Exemption from Dividend Distribution Tax Makes REITs More Attractive: ICRA

In ICRA’s opinion, the exemption from Dividend Distribution Tax (DDT) provided to the dividend distributed by the Special Purpose Vehicle (SPV) to the Real Estate Investment Trust (REIT) would help improve the potential returns for the investors thus making REITs an attractive investment option. “Dividend Distribution Tax acted as an additional layer of taxation in the system since the earnings of the SPV are already subject to corporate tax. The exemption thus would help improve the yields to the investors, bringing it nearly at par with the returns in case of direct ownership of assets”, says Mr. Rohit Inamdar, Senior Vice President, ICRA Ratings.

The Government of India (GoI) has provided a tax exemption to the dividend distributed by the SPV to the REIT, out of its current income on or after the specified date (i.e. date of acquisition by the business trust of such holding), through an amendment introduced in the Finance Bill dated February 29, 2016. However, to be eligible for the exemption, the REIT should hold the entire equity stake in the SPV, excluding the stake required to be held mandatorily by any other person in accordance with any law or directions of the GoI or any regulatory authority.

The REITs act as a vehicle for owning and operating income generating real estate assets. It provides an avenue to retail[1] as well as institutional investors to participate in real estate ownership, management and development without actually owning commercial real estate assets. Structured like a mutual fund, REIT utilises the pooled capital of an investor base to deploy across various income-producing real estate assets. While REITs are an established market participant in developed economies like USA, the UK, France and Singapore, having emerged as a preferred investment vehicle, they are yet to take off in India. A detailed note on REITs in the Indian context (Indian Real Estate Industry: REITs a boost for real estate, but tax issues could limit the potential) was published by ICRA in May 2015 (http://icra.in/Files/Articles/SH-2015-Q2-1-ICRA-Real%20Estate.pdf). This note gives an update on the recent developments.

 The Securities and Exchange Board of India (SEBI) introduced the final guidelines in the form of SEBI (REIT) Regulations, 2014, in September 2014. For the next two years, through various GoI incentives, a partial pass-through status was accorded to REITs. For instance, the Union Budget FY2015 provided for taxation of interest income in the hands of investor rather than REIT. The Union Budget FY2016 further extended the pass-through status to rental income and rationalised the capital gain structure for sponsors. But certain tax inefficiencies remained, most notable of them being the Dividend Distribution Tax (DDT), which has now been addressed in the Union Budget FY2017.

REIT can hold commercial assets either on its own, referred to as Direct Ownership or through Special Purpose Vehicles (SPVs), referred to as SPV structure. While the rental income earned by the REIT from its own assets (and in-turn distributed to investors) was accorded a pass through status in FY2016 making it taxable in the hands of the investor, the earnings distributed by the SPV to REIT attracted the DDT. This resulted in a disparity in the returns to investors in the two scenarios. With the recent amendment, the dividend distributed by the SPV to REIT and in turn to the investor, is entirely exempt from taxation (i.e. at the level of SPV as well as the investor). However, in case of direct ownership of assets the income thus distributed by the REIT to investors is rental in nature and taxable. While the post tax yield to investors continues to remain higher in case of direct ownership of assets vis-à-vis SPV structure, the gap has been significantly bridged through the DDT exemption.

The below exhibit gives a comparison of the return to the investors in the SPV structure with the Direct Asset Ownership structure.

 Exhibit 1: Returns to Investors in Direct Ownership of Assets vis-a-vis SPV Structure

While the exemption from DDT is a positive step, certain tax disadvantages remain. The transfer of shares in the SPV in lieu of REIT units will continue to attract Minimum Alternative Tax (MAT) if routed through the Profit & Loss account. The MAT liability, however, arises on the eventual transfer or sale of units rather than at the time of exchange. The tax inefficiencies in the system remain higher in case of direct ownership of assets. Also stamp duty charges are applicable on the transfer of properties, ranging between 6%-9%, depending on the state, thus increasing the overall transaction costs. The pass-through status accorded to REITs remains incomplete as capital gains on sale of assets by the REIT and other income continue to remain taxable at the REIT level.

“With the exemption of DDT, most issues pertaining to the REIT roll out have been ironed out, with the SPV structure of asset ownership having emerged as the more favourable option. Further the Securities and Exchange Board of India has recently consented to allow Foreign Portfolio Investors (FPI) to invest in REITs, a move which is expected to give a support on the demand side.” Mr. Inamdar further adds.

The introduction of REITs in India is expected to boost the real estate sector by unveiling an alternative source of capital for developers – key beneficiaries of the REIT regime being the ones with a portfolio of commercial office space as well as retail malls. With nearly 350 million square feet (sqft) to 400 million sqft commercial office space available in the top seven cities taken together, there are ample potential assets available for REIT listing. Markets like Bangalore and Gurgaon, given the presence of large grade ‘A’ commercial office space, IT parks etc, are expected to witness healthy activity levels.