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Although the new FDI norms have liberalised investments in the construction industry, more needs to be done, write Samir Kanabar & Anand Laxmeshwar, senior tax professionals with Ernst & Young, India.

Until the cookie crumbled, the Indian realty sector had been one of the most appealing sectors for investors and, if some eminent voices are to be believed, continues to remain so.

It is trite, or rather an understatement, to say that the primary catalyst for the exponential growth in the realty space has been the influx of foreign capital, aided by the liberalised foreign investment norms introduced by the government to unlock the sector’s potential.

Until early 2005, only non-resident Indians (NRIs) and persons of Indian origin (PIOs) were permitted to invest in this sector. Except for hotels and industrial parks, foreign investors (other than NRIs) were allowed to invest in development of integrated townships and settlements.

Investments in special economic zones (SEZs) were permitted, but did not flourish for lack of a stable policy regime. Since 2005 however, there have been a spate of policy decisions that have galvanised foreign investments across the spectrum.

In this article, we shall broadly cover the FDI guidelines so far as they relate to foreign investors wanting to participate in Indian realty.

Direct investments
Direct investments refer to investments made directly into the project company, and are guided by specific policies depending on the asset class being developed. The press note (PN) 2 issued by the Department of Industrial Policy and Promotion (DIPP) liberalised investments in real estate projects.

In view of the provisions of PN2, automatic route of FDI has been thrown open to foreign investors for investments in townships, housing, built-up infrastructure and construction development projects. Apart from PN2, there are also specific policies in place for investments into SEZs, industrial parks and hotels.

Real estate
FDI up to 100% is permitted in Greenfield real estate developments such as townships, housing, built-up infrastructure and construction development projects subject to fulfilment of certain conditions, which inter alia include the following: 

  • Requirement of minimum developable area; built-up area of 50,000 sq m in case of construction-development projects, land area of 10 hectares in case of serviced housing plots, any one of the above, in case of combination projects.
  • Minimum capitalisation of US$ 10 million for a wholly-owned subsidiary and US$ 5 million for JVs with Indian partners; to be brought in within a period of 6 months of commencement.
  • A lock-in period of three years for the original investment from the date of completion of minimum capitalisation. Money can be repatriated earlier, but with prior approval of the FIPB;
  • Completion of at least 50% of the project within a period of five years from the date of obtaining all statutory clearances.
  • Prohibition on sale of undeveloped plots.

A SEZ is a specially delineated area, which is a duty free enclave. It is deemed to be foreign territory for purposes of trade operations and Indian duties and tariffs. Hundred% FDI was always permitted in setting up and operation of SEZs. In spite of tax incentives being granted for development of SEZs, the participation from private and foreign investors was unenthusiastic, primarily on account of a lack of a formal framework.

The SEZ Act, 2005 and the SEZ Rules now provides the legislative framework for SEZs and seeks to establish a stable policy regime for investors, developers as well as entrepreneurs setting shop within a SEZ.

A developer proposing to establish an SEZ is required to obtain approvals from the Board of Approvals, which is a designated committee set up under the SEZ Act. Further, depending on the sector to which the SEZ caters, certain area requirements are required to be satisfied such as a contiguous area of 1,000 hectares for multi-product SEZs, 100 hectares for SEZs in a specific sector or in a port or airport, etc. 

Industrial parks
Industrial parks are defined to mean projects in which infrastructure facilities in the form of developed plots of land or built-up space is developed and made available to the allottee units for the purposes of industrial activity as defined.

FDI in industrial parks is allowed under PN3 and is subject to the following conditions: 1. It should comprise of a minimum of 10 units and no single unit should occupy more than 50% of the allocable area; & 2. Minimum percentage of area allocated for industrial activity should not be less than 66% of total allocable area.

As per PN3, FDI in industrial parks would not be subject to the conditionalities of PN2 and is permitted in setting up as well as established industrial parks. 

FDI up to 100% is permitted in the hotel sector under the automatic route of investment under PN4 of 2001. Investments in hotels are not required to comply with PN2.

Indirect investments
Indirect investment means investment in projects through a holding company in India as against investments directly into the project companies. Till recently, such investments required prior Government approval and were subject to the same conditions as for direct investments.

This has however changed with the issuance of PN2 of 2009 and PN4 of 2009, which distinguishes between indirect investments via a holding company that is ‘owned and controlled’ by an Indian resident, vis-à-vis one that is ‘owned and controlled’ by a non-resident.

An investment via a holding company that is ‘owned and controlled’ by a non-resident is subject to the same conditions as for direct FDI. On the other hand, an investment via a holding company that is ‘owned and controlled’ by an Indian resident is regarded as domestic investment, i.e., such investment should not be subject to FDI guidelines.

An Indian ‘owned and controlled’ company has been defined as an Indian company which satisfies the following two conditions: 1. More than 50% of the equity interest in it is beneficially owned by resident Indians or Indian companies (owned and controlled ultimately by Indian residents); and 2. Power to appoint majority of the directors rests with Indian residents or Indian companies (owned and controlled by Indian residents). 

Investment in the holding company could require prior Government approval, if holding of investments is the only business undertaken by the holding company. A conjoint reading of press notes and subsequent news reports indicates that so long as the holding company is regarded as Indian ‘owned and controlled’ the conditions outlined in PN2 should not apply.

This technically opens the door for foreign participation in hitherto prohibited, but highly attractive assets such as: 1. Brownfield projects like fully-tenanted commercial properties; or 2. Small ticket developments in metropolitan cities like Mumbai, where it might be difficult to meet the minimum area requirement of 50,000 sq m.

The rationale for these press notes has however been a subject matter of debate, especially in view of the possibility of investment now being channelled into previously prohibited sectors/projects.

Unfinished agenda
While liberalisation of realty has been a welcome step, it may be essential to plug-in some open issues and further ease certain norms in the existing policy guidelines to stimulate fresh investments in the current scenario. Some of the issues are as follows:

Relaxation of the restriction on sale of undeveloped plots and investment in Brownfield construction projects, especially given the current scenario wherein there could be several distressed assets.

Also, clarity on whether the lock-in would be applicable even in case of transfer of shares from one non-resident to another non-resident, given that the foreign investment in such cases remains intact.
Industrial parks

For industrial parks, apart from PN3, there exists the Industrial Park Scheme, 2008 as well as various state specific industrial park/IT park policies providing direct and indirect tax sops to parks fulfilling certain specified conditions. 

In many cases, such schemes permit the park to have units undertaking activities that are beyond the scope of ‘industrial activities’ as permitted under PN3. Clarity is needed that such activities would not hinder the possibility of attracting FDI in such Parks.

Funding real estate projects
A critical element of the overall investment plan is an appropriate funding strategy for the project. This strategy is a direct determinant of the ability to repatriate capital once the project starts generating operating cash flows and/ or on exit from the project.

This is especially true for an indirect investment, since the cash repatriation strategy would need to address cash repatriation from the downstream project company as well. Given this outlook, investment in equity instruments may not be attractive since not only is repayment of equity a cumbersome process, but any dividends declared for distribution of profits are subject to a dividend distribution tax (‘DDT’) of almost 17%.

Exchange control regulations though circumscribe the instruments that could be issued to a foreign investor. Shareholder loans are generally prohibited except for development of integrated township, Industrial Parks and hotels. Albeit one could explore infusing funds into project companies in the form of fully and mandatorily convertible debentures. 

By and large, though the relaxations in the norms for foreign investment enveloping the sector have been appreciable, more relaxations would help provide further impetus to the sector.

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