Finance Act, 2013 Finally Passed: Foreign Debt Further Encouraged
We had earlier sent you our hotline on Budget 2013 (India Budget Insights 2013-14) on February 28, 2013 in which we had discussed some of the key changes proposed under the Finance Bill 2013. A copy of the hotline can be found by clicking here. We then hosted a roundtable and webinar in collaboration with Asia Pacific Real Estate Association at our offices in Mumbai and later in New York on new structures evolving in the real assets space post Budget 2013 with a heavy focus on structured debt products. Copy of the transcript of the roundtable, our research paper on Singapore v. Mauritius, Cyprus debt crisis and our research paper on debt and private equity in real assets can be found by clicking here.
Budget 2013 has now been passed by the Parliament and signed into law by the President of India, with a few amendments and this Private Debt and Private Equity in Real Assets Update provides a brief analysis of some of the provisions that have been changed in the Finance Act, 2013 (as it has now been passed) with their impact on the private debt and private equity investments in the real assets industry.
Interest on foreign debt slashed from 40% to 5%
In a major shot in the arm to foreign debt investments in India, the Government has reduced the tax on interest income at the hands of Foreign Institutional Investors ("FII") and Qualified Foreign Investors ("QFI") from 40% to 5%, subject to certain ceiling as may be prescribed by the Government. The reduction of tax payable on foreign debt is a welcome surprise by the Government considering no such reduction was proposed (or even considered) for payments made in relation to debt securities issued by non-infrastructure sector companies at the time of the Budget proposal.The reduction in tax has been introduced by a new provision in the Income Tax Act, 1961 (Section 194LD) which provides that interest payments made to Foreign Institutional Investors (FIIs) and Qualified Financial Investors (QFIs) on or after June 1, 2013 but before May 31, 2015 on (i) rupee denominated bonds of an Indian company; and (ii) a Government security; would be subject to a tax at the rate of 5%, instead of the ordinary rate of up to 40% (FIIs were taxed at a lower rate of 20% on interest income). However, the lower withholding rate would be applicable only on interest paid on bonds whose interest rates do not exceed the rate as may be specified by the Central Government in this regard. At present, the Central Government is yet to prescribe the applicable cap on interest rates in this regard.
Elimination of debt allocation sub-limits in the FII / QFI regime
Foreign investment in listed rupee debt was earlier permitted only if an entity was an FII, and even then the investment was subject to the FII buying debt limits, which with the exception of a few cases expired upon redemption or sale of their debt investments. The total debt limits available were USD 25 billion for corporate bonds and USD 25 billion for infrastructure bonds. Later, even QFIs were allowed entry into the corporate debt markets but with a small window of USD 1 billion within which they could purchase listed corporate bonds.
Effective April 1, the Government announced a major rationalisation of foreign investment in corporate bonds. No more bidding now and no need to be an FII for purchasing debt limits - QFI's basket to acquire corporate bonds has been extended from USD 1 billion to USD 51 billion. Just for a quick background, QFI's are foreign investors that can directly invest in listed equity and listed non-convertible debentures without the need to go through an FII. For a better understanding of the QFI regime, please read research paper debt and private equity in real assets by clicking here.
Through corresponding circulars issued by the Reserve Bank of India and the Securities and Exchange Board of India, the various sub-limits for investment in debt in India have now been broadly merged into two categories - government debt and corporate debt. More importantly, the process for allocating limits through auctions has been liberalized significantly, as now until overall investment reaches 90% (coming up to around USD 45.9 Billion!) of the total debt limit, investments can be made by eligible investors without going through the auction process. A large amount of such debt limits currently remains unutilized. For more details on rationalization of debt limits, please refer to our hotline 'Foreign Debt Encouraged - Government Rationalises Debt Allocations' by clicking here.
The rationalization of sub-limits and the liberalization of the operational mechanism for utilizing the debt will prove very useful to the investment community, especially on two counts - (i) this would reduce the cost of the investor (as bidding costs for debt limits were quite expensive); and (ii) the investor would no longer be under an uncertainty as to whether would be able to acquire the debt limits, which became a huge concern especially when the ability to re-utilize the debt limits available was restricted under various SEBI debt limit circulars. Availability, allocation and expiry of debt limits and bidding for them were one of the largest challenges that were keeping foreign investors from considering investments in such listed debt instruments. However, with such simplification and importantly buybacks of shares being now subjected to an additional tax of 20%, foreign investors are likely to take the structured debt route for investing into India, especially in those classes where returns are expected by way of cash up-streaming.
GAAR / Tax residency
There was some amount of anticipation in the market on the GAAR front, especially in light of the Press Release made by Ministry of Finance on January 14, 2013. However, the Government failed to cover all bases that it had promised through the Press Release. Some of the key changes made to GAAR under Finance Act, 2013 are as follows:
To defer the implementation of GAAR for 2 years.
GAAR shall apply only if the main purpose of an arrangement is to obtain a tax benefit. Previously, GAAR would apply even if obtaining the tax benefit is one of the main purposes of an arrangement. Presumably, the new GAAR provisions may not apply if an arrangement is backed by sufficient business purpose.
Factors such as the holding period of the investment, availability of an exit route and whether taxes have been paid in connection with the arrangement may be relevant but not sufficient for determining commercial substance. Interestingly, these were the key factors considered by the Supreme Court of India when it decided that the USD 11.1 billion Vodafone-Hutch transaction was not a sham and could not be taxed in India.
GAAR cases shall be scrutinized by an Approving Panel chaired by a retired High Court Judge, a senior member of the tax office (of the rank of Chief Commissioner of Income Tax) and a reputed academician or scholar with expertise in taxation or international trade and business. Previously, provisions relating to the Approving Panel only contemplated members from the tax department, which raised key questions on independence, lack of objectivity and bias.
Further, the Finance Act, 2013 has also added language in relation to availing of treaty benefits, requiring for an assessee claiming treaty benefits to provide such documents and information as may be prescribed. It remains to be seen if this language will be utilized to deny treaty benefits to bona fide investors.
Transfer of 'Real' Assets by Infra / Realty Companies at Reckoner Value
As a background, Section 50C (Special provision for full value of consideration in certain cases) of the ITA provides for computation of capital gains by a transferor in cases where land and building (not development rights) are transferred at a price below the circle rate of the property. Under this provision, if the consideration accruing / received by a transferor is less than the value adopted / assessed / assessable by any authority of a State Government for the purpose of payment of stamp duty on such transfer, the value so adopted / assessed / assessable shall, for the purposes of computing capital gains from transfer of such asset, be deemed to be the full value of the consideration received / accruing as a result of such transfer. However, since Section 50C was limited only to capital assets, transfers by real estate developers were outside the purview of Section 50C as real estate for real estate developers would qualify as stock-in-trade and hence business income, not capital gains. Several Indian real estate assets could be flipped to the fold of offshore companies for the purpose of offshore listings under this route at prices much below market value, as the founders would acquire shares in the offshore company.
The Finance Act 2013 has now inserted a new section 43CA (Special provision for full value of consideration for transfer of assets other than capital assets in certain cases) in the ITA. Under this provision, where the consideration accruing / received by a transferor of an asset (other than a capital asset), being any land or building or both, is less than the value adopted / assessed / assessable by any authority of a State Government for the purpose of payment of stamp duty on such transfer, the value so adopted / assessed / assessable shall, for the purposes of computing profits and gains from transfer of such asset, be deemed to be the full value of the consideration received / accruing as a result of such transfer. Extending such deeming fiction to assets other than capital assets is likely to be a major dampener for real estate developers who may want to do an intra-group transfer or restructuring at book value. This may also adversely impact potential restructuring by asset-heavy companies such as infrastructure and real estate companies looking to introduce foreign investment in SPVs where the land / building has been held at the holding company level - as the transfer by the holding company of the land / building at value below the circle rate to the SPV into which foreign investors may invest may no longer be tax efficient.
In addition to the insertion of 43CA, the Finance Act, 2013 has also added an additional anti-avoidance provision making modification to Section 56(2)(vii)(b). Previously 56(2)(vii)(b) stated that where any immovable property, whose stamp duty value exceed INR 50,000, was received by an individual or a Hindu Undivided Family or "HUF" (an India specific entity that relates to ancestral property held collectively by a family and administered by the head of the family) without payment of any consideration, then tax would be levied on the stamp duty value of the immovable property on such Individual / HUF. The Finance Act, 2013 has now extended the scope of this provision to also apply even in cases where the Individuals / HUFs receive a consideration lower than the stamp duty value.
Budget 2013 has been a big disappointment for the real estate sector primarily on account of imposition of 'distribution tax' on buyback of shares. Currently, most companies involved in real estate distributed profits to private equity investors by way of buyback, which resulted in capital gains at the hands of the investor and would be exempt in most cases as the investor would be from a traety jurisdiction like Mauritius, Singapore etc. private equity investors will now have to look at other options, for instance, capital reduction, secondary sales to promoters etc. to receive their yield on the project or final exits in a tax efficient manner. Please refer to our research paper debt and private equity in real assets by clicking here and also to a recent newspaper article on the matter by clicking here.
Budget 2013 has also failed to address some of the important relaxations which the industry was looking forward to. For instance, the tax pass though status has only been limited to Venture Capital Funds registered as Category I Alternate Investment Funds and not to other categories of Alternative Investment Funds (including real estate funds largely organized as Category II Alternative Investment Funds). There has been no relaxation in the taxation of indirect transfer of shares which were at times used to give an exit to foreign investors which could not exit at India level on account of 3 year lock-in. Also, there has been no clarity on the applicability of Indian minimum alternate tax ("MAT") to foreign companies and to SEZ in particular. However, the encouragement to structured debt products is likely to go long way in developing private equity in real assets space which has been largely inclined towards debt products in the recent past.