Tracking FDI in real estate
Tracking FDI in real estate
Samir Kanabar and Shashidhar Upinkudru discuss Tax effective funding & repatriation of investments for foreign funds
With a developing economy and a huge population, the Indian real estate sector has the potential for robust demand and a high growth rate. Subsequent to the opening up of the sector for foreign investment, the sector has been an attractive investment destination for foreign real estate funds and has seen several significant investments over the last few years.
Some funds have also initiated the process to repatriate proceeds and exit from their existing investments. However this can be a difficult process given the tax structure, company laws and exchange control regulations.
Hence, there is a need to plan the investments upfront so as to facilitate ease of investment and exit, which is to make profit extraction tax efficient, while being compliant with local tax laws and maximizing cash repatriations.
Designing and planning investments to achieve the aforesaid objectives depends on various critical factors such as: available funding options, location of the investing company, asset class in which the investment is to be made, project profitability and timing of cash flows.
The capital structure also has to be primarily tailored to the commercial terms, such as distribution waterfalls, preferred returns, subsequent promote payments, voting rights, tranche wise infusions, consolidation requirements, IPO exits and so on.
Prior to June 2007, investments were generally routed through the issue of hybrid instruments such as optionally convertible debentures/ preference shares, which are intrinsically debt-like instruments.
However, the Government was apprehensive that such instruments were easily repatriable through redemption of preference shares/debentures resulting in inflow of ‘hot’ money and hence, made a conscious effort to amend the Foreign Direct Investment (FDI) regulations in order to achieve the intended purpose of retaining the FDI within India for a longer duration till project development.
Presently, the investments through FDI route in real estate sector can only be in the form of Equity shares, Compulsorily Convertible Preference shares (CCPS), Compulsorily Convertible Debentures (CCDs). External Commercial Borrowings are presently not allowed in the real estate sector except for Integrated Townships.
Equity shares entail repatriation of profits and capital through dividends, capital reduction or buy-back of shares. While dividends declared by an Indian company would be exempt in the hands of the stockholders (i.e. investors), it entails a tax cost @ 16.995% in the form of Dividend Distribution Tax (DDT).
In addition, dividends can be declared only out of profits. Hence, even if the project company has sufficient cash in a particular year, it may not be able to declare dividends, in the absence of book profits, which is dependent upon the method of accounting.
Further, declaration of dividends requires the company to transfer a percentage of profits to statutory reserves resulting in further reduction in the amount available for distributions.
The equity investment could also be recouped through buy-back of shares or capital reduction (especially, if the company has cash flows but not adequate profits). While, capital reduction being a court driven process is rarely resorted to, cash extraction through buy-back of equity shares is not uncommon.
Buy-back of equity shares, also suffers from certain limitations such as only 25% of shares and net worth can be repatriated and is taxable as capital gains in the hands of shareholders.
The capital gains implications could be mitigated if the investments are routed through certain tax efficient jurisdiction provided substance can be demonstrated in such jurisdictions.
Compulsorily Convertible Preference Shares (in lieu of equity)
Investments through CCPS stand on a similar footing to equity shares vis-à-vis dividend distribution and DDT implications. However, dividends on CCPS are capped at State Bank of India Prime Lending Rate plus 300 basis points. The preference shares have to be compulsorily converted into equity shares.
Compulsorily Convertible Debentures (in lieu of equity)
CCDs are instruments which have the characteristics of both – Equity and Debt. In order to qualify as FDI, the debentures should be compulsorily convertible into equity shares and cannot be redeemed. The returns on CCDs would be by way of interest payouts.
The interest payouts would help in achieving a tax break for the project company as the interest would be allowed as tax deductible expenses for the project company resulting in tax savings of about 34%.
However, withholding tax on interest payouts is payable – which could be reduced if the debentures are funded through countries with which India has a tax treaty which offers beneficial tax rates. The India-Cyprus tax treaty provides for an interest withholding tax rate of 10%.
The capital could be repatriated under CCDs only after conversion into equity shares. Subsequent to conversion buy-back of shares could be carried out for repatriating the funds.
Location of investing company
Given the limited options available for funding the investments and in light of the tax costs associated with it, the foreign investors’ tax burden could stand reduced if they have invested through jurisdictions, which are generally tax favourable.
India has entered into tax treaties with certain countries that offer favourable tax incentives to the foreign investors such as capital gains exemptions, lower tax rates for interest and so on.
However, the Indian Revenue authorities are increasingly challenging transactions which use these jurisdictions for investing into India solely to gain Indian tax benefits.
Asset Classes – Build to sell projects
Residential projects are characterized as self liquidating assets. The projects are on a build-to-sell basis and generally the assets are sold before the construction is completed. In case of residential projects, the revenues could start flowing in from the first year of construction itself.
It is generally preferable to have a higher component of CCDs in the capital structure for such projects. This would enable a tax break on interest payouts in the initial years resulting into lower tax costs for the project company.
Besides buy back of shares, cash extraction for the foreign investor is also achieved in such projects, by exiting by selling the FCDs / shares to the Indian partner for consideration being its share of the cash assets, nearing completion of the project. The Indian partner then effectively takes over the company including all its cash assets.
Build to lease projects
Commercial projects (offices, malls etc) are generally constructed on a build-to-lease model. Typically, the revenues start generating, once the project is fully developed/ constructed. There is a gestation period in the projects and the taxability is deferred till the completion of the project and accordingly, tax break on interest payments is not warranted in initial years.
Income generated from such projects would be taxable under the head ‘Income from House Property’. Expenses actually incurred are disregarded and instead an ad-hoc deduction of 30% is allowed from the gross revenues.
The only other expenses allowed are interest on borrowed funds and property taxes. Interest pertaining to construction period is allowed equally over 5-years post completion of construction.
CCDs with a moratorium on interest accrual during the construction period are also considered for such projects. Exits are generally through sale of instruments to REITS, etc.
Special Economic Zones
SEZs enjoy a tax holiday for the developers for 10 consecutive years out of first 15 years from SEZ notification. Having such a tax holiday means no requirements of tax breaks and accordingly less debt in the capital structure. Further, SEZ developers are also exempted from payment of DDT. Accordingly, it is advisable to have an equity structure for SEZ development projects.
In summary, to zero-in on funding alternatives available, one needs to critically evaluate the asset classes in the real estate project, the timing of cash inflows as well as outflows, and the jurisdiction of investments to determine the optimal capital structure.
The authors are senior tax professionals from Ernst & Young, India