer from purchasing multiple units nor does it limit the builder (under his personal name) from buying a unit in his own project. The only condition is that the exemption from Section 111 is available to first-time buyers who purchase it directly from the builder. Moreover, if the builder of an existing project has wealth that he wants to declare, he can purchase a unit in his own project. A builder of a new project can also ‘double dip’ i.e. claim exemption from Section 111 when building the unit under a company or AOP, and then again claim exemption from Section 111 by buying the constructed unit in his personal name or a dependent’s name.
In the recent past, small investors have seen significant proportions of their life savings disappear by investing in institutional projects such as the Fazaia Housing Scheme in Karachi, Bahria Town Karachi and DHA Valley Islamabad. To avoid the same, investors must do their due diligence on the project and ensure the builder/developer has the necessary approvals in place.
The payments for buying units should be completed by September 30, 2022. Any risk-averse builder, who has significant capital tied into a project and wants to realise his profit as soon as possible, should build for the ‘high-end’ segment. This segment can purchase the unit outright by the completion date. The builder could also target those who have undeclared sources of income and want to purchase a unit in the project to seek exemption from 111.
Targeting lower- and middle-income families may not be a smart decision. With the economic slowdown in the post-Covid-19 environment, these families may be consuming their savings to survive the downturn and may not have surplus funds to pay for the unit by completion.
FIXED TAX REGIME
The tax payable on the development of the qualifying project has been fixed at a very nominal rate, based on the area of the housing unit. As taxes are not payable based on the profit of the builder, FBR has no reason to review the books or accounts of the builder. The taxes have to be paid on a quarterly basis. This will save the builder from harassment from FBR and incentivise them to complete a larger number of projects under the ordinance by the completion date (September 30, 2022).
Under the ordinance, builders and developers can incorporate maximum profit or gain of 10 times the amount of the tax paid.
Comment: It does not matter what the price of the flat is. The tax schedule shows that a flat less than 3,000 sq ft in Karachi will attract a tax of Rs80/sq ft. The more expensive the housing unit that is built, the lower the effective tax rate will be. The table above shows a hypothetical scenario, assuming a 2,000 sq ft apartment in Karachi at different prices and the fixed tax on them. An effective tax rate of 0.53 percent is no tax at all and is even lower than turnover taxes that the government charges. If the target is to minimise the tax, the builder should be building expensive units.
The ordinance isn’t clear on how profit over the maximum allowable profit will be taxed. Any mechanism to tax the additional profit will open the process to verification of income by FBR and will defeat the whole purpose of the ordinance of simplified tax regime. It is hoped that the budget or the finance act in June will provide clarity on the taxation of additional profit, without opening up the Pandora’s box of verification of income. A shrewd builder can reduce the accounting profit to the maximum allowable profit by incurring extra costs.
LOW-COST HOUSING
The ordinance provides an opportunity to further reduce the fixed tax. If the project is for developing ‘low-cost housing’ under the Naya Pakistan Housing and Development Authority or the Ehsaas programme, then the tax liability is reduced by 90 percent. Using the example of the low-end unit in the above example, if the unit qualifies as ‘low-cost housing’, the applicable tax would be Rs16,000 instead of Rs160,000.
Comment: The builder needs to decide if saving Rs144,000 (Rs160,000 - Rs16,000) of taxes is worth it when multiples of that profit can be made by building for high-end units for well-off buyers. The builder also needs to assess how potential low-cost housing buyers would pay for their housing units. In addition, building low-cost housing may come with additional monitoring by the Naya Pakistan Housing Development Authority (NAPHDA) and mortgage providers etc. A risk-averse builder may, thus, want to steer clear of building for the low-cost housing segment to avoid red tape and to realise profits quickly.
EXEMPTION FROM CAPITAL GAINS ON THE SALE OF RESIDENTIAL PROPERTY UNDER NEW CLAUSE 114AA IN THE SECOND SCHEDULE
This exemption is an anomaly as it has nothing to do with generating new construction activity or creating new jobs. A new clause has been inserted in the Income Tax Ordinance which allows the seller of a constructed property, not exceeding 500 sq yards for a house and 4,000 sq ft for a flat, to not pay any capital gains tax on it, provided the unit was being used for the personal accommodation of the owner, spouse or dependents and the utility bill is in the name of the owner.
Comment: As per existing provisions, capital gains tax on a constructed property that is held for more than four years is zero. It appears that the purpose of this clause is to provide owners of existing properties the opportunity to sell their properties, without paying any taxes or holding them for four years. For those investors who were biding their time to four years before they can sell their investment tax-free, this surreptitiously introduced clause provides the perfect opportunity for an exit.
MAXIMISING THE BENEFITS
There are additional nuances in the ordinance but. based on what has been discussed above, an investor can utilise the maximum incentives in the following manner:
Decide on investing in a new project to claim exemption on the capital invested from Section 111.
Register the new entity (company or AOP) and the new project with FBR and open a new bank account for it.
Design the project so that it can be started (no need to worry about approvals or NOCs if establishing a new real estate company to build it) before December 31, 2020 and completed by September 30, 2022.
Before December 31, 2020, have the entity acquire the plot and arrange for shareholders/partners to deposit all the capital into the project bank account. This is no time to be shy. The builder can build the most expensive building, as any capital invested into the project will be exempt from Section 111. The more capital that is invested, the maximum amnesty that is availed.
Investors should build the most expensive unit that they can afford to build and sell, and avoid the low-cost housing segment, as it will require additional regulatory oversight from NAPHDA, as well as require mortgages to low-income populations for which the ecosystem does not exist at the moment.
Make sure the project is completed before September 30, 2020, and get the certificate of completion from the relevant authority or Nespak.
Pay the taxes quarterly.
Market the project aggressively to well-off people, encouraging them to buy the units and make the full payment before September 30, 2022, as purchasers will be able to claim exemption for Section 111. The builder can also “double dip” on claiming exemption from Section 111 by buying the built units in his/her own personal name.
To avoid paying capital gains tax, the purchaser can hold on to the units for 4 years (or 3 years if the period is reduced to 3 years in future legislation) and then sell it. The recently-introduced quick exit is for those holding constructed property right now. It does not apply to property that will be constructed under the construction package.
WHAT THE PACKAGE MAY LOOK LIKE IN ACTION
We will use the prices of Skyline Apartments, near the Islamabad Airport. They have been recently launched by the Federal Government Employees Housing Authority (FGEHA) and provide us with a good benchmark for current projects that are expected to be launched after the ordinance.
The project has three types of units, providing a price point for three quality of housing units i.e. high-end, medium-end and low-end. We will assume that the low-end unit is built under low-cost housing. The profit margin is assumed to be 20 percent for high-end, 15 percent for medium-end and 10 percent for low-end units, respectively. This is a reasonable assumption, as builders construct high-end units to realise higher profit margins. For comparison, we will assume another high-end unit is being built under an existing project.
There are three sections in the table below. The first calculates the profit the builder makes and the exemption he or she can claim from Section 111 and the fixed taxes paid. The second calculates the tax-free profit a purchaser will make if he or she buys the unit and holds it for four years, thus paying zero capital gains tax. It is assumed the price of the unit will increase by 20 percent over 4 years, which is a reasonable assumption considering Pakistan is going through double digit inflation. The final section shows the maximum profit the builder makes if double dipping.
For a builder: The table shows building a high-end unit in a new project and paying a nominal tax of Rs148,000, will result in a maximum profit of Rs4,092,000, and exemption from Section 111 for wealth of Rs18,414,000. The effective tax rate on profit is 3.6 percent, which translates into 0.8 percent tax on amnesty claimed. The table also shows that it is not optimal to build for low-cost housing. Whereas the builder saves Rs140,160 in taxes (Rs148,800 tax on high-end - Rs8,640 tax on low-end), the builder misses out on profit of Rs1,311,840. If the intention is to maximise profits and to realise it at the earliest, the builder should be building high-end housing units targeting buyers that intend to seek exemption under Section 111.
For a buyer: There is no difference in the profit and exemption under Section 111 for the buyer, whether he/she buys a unit in a new project or an existing one. However, there is a high likelihood that the project will meet the completion date if it is an existing project. As such, to minimise risk, a buyer should opt for an existing project.
The bottom line: The objective of the construction package is wide-ranging, from propelling existing and new construction projects to developing low-cost housing. However, the design of the package falls far short of it as it may mostly result in the completion of existing projects targeted at high-end buyers.
Header image by Aun Jafri/White Star
Disclaimer: All investments in real estate are speculative in nature and involve substantial risk of loss, including complete loss of principal as can be attested by local and overseas Pakistanis in recent high profile real estate projects. Various statements contained in this article include projections that are subject to significant business, economic, competitive, regulatory and other risks, most of which are difficult to predict and could cause actual results to differ materially from rosy results shown herein. Please consult your financial advisor, tax accountant and project manager before undertaking any investment.
The writer is a real estate project financing specialist for residential real estate construction at one of the premier real estate companies in Canada. He has worked in real estate investing and management in the US, the UK and France
Published in Dawn, EOS, May 24th, 2020
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