Real estate investment trusts (REITs) have metamorphosed the global real estate and the financial services industry. Simply put, a REIT is an investment vehicle that owns rent-yielding properties (RYP). Derived from mutual funds, REITs provide investors with a regular income-stream, investment diversification and long-term capital appreciation.
Not all REIT markets have enjoyed equal success, though. Singapore has created a vibrant REIT market, whereas Hong Kong has struggled. Why? Experientially, REIT regimes have shared an umbilical link with the tax framework in which they have operated. As an asset class, rental yields tend to be only marginally higher than the bank rate; plus, REITs are publicly traded with a diversified investor participation. Hence, as the Singapore experience indicates, for a
REIT regime to be successful, the tax framework needs to not only accommodate an efficient cash throughput to boost the frugal yields but also be simple enough for all participating investors to comprehend. This is a key reason why REITs in India (I-REITs) have remained stillborn; announced in the July 2014 budget, no I-REITs have yet been launched.
The tax framework generally supports a single-level tax on I-REIT income, which may be levied either at the I-REIT- or the investor-level. An exception to this rule is dividends distributed by companies which attracts dividend distribution tax (DDT), and this may be the single biggest villain in the I-REIT story. Allow us to explain. Regulations require an I-REIT to be constructed as a trust, which may hold the RYP either a) directly, b) through a company which owns the property (SPC), or c) through a limited liability partnership which owns the property (SP-LLP).
Setting up of an I-REIT is expected to be facilitated by a developer contributing RYP/SPC shares/LLP interest in exchange for REIT units. Once up, the I-REIT must distribute at least 90% of the net income from the RYP.
Contribution of SPC shares in exchange for REIT units is tax-exempt. For reasons unknown, however, a similar tax exemption does not apply for contribution of RYP or LLP interest. It is expected that I-REITs will be set up by developers contributing SPC shares, which will result in I-REITs holding RYPs via SPCs. Income distributions from SPCs will consequently need to be by way of dividends, which will suffer DDT of approximately 20%, in addition to the corporate income-tax payable by the SPCs. This DDT is an additional cost, diluting the cash throughput from the frugal rental yields.
The government’s reticence in doing away DDT is driven by revenue-loss considerations; however, this is specious. As contemporary data on dividend yields evidences, presently, developers seldom declare dividends. If loss of future DDT revenues from I-REITs is the governments concern, this concern may not necessarily hold steam if one were to weigh the DDT foregone with the overall benefits to the economy. I-REITs could potentially result in an efficient reallocation of capital and risks, and release a virtuous economic cycle. Developers could create more assets with the I-REIT-infused liquidity, yielding greater employment and uplifting the general economic sentiment. Further, an inflation-hedged, low-risk alternative investment opportunity that I-REITs will create would attract a new class of investors and improve the overall depth of capital markets. The additional direct and indirect tax revenues that would be generated from the new assets, new employments, enhanced economic activity and capital market transactions should more than compensate for the DDT foregone. In short, maybe this is the opportune moment to revisit the levy of DDT on SPCs, which could potentially act as a powerful catalyst for I-REITs to be launched.
However, solely resolving the DDT conundrum may not be the elixir, as a few other irritants like holding period, cum-dividend purchases, treatment of certain interest and capital gains incomes continue. To clarify, holding period for I-REIT units, to qualify as long-term assets (and thereby be tax-exempt on sale) is pegged at 36 months, while the comparable time threshold for a tax-exempt sale of listed equity shares is 12 months. This ought to be harmonised to encourage investor participation in I-REITs. Any distributions by an I-REIT would be taxed in the hands of the unit-holder. This could lead to economic double taxation if the unit-holder has not held the unit for the full period in respect of which the distribution is made, and has purchased it on cum-dividend basis. A concessional tax rate applies where I-REIT distributes interest received from a SPC. This concession is not extended to distribution of interest received from a LLP. Property disposition by I-REIT would attract immediate tax, resulting in (i) lesser cash for replacement acquisitions, and (ii) lower net asset value for the I-REIT. Providing a roll-over benefit whereby tax is deferred on reinvestments would encourage I-REIT managers to optimise portfolios by churning RYPs in favour of relatively higher yield ones. Unmooring I-REITs from the trappings of an unwieldy tax framework is essential if India is to share the echelons of successful REIT regimes, and fully exploit the economic potential of this product. The forthcoming budget provides an opportunity for this; one hopes that the government makes the requisite amendments, helping I-REITs see a new dawn.
With inputs from Anand Laxmeshwar, director, and Jinesh Jobalia, BMR & Associates LLP
The author is partner, BMR & Associates LLP. Views are personal