*An eight-part series covering the commercial and legal considerations of REIT listings in India. Click here to read Part III.
The Government started putting in place a framework for taxation of business trusts even before the regulations governing Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts (InvITs) were notified by the Securities Exchange Board of India (SEBI). This was not without reason – progressive regulations and tax reforms have influenced the progress of REITs globally, with REIT markets witnessing sudden growth spurts in countries such as Singapore and Hong Kong almost immediately following favourable tax amendments.
Closer home, five years and multiple amendments later, the Indian tax regime for REITs is a complex proposition and comes with a wishlist from nearly all stakeholders involved in a typical REIT. With Indian real estate likely to provide investment opportunity worth up to USD 77 bn through REIT-eligible commercial office and retail properties across India's top seven cities by 20201, there can be no better time to look at some of the key issues.
Setting Up of the REIT
The REIT Regulations enable the pooling of assets into a REIT through a transfer of shareholding, or interest and rights in holding companies (Holdcos) or special purpose vehicles (SPVs) to the REIT, or the transfer of the entire ownership of real estate assets to the REIT, in exchange for REIT units. This flexibility is significant, considering typical holding structures involve multiple joint development partners, landowners and other stakeholders involved in a real estate asset portfolio, not all of whom may be shareholders in a Holdco/SPV. It is even significant from the perspective of sponsor and sponsor groups who may hold interests in real estate assets other than in the form of shareholding.
However, while the REIT Regulations provide this flexibility, the current taxation framework only provides an exemption from capital gains tax and minimum alternate tax (MAT) in the case of transfer of shares in lieu of REIT units. Any other form of contribution to the REIT – i.e., in the form of ownership of real estate assets, or interest and rights in a real estate asset, is treated as a 'transfer' for the purposes of the Income Tax Act, 1961 (IT Act), making it subject to taxes ranging from 20% to 40%2, depending on the nature of the income in the hands of the transferor, legal status of the transferor and the period of their holding, etc.
Further, such forms of contribution to the REIT (i.e. other than shares of an SPV) also attract stamp duty and registration charges, which would be applicable to any such transaction of transfer of immovable property, or interest and rights in immovable property. Moreover, gains arising from such contributions to the REIT (other than by individual shareholders or trusts) will not be eligible for a MAT exemption, which is available in case of share transfers in lieu of units. This is in contrast with certain developed REIT jurisdictions such as Singapore, where a transfer of assets in lieu of units is tax exempt.
The transfer of shareholding in exchange of REIT units is not entirely devoid of complications either: presently, only an exchange of shares held as capital assets (and not other securities such as compulsorily convertible debentures or shares held as stock in trade) are eligible for exemption under the IT Act.
Tax Implications on an Ongoing Basis
REITs have been conferred as hybrid pass-through status for income tax purposes, meaning that the onward distribution of income by a REIT to its unitholders retains the same character as the underlying income stream received by the REIT. Interest income and rental income from property held directly by the trust, is not taxable in the hands of the REIT. However, any capital gains on the sale of assets/ shares of an SPV are taxable in the hands of the trust, depending on the period of holding whereas dividend income is not liable to tax. Further, any other income earned by a REIT shall be subject to tax at the maximum marginal rate.
For unitholders, in the context of distributions received from a REIT, interest income is taxable in the hands of the investors and the REIT would be required to withhold tax at the rate of 5% in the case of a non-resident investor and 10% in the case of a resident investor. In relation to a non-resident investor, the actual tax liability on such interest income will correspond to the amount of tax withheld, whereas a resident investor's tax liability may vary depending on the applicable slab rates ranging from 5% to 30%.
Similarly, distribution made from any rental income from properties directly held by the REIT, are chargeable in the hands of the unitholders at applicable rates. REITs are also required to withhold tax at the concessional rate of 5% on interest payable on external commercial borrowings. However, distribution made from dividend income, or capital gains on sale of assets or shares of an SPV are not taxable in the hands of the unit holders.
A sale of units on the stock exchange is subject to capital gains tax, depending on the period of holding, where the date of purchase and cost of shares of an SPV are considered to compute the period of holding of such units. Such capital gains would be taxed at the rate of 10% if the units have been held for more than 36 months, which is taxed at 15% in other cases. Additionally, for unitholders that are Indian companies, MAT may be payable at the time of sale of units.
In the hands of an SPV (the concept of Holdco is not recognised under the IT Act as yet) the rental income from assets, as well as the capital gains on the sale of assets are taxable at applicable rates. However, in respect of interest paid to REITs, a deduction on interest is available and there are no withholding requirements. Additionally, dividend distributed by the SPV to the REIT, from its current income, would not be subject to dividend distribution tax (DDT).
Cognisance of Holding Structures Under the REIT Regulations
The current pass-through treatment of REITs in India is not completely aligned with the definition of Holdcos/SPVs under the REIT Regulations, either. Taking cognisance of typical holding structures in the real estate sector, the REIT Regulations have been amended over time to provide that shareholding to the extent of 50% in a Holdco/SPV, subject to certain other conditions, satisfies the eligibility criteria for inclusion in a REIT structure. However, under the extant taxation framework, the concept of Holdcos is not recognised as yet, and exemptions available to an SPV from payment of DDT are on the basis that 100% of the shareholding in the SPV is held by the REIT, with such dividend being distributed by the SPV directly to the REIT.
This conditionality creates tax leakage in case of structures where the shareholding of the REIT in the Holdcos or SPVs is not 100%, thereby reducing the flexibility in structuring available to sponsors and sponsor groups.
Way forward
There are several positives when it comes to the extant tax framework for REITs in India, even when compared to developed REIT regimes. For instance, the withholding tax for foreign investors in India is 5%, compared to rates as high as 30%, 49% and 24% in Japan, Australia and Malaysia, respectively. Similarly, the tax exemption available in India in case of a transfer of shares in lieu of REIT units, is not available in developed jurisdictions such as Australia. However, there are other aspects where lessons may be learnt from successful REIT markets globally, for instance: taxation of individual unitholders, which are subject to nil income tax in countries such as Singapore and Hong Kong; or the taxation of corporate unitholders, who are subject to lower rates of taxation in countries such as Singapore and Malaysia, and nil tax in Hong Kong. Similarly, REIT distributions made to non-resident unitholders out of rental income is subject to a much lower withholding rate in countries such as Singapore and Australia as compared to India.
Separately, independent of global best practices, an aspect that deserves to be considered in depth is the taxability of capital gains on the sale of units, which are presently subject to a threshold of 36 months (as opposed to listed shares (12 months) and immovable property (24 months). Given that REIT units are in other aspects treated at par with listed shares, there is a case to be made for the alignment of the tax treatment of capital gains in the case of listed units with that of listed shares. Along the same vein, the availability of grandfathering benefit (i.e. fair market value on January 31, 2018) introduced under the Finance Act, 2018, in relation to unlisted shares proposed to be swapped for REIT units, deserve a relook considering the potential of exposing prospective unitholders to significant tax burdens.
Footnote
2 All tax rates specified in this article are exclusive of applicable surcharge and education cess
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
