REAL Estate Investment Trust [REIT] is an American invention and has more than 50 years of history. Dwight D Eisenhower introduced REIT as part of Cigar Excise Tax Extension of 1960. According to reit.com, 50th anniversary of US Reit industry was celebrated on September 14, 2010.
The basic idea behind the creation of REIT is simple and noble – allow small investors to participate and gain from income producing commercial real estate investment. According to National Association of Real Estate Investment Trusts (NAREIT), the primary intention of the US Congress in authorizing the use of REITs was to provide a means whereby small investors can secure advantages normally available only to those with larger resources, in connection with real estate investment. The advantages included greater diversification of investment, expert investment counsel and the means of collectively financing projects that the investors could not undertake singly. NAREIT mentions that without a model for real estate investment akin to mutual funds, "only a select few would have the opportunity to gain from the three most fundamental benefits of real estate investment (aside from owner-occupied housing): 1) current income; 2) long-term capital preservation and appreciation; and, 3) investment diversification." Incidentally, in the USA, REITs are also recognised as an investment option for the 401(k) plan (for retirement planning).
Although REITs originated in the United States, the concept subsequently caught on in Europe and elsewhere and there are now more than 20 countries including Hong Kong and Singapore where REITs are found.
According to the OECD, "a REIT may be loosely described as a widely held company, trust or contractual or fiduciary arrangement that derives its income primarily from long-term investment in immovable property, distributes most of that income annually and does not pay income tax on the income related to immovable property that is so distributed."
In India, REITs have been in the works for some time now. The early attempts by SEBI in 2008 and 2010 did not fructify in the absence of clarity on the taxation issues that arise from the REITs. SEBI again came up with a draft regulation in 2013 and the Budget, 2014 has now clarified the taxation aspect and it is expected that there will be substantial activity around REITs now in India as well.
In terms of the scheme proposed by SEBI and recently approved by its Board, the sponsors who are usually developers or private equity players will set up the Real Estate Investment Trust and appoint the trustee. The REIT will be set up as a Trust under the Indian Trusts Act, 1882 which will then apply to be registered with the SEBI. On being satisfied that the REIT fulfills the eligibility criteria as laid down in its guidelines, SEBI will then grant registration to the trust. After registration, the Trust will be eligible to raise funds through an IPO. The units of the trust will have to be compulsorily listed on the stock exchange. The REIT may also come up with follow on public offer subsequently. It is provided that the REIT may raise funds from any investors, resident or foreign. However, initially, the units of the REITs will be offered only to HNIs/institutions and the minimum subscription size shall be Rs. 2 lakhs and the unit size shall be Rs. 1 lakh. From this scheme of the proposed REIT, it appears that unlike in the USA, the Indian REIT is not so much for pooling resources of retail investors as for providing finance for real estate developers who can offload their inventory on the REIT thereby freeing their resources for further development.
The REIT will have to invest at least 90% of the value of the REIT assets in completed revenue generating properties while 10% may be invested in other assets as per the regulation. REITs can invest either directly in the properties or through an SPV. In case of investment through SPVs, 90% of the assets of the SPV must be in revenue generating properties and the REIT must have control over the SPV. It has also been stipulated that the REIT shall not invest in vacant land or agricultural land or mortgages other than mortgage backed securities. The REIT shall only invest in assets based in India. Further, to ensure regular income to the investors, the REIT must distribute at least 90% of the net distributable income after tax of the REIT to the investors.
The proposed tax structure therefore is obviously different for the different players of the REIT game – the unit holders, the REIT itself, the SPV through which the REIT will hold the commercial assets and finally the Sponsors.
In so far unit holders are concerned, the units will be treated like listed shares. Consequently, there will be no tax on the transfer of these units in case of long-term capital gains if STT has been paid. However, unlike in case of listed shares, to qualify as long-term capital gains, the holding period in the hands of the unit holder has to be 36 months in place of 12 months, in case of shares. For short-term capital gains arising to the unit holders, the tax will be @15%.
As far as distribution of income by the REIT to the unit holder is concerned, it is important to note that the newly introduced section 115UA provides that any income distributed by a business trust to its unit holders shall be deemed to be of the same nature and in the same proportion in the hands of the unit holder as it had been received by, or accrued to, the business trust. Section 10(23FD) provides that any distributed income, received by a unit holder from the business trust, not being in the nature of interest will be exempt from tax. Thus, if the trust distributes dividend, capital gains etc. earned by it to the unit holders, there will be no tax in the hands of the unit holders. Only in the case of distribution of interest income of the trust, the unit holders will be charged to tax in their individual capacity. There is also a provision for deduction of tax at source on such interest-10% in the case of resident unit holders and 5% in the case of non-resident unit holders.
Coming to the trust itself, section 10(23FC) provides that any income of a business trust by way of interest received or receivable from a special purpose vehicle will be exempt. However, if the trust earns interest income directly, there is no exemption. As in the case of other shareholders, dividend received by it from the SPV will be exempt from tax. The income by way of capital gains on disposal of assets by the trust shall be taxable in the hands of the trust at the applicable rate. Any other income of the trust shall be taxable at the maximum marginal rate.
As for the SPV, it will have to bear the burden of dividend distribution tax when it pays dividend to the trust. However, since there is pass through in respect of interest in the hands of the trust, the SPV is exempted from withholding tax on interest paid to the business trust u/s 194A.
In so far as the sponsors are concerned, it has been provided that the transfer of shares of the SPV in exchange of the units at the time of the formation of the SPV will be deferred and taxed at the time of disposal of units by the sponsor. However, the preferential capital gains regime consequential to levy of STT available in respect of units of business trust will not be available to the sponsors in respect of these units at the time of disposal. Further, for the purpose of computing capital gain, the cost of these units shall be considered as cost of the shares to the sponsor. The holding period of shares shall also be included in the holding period of such units.
The above survey of the REIT structure in India indicates some differences with the regime prevalent in the USA and elsewhere. The Indian REIT is permitted to invest in immovable properties only in India. It is also not a completely pass through entity. Therefore the issues that arise elsewhere about the status of the REIT for tax treaty purpose- whether it is entitled to treaty benefits since it is not ‘liable to tax' in the country of residence, may not arise in the case of Indian REITs. However, a foreign REIT may invest in a domestic REIT and if it is not ‘liable to tax' in its country of residence, the question of applicability of treaty benefits to the foreign REIT could arise. Since in terms of existing section 90(2) of the Income Tax Act, domestic law or treaty law whichever is more beneficial to the taxpayer applies, the issue becomes important only where the treaty gives a more beneficial treatment to the taxpayer.
This will be particularly relevant in the context of capital gains from the alienation of units of REITs. If a foreign investor in the Indian REIT comes from Mauritius or Singapore and is entitled to the treaty benefits, then under the existing treaty, the domestic law difference between short term and long term capital gains and differing tax treatment of the same will be meaningless. Such foreign investors will therefore be positively discriminated as against the domestic investors. In fact, the prospect of round tripping of Indian black money coming back to the lucrative real estate sector cannot be ruled out.
While dealing with REITs, one issue that arises in the treaty context is the applicability of Article 13(4) relating to capital gains. Article 13(4) of the OECD Model provides that gains derived by a non-resident from the alienation of shares deriving more than 50% of their value directly or indirectly from immovable property may be taxed by the source State. It is undeniable that the underlying asset of a REIT is immovable property. It is also a fact that the REIT will invest in income generating immovable properties. In such a situation, Article 13(4) which is essentially an anti abuse measure may apply provided of course that recourse to treaty is taken in the first instance.
OECD had dealt with the issue in its paper - ‘Tax treaty issues related to REITs' that was subsequently incorporated in the 2010 commentary. According to the OECD, small investors investing up to 10% in a REIT should be treated as investing in portfolio equity investment. "A small investor in a REIT has no control over the immovable property acquired by the REIT and no connection to the particular property held by the REIT. Such a small investor cannot be viewed as having made an investment in the underlying immovable property held by the REIT any more than a shareholder of a multinational company can be viewed as having made an investment in the particular assets held by the company. Rather, the small investor in the REIT invested in the REIT as an entity. The small investor is looking to the distributions from the REIT and the application in its REIT interest for its investment returns just as a shareholder in a multinational company is looking to corporate dividends and share appreciation for its investment return." The OECD therefore proposes to tax the REIT distributions in such case as applicable to portfolio investments in shares.
However, distinguishing small investors from large investors, the OECD report cautions: "Clearly, a large investor should not be allowed to get the benefit of the lower rate applicable to portfolio interests in a REIT by simply dividing its investment in the REIT among a number of associated entities. This is why the provision put forward does not grant the lower rate to an investor who holds "directly or indirectly" capital that represents at least 10% of the value of the overall capital of the REIT. Also, the lower rate should not be granted in cases of abuse of the provision, for example, where a company with a holding of 10% or more has, shortly before the payment of a distribution, transferred its interests in a REIT to a number of small investors for the purpose of securing the benefits of the lower rate, with a commitment to re-acquire these interests after the distribution…"
In this context, one point that may arise is whether Article 13(4) can be applied to a REIT that is not organised as a company. In this connection, it may be noted that Article 13(4) of the UN Model is worded differently and now (since 1999) specifically includes trusts: "Gains from the alienation of shares of the capital stock of a company, or of an interest in a partnership, trust or estate, the property of which consists directly or indirectly of immovable property situated in a Contracting State may be taxed in that State…" Most of the Indian treaties however refer only to company shares.
Interest income, as we have seen earlier, has been granted a pass through status. It will be taxed only in the hands of the unit holders. It will therefore be interesting to see if under a treaty interest is exempt in the source State in the hands of any entity. Altogether, interesting times both for investors and the tax planners. |