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This year’s budget saw amendments enacted in relation to taxation of real estate investment trusts (REITs) and of investors in REITs. The Securities and Exchange Board of India (Sebi) has also finalized the regulations in relation to REITs. REITs are being held out to be an alternative route to direct investment in commercial real estate for investors. While this may be the spirit of the REIT regulations, does it also hold true from a tax angle?

Under the Sebi regulations, a REIT would be structured as a trust. The trust would invest in commercial real estate, either directly or through special purpose vehicles (SPVs). The SPV has to be a body corporate—it can, therefore, be either a company or a limited liability partnership (LLP). The REIT will raise funds from investors through an issue of units, which will be listed on a stock exchange.

When one invests in a commercial property, the rent from it is taxed as income from house property, and deduction is allowed for municipal taxes paid and for 30% of the net rent after deduction of municipal taxes. Effectively, therefore, a maximum of 70% of the rent income is taxable at the slab rate to the investor. Up to a total income of 1 crore of the investor, the maximum tax rate applicable is 30.90%. If it exceeds 1 crore, the maximum rate applicable is 33.99%. On sale of the property, if the property is held for more than 36 months, the long-term capital gains is taxable at 20.60% (or 22.66% if the investor’s income exceeds 1 crore), with the gains computed after indexation of the cost by applying the cost inflation index.

In case of REITs, the rental income will be computed for taxation in the same manner as a direct investor in the hands of the entity owning the property—either the SPV or the REIT itself. Such rental income will be taxed at a flat rate of 33.99%, irrespective of the slab rates or income level of the investors. The long-term capital gains earned on sale of the property by the SPV or by the REIT, as the case may be, would be taxed at 20.60% or 22.66% (where income exceeds 1 crore), in the same manner as an investor.

However, if the SPV is a company, the dividends paid by the SPV to the REIT would suffer a dividend distribution tax of 16.995%. This can be minimized to the extent that the SPV is funded through interest bearing loans by the REIT, since the interest would be tax deductible for the SPV. In case the SPV is an LLP, there would be no dividend distribution tax on the income earned by the REIT from the LLP.

If the REIT has invested in property through an SPV, and sells the shares of the SPV (held for at least three years) instead of selling the property, the long-term gains on sale of such shares would be taxed at 20.60% (or 22.66%).

The interest income earned by the REIT from the SPV would not be taxable, but would be taxable as income of the unitholders. However, while other income would be taxed as income of the REIT, the distribution of such income would not be taxable as income of the unitholders. If the unitholders sell the units of the REIT on the stock exchange, after having held the units for at least three years, the capital gains arising on such sale are not taxable. Short-term capital gains are taxable at 15.45% (or 16.995% where total income is above 1 crore).

Therefore, in effect, if the SPV is an LLP or the property is held directly by the REIT, the impact of taxation is almost the same as in the case of direct investment in the property, except that the tax rate of the REIT may be slightly higher than the slab rate of the investor. However, if the SPV is a company, the dividend distribution tax would be an additional outflow. So also, in case of corporate unitholders, while the income from the REIT or long-term capital gains on sale of the units of the REIT is exempt, there would still be a liability to minimum alternate tax on the book profits, which currently is as high as 19.05% (or 20.96%). Corporate investors may, therefore, prefer direct investment in immovable property. Further, since income from REITs is exempt, this could also have an adverse effect in the form of a higher disallowance of expenses under section 14A, which requires a formula driven disallowance of expenses incurred to earn exempt income, particularly for companies and other businesses.

Whether REITs will really become popular would largely depend upon promoters, for whom the tax treatment of capital gains is different, and not so advantageous. Promoters do not enjoy tax exemption on sale of their units on the stock exchange, though exchange of shares of SPVs held by them in exchange for units is exempt. In effect, their tax liability is only deferred till the sale of the units. Stamp duty treatment, which differs from state to state, would also impact returns through REITs, which would be one of the factors that investors would look at while investing in REITs.

Gautam Nayak is a chartered accountant.

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