JAIRAJ PURANDARE decodes the taxation structure applicable to REITs according to the Finance Bill 2015.
Understanding the need for additional funds for the real-estate sector, globally successful investment vehicle REIT was introduced in India. The benefits of REIT are that it enjoys a tax pass through status and brings in increased transparency as a result of corporate governance and increased financial disclosures. Settled in the form of a trust under the Indian Trusts Act, 1882, a REIT generally comprises a SEBI-registered trustee, sponsor and manager. It can raise capital or debt by issuing listed units or debentures to investors. REITs can also invest in shares and debt of Indian special purpose vehicles (SPVs) mainly owning real-estate assets, owned by the sponsor.
In the previous Finance Act 2014 (announced in July 2014), a special taxation regime was announced with respect to REITs. However, this regime left a lot to be desired on account of only a partial pass through status accorded. The income of the REIT (excluding dividend, capital gains and interest) was being taxed at the maximum marginal rate with capital gains tax liability for the sponsor at the time of transfer or sale of units in the REIT even on a recognised stock exchange. The concept, therefore, did not draw much enthusiasm from the real-estate sector then.
The Finance Bill 2015 (introduced on February 28, 2015) contains some welcome remedial measures for taxation of REITs, which are proposed to be made applicable from June 1, 2015. The major takeaways from the bill are briefly discussed below:
Sponsor: It is now proposed in the Finance Bill 2015 to tax capital gains arising on the transfer of such listed units on a par with listed equity shares; that is at 15 per cent for short-term capital gains and nil for long-term capital gains. With this proposal, the sponsor would be brought on a par with other unit holders as far as taxation of transfer of units in the REIT is concerned. The sponsor may acquire the listed units of a REIT in exchange for shares of the SPV. Such exchange will now not be considered as a transfer and consequently be a non-taxable transaction under the Income Tax Act 1961 (the IT Act). Taxability of such units of the REIT acquired in exchange of shares of the SPV is now proposed to be deferred to the time of transfer or sale of units in the REIT by the sponsor. As the units of a REIT are compulsorily required to be listed on a recognised stock exchange, sale of units in a REIT on such a stock exchange is taxed in pari materia with the sale of a listed equity share. Accordingly, where the units have been held for 12 months as on the date of transfer, the short-term capital gains arising on their transfer would be taxed at 15 per cent. If these units have been held for more than 12 months, long-term capital gains on the sale of these units on such a recognised stock exchange would be exempt. In both the above transactions, the Securities Transaction Tax (STT) needs to be levied on such transfer.However, it is to be noted that in case the holder of such units is a corporate entity, such long-term capital gains would attract levy of Minimum Alternative Tax (MAT). It is also interesting to note that while the exchange of shares of the SPV by the sponsor for the units in the business trust is an exempt transaction under the tax law, the definition of SPV as per the IT Act is slightly different from that under SEBI regulations. According to SEBI regulations, SPV could be a company or a Limited Liability Partnership (LLP). However, as per the IT Act, SPV is defined as a company. It may, therefore, have to be examined whether the exemption for such transfer can be availed by a SPV that is an LLP.
REIT: A REIT is permitted to invest in real-estate assets either directly or through an SPV. As far as the income of the REIT is concerned, it is proposed to extend the pass through status to the income earned by the REIT by way of leasing any real-estate asset owned directly by the business trust. Such rental income was earlier subject to tax at the maximum marginal rate. Such rental income received by a REIT will also be out of the ambit of the tax deducted at source (TDS) provisions. However, rental income received from assets held by the REIT through an SPV will continue to be taxed at the maximum marginal rate.
Unit holders: When a REIT distributes its (exempt) rental income earned from assets owned directly by it, such income will be taxable in the hands of the unit holders. The REIT will be required to withhold tax on such distribution at 10 per cent in the case of resident unit holders and at the rates in force (up to 40 per cent) in the case of non-resident unit holders. Thus, foreign investors may not consider investment in REITs, which directly own real-estate assets, tax-efficient. Under the present Indian tax laws, the income distributed by a REIT to its unit holders is considered not to change its character in the hands of the unit holders. For example, in case rental income from real-estate assets is distributed to unit holders, such income would be considered income from renting of real-estate assets in the hands of the unit holders. It would, therefore, be interesting to examine whether the deductions available to the owner of a property in computing income from house property can also be claimed by the unit holders receiving rental income distributed by a REIT.
These are welcome tax measures and indicate a step in the right direction to encourage investment in the real-estate sector. One also hopes that the legislative intentions expressed by the proposals in the Finance Bill 2015 are not negated by an aggressive and unfriendly tax administration of these provisions. We have discussed below a case study of how the REITs structure will operate in India.
Supposedly, Ltd-A is a company with requisite experience as a developer of real estate, as provided in the SEBI regulations for REITs. Ltd-A owns 100 per cent of the share capital of its SPV; in turn, Ltd-B owns various complete buildings, ready to be let out for commercial purposes. Ltd-A would like to exit from the commercial projects it is carrying out through its SPV, which is Ltd-B.
Ltd-A can consider setting up a REIT, registered with SEBI, in its capacity as a sponsor. Ltd-A would be required to transfer its entire shareholding in Ltd-B to the REIT and in exchange acquire at least 25 per cent of the units of the REIT, prior to allotment of units of the REIT to the public. There would be no capital gains in the hands of Ltd-A at the time of such exchange of shares to Ltd-B for units of the REIT.
The REIT can then be invested in completed and rent-generating properties either directly or through Ltd-B. Various income streams that may be received by the REIT would include, inter alia, dividend paid by Ltd-B on the shares held by the REIT in Ltd-B, rental income from real-estate assets held by the REIT directly and through Ltd-B, interest received from Ltd-B on debt, and so on. As per the SEBI regulations pertaining to REITs, Ltd-A is required to hold the units of the REIT for at least three years. After the end of three years, Ltd-A can exit from the REIT by selling the units of the REIT held by it. However, prior to such sale, Ltd-A will be required to arrange for another person to act as a sponsor for the REIT.
About the Author:
Jairaj (Jai) Purandare, Chairman, JMP Advisors Pvt Ltd, based in Mumbai, has over three decades of experience and significant expertise in advising multinational and Indian clients across fields on investment proposals to regulatory authorities including the FIPB and the RBI. He has been named among the leading tax advisors in India by Euromoney in its report, World´s Leading Tax Advisors.
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