Chapter 8: Capital Gains including Recharacterization of Transactions

Contents
Basic structure of Capital Gain..........................................................................................61
Section 37A:..................................................................................................................61
Section 37: Capital assets (other than specified in section 37A) may include:.............61
Consideration received shall be the total amount received or FMV whichever is
higher.........................................................................................................................61
Original..............................................................................................................................72
Total...................................................................................................................................72
4. Capital Gain – Pakistan Source Income – Section 101....................................72
*Q.8.6............................................................................................................................73
Answer to Q.8.6...........................................................................................................77

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 Chapter 8: Capital Gains including Recharacterization of Transactions
Chapter 8
CAPITAL GAINS INCLUDING RECHARACTERIZATION OF
TRANSACTIONS

Basic structure of Capital Gain

Gain on the disposal of a capital asset in a tax year is chargeable under the head capital gains on
accrual basis. There are two categories of capital assets as under:

Section 37A:
 Shares of a public company;
 Vouchers of PTCL;
 Modaraba certificates;
 An instrument of redeemable capital as defined in the Companies Act 2017;
 Debt securities; and
 Derivative products

Section 37: Capital assets (other than specified in section 37A) may
include:
 Shares of a private company;
 Membership card;
 Share in a partnership firm;
 Immoveable properties;
 Mining rights; and
 Certain personal assets specifically categorized as capital assets such as antiques.

1. Section 37: Capital Assets (other than specified in section 37A)

1.1 Capital asset has been defined as property of any kind, connected with business or not, but
does not include:
i. Stock in trade, consumable stores or raw materials held for business
ii. Depreciable asset or amortizable asset (i.e. fixed assets and intangibles for business
use)
iii. Movable property held for personal use of the person or any dependent family member
excluding capital assets mentioned in section 38(5) such as antiques.
1.2 Capital gains shall be computed as consideration received less cost of the capital asset +
incidental expenses for acquiring and disposing the capital asset.
Consideration received shall be the total amount received or FMV
whichever is higher.
FMV in case of a listed company shall be market value as per stock exchange quotation.
In case of an unlisted company, break-up value of shares of the company should be
considered as FMV.
Where an asset is lost or destroyed, consideration received shall be the scrap value along
with any compensation, indemnity or damages received under an insurance policy,
agreement, settlement or judicial decision.

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Note for students: Insurance premium is not considered as incidental expense with
reference to acquisition or disposal of a capital asset. However, in case a capital asset is lost
or destroyed and the insurance claim is taken as consideration received then the insurance
premium shall be considered as incidental expense.
1.3 Capital gain on disposal of immovable property is taxable as a separate block of income with
certain special provisions as under:
Note for students:
Gain or loss on disposal of immovable property in the following cases shall not fall within the
ambit of capital gain:

- A building used for business purpose is a depreciable asset and as per section 22(8)
gain on disposal of a depreciable asset is taxable under the head income from business
and therefore separate tax rates for gain on disposal of immovable property under the
head capital gain are not applicable in this case; and

- Immovable properties sold by builders and land developers etc whose income is
taxable under the head income from business

(A) Definition of consideration received of immovable property: The FBR is

empowered to notify the FMV of immovable properties situated in different parts of
Pakistan through notifications and the consideration received for the calculation of capital
gain and withholding tax purposes shall be:

Where the FMV has been notified by the FBR: Consideration received shall be
higher of actual sale proceed or the FMV notified by the FBR.

Where the FMV has not been notified by the FBR: Consideration received shall be
higher of actual sale proceed or the value fixed by the District Officer (Revenue) or
provincial or any other authorized authority for the purpose of stamp duty of that
immovable property.

(B) Tax rates on capital gain on disposal of immovable properties are as under:

For immovable properties acquired before 1.7.2016

- 5% where the holding period is up to 3 years; and

- 0% where the holding period is more than 3 years.

For immovable properties acquired on or after 1.7.2016

- 10% where the holding period is up to 1 year;

- 7.5% where the holding period is more than 1 year and up to 2 years;
- 5% where the holding period is more than 2 years and up to 3 years; and
- 0% where the holding period is more than 3 years.

(C) Advance tax on transfer of immovable property: Two provisions for advance tax on
transfer of immovable property have been introduced as under:

(i) Section 236C for collection of advance tax from the seller / transferor; and
(ii) Section 236K for collection of advance tax from the purchaser / transferee.

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(i) Section 236C: Recording authorities of immovable property shall collect advance tax
@ 1% (2% in case of non-filer) of the gross consideration from the transferor which is
adjustable from the tax liability of the transferor.
However, the said advance tax shall be minimum tax liability where immovable
property is acquired and disposed off within the same tax year.
Advance tax shall not be collected from the transferor where the capital gain on disposal
of immovable property is exempt including on account of holding period of the
immovable property.

(ii) Section 236K: Recording authorities of immovable property shall collect advance
tax @ 2% (4% in case of non-filer) of the gross consideration from the purchaser/
transferee which is adjustable from the tax liability of the purchaser / transferee.
If payment is being made in installments before transfer / allotment then the person
responsible for collecting such installments shall collect the advance tax.
This advance tax shall not be collected in certain cases including the following:
- where the value of immovable property is up to Rs.4 million; and
- any government scheme for expatriate Pakistanis where the payment is made in
foreign exchange remitted from outside Pakistan through normal banking channel
Note for students: The limit of Rs.4 million is applicable only for section 236K for the
purchaser. It means that if the value of property is up to Rs.4 million then only the
seller / transferor shall pay the advance tax.
On the other hand, if the capital gain on disposal of immovable property is exempt
including on account of holding period then only the purchaser shall pay the advance
tax where the value is more than Rs.4 million.

(D) Reduced tax rate on capital gain on disposal of immovable property: Tax rates
shall be reduced by 50% on first sale of immovable property acquired or allotted to ex-
servicemen and serving personnel of Armed Forces or ex-employees and serving
personnel of Federal and Provincial Governments being original allottees.

(E) Exempt capital gain on disposal of immovable property: Capital gain is exempt in
case of first sale being an original allottee by dependent of:

- a shaheed belonging to Pakistan Armed forces; and

- a person who dies while in the service of Pakistan Armed Forces or Federal or
Provincial Governments.

No advance tax shall be collected from the seller in the above cases.

1.4 Where a taxable capital asset (other than immovable property and capital assets covered u/s
37A) is held for more than one year then 25% of the capital gain is exempt and 75% is
taxable.
However, capital loss if any shall not be restricted and the full amount of loss shall be set-off
or carried forward in accordance with the provisions of losses.
1.5 On disposal of the following capital assets, loss if any shall not be recognized but gain if any
is taxable subject to the holding period of capital asset [section 38(5)]:
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i. A painting, sculpture, drawing or other work of art
ii. Jewellery
iii. A rare manuscript, folio or book
iv. A postage stamp or first day cover
v. A coin or medallion
vi. An antique

If the holding period of the above capital assets is more than one year then 25% of the
capital gain is exempt.

1.6 Exempt Capital Assets: Capital gain on disposal of the following capital assets is exempt:
- Shares of a company in Export Processing Zone (EPZ) – Clause 114 P-I 2 nd Schedule;
- Immovable property sold to a Developmental REIT Scheme with the object of
development and construction of residential buildings shall be exempt up to 30.6.2020 –
Clause 99A P-I 2nd Schedule
- Transfer of a membership right held by a member of an existing stock exchange, for
acquisition of shares and trading or clearing rights acquired by such member in new
corporatized stock exchange in the course of corporatization of an existing stock
exchange – Clause 110B P-I 2nd Schedule.
1.7 Non-recognition rules:
In the following modes of transfer of a capital asset, no capital gain or loss shall arise where
the recipient is a resident in Pakistan in the relevant tax year:
a) Transfer of assets between spouses under an agreement to live apart
b) Under a gift from a relative, bequest or will
c) By succession, inheritance or devolution
d) A distribution of assets on dissolution of an AOP or on liquidation of a company
Definition of relative as per section 85(5): “relative” in relation to an individual, means –
(a) an ancestor, a descendant of any of the grandparents, or an adopted child, of the
individual, or of a spouse of the individual; or
(b) a spouse of the individual or of any person specified in clause (a).

Deemed cost for the recipient:

The recipient of the capital asset shall be treated to have acquired the capital asset at the
FMV at the time of such transfer – section 37(4A).

However, in case of transfer of an asset between spouses under an agreement to live apart,
the cost in the hands of transferor shall be treated the cost for the recipient – section 79(3).

Taxability in the hands of recipient

Transfer of assets under an agreement to live apart is exempt in the hands of recipient:
section 48

2. Section 37A: Specified capital assets

2.1 A separate section 37A has been introduced to cater the disposal transactions of the
following securities:

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 Shares of a public company;
 Vouchers of PTCL;
 Modaraba certificates;
 An instrument of redeemable capital as defined in the Companies Act;
 Debt securities; and
 Derivative products.
2.2 Public company means [section 2(47)]:
a) A company listed in Pakistan at the year end
b) A company in which 50% or more shares are held by:
 the Federal or Provincial Government; or
 a foreign government; or
 a foreign company wholly owned by a foreign government
c) A unit trust including mutual funds.

2.3 Definition of redeemable capital as per section 2(55) of the Companies Act 2017 is as under:

“redeemable capital” includes sukuk and other forms of finances obtained on the basis
of participation term certificate (PTC), musharika certificate, term finance certificate
(TFC) or any other security or obligation not based on interest, representing an
instrument or a certificate of specified denomination, called the face value or nominal
value, evidencing investment of the holder in the capital of the company other than
share capital, on terms and conditions of the agreement for the issue of such instrument
or certificate or such other certificate or instrument as the concerned Minister-in-Charge
of the Federal Government may specify for the purpose.

In short, redeemable capital is any interest or profit based certificates issued by a

company other than shares.

2.4 Debt securities means – section 37A(3A):

(a) Corporate Debt Securities such as Term Finance Certificates (TFCs), Sukuk Certificates
(Sharia Compliant Bonds), Registered Bonds, Commercial Papers, Participation Term
Certificates (PTCs) and all kinds of debt instruments issued by any Pakistani or foreign
company or corporation registered in Pakistan; and
(b) Government Debt Securities such as Treasury Bills (T-bills), Federal Investment Bonds
(FIBs), Pakistan Investment Bonds (PIBs), Foreign Currency Bonds, Government Papers,
Municipal Bonds, Infrastructure Bonds and all kinds of debt instruments issued by Federal
Government, Provincial Governments, Local Authorities and other statutory bodies.

2.5 “Derivative products” means a financial product which derives its value from the
underlying security or other asset, may be traded on a stock exchange of Pakistan and
includes:
- deliverable futures contracts;
- cash settled futures contracts;
- contracts of rights;
- options; and
- future commodity contracts entered into by the members of Pakistan Mercantile
Exchange whether or not settled by physical delivery.

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2.6 Tax rates u/s 37A: Different slabs have been specified for the tax year 2019 (separate
block of income) as under:
Rate of tax
S. # Period Filer Non-filer
1 Where the security was acquired before 1.7.2013 0% 0%
2 Where the security was acquired between 1.7.2013
to 30.6.2016 and the holding period is:
- Less than 12 months 15% 18%
- 12 months or more but less than 24 months 12.5% 16%
- 24 months or more 7.5% 11%
3 Where the security was acquired on or after 1.7.2016 15% 20%
4 Future commodity contracts entered into by the
members of Pakistan Mercantile Exchange
5% 5%
Cash settled derivatives traded on stock exchange

Tax rates on capital gain in certain special cases are as under:

Mutual fund, collective investment schemes and Real Estate Investment Trust (REIT)
shall deduct tax at the following rates on the disposal of their units:
 10% in case of stock fund [12.5% if dividend receipts of the fund are
less than capital gain]
Definition of stock fund – section 2(61A): “stock fund” means a collective
investment scheme or a mutual fund where the investible funds are invested by way
of equity shares in companies, to the extent of more than 70% of the investment.
 10% in case of other fund [25% for a company]
2.7 Capital gains shall be computed on FIFO basis as consideration received less cost of the
capital asset + incidental expenses for acquiring and disposing the capital asset.
FIFO method shall not apply in respect of sale of shares purchased on the same trading day.

In case of market based transaction of any security, a notional expense @ 0.5% of sale
proceed and 0.5% of cost of security shall be taken in lieu of brokerage, commission,
transaction fee, levy, Laga or any other similar incidental expense – Rule 13N(8). However,
this notional deduction is not applicable in case of:

- units of open ended mutual funds; and

- future contracts entered into by members of PMEX.

“market based transaction” means transaction executed at any registered stock exchange
in Pakistan or at the platform of National Clearing Company of Pakistan Ltd (NCCPL).

“supportive evidence” for acquisition of securities shall be:

- broker’s bill for the purchase;
- broker generated computerized ledger statement of the investor’s brokerage account
- Central Depository Company’s statement of the investor’s account; and
- payment through cheques.
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2.8 Consideration received shall be the total amount received or FMV whichever is higher.
Where an asset is lost or destroyed, consideration received shall be the scrap value along
with any compensation, indemnity or damages received under an insurance policy,
agreement, settlement or judicial decision.
2.9 Non-recognition rules shall also apply in the case of transfer of securities specified in section
37A.

2.10 Minimum tax under section 113 i.e. turnover tax is not applicable on turnover by a
company representing sale proceed of listed shares and securities - Clause 11A(i) Part IV
2nd Schedule.

2.11 Loss adjustment: Loss on disposal of securities under section 37A shall be set off only
against the gain from any other securities u/s 37A and any unadjusted loss shall not be
carried forward to the subsequent tax year.

However, capital loss u/s 37 can be adjusted against capital gain u/s 37A.

Loss adjustment is not allowed in the following cases:

Wash Sale:
Where capital loss realized on disposal of a specific security by an investor is preceded or
followed in one month’s period by purchase of the same security by the same investor,
thus maintaining his portfolio.

It means that capital loss, if any, shall not be recognized if the purchase and sale (or sale
and purchase) are made within one month’s time.

Cross Trade:
Where an investor maintains accounts with two related brokerage houses and transfers his
security from one account to another then capital loss, if any, shall not be recognized.

It means that disposal of security to any outsider is considered as disposal.

Tax Swap sale:

Where an investor having realized loss on a particular security does not repurchase the
same security but purchases another similar security in the same sector thus not only
reducing capital gain tax, but also maintaining the portfolio broadly in the same sector.

Example of tax swap sale:

Mr. A earned capital gain of Rs.5 million on disposal of shares of C Ltd, a listed company
engaged in export of rice and sugar.

He has 400,000 shares of Y Ltd, a listed company engaged in textile. He disposed of such
shares at a loss of Rs.4.5 million and purchased shares of 400,000 of Z Ltd, a listed
company engaged in textile.

Answer:
Capital loss on disposal of shares of Y Ltd shall not be considered as this transaction falls
within the ambit of tax swap sale.

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Q.6 (b) Dec 2008 ICAP CFAP: Explain the following with reference to Income Tax Ordinance:
(i) Capital assets
(ii) Valuation of capital assets
(iii) Capital gains
(iv) Adjustment of capital loss against capital gains (Marks 8)

*Q.8.1 [Q.3(a) Sept 2007 ICAP CAF]

Mr. ZA inherited certain assets from his father in the year 20X2. The FMV of the assets on the
date of inheritance were as follows:
FMV (Rs.)
25,000 shares of a private limited company 2,500,000
21,000 shares of a public listed company 462,000
Membership card of Stock Exchange 20,000,000
Jewellery 1,500,000

During the tax year 20X8, Mr. ZA undertook the following transactions:
(1) He gifted some of the assets to his son Mr. IQ. The detail and FMV of the assets are as
follows:
FMV (Rs.)
10,000 shares of the private company 2,000,000
10,000 shares of the public listed company 1,700,000
Membership card of Stock Exchange 40,000,000

(2) The remaining shares were sold as follows:

 shares of private company for Rs.3,000,000,
 shares of public limited company for Rs.1,500,000.

Mr. IQ sold all the assets transferred through gift in the same year (8 months after the date of
gift). The assets fetched the following amounts:
Sales Proceeds
(Rs.)
10,000 shares of a private limited company 2,500,000
10,000 shares of a public listed company 1,500,000
Membership card of Stock Exchange 55,000,000
Required:
i) Based on the above information, compute the taxable income of Mr. ZA and Mr. IQ for the
tax year 20X8. Assume that incidental expenses are included in the above figures.
ii) Give brief explanation for the items not included in the taxable income. (Marks 10)

*Q.8.2 [Q.6(b) March 2010 ICAP CAF]

Mr. S, a resident individual, earned Rs.700,000 from the sale of assets as shown below:
Purchase Sale
Price Price Gain /
Date (Rs.) Date (Rs.) (loss) Rs.
Listed company shares 10.12.20X6 350,000 31.07.20X7 200,000 (150,000)
Unlisted company shares 15.07.20X6 500,000 30.11.20X7 900,000 400,000
Jewellery 15.05.20X6 750,000 20.12.20X7 1,400,000 650,000
Sculpture 01.07.20X3 400,000 31.01.20X8 300,000 (100,000)

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Private company shares 01.01.20X7 1,300,000 15.02.20X8 1,200,000 (100,000)
Required: Discuss the treatment and the implications of each of the above transactions under
the Income Tax Ordinance, giving brief reasons to support your conclusion. (Marks 5)

*Q.8.3 [Q.5 Sept 2011 ICAP CAF]

Mr. Feroz has been the CEO of AF Pakistan Ltd (AFPL) for several years. He was given 2,000
shares on 1.6.20X6 by AF AG, Germany (the parent company of AFPL) at a price of €2.5 per
share. The market price on that date was €8.2 per share. The shares were transferable on
completion of one year of service, from the date of issue of shares.
The market price of the shares as on 1.6.20X7 was €12.5 per share. On 10.4.20X8, Mr. Feroz
sold all shares at €13 per share. He paid a commission of €50 to the brokerage house.
The relevant exchange rates are as follows:
1.6.20X6 €1 = Rs.118.10
1.6.20X7 €1 = Rs.121.40
10.4.20X8 €1 = Rs.123.90
Required: Compute the amount to be included in the taxable income of Mr. Feroz for tax years
20X6, 20X7 and 20X8 and specify the head of income under which the income would be
classified. (7 marks)

*Q.8.4
Mr. Jugnoo, chief accountant in Roshni Ltd (unlisted company), had received 6,000 shares of the
company in July 20X6, under an employee share scheme. Mr. Jugnoo had the option to transfer
the shares in March 20X8 or thereafter. The market value of shares at the time of issue was
Rs.12 per share. In March 20X8 the share attained a market value of Rs.20; however, Mr. Jugnoo
sold the shares in May 20X9 when the share price was Rs.35 per share.
Required:
(i) With reference to above, briefly explain the relevant provisions of the Income Tax Ordinance
relating to employee share scheme. (Marks 6)
(ii) Compute the amount to be included in the taxable income for each tax year. (Marks 4)

*Q.8.5
Mr. Faqeer is the Finance Manager of Bhikari (Private) Ltd. He has been granted share options of
the company as follows:
− Option was granted at a price of Rs.20 per option, to acquire 5,000 shares after 2 years,
on payment of Rs.30 per share.
− FMV of option at the time it was granted was Rs.65 per option.
Two years period was completed in the tax year 20X5 and Mr. Faqeer decided to utilize the share
options as follows:
− 2,000 options were sold in the market at Rs.110 per option.
− 3,000 shares options were exercised by making additional payment of Rs.30 per option.
After two months, these shares were sold in the market at Rs.150 per share. At the time of
exercise of option, market value of share was Rs.135.
*Work out the tax liability of Mr. Faqeer in respect of above transaction, in the year in which the
options were granted as well as in the year 20X5. Also specify the heads of income in which it
shall be classified. (Marks 10)
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*Note for students: Answer should be divided into four parts as under:

(a) Option granted in the tax year 20X3

(b) Disposal of option in the tax year 20X5
(c) Exercise of option under ESS
(d) Disposal of shares

2.12 Computation of capital gain or loss on derivatives – Rule 13E

(1) In case of long position in deliverable futures contracts , capital gain or loss shall be
computed as the difference between cost of acquisition of securities underlying the futures
contract and the consideration from disposal of those securities to close the long position at or
before maturity of the contract.
(2) In case of short position in deliverable futures contracts , capital gain or loss shall be
computed as the difference between the consideration from short sale of securities underlying
the futures contract and the cost of acquisition to purchase those securities to close the short
position on or before maturity of the contract.
(3) In case of cash settled futures contracts, capital gain or loss shall be the cash payment
which the investor respectively receives from or makes to the other party to such contract to
settle the contract on or before maturity of the contract.
(4) In case of options, capital gain or loss shall be the difference between exercise price of the
options and the consideration from disposal of the securities underlying such options.
(5) In case of contracts of right, capital gain or loss shall be the difference between cost of
acquisition of right shares underlying the contract and the consideration from disposal of those
shares. [cost of right is the discounted price at which the right shares are issued to a shareholder
by the issue – Rule 13L(1)(d)(i)]

Q.3(a) June 2016 ICAP CFAP

Under the provisions of the Income Tax Rules, 2002 briefly explain how capital gain or loss in
case of each of the following derivatives would be computed:

(i) Cash settled futures contracts. (Marks 2)

(ii) Options. (Marks 2)
(iii) Contracts of right shares. (Marks 2)

2.13 Securities lending and borrowing: Rule 13P(h)

An investor borrows securities from another person for a specified period under an outright
purchase and re-sale contract. Investor sells the borrowed security in the market and on or
before contract completion date repurchases it to return to the lender. The borrowing investor
pays financial charges for the period of use of security.
Tax treatment
The net difference in the hands of the borrower resulting in completing the whole transaction,
including the financial charges, is to be treated as capital gain or loss. The income of the lender,
being mark-up income, shall not be subject to capital gain.
Example
A borrowed 1,000 shares from B for short term at an agreed value of Rs.100 per share on which
mark-up for the specified period is to be paid by the borrower. A sold such borrowed securities at
Rs.101 per share and subsequently re-purchased 1,000 shares at Rs.90. At the time of
settlement, the borrower also paid Rs.2 per share as mark up.
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Solution:
Rs.
Sale of borrowed securities 1,000 x 101 101,000
Less: Repurchase cost 1,000 x 90 90,000
0.5% of sale value 505
0.5% of repurchase cost 450
Finance charge paid to the lender 2,000 92,955
Taxable capital gain of the borrower 8,045

Finance income of the lender 2,000

2.14 Pledge Call transaction

(i) Details of the transaction
When a borrower defaults in payment to the lender, and securities were pledged as
collateral, the lender is entitled to transfer such securities from the person in default to his
own account.
(ii) Tax treatment
Such transfer will be treated as disposal and the day-end price will be taken as deemed
consideration for the purpose of computation of capital and tax thereon.

Q.2(b) June 2017 ICAP CFAP

What do you understand by ‘Pledge call transaction’? Briefly describe the tax treatment of a
pledge call transaction under the Income Tax Rules, 2002. (Marks 5)

3. Taxability of Dividend in specie and Bonus Shares

(a) Difference between bonus shares and dividend in specie is as under:

 Bonus shares is a situation where A Ltd issues additional shares of A Ltd to its
shareholders free of cost in lieu of cash dividend
 Dividend in specie is a situation where A Ltd has shares of B Ltd and transfers
the same to its shareholders free of cost in lieu of cash dividend.
(b) Taxability of Dividend in specie
The amount of dividend in specie (i.e. FMV of shares at the time of transfer to the shareholder)
shall be taxed as dividend income under FTR at the rates specified for normal dividend income.

On the disposal of shares received as dividend in specie, the difference between the
consideration received and the cost (i.e. the amount of dividend income) shall be taxable as
capital gain under section 37 or 37A as the case may be.

(c) Taxability of Bonus Shares

History of tax provisions regarding bonus shares

 Face value of bonus shares was excluded from the definition of “income” up to the tax
year 2014. It means that bonus shares were not taxable at the time of receipt but capital
gain on its disposal was taxable based on the Supreme Court Judgement in case of
Ebrahim Brothers Ltd dated 26.4.1992 and FBR circular letter dated 18.5.1972.

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 From the tax year 2015 onward, market value of bonus shares when received was
taxable as dividend income under FTR @ 5% and any excess sales proceed on disposal
was taxable under the head capital gain

 From the tax year 2019, provisions regarding taxability of bonus shares under FTR have
been deleted and now the situation before the tax year 2015 has been revert back.

Tax treatment of bonus shares is as under:

 Face value of bonus shares in not taxable when received by the shareholders.
 In respect of valuation of bonus shares for determination of capital gain at the time of
disposal, it has been held by the Supreme Court that the cost of old shares would be
spread over on total number of shares including bonus shares.
Reference: Ebrahim Brothers Ltd Vs CIT dated 26.4.1992 and FBR circular letter dated
18.5.1972.

EXAMPLE: 500,000 shares of a private company of face value of Rs.10 each were purchased @
Rs.15 per share. 100,000 bonus shares were received and total 600,000 shares were sold @
Rs.16 per share.

Taxable capital gain (based on Supreme Court decision)

Original Bonus Total

Shares Shares
Number of shares 500,000 100,000
Rs. Rs. Rs.
Sale proceed @ Rs.16 8,000,000 1,600,000
Cost of acquisition
7,500,000 / 600,000 = 12.5 6,250,000 1,250,000
(500Kx15) / (500K+100K)
Capital Gain 1,750,000 350,000 2,100,000
(9.6m-7.5m)

4. Capital Gain – Pakistan Source Income – Section 101

101(13) Any gain arising on the disposal of shares in a resident company shall be Pakistan
source income.
101(10) [portion related to shares]: Any gain from the alienation of any share in a company the
assets of which consist wholly or principally, directly or indirectly, of rights to explore
natural resources in Pakistan.
It means that capital gain on shares of a non-resident company is a foreign source income and a
non-resident shareholder is not subject to tax in Pakistan for such income.
However, if a non-resident company is involved wholly or substantially in exploration of natural
resources in Pakistan then capital gain on shares of such a company is a Pakistan source income
and a non-resident shareholder is taxable in Pakistan subject to tax treaty.

*Q.8.6
S Ltd is a wholly owned subsidiary of H Ltd, a company incorporated in UK. H Ltd does not have
a permanent establishment in Pakistan. S Ltd has been operating in Pakistan since 20X1 as a
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branch. The branch, under an agreement with the Baluchistan Government, has been given the
right for exploration of mineral resources which is its principal activity.
In August 20X8, H Ltd disposed off its entire shareholding in S Ltd to an enterprise in Brazil and
made a gain of US$800,000 on the transaction. H Ltd’s management has an opinion that this
transaction is not taxable in Pakistan as the deal took place outside Pakistan and the sale
proceed was also received outside Pakistan.
Required:
1) State whether or not the aforesaid view of H Ltd is correct.
2) Explain whether or not your conclusions would differ if S Ltd was engaged in the
business of textile.

5. Recharacterisation of income and deductions – Section 109

Summary of section 109 is as under:
(1) the Commissioner may –
(a) recharacterise a transaction that was entered into as part of a tax avoidance scheme;
(b) disregard a transaction that does not have substantial economic effect;
(c) recharacterise a transaction where the form of the transaction does not reflect the
substance; or
(d) disregard any entity or a corporate structure that does not have an economic or
commercial substance or was created as part of the tax avoidance scheme.
(2) “tax avoidance scheme” means any transaction where one of the main purposes in entering
into the transaction is the avoidance or reduction of tax liability i.e. reduction, avoidance or
deferral of tax or increase in tax refund including the effect of tax treaty.

Examples may be:

A. Unadjustable deposit from the tenant is included in chargeable rent which is not the case of
adjustable deposit. If an owner receives deposit and adjustment is a minor % such as 0.5%
every month then the Commissioner may treat the deposit as unadjustable based on its
substance rather than its form.
B. If Mr. A wants to dispose off his capital asset and instead of disposal he transfers it as a gift
to Mr. B to avail the benefit of non-recognition rule and then Mr. B disposes off the said
capital asset. The Commissioner may disregard the concept of non-recognition rule and he
may treat it as a normal sale at FMV in the hands of Mr. A.
C. Salary expense is tax expense for a company while dividend is an appropriation and not a tax
expense. If salary of employees of a private company who are also the shareholders is extra
ordinary higher then the Commissioner may treat the same as dividend instead of salary in
the hands of company as well as employees.
However, certain schemes of tax avoidance have specifically been allowed in the Ordinance such
as group relief and group taxation [refer chapter on losses] and the Commissioner can not
recharacterize such transactions.
Q.2 Dec 2003 ICAP CFAP
The charge to tax is based on substance of a transaction rather than its form. Explain with
reference to Section 109 of the Income Tax Ordinance 2001 the provisions under which an
income or deduction could be “recharacterized” by the tax authority for the purposes of taxation.
(Marks 12)

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Q.6(a) Dec 2011 ICAP CFAP
In the light of the provisions of Income Tax Ordinance, 2001 explain the term “Tax avoidance
scheme”. Under what circumstances the Commissioner may exercise his powers to recharacterise
or disregard a transaction? (Marks 5)

Q.3(b) Dec 2016 ICAP CFAP

In view of the provisions of the Income Tax Ordinance, 2001 describe the circumstances in which
the Commissioner may recharacterise or disregard a transaction. (Marks 3)

*Q.8.7 [Q.3 Dec 2004 ICAP CFAP]

Conglomerate Group plc of United Kingdom (CG) had made a major investment (approx 95%) in
shares of ABC Ltd a Pakistani unquoted public company. The investment was made 40 year ago
and the company invested UK £1,250,000. CG was allotted 100,000 shares of Rs.100 each. The
currency parity, prevalent at that time, was £1 = Pak Rs.8.
In March 20X8, CG decided to dispose the shares and started negotiations with local and foreign
investors and finally struck a deal with a Pakistan based company. It was decided that CG would
be entitled to the interim dividend of Rs.50 million for the year 20X8 of ABC Ltd out of its current
and accumulated profits. The buyer will pay Rs.475 per share resulting in a receipt of £350,000
and a loss of £900,000 to CG based on current currency parity.
Required:
(a) Please compute the tax liability of CG in the tax year 20X8. (Marks 4)
(b) Please quantify the effect on tax liability if the transaction is not acceptable to the
Commissioner, in terms of section 109. (Marks 4)

Answers
Answer to Q.8.1
Mr. ZA
Tax Year 20X8
Computation of taxable income
Rs.
CAPITAL GAIN
Shares of a private company
Consideration received of 15,000 shares 3,000,000
Less: FMV in the year 20X2 as deemed cost @ Rs.100 per share 1,500,000
1,500,000
75% is taxable as the holding period is more than one year 1,125,000

Shares of public company

Sale proceed of 11,000 shares 1,500,000
Less: Deemed cost of 11,000 shares @ Rs.22 242,000
Capital gain u/s 37A taxable as separate block of income 1,258,000 --
Taxable capital gain at normal slab rates 1,125,000

Mr. IQ
Tax Year 20X8
Computation of taxable income
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Rs.
CAPITAL GAIN
Shares of a private company
Consideration received of 10,000 shares 2,500,000
Less: FMV at the time of gift as deemed cost 2,000,000 500,000

Shares of public company (separate block of income) --

Membership card of stock exchange

Consideration received 55,000,000
Less: FMV at the time of gift as deemed cost 40,000,000 15,000,000

Taxable income 15,500,000

Notes:
1) The recipient of a capital asset shall be treated to have acquired the capital asset at the
FMV at the time of certain types of transfer including by way of gift or through
inheritance. Therefore, FMV in the year 20X2 when Mr. ZA received certain capital assets
through inheritance is treated as cost. Likewise, FMV at the time of gift is treated as cost
for Mr. IQ.
2) Loss on disposal of shares of a public company by Mr. IQ (Rs.1,500,000 – 1,700,000 =
Rs.200,000) is a separate block of income u/s 37A. This loss can not be carried forward
but can be adjusted against any gain on disposal of any securities specified u/s 37A.
There is no such gain and therefore this loss is dead.
3) According to non-recognition rule, no gain or loss arises on transfer of capital assets inter
alia by way of gift where the recipient is a resident person for tax purpose. Therefore,
transfer of capital assets by Mr. ZA to Mr. IQ by way of gift is not subject to tax
assuming that Mr. IQ is a resident person during the relevant tax year.
4) Where a taxable capital asset (other than securities u/s 37A and immovable property) is
held for more than one year then 25% of the capital gain is exempt and 75% is taxable.
Therefore, 25% of the capital gain on disposal of shares of a private company is exempt
in the hands of Mr. ZA as the holding period is more than one year.

Answer to Q.8.2

Shares of listed company

Loss on disposal of shares of a listed company can be adjusted only against gain
on securities specified u/s 37A in the year of loss but the said loss can not be
carried forward. There is no such gain and therefore, the loss on shares of listed
company is dead. Nil

Shares of unlisted company

75% of the gain is taxable as the holding period is more than one year 300,000
Jewellery
75% of the gain is taxable as the holding period is more than one year 487,500
Sculpture
There are certain capital assets inter alia sculpture in which case loss is not
recognized Nil

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Shares of private company
Loss on disposal of shares of a private company can only be adjusted against
capital gain or alternately it can be carried forward to be adjusted against future
capital gain for a period of subsequent 6 years (100,000)
Taxable capital gain for the year 687,500

Answer to Q.8.3
AF AG, Germany is not listed in Pakistan and therefore any gain on disposal of the share of this
company is taxable u/s 37.

Tax year 20X6:

No tax effect as the CEO had no right to transfer the shares in the tax year 20X6.

Tax year 20X7:

FMV on 1.6.20X7 €12.5 x 2,000 shares x Rs.121.4 3,035,000
Cost paid on 1.6.20X6 €2.5 x 2,000 shares x Rs.118.1 590,500
Taxable under the head salary 2,444,500

Tax year 20X8:

Consideration received on 10.4.20X8
2,000 shares x €13 x Rs.123.9 3,221,400
Less: cost paid 590,500
amount taxed under the head salary 2,444,500
commission paid €50 x Rs.123.9 6,195 3,041,195
180,205

Taxable capital gain Rs.180,205 x 75% 135,154

Answer to Q.8.4

Tax Year 20X7: Not taxable as Mr. Jugnoo did not have right to transfer shares.

Tax Year 20X8: 6,000 shares x FMV Rs.20 per share = Rs.120,000 is taxable under the head
salary as he has free right to transfer the shares.

Tax Year 20X9: Taxable amount under capital gain would be as under:

Consideration received 6,000 x 35 210,000

Less: amount charged in 20X8 120,000
Capital gain 90,000

Holding period is more than one year:

75% is taxable 67,500

Answer to Q.8.5

(a) Option granted in the tax year 20X3

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Option granted under employee share scheme (ESS) is taxable when disposed off at the
consideration received less any cost paid for the option. No tax implication in the tax year 20X3
as the option was not disposed off. FMV of option in the tax year 20X3 is not relevant.

(b) Disposal of option in the tax year 20X5

Taxable amount under the head salary is the consideration received less cost paid for the option.
Taxable amount is 110 – 20 = Rs.90 per option x 2,000 = Rs.180,000.

(c) Exercise of option under ESS

It is taxable under the head salary in the year of issue of shares at FMV at the date of issue of
shares less cost paid for shares and option. Taxable amount is 135 – 30 – 20 = Rs.85 per share x
3,000 = Rs.255,000

(d) Disposal of shares

Taxable amount is 150 – (30 + 20 + 85) = Rs.15 per share x 3,000 = Rs.45,000
The capital gain is fully taxable as the holding period is not more than one year and the company
is not a public company for Pakistan tax purpose.

Answer to Q.8.6
H Ltd and S Ltd are both non-resident companies and as non-resident they are taxed only on
Pakistan source income.
Section-101 (geographical source of income) specifies the conditions for Pakistan source income
and states that any gain on the alienation of any shares in a company, the asset of which consist
wholly or principally, of the lease of immovable property or of the right to explore and exploit any
natural resources of Pakistan, is Pakistan source income. There is no condition here that the
shares sold should be of a resident company.
S Ltd is operating in Pakistan as a branch and is in the business of exploration of mineral
resources as a principal activity. The gain of US$800,000 made by H Ltd on the sale of shares of
S Ltd is Pakistan source income and thus taxable as ’capital gains’ subject to tax treaty.
If S Ltd was engaged in the business of textile, its assets wholly or principally would not be
consist of any lease of immovable property or the right to explore and exploit natural resources in
Pakistan. S Ltd being a non-resident company, any gain on the disposal of its shares would be
foreign source income for H Ltd and therefore not taxable in Pakistan.

Answer to Q.8.7
(a) Rs.
Sale proceed of shares Rs.475 x 100,000 47,500,000
Cost of shares to CG in Pak Rs. = £1,250,000 x 8 10,000,000
Capital gain 37,500,000
Holding period is more than one year, 75% is taxable 28,125,000
Income tax on capital gain 29% of Rs.28,125,000 8,156,250
Income tax on dividend income @ 15% of Rs.50 million 7,500,000
Total tax liability 15,656,250

Notes:
1) Tax rate on dividend is 15% under FTR for a shareholder including corporate
shareholder.
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2) Capital gain: section 71 provides that every amount shall be taken in Pak Rupees. If an
amount is in foreign currency the same shall be converted into Pak Rupees at the State
Bank of Pakistan rate on the date the amount is taken into account for the purpose of
this Ordinance. Therefore, cost and consideration in £ would be ignored.

(b) Possibility of recharacterization by the Commissioner u/s 109

According to section 109 the Commissioner may recharacterise inter alia a transaction that
was entered into as part of a tax avoidance scheme or where the form of transaction does
not reflect the substance.
In the case of CG the Commissioner may consider the remittance of interim dividend as part
of consideration against disposal of shares instead of dividend income. If the Commissioner
recharacterises the transaction in this manner, tax liability would be as under:

Rs.
Sale proceed of shares 47,500,000 + 50,000,000 97,500,000
Cost of shares to CG in Pak Rs. = £1,250,000 x 8 10,000,000
Capital gain 87,500,000
Holding period is more than one year: 75% is taxable 65,625,000
Income tax on capital gain 29% of Rs.65,625,000 19,031,250
However, if declaration of interim dividend has been a regular practice by ABC Ltd then CG
would have a strong case that declaration of interim dividend was genuine and not merely a
tax avoidance scheme.

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