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A Real Estate Investment Trust or a ‘REIT’ is a collective investment vehicle that invests in a diversified pool of professionally managed, investment-grade real estate. In its simplest form, a REIT provides ownership of a portfolio of properties in units that are held by investors as a way of securitising property. While any income-generating property could be held in a REIT, assets typically held by REITs comprise office, residential, retail, hospitality and industrial or logistics property.
REIT markets first emerged in the 1960s in the US and the market capitalisation of US REITs has since soared from $5 billion to roughly $900 billion in 2014. The US was followed by Australia in the early 1970s with a number of Asian countries introducing REIT regulations in the late 1990s and early 2000s. Almost 30 countries have operating REIT markets, a further 12 have REIT legislation in place, while a number of other countries have such legislation under active consideration. India is a latecomer to this market; REIT regulations were framed by the Securities and Exchange Board of India (Sebi) in September 2014 while the taxation framework was incorporated in the income tax law by the Finance Act 2014.
While REIT regulations vary across countries, all REIT regulations share certain common features:
- Distribution requirements – Regulations typically require REITs to distribute a significant proportion (in India, it’s 90 percent) of their taxable income to their investors
- Asset requirements – The rules also require a substantial portion (80 percent, in the Indian context) of a REIT’s assets to consist of income-generating real estate assets
- Income requirements – A substantial portion (75 percent in India) of a REIT’s annual income is to be derived from income related to real estate, such as rents from property
- Ownership requirements – REIT regulations typically require REIT ownership to be diversified, and for REIT units to be freely transferable securities; the Indian regulations require a REIT to be a listed vehicle with at least 200 investors.
Although most REIT frameworks incorporate the features above, market experience suggests that REITs have been more successful in markets that have provided an enabling and conducive taxation framework. Within Asia for instance, while Japan, Singapore, Hong Kong, Taiwan and Korea introduced REIT legislation a few years apart, deeper markets have developed in Japan and Singapore relative to the other countries. Accordingly, developing an appropriate taxation framework is a critical pre-condition for a vibrant REIT market.
An ideal tax framework seeks to exempt REITs from tax, with income distributions being liable to tax to investors at applicable rates. This single feature distinguishes markets where REITs have been more effective. The Indian taxation framework is less than optimal in this regard. For a number of reasons, qualifying income-generating real estate assets tend to be held individually in special purpose vehicles. REITs, when established, will likely be formed by a contribution of shares of such special purpose vehicles, as opposed to a direct contribution of the real estate assets, into the REIT. Income earned by the special purpose vehicles will be subject to corporate income tax; further, dividend distributions by the special purpose vehicle will be liable for a dividend distribution tax. While the net income distributions will thereafter suffer no further tax at the level of the REIT or in the hands of investors, the overall tax incidence on income earned from the real estate assets results in a relatively unattractive yield for investors. A superior taxing outcome, and consequently a higher yield, would have accrued to investors had the REIT held the real estate assets directly rather than through a special purpose vehicle.
Further distortion is likely to result from a tax provision, which attaches a lower effective rate of tax to interest payments made by a special purpose vehicle to the REIT, which the REIT then distributes to its investors. Yields that REITs could deliver would vary based on the capital structure that a REIT is able to implement; as a result, two REITs with similar asset holdings could deliver vastly different yields to their investors based not on their asset management capabilities, but their financial engineering capabilities.
Distortions in yield caused by alternate holding constructs as well as the capital structures implemented increase complexity for investors and should therefore be eliminated.
From an asset owner’s perspective, the REIT regulations envisage a transaction construct under which the asset owner will contribute his assets (or shares of a special purpose vehicle which in turn holds the asset) in exchange for units of the REIT. Such an exchange will not trigger current tax. However, the taxation framework provides for a tax to be imposed on such units when they are sold by the asset owner at a future date. Significant asset owners contrast this tax outcome with that resulting from a listing of their asset holding company; if they were to pursue a listing, a transfer of their shareholding in the company following a listing would be exempt from tax. Unless REITs provide asset owners with an equivalent tax position, they may find the REIT proposition unattractive. Large property owners staying away from REITs would constrain the growth of the market besides potentially impacting the quality of assets that do find their way into REITs.
There are other inhibiting tax provisions as well. A transfer of the shares in a special purpose vehicle held by an asset owner to the REIT will result in a change in the shareholding of the special purpose vehicle. If the special purpose vehicle has accumulated tax losses (which may not be an unusual fact pattern where large assets have been developed within the special purpose vehicle and have started generating rentals relatively recently), such losses are wiped out when the ownership transfer occurs. This would not be an issue if there was no tax on the REIT or the special purpose vehicle, but otherwise represents a cost. A transfer of shares in a special purpose vehicle in exchange for units of the REIT could also render the asset owner liable to minimum alternate tax or MAT at 21 percent; MAT would apply on the difference between the fair value of the shares contributed to the REIT and their historical cost of acquisition. Accordingly, while the exchange of shares for REIT units does not trigger current capital gains tax, it could still trigger MAT which applies at an equivalent rate.
Beyond tax, the other set of regulations that require calibration are the provisions in the Foreign Exchange Management Act, 1999. While the REIT regulations formulated by Sebi permit non-resident investors to invest in REIT units, and the taxation framework contained in the Income-tax Act, 1961 contains provisions that will apply to non-resident investors in REITs, non-residents can invest in REITs only after FEMA regulations are amended to permit them to make such investments. Almost 6 months since the REIT regulations have been formulated, this amendment is still awaited.
The cumulative impact of the distortions and regulatory gaps and inadequacies has been that the Indian market has not so far seen a REIT being established. The market holds high expectations from the 2015 Budget due later this month, and the hope is that these gaps will be addressed. Tax policy formulation has often sacrificed market development at the altar of tax revenues. The considerable positive externalities that a thriving REIT market could generate by providing a liquid, alternate, stable investment class which could provide an inflation hedge, by freeing up development capital in a capital starved economy, by improving the management of real estate assets, by bringing greater transparency into a market that has historically been opaque, by creating a range of new jobs and skills, and by introducing high corporate governance standards into an industry with which such standards have traditionally not been associated considerably outweigh any notional revenue loss that could result from providing for an enabling optimal taxation framework. At a more technical level, the taxation of REITs has been defined by force fitting the tax provisions within the existing framework of the Income-tax Act, 1961. A more practical approach may be to include a separate chapter to address the taxation of REITs such that a more comprehensive, coherent framework can be defined. The NDA Government has a substantial agenda to revive the sputtering investment cycle and to place the economy firmly on a growth path. Fixing the REIT taxation and regulatory framework should find place on this agenda.
(With inputs from Anand Laxmeshwar, director, BMR & Associates LLP)
Bobby Parikh is chief mentor and partner, BMR & Associates LLP
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