New Tax on the Income Distributed by REITs and InvITs

A Comprehensive Overview

Brief Overview about REITs & InvITs

Real Estate Investment Trusts (REITs) are investment trusts that own and operate real estate properties generating regular income and capital appreciation on their investments. REITs pool money from investors and invest those money in the real estate sector to generate regular income and capital appreciation. Normally, such investments are made through Special Purpose Vehicles (SPVs) or directly in the real estate properties. REITs invests in these SPVs through Equity, interest-bearing loans or debt instruments.

Similarly, Infrastructure Investment Trusts (InvITs) are trusts that pool money from investors to invest in income-generating assets. The focus of InvITs is to invest in infrastructure projects which will have consistent cash flow over a period of time like roadways, power transmissions projects, power generation plants etc. InvITs also invest through SPVs in infrastructure assets.

Parties Involved in the Transaction

There are broadly 3 (Three) kinds of parties involved in the transaction i.e. Investor, Business Trust (REITs/InvIT) and Special Purpose Vehicles (SPVs).

• Business Trust: REITs, together with “InvITs” are referred to as “Business Trust”.
• Special Purpose Vehicle (SPV): SPV is an Indian Company/LLP in which the business trust holds controlling interest and any specific percentage of shareholding or interest, as may be required by the regulations under which such trust is granted registration.
• Investors: Unit holders holding units issued by the Business Trust.

Source of Income and Taxation Aspect

The sources of income of 3 parties i.e. SPV, Business Trust and Investors along with their taxation on such income are as follows:

A. Special Purpose Vehicle (SPVs)

i. Source of Income: The SPVs are primarily working in Real estate business and infrastructure projects like Highway Road project, Power Transmission Line, Real estate business etc. The main source of income of these SPVs are in the form of Toll Charges, Power Transmission charges, Rental Income etc.

ii. Taxation: The SPVs are liable to pay taxes on these income as per the prevailing income tax provisions. Since SPVs are incorporated as companies/LLP, the tax rate will be applicable which may vary from 15% to 30% depending upon the tax regime chosen by the concerned SPVs.

Note: The choice of Tax regime by SPV will impact the taxability of dividend received by Unit Holders from REITs/InvITs. The same will be elaborated in ensuing paragraphs.

B. Business Trust (REITs/InvITs)

i. Source of Income: The various sources of receipts for business trusts includes interest income, dividend income, debt/capital repayment from SPV, Rental income (In case of REITs), Income from Capital Gains, Other Income, etc.

ii. Taxation: Section 115UA¹ of the Act provides a pass-through status to the business trusts in respect of interest income, dividend income, Debt Repayment received from SPV and rental income (in case of REITs). The taxation implication on each component is summarised as below:

Note-1: As per amendment to Section 193⁵ of the Act, No TDS is required to be deducted in case of Interest payment by SPV to Business Trust.

C. Investors / Unit Holders

i. Source of Income: As mentioned above, trust mainly receives fund in the form of dividend, interest on loan given to SPV along with repayment of principal amount of loan and rental income (in case of REITs). In fact, these trusts are mandatorily required to distribute 90% of its distributable cash flow to the unit holders.

Further, as per Section 115UA of the Act, income distributed by a business trust to its unit holders shall be deemed to be of the same nature and in the same proportion in the hands of the unit holder as it had been received by the business trust. Meaning thereby, if the SPV pays interest amount to the trust for the Loan/debt taken, that amount has to be given by the trust (REITs/InvIT) to the unitholders in the form of interest income only.

In view of above, investors of these REITs/InvITs, normally, receive:

• Interest;
• Dividend;
• Rental Income (In case of REITs);
• Portion of debt repayment which was made by SPV to REITs/InvIT; and
• Other Income (Mainly the Interest from surplus fund and Capital Gain on sale of asset).

Note: Every Business Trust at the time of distribution of income to unit holders provides the detailed breakup of per unit distribution. The breakup includes the component of Interest, Dividend, Capital Repayment & other income per distribution.

ii. Taxation: As has been stated above, since interest, dividend, rental income has been accorded as pass-through status at the level of business trust, these are made taxable in the hands of the unit holder(s). With respect to distributions made by the business trust to its unit holders which are shown as repayment of debt, it was also pass through at Trust level and was also not taxable in the hand of unit holders. No such provision existed before the Finance Act 2023 for treatment of amount received by unit holder as debt repayment portion in the distributed income. Now Finance Act, 2023 has made certain changes in various sections to provide for treatment of above in the hands of unit holders.

Changes in Finance Act 2023: Section 48 & Section 56(2)(xii)

As per explanation to Section 48 of income tax act, any amount received except following will be considered as reduction in cost of acquisition of units of REITs and InvITs:

• Interest – As per Section 10(23FC); or
• Dividend – As per Section 10(23FC); or
• Rental income (in case of REITs) – As per section 10(23FCA); or
• Debt repayment portion upto the amount at which such units was issued by the trust [Amount not chargeable to tax u/s 56(2)(xii)]; or
• Income Chargeable to tax in the hands of the business trust under section 115UA(2) (i.e. Interest income and capital gains).

Thus, debt repayment must be reduced from cost of acquisition at the time of sale of units. As a consequence the amount received as debt repayment will in turn taxed as Capital gain at the time of transfer/sale of unit.

Example 1: Mr. X bought one unit of InvIT at ₹200 and selling it after 3 year at ₹300 in the open market. During this period InvIT distributed ₹20 as debt repayment. To calculate Capital Gain Mr. X needs to reduce ₹20 from the cost of acquisition thus the net cost of acquisition is ₹180 (₹200 – ₹20) and the capital gain is ₹120 (₹300 – ₹180) instead of ₹100 (₹300 – ₹200). Thus, the debt repayment portion is taxed under the head Capital Gain at the time of sale of Unit in the hands of unit holder.

Comprehensive Numerical Illustration: 12-Year Trajectory

Example: Mr X bought one unit of InvIT from primary market for ₹200/- on Year-1. Mr. X received debt repayment as a component of distribution from InvIT as per following:

Secondary Market Acquisition Dilemma

For an example, M/s XYZ InvIT issues units at primary market on year-0 at ₹100/- per unit. Mr. X has purchased Units of InvITs in the Year-10 for ₹200/- from secondary market when debt repayment component in the distribution by InvITs exceeds its issue price ₹100/-.

In the instant case, any amount received as debt repayment will be treated as Income from other source in the hands of Mr. X. Meaning thereby holding period is not relevant for taxing the debt repayment under the head Income from other source. The amount of Debt repayment portion in the income distribution history of REITs/InvIT from the date of issue of Units is relevant for Investor.

Now Investors buying units of REITs/InvITs from secondary market need to calculate the amount of Debt repayment already made by respective REITs/InvITs so that correct tax treatment can be exercised at the time of receipt of debt repayment from InvIT/REITs. Govt. should provide any mechanism for detail disclosure by InvIT/REITs for tracking such debt repayment from the beginning of the Issue date in a standardised manner.

Present Market Scenario (Distribution Details) of REITs/InvIT

In India, few REITs and InvITs are traded in the stock exchanges. From the distribution history of such REITs and InvIT, it has been observed that the debt/capital repayment component forms a significant share of distributions made by certain REITs like Embassy and Brookfield.

Embassy REITs has distributed near about 47% of its distribution as capital repayment whereas Brookfield distributes near about 53% of its distribution as capital repayment. The Capital Repayment portion of few REITs and InvIT for the Latest Quarter i.e. Q-4 of FY 2022-23 and cumulative distribution (from inception to 31st March 2023) as on 31st March, 2023 are as follows:

From above table, it is understood that the portion of debt/capital repayment in the distribution is increasing year by year. In the initial years of distribution of income, debt repayment portions were not significant, gradually over the period the debt repayment portion of the Income distributed increased manyfold.

Tax Impact on Foreign Investors

Many foreign investors like sovereign wealth fund (SWF), pension fund, subsidiary of the Abu Dhabi Investment Authority etc. are getting income tax exemption vide section 10(23FE) in respect of income earned by way of dividend, interest or long-term capital gains arising from an investment made by it in business trusts in India.

Such investors are also getting the amount in the form of debt repayment as part of their return from the REITs/InvIT. No such exemption was available to them in Section 10(23FE) in the original Finance Bill, 2023, but now as per Finance Act 2023, Exemption is also extended to the income taxable U/s 56(2)(xii).

Conclusion

The changes in the Finance Act 2023, compared to the original proposed provision in the Finance Bill, 2023 is a welcome change. Now the income received in the form of Debt repayment will be charged at concessional capital gain tax and not taxed at the investor’s income tax slab rate. But the worrying area for investor is, while dealing with the selling and buying of units of REITs/InvIT Investor should collect the history of debt repayment component of Income distributed by REITs/InvIT from the date of issue of Unit(s) which is a cumbersome work for investor.