Impact of Budget 2017 on Private Equity in Real Assets: Not much to Cheer!
In line with the expectations, and as an aftermath to the hugely controversial demonetization exercise, Budget 2017 announced on February 1 has clearly toed the populist line. Whilst significant incentives were announced for affordable housing, other amendments, such as the introduction of thin capitalization norms, are likely to severely impact the interests of private equity investors in the real estate sector.
Summarized below are a few key amendments introduced by Budget 2017 and their impact on private equity in real assets.
The Big Dampeners
1. Thin Capitalization Norms Introduced
More than 70% of the foreign funding in real assets is received in the form of structured debt. Most particularly, non-convertible redeemable bonds were the most popular source of receiving foreign funds hitherto. Legitimate tax optimization of cash up-streaming in cash accretive assets (such as real estate, roads, hospitals, and infrastructure) is the cornerstone of any investment in these sectors globally.
Budget 2017 has now borrowed from BEPS Plan Action 4 and introduced thin capitalization norms for ‘associated enterprises’ in an attempt to prevent excessive interest deductions being claimed by Indian companies. The explanatory memorandum to the Finance Bill, 2017 provides as under:
“In view of the above, it is proposed to insert a new section 94B, in line with the recommendations of OECD BEPS Action Plan 4, to provide that interest expenses claimed by an entity to its associated enterprises shall be restricted to 30% of its earnings before interest, taxes, depreciation and amortization (EBITDA) or interest paid or payable to associated enterprise, whichever is less.”
2. Income from house property
Earlier, any loss arising under the head ‘house property’ could have been set off against income from any other head.
Since housing was also considered as an investment asset, a large population was acquiring multiple housing assets backed with the support of tax incentives on purchase of second house and thereafter.
Budget 2017 provides that a loss under the head ‘house property’, in excess of INR 200,000 may not be set off against income from any other head.
3. Promotion of affordable housing projects
4. Long term capital gains concessions
With the view to furthering investments in real estate, effective April 1, 2018, the holding period for capital gains arising from immovable property has been reduced from 36 months to 24 months. Further, the base year for indexation benefits has also been prescribed to be April 1, 2001 from April 1, 1981 earlier. These measures should allow for greater mobility of assets in the real estate sector and enhance liquidity for investments in the sector.
5. Notional rental income: Delaying the taxation
Currently, unsold inventory in a project which is completed is deemed to provide developers notional rental income, and as such, is taxed in the hands of the developers. This prompted developers to offload units at the earliest possible, at times, even at prices below market prices. The industry has been requiring the roll back of this provision. The Delhi High Court, in the case of Ansal Developers, had earlier upheld the clause in relation to the taxation of the notional income of the developer. While the Budget was expected to bring cheer, the cheer was limited, since the Finance Bill provides that this deeming fiction of notional income shall apply only 1 year post the completion of the project. Having said that, the 1 year extension provides developers a breathing space of 1 year post the completion of projects to offload the units.
6. Interest expenditure: A step forward
Substantial foreign funding in Indian real estate is structured debt, being infused as non-convertible debentures (“NCD”), since this benefits the company to obtain interest expense benefit and the investor to have security over the asset. Interest on NCDs payable to foreign portfolio investors (“FPI”) is taxable at the rate of 20%, which has now been reduced to 5%, under the provisions of the ITA till July 1, 2017. This was a major boost for the real estate sector, where back-ending the coupon rate is quite common due to the liquidating nature of real estate.
The Bill now extends the benefit of reduced withholding of 5% on interest payable to non-residents on non-convertible debentures for all interest payments till July 1, 2020. The extension of the reduced withholding benefits would greatly encourage further foreign investment into the real estate sector.
Budget 2017 appeared to offer a lot of goodies to the real estate sector in the speech of the Finance Minister. However, the fine print of the provisions presents a different picture. The combined effect of the measures could result in the growth of the real assets sector as a whole, but with introduction of thin capitalization norms and withdrawal of deductions on housing loans, this government has made its priorities very clear. Incentivize only where needed, and tax where possible.
As regards the demand side, in the short run, it is quite possible that the perspective of individual flat buyers, towards real estate (due to withdrawal of tax deductions on loss from housing property) changes from that of an investment asset to being limited to merely a consumption story.
– Supratim Guha, Abhinav Harlalka & Ruchir Sinha
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1 Section 80-IBA of the ITA