Typically, RE Funds invest in project specific single asset companies with the asset being self-
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liquidating, in most cases by subscribing to a mix of debt and equity instruments, as debt is favorable for investee companies to reduce book profits or tax burden. Additionally, redemption premium can be structured to provide equity upside. Nevertheless, if the income of the domestic fund is characterized as capital gains it gives a better position as compared to characterization of income as a business income or interest.
Subscription to debt instruments is also preferred because in the Indian context exit by way of an IPO is a rarity as real estate companies seldom meet the listing requirements. Also, for distribution of dividends on equity instruments, as a pre-requisite, the investee company shall require distributable profits as. This again is difficult to achieve because the real estate industry is very capital heavy.
B. Offshore Real Estate Funds
FPIs are allowed to invest in listed / to be listed NCDs of Indian companies. Under this route, any private or public company can list its privately placed NCDs on the wholesale debt market segment of any recognized stock exchange. An FPI can then purchase these NCDs on the floor of the stock exchange.
RBI and SEBI have permitted direct subscription of ‘to be listed’ NCDs by the FPI, thus, doing away with the requirement of a warehousing entity. These ‘to be listed’ NCDs have to listed on a recognized stock exchange within fifteen days of issuance, else, the FPI are required to dispose-off the NCDs to an Indian entity / person.
Further, since NCDs are subscribed to by an FPI entity under the FPI route and not the FDI route, the restrictions applicable to the FDI investors in terms of pricing are not applicable to NCD holders. The FPI Regulations have retained the flexibility to invest in listed / to be listed NCDs.
C. Real Estate Investment Trusts
(“REIT”)
SEBI released the REIT Regulations on September 26, 2014. REITs would serve as an asset-backed investment mechanism where an Indian trust is set up for the holding of real estate assets as investments, either directly or through an Indian company set up as a SPV. However, the tax treatment of REITs continues to remain an issue.
The Finance Act, 2014, had made certain
amendments to the Tax Act to clarify the income tax treatment of REITs. REITs will have a tax pass through status for income received by way of interest or receivable from the SPV as per s. 10 (23FC), 10 (23FD) and 115UA of the Tax Act.
Further, the Finance Act, 2015 extends the pass through status to REIT investors even in relation to rental income earned in respect of property directly held by the REIT. Sponsors of REITs who acquired units through swap of SPV shares can now benefit from capital gains tax relief applicable upon sale of listed units on the stock exchange. Additionally, the Finance Act, 2015 provides relief to sponsors from MAT in respect of gains arising on transfer of a capital asset, being share of a special purpose vehicle to a business trust in exchange of units allotted by that trust. In respect of distribution of rental income by the REIT to non- resident investors, there is a withholding tax which will be applied on such income at the rates in force, which can go up to 40%. Such withholding tax paid in India under this provision should be creditable in the jurisdiction of residence of the investors. From a foreign investor point of view, a direct holding of assets by the REIT may not be tax efficient.
Long term capital gains on sale of units as well as dividends received by REITs and distributed to the investor shall be tax exempt. Interest income received or receivable by the REIT from any SPVs is tax exempt and foreign investors shall be subject to a low withholding tax of 5% on interest payouts.60 From a sponsor’s perspective, capital gains tax benefit has been given only in cases where shares of the SPV holding the real estate assets are transferred to a REIT against the units of a REIT, and not when real estate assets are directly transferred to a REIT by the sponsor. By doing so, there is an additional corporate layer imposed between the REIT and the real estate asset, which could result in a tax leakage of about 45% (corporate taxes of 30% at the SPV level and distribution tax of 15% on dividends, exclusive of surcharge and cess). To the sponsor, there is no tax benefit (but mere deferral) because she gets taxed when the REIT units are ultimately sold on the floor at a much more appreciated value, even though the units of a REIT would be listed and exempt from capital gains tax if held by other unit holders for more than three years.The only way to achieve tax optimization seems to be by way of infusion of debt into the SPV by a REIT. In such a situation, interest from the SPV to the REIT will be a deductible income
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for the SPV, thus allaying both distribution taxes and corporate taxes. Interest from the SPV would be tax exempt at the REIT level and only a 5% withholding will be applicable on distributions by the REITs to the foreign unit-holders. This should help neutralize REIT taxation at India level, considering that the 5% withholding tax paid in India should also be creditable offshore.
The critical question that would then come up is how the SPV would use this debt. The debt can either be used to retire existing debt, or be structured to retire promoter equity in the SPV. If the debt is used for retiring equity, the risk of ‘deemed dividend’ characterization would need to be carefully considered. Though other creative structures may be devised to minimize tax exposure for the sponsor, it will be critical to ‘dress up’ the SPV appropriately with the right amount of debt and equity, before the SPV is transferred to the REIT.
Apart from the tax challenges set out above, there are also several non-tax issues that make the Indian REIT story unattractive. The requirement for a sponsor to have a real estate track record is likely to rule out a substantial portion of yield generating assets. This eliminates the possibility of non-real estate players
such as hotels, hospitals, banks and others becoming sponsors of REITs.61
The Finance Act, 2015, modifies the extant regime by making capital gains completely exempt in the hands of the sponsor in ordinary cases. For this purpose, the Finance Act, 2015 has introduced an amendment allowing for the long term capital gain exemption and beneficial 15% rate on short-term capital gains on the sale of REIT units by the sponsor as part of an offer for sale at the time of initial listing or by way of subsequent sale on the stock exchanges.
Most importantly, in the absence of capital gains and stamp duty exemptions being accorded to the sponsor for direct transfer of property, the pass- through that has been given for rental income would remain largely ineffectual since developers would be unwilling to transfer property into the Business Trust after incurring such significant costs. Further, since no pass-through in respect of dividend distribution by the SPV, the pass-through accorded to Business Trusts remains partial and not in line with investor expectations.
61. http://www.nishithdesai.com/information/research-and-articles/nda-hotline/nda-hotline-single-view/article/reits-tax-issues-and-beyond-1.html?no_ cache=1&cHash=a54570354bb5bc1969d720fba3cad33a
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The following table summarizes the (i) requirements for eligibility under the India-Mauritius DTAA and the India-Singapore DTAA, (ii) the substance requirements that companies in Mauritius and Singapore will have to demonstrate in order to claim
benefits under the two treaties and (iii) the tax rates that should be applicable to companies under the relevant tax treaties read with the provisions of the domestic tax law.