REIT / InvIT Tax Regulations: Only Half Way House

Background
Introduction of Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts (InvITs) is one area where the regulators seem to be moving with alacrity.

While initiated by the previous regime, the present government seems to have lapped onto this favourably with the finance minister [Arun Jaitley] devoting an entire paragraph to this initiative in the budget speech and clearly showcasing the intent - "to provide necessary incentives for REITS which will have pass through for the purpose of taxation" and similar pass through treatment for InvIT's. The finance minister was confident that these two instruments would attract long-term finance from foreign and domestic sources including NRIs.

While one would appreciate the proactive efforts by Sebi [Securities and Exchange Board of India] and the Tax Department to achieve the intended objectives, the tax efficiencies suggested by the FM have not been really implemented in letter or spirit in the tax amendments and this could seriously jeopardise the success of these new instruments.

First and foremost, the structure does not provide a level playing field on two counts:

1. Distribution of income: Between resident investors and foreign investors - being extremely favourable to foreign investors and highly tax inefficient for resident investors/ resident promoters.

2. Setting up the structure: Resident promoters of entities who list a company on the stock exchange are at a tremendous advantage to resident promoters who will list REITs/InvITs
These aspects are dealt with at length below:

1. Distribution of income

A. No Pass Through - Dividend Distribution Tax leviable
REITs/InvITs as a concept give "fractional ownership" to investors in real estate and infrastructure projects. This concept of fractional ownership should effectively result in only one layer of taxation and is typically achieved by ownership of assets by a Trust which pays taxes in the like manner and extent as its beneficiaries.

Indian circumstances are peculiar in as much as most real estate and infrastructure projects are held in SPVs [special purpose vehicles]. Moving them around attracts huge stamp duty and there are other constraints on land transfer. On the other hand, infrastructure regulators invariably require each infra project to be ring fenced in a separate SPV. Hence, the need for the SPVs to be regarded as pass-through.  To achieve complete pass through, the SPV has to be treated as a disregarded entity and accordingly Dividend Distribution Tax must be not levied on these entities.

Moreover, the REIT/InvIT is unable to acquire the asset directly since the capital gains tax deferment is applicable only to transfer of shares. Also, there is no specific exemption for transfer of interest in an LLP [Limited Liability Partnership] to the InvIT even though SEBI regulations allow the holding of LLPs below the InvIT .

B. Pass Through - Interest
SPVs holding assets will have some debt in the SPVs replaced by debt from the REIT/InvIT out of money raised from the listing. The interest extracted from SPVs suffers no tax in the hand of the REIT/InvIT but will suffer 34 per cent  (TDS 10 per cent) tax in the hands of resident investor and five per cent in the hands of the foreign investor. Accordingly, far more attractive for a foreign investor.

2. Setting up the structure

Since REIT/InvIT is a new animal, utilising this structure will necessarily require transferring the assets to the trust. While the tax dept has graciously 'agreed to defer' the capital gains on transfer of shares (not assets), it has missed two important aspects which do not bring it to a level playing field with other businesses listing companies.

A) The transfer could result in a MAT (Minimum alternative tax liability) at 20 per cent on the transferor, which could be a deal breaker due to immediate substantial cash outflow.  This MAT would not apply to a foreign investor swapping his shares for units in the REIT.

Therefore, restructuring for a REIT/InvIT attracts immediate MAT at the rate of 20 per cent and deferment of capital gains tax to the point of sale of units. On the other hand, restructuring for an IPO by a company through mergers/demergers are generally tax exempt transactions and also the promoter does not suffer MAT and gets complete tax exemption.

B) It may further be pointed out that the promoter of the REIT/InvIT would not only have to pay capital gains on the deferred capital gain at the time of sale but also on the incremental increase in the unit value beyond the transferred price post listing of REIT/InvIT.

C) The promoter of a company going for an IPO gets tax exemption for the shares he offers for sale in the IPO as well as exemption on subsequent sale of shares on the stock exchange which will not be available to a REIT/InvIT promoter - hence not a level playing field.

D) Foreign investors, however, are able to get treaty protection and are exempt from capital gains. Hence, domestic promoter suffers serious tax inefficiencies - both vis-a-vis foreign promoter and resident promoter of listed companies.

E) The long term duration of 36 months to become a 'long term asset' as compared to 12 months for a listed share is also a constraint on the marketability of these instruments and is not at par with listed companies.

For the above reasons, there may be serious doubts as to how successful these new instruments will be to attract much needed capital for the real estate and infrastructure sectors, particularly from domestic investors.

The views expressed in this article are personal.
Vivek Mehra is  the executive director and tax M&A Leader, PwC India