Budget 2012 - Top Considerations for Offshore and Domestic Real Estate Funds
Further to our analysis of Budget 2012 (India Budget Insights (2012 - 13) circulated last week, this Real Estate Alert discusses few of the changes introduced by Budget 2012 relevant to offshore and domestic realty funds and the sector in general.
While Budget 2012 has made some announcements on the policy front which may aid the sector in terms of boosting domestic demand, the key expectations such as removal of minimum alternate tax of 18.5% and dividend distribution tax of 15%1 on Special Economic Zones (SEZ), granting of infrastructure status to SEZs, IT Parks and townships, introduction of an effective Real Estate Investment Trust (REIT) regime to facilitate exits, implementation of the Real Estate Regulatory Bill and the Land Titling Bill to ensure greater transparency were not addressed.
On the other hand, Budget 2012 has brought about several provisions that may have far reaching implications for offshore realty funds such as the ability to claim treaty benefits, expanding the definition of royalties (relevant particularly for the hospitality sector), withholding of tax on payments made by one non-resident to another non-resident where the income is subject to Indian tax, irrespective of their presence in India, and, importantly, introduction of the General Anti Avoidance Rules (GAAR) provisions. Particularly, the proposal to retroactively override the Supreme Court's decision in the Vodafone case with effect from 1962 raises a question as to whether foreign investments are protected in India at all and whether it will give rise to claims under bilateral investment protection treaties.
Budget 2012 also proposes to tax an Indian company at the rate of 30% on issue of shares to an Indian resident at a price above the fair market value of the Indian company shares, considering this difference as 'other income' for the Indian company. Transfer pricing, which was hitherto applicable only to international transactions, has been made applicable to certain domestic transactions as well making project management fees, development fees, marketing arrangements and similar arrangements expensive.
On the positive side, whilst affordable housing segment clearly emerges as the focus area on the policy front, Budget 2012 does little to address the liquidity crisis being faced the sector, and in many senses takes a lot more than it gives.
We now analyze few of these changes and their likely implications on the sector and investments therein. For a more detailed analysis of these provisions from a tax perspective, please see our hotline (India Budget Insights (2012 -13) circulated last week.
Real Estate VCFs - Pass Through Status
The Budget proposes to extend the tax 'pass-through' status to SEBI registered venture capital funds ("VCF") or a venture capital company ("VCC") for their income from investments in venture capital undertakings ("VCU") operating in all sectors (as against certain identified sectors such nanotechnology, information technology relating to hardware and software development, bio-technology, infrastructure, etc.), except the ones specified in the negative list by SEBI. Reflecting the true 'pass-through' position, not only the character of the income in the hands of the investor would be retained as that in the hands of a VCF / VCC, Budget 2012 also proposes that income shall be taxable in the hands of the investors the moment it accrues, arises or is received by the VCFs / VCCs. Currently, the income for the investors in the VCFs / VCCs was only taxable when actually received by them upon distribution irrespective of when such income having accrued or received by the VCF / VCC from the underlying VCUs. Following such proposal, the income of VCFs, from real estate companies will be taxed directly in the hands of their investors.
Domestic Transfer Pricing Introduced
If the specified domestic transactions between two related persons or two units of the same entity exceed INR 50 million (USD 1 million), then in order to determine the correctness of (i) the income from domestic related party transactions and (ii) the domestic related party expenditure of the parties, the transfer pricing regulations (including procedural and penal provisions) would be extended to such domestic transactions as well.
Affordable housing seemed to be the focus area for real estate in Budget 2012. External Commercial Borrowing ("ECB") for the affordable housing segment has been permitted. Interest withholding on ECB has been reduced from 20% to 5% for three years. Investment linked deduction of capital expenditure for hospitals and affordable housing at the enhanced rate of 150% as against the current rate of 100% has been permitted. On indirect taxes front, service tax exemption for construction services relating to specified infrastructure, residential dwelling, and low-cost mass housing up to an area of 60 square meters has been provided.
Holding company structures: Cascading DDT impact removed
Budget 2012 proposes to amend Section 115-0 to exempt dividends received from subsidiaries. Under Section 115-O of the Act, an Indian company is required to pay dividend distribution tax ("DDT") at the rate of 15% on dividends that are declared, distributed or paid by a domestic company. Hitherto, dividends received by a company from its subsidiary were tax exempt only if the holding company was not a subsidiary of another company. This restricted the dividend benefit to two tier structures only. Budget 2012 makes the dividend benefit applicable to multi-tier structures, thus providing a big fillip to large corporate groups which require multiple entities. For the purpose of this provision a company is regarded as a subsidiary of another company only where the parent holds more than half in nominal value of the equity share capital of the subsidiary.
QFIs allowed to access corporate debt
Budget 2012 proposes to allow Qualified Foreign Investors ("QFIs") to access the corporate bond market. Currently, only SEBI registered foreign institutional investors ("FIIs") having debt allocation limits are permitted to purchase listed debt securities of Indian real estate companies. However, non-residents other than FIIs that were not permitted entry into this market.
Company to be taxed if shares issued at premium
Budget 2012 proposes to tax any consideration for issue of shares that exceeds the face value of such shares, if the aggregate consideration received for such shares as exceeds the fair market value ("FMV")2 of the shares. This applies in respect of issuance of shares to an Indian tax resident by a private limited company or unlisted public limited company (i.e. a company in which the public is not substantially interested). Such excess premium would be chargeable to tax as "income from other sources" at the maximum marginal rate of 30%. The provision is not applicable if the consideration is received from a non-resident or by a VCU from VCF or VCC.
With the intention of gradually transitioning towards the Goods and Service Tax ("GST") regime, Budget 2012 has proposed that the service tax law will henceforth follow the 'Negative List approach'. Under this approach, all services3 , except those specified in the negative list and those specifically exempted, would be chargeable to service tax. The base rate of service tax too has been increased from 10% to 12% uniformly on all services.
Budget 2012 proposes to introduce comprehensive GAAR provisions providing wide powers to the revenue authorities in taxing 'impermissible avoidance arrangements' including the power to disregard entities in a structure, reallocate income and expenditure between parties to the arrangement, alter the tax residence of such entities and the legal sites of assets involved, treat debt as equity and vice versa, and the like. For a detailed analysis please see our hotline on Budget 2012 (India Budget Insights (2012 - 13)
Obligation to withhold tax
Budget 2012 seeks to include an explanation to extend the application of withholding tax on payments to non-residents, to all persons, resident or non-resident, whether or not the non-resident has a residence or place of business or business connection in India; or any other presence in any manner whatsoever in India. For analysis of withholding royalty (relevant for hospitality sector), please see our hotline on Budget 2012 (India Budget Insights (2012 -13).
Eligibility to claim treaty benefits
The Budget proposals give rise to onerous compliance challenges for foreign investors. For claiming treaty benefits, non-resident taxpayers will be required to obtain a tax residency certificate containing specific particulars as may be prescribed by the Revenue.
Withholding on Immovable Property
Further, withholding of tax on transfer of immovable property (other than agricultural land) is proposed to be imposed wherein every transferee, at the time of making payments or crediting the consideration for transfer of immovable property, shall deduct tax at the rate of 1% of such sum, subject to de-minims4 principles.
Reopening past cases
Budget 2012 also increases the time period for taxing prior transactions from 6 years to 16 years, making it extremely difficult for taxpayers to maintain necessary documentation and manage litigation risks. Further, the provision contains a carve out which does not make the limitation period applicable to income which has escaped assessment including income in relation to any asset (including financial interest) in any entity located outside India.
2 FMV is the higher of (a) the amount, as may be substantiated by the company before the tax officer based on the value of its assets including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licenses, franchises or any other business or commercial rights of similar nature; or (b) as may be determined as the method prescribed under the relevant rules for calculation of FMV. Though the rules for this new provision have not been prescribed, formula to determine FMV under current rules is essentially linked to the NAV.
4 No deduction of tax is required to be made where consideration paid or payable for immovable property is less than (i) Rupees fifty lakhs where the property is situated in specified area, (ii) Rupees twenty lakhs in other cases.