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July 2015

Real EstateCompendium

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© Nishith Desai Associates 2015


Primary Contacts

Nishchal Joshipura Partner – Private Equity and M&A, Nishith Desai Associates [email protected]

Nishchal Joshipura is a Partner in charge of Private Equity and M&A practice at Nishith Desai Associates. He is also Partner in charge of the Real Estate Practice Group and Mergers & Acquisition. He is a Chartered Accountant, an MBA and a Lawyer. Nishchal specializes in legal and tax structuring of cross-border transactions and assists clients on documentation and negotiation of Private Equity, Private Debt and M&A deals. His other practice areas include Corporate & Securities laws, Transfer Pricing, International Taxation, Globalization, Structuring of Inbound/Outbound Investments, Structuring of Offshore Funds, Taxation of E-Commerce and Exchange Controls. He has been highly recommended by various legal directories for advice on Private Equity, Investment Funds and M&A.

Ruchir Sinha Head, Real Estate Practice Group, Co-Head, Private Equity and M&A, Nishith Desai Associates [email protected]

Ruchir Sinha co-heads the Private Equity and M&A practice at the firm and Heads the Real Estate practice group. Ruchir advises clients on private equity investments, merger & acquisition, fund formation across industries from a legal, tax and regulatory perspective. He has advised several global funds in formulating, negotiating and implementing optimum tax-efficient structures for foreign investments into India. He was nominated amongst the top 3 lawyers in India (under 35 category) at IDEX Legal Awards. He is also the recipient of the Real Estate Section Scholarship of the International Bar Association for his paper on ‘Funding Real Estate Projects’. He has also worked closely with the Indian securities regulator, SEBI, on drafting of the Indian REIT Regulations.



Nishith Desai Associates (NDA) is a research based international law firm with offices in Mumbai, Bangalore, Silicon Valley, Singapore, New Delhi & Munich. We specialize in strategic legal, regulatory and tax advice coupled with industry expertise in an integrated manner. We focus on niche areas in which we provide significant value and are invariably involved in select highly complex, innovative transactions. Our key clients include marquee repeat Fortune 500 clientele.

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Nishith Desai Associates has been ranked as the Most Innovative Indian Law Firm (2014 & 2015) at the Innovative Lawyers Asia-Pacific Awards by the Financial Times - RSG Consulting. Nishith Desai Associates has been awarded for “Best Dispute Management lawyer”, “Best Use of Innovation and Technology in a law firm”, “Best Dispute Management Firm”, and “M&A Deal of the year” by IDEX Legal 2015 in association with three legal charities; IDIA, iProbono and Thomson Reuters Foundation. Nishith Desai Associates has been recognized as a Recommended Tax Firm in India by World Tax 2015 (International Tax Review’s directory). IBLJ (India Business Law Journal) has awarded Nishith Desai Associates for Private equity & venture capital, structured finance & securitization, TMT and Taxation in (2014/2015). IFLR1000 has ranked Nishith Desai Associates in Tier 1 for Private Equity (2014). Chambers and Partners ranked us as # 1 for Tax and Technology-Media-Telecom (2014/2015). Legal 500 ranked us in # 1 for Investment Funds, Tax and Technology-Media-Telecom (TMT) practices (2011/2012/2013/2014). IDEX Legal has recognized Nishith Desai as the Managing Partner of the Year (2014).

Legal Era, a prestigious Legal Media Group has recognized Nishith Desai Associates as the Best Tax Law Firm of the Year (2013). Chambers & Partners has ranked us as # 1 for Tax, TMT and Private Equity (2013). For the third consecutive year.

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We have been ranked as the best performing Indian law firm of the year by the RSG India Consulting in its client satisfaction report (2011). Chambers & Partners has ranked us # 1 for Tax, TMT and Real Estate – FDI (2011). We’ve received honorable mentions in Asian Mena Counsel Magazine for Alternative Investment Funds, International Arbitration, Real Estate and Taxation for the year 2010.

We have been adjudged the winner of the Indian Law Firm of the Year 2010 for TMT by IFLR. We have won the prestigious “Asian-Counsel’s Socially Responsible Deals of the Year 2009” by Pacific Business Press.

About NDA


Provided upon request only

In addition to being Asian-Counsel Firm of the Year 2009 for the practice areas of Private Equity and Taxation in India. Indian Business Law Journal listed our Tax, PE & VC and Technology-Media-Telecom (TMT) practices in the India Law Firm Awards 2009. Legal 500 (Asia-Pacific) has also ranked us #1 in these practices for 2009-2010. We have been ranked the highest for ‘Quality’ in the Financial Times – RSG Consulting ranking of Indian law firms in 2009. The Tax Directors Handbook, 2009 lauded us for our constant and innovative out-of-the-box ideas. Other past recognitions include being named the Indian Law Firm of the Year 2000 and Asian Law Firm of the Year (Pro Bono) 2001 by the International Financial Law Review, a Euromoney publication.

In an Asia survey by International Tax Review (September 2003), we were voted as a top-ranking law firm and recognized for our cross-border structuring work.

Our research oriented approach has also led to the team members being recognized and felicitated for thought leadership. NDAites have won the global competition for dissertations at the International Bar Association for 5 years. Nishith Desai, Founder of Nishith Desai Associates, has been voted ‘External Counsel of the Year 2009’ by Asian Counsel and Pacific Business Press and the ‘Most in Demand Practitioners’ by Chambers Asia 2009. He has also been ranked No. 28 in a global Top 50 “Gold List” by Tax Business, a UK-based journal for the international tax community. He is listed in the Lex Witness ‘Hall of fame: Top 50’ individuals who have helped shape the legal landscape of modern India. He is also the recipient of Prof. Yunus ‘Social Business Pioneer of India’ – 2010 award.

We believe strongly in constant knowledge expansion and have developed dynamic Knowledge Management (‘KM’) and Continuing Education (‘CE’) programs, conducted both in-house and for select invitees. KM and CE programs cover key events, global and national trends as they unfold and examine case studies, debate and analyze emerging legal, regulatory and tax issues, serving as an effective forum for cross pollination of ideas.

Our trust-based, non-hierarchical, democratically managed organization that leverages research and knowledge to deliver premium services, high value, and a unique employer proposition has now been developed into a global case study and published by John Wiley & Sons, USA in a feature titled ‘Management by Trust in a Democratic Enterprise: A Law Firm Shapes Organizational Behavior to Create Competitive Advantage’ in the September 2009 issue of Global Business and Organizational Excellence (GBOE).



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Please see the last page of this paper for the most recent research papers by our experts.



IndexPART A: NDA HOTLINES AND OTHER MATERIALS ON FDI IN CONSTRUCTION –

DEVELOPMENT SECTOR

1. Hotline titled ‘Foreign Investment Norms for Real Estate Liberalized’

dated November 07, 2014,analyzing the changes introduced by the

union cabinet press release dated October 29, 2014. 01

2. Hotline titled ‘Foreign Investment Norms in Real Estate Changed’

dated February 06, 2015, analyzing Press Note 10 of 2014. 09

3. NDA Recommendations titled ‘FDI in Real Estate Construction and

Development’ submitted to APREA, providing observations and

recommendations on the DIPP Clarifications to Press Note 10 of 2014. 12

4. Hotline titled ‘Government Tightens Norms for Foreign Investment in

Corporate Bonds’ dated February 10, 2015, analyzing the RBI Circular

and SEBI Circular restricting FPI investment in corporate bonds with

residual maturity of 3 (three) years. 16

5. NDA Recommendations titled ‘Recommendations on FPI Investment in

Corporate Bonds’ submitted to ASIFMA, analyzing the RBI Circular

and SEBI Circular restricting FPI investment in corporate bonds with

residual maturityof 3 (three) years and providing recommendations. 19

6. Hotline titled ‘Foreign investment structure seen as a ‘Colorable Device’

and held illegal’ dated June 09, 2015,analyzing the decision of the

Bombay High Court in the case of IDBI Trusteeship Services Limited vs.

Hubtown Limited. 22

PART B: NDA HOTLINES AND PRESS PUBLICATIONS ON REITS

1. Article titled ‘Budget unlikely to give any fillip to REITs’ published in

Economic Times on March 01, 2015. 29

2. Article titled ‘REITs: Tax Issue and Beyond’ published in Livemint on

October 21, 2014. 31

3. Hotline titled ‘Tax Provisions introduced in the Budget 2014’

dated July 15, 2014, analyzing the tax provisions of the proposed

REIT regime. 33

4. Article titled ‘SEBI’s Draft Regulations on Real Estate Investment

Trusts’ published in World Securities Law Report (Bloomberg BNA)

dated December 2013. 38

FDI Related Recommendations



Contents1. FOREIGN INVESTMENT NORMS FOR REAL ESTATE LIBERALIZED 01

2. FOREIGN INVESTMENT NORMS IN REAL ESTATE CHANGED 09

3. FDI IN REAL ESTATE CONSTRUCTION AND DEVELOPMENT 12

4. GOVERNMENT TIGHTENS NORMS FOR FOREIGN INVESTMENT IN

CORPORATE BONDS 16

5. RECOMMENDATIONS ON FPI INVESTMENT IN CORPORATE BONDS 19

6. FOREIGN INVESTMENT STRUCTURE SEEN AS A ‘COLORABLE DEVICE’

AND HELD ILLEGAL 22

15© Nishith Desai Associates 2015


1. Foreign Investment Norms For Real Estate Liberalized

￭ Minimum area threshold reduced from 50,000 sq ft. to 20,000 sq ft.

￭ No minimum area threshold, if 30% project cost is contributed towards development of affordable housing.

￭ Are investments in completed yield generating real estate assets allowed?

In a recent press release issued in relation to its meeting dated October 29, 2014 (“Press Release”), the Union Cabinet has cleared the further liberalization of Foreign Direct Investment (“FDI”) in ‘construction-development sector’, in line with the announcements in the Finance Minister’s budget speech for 2014.

I. Changes

The changes sought to be made by the Press Release are set out below.1

Provisions Revised policy pursuant to Press Release Existing Policy

Minimum Land Requirements

Minimum area to be developed under each project would be:

(i) Development of serviced plots: No minimum land requirement;

(ii) Construction-development projects:

Minimum floor area of 20,000 sq. meters;

(iii) Combination project: Any of the above two conditions need to be complied with.

Minimum area to be developed under each project would be as under:

(i) Development of serviced housing plots: Minimum land area of 10 hectares;

(ii) Construction-development projects: Minimum built-up area of 50,000 sq. meters;


Minimum Capitalization Requirements

Minimum capitalization of USD 5 million. For wholly owned subsidiary: minimum capitalization of USD 10 million;

For joint ventures with Indian partners: minimum capitalization of USD 5 million.

1. The changes brought in by the Amendment are expected to be formalized in the form of a Press Note or by way of inclusion in the FDI Policy, and till such time the changes do not have the binding force of law.

16 © Nishith Desai Associates 2015


Timing of investment

The funds would have to be brought in within 6 months of commencement of the project.

‘Commencement of the project’ has been explained to mean ‘date of approval of the building plan/ lay out plan by the relevant statutory authority’.

Subsequent tranches can be brought in till the earlier of:

(i) Period of 10 years from the commencement of the project; or

(ii) The completion of the project.

The funds would have to be brought in within 6 months of ‘commencement of business of the Company’.

No such concept of 10 years from commencement of business earlier.

Lock-in The investor is permitted to exit from the investment at (i) 3 years from the date of final installment, subject to development of trunk infrastructure, or (ii) on the completion of the project.

‘Trunk infrastructure’ has not been defined, but is explained to include roads, water supply, street lighting, drainage and sewerage.

Repatriation of FDI or transfer of stake by a non-resident investor to another non-resident investor would require prior FIPB approval.

The investor is permitted to exit from the investment at expiry of 3 years from the date of completion of minimum capitalization.

For investment in tranches: The investor is permitted to exit from the investment at the later of (a) 3 years from the date of receipt of each tranche/ installment of FDI, or (b) at expiry of 3 years from the date of completion of minimum capitalization.

Prior exit of the investor only with the prior approval of FIPB.

Sale of developed plots only

Only developed plots are permitted to be sold. Developed plots would mean plots where trunk infrastructure is developed, including roads, water supply, street lighting, drainage and sewerage.

The requirement of completion certificate has been done away with.

Sale of undeveloped plots prohibited. Undeveloped plots would mean plots where roads, water supply, street lighting, drainage and sewerage, and other conveniences, as applicable under prescribed regulations, have not been made available.

The investor was required to provide the completion certificate from the concerned regulatory authority before disposal of serviced housing plots.

Minimum development

No requirement of any such minimum develop-ment.

At least 50% of the project must be devel-oped within a period of 5 years from date of obtaining all statutory clearances.

Exemption They are no longer exempt from the sale of undeveloped plots.

Certain investments were exempt from complying with the following requirements: (i) minimum land area; (ii) minimum capi-talization, (iii) lock-in, (iv) 50% development within 5 year requirements and (v) sale of undeveloped plots.

Foreign Investment Norms For Real Estate Liberalized



Affordable Housing

Projects which allocate 30% of the project cost for low cost affordable housing are exempt from the minimum land area, and minimum capitalization requirements.

No such exemption.

Certificate from architect

The investee company required to procure an architect empanelled by any authority author-ized to sanction building plan to certify that the minimum floor area has been complied.

No such requirement.

Completed projects

It has been clarified that 100% FDI permit-ted in completed projects for operation and management of townships, malls/ shopping complexes and business centers.

No such provision/ clarification

Responsibility for obtaining all necessary approvals

Investee Company. Investor/ Investee company.

II. Analysis

Particulars Revised policy pursuant to Press Release Existing Policy

Minimum Land Requirements

Minimum area to be developed under each project would be:

(i) Development of serviced plots: No minimum land requirement;

(ii) Construction-development projects:

Minimum floor area of 20,000 sq. meters;


Minimum area to be developed under each project would be as under:

(i) Development of serviced housing plots: Minimum land area of 10 hectares;

(ii) Construction-development projects: Minimum built-up area of 50,000 sq. meters;


A. Serviced plots and combination projects

Removal of minimum land requirements for serviced plots is a substantial relaxation. It appears that in case of combination projects as well, there shall be no minimum land requirement. Such relaxation could attract creative structuring for foreign investments in smaller areas.

B. Construction- development projects

In case of construction-development projects, the minimum land requirement has been reduced from 50,000 sq. meters of built-up area to 20,000 sq. meters of floor area. The introduction of floor area concept, as against the earlier benchmark of built-up area may need to be examined. ‘Floor area’ has been stated to be defined ‘as per the local laws/ regulations of the respective state governments / union territories’. Definitions of ‘floor area’ vary from state to state. While floor area is defined for some areas, other areas do not have any definition of the term, such as



C. Commencement of business of company to commencement of project

‘Commencement of business of the company’ had not been defined in the FDI Policy. It was seen practically that the regulator’s view was that the period of 6 months was to be calculated from the earlier of the date on which the investment agreement was signed by the investor, or the date the funds for the first tranche are credited into the account of the company. However, the criterion has now been changed to 6 months from the commencement of the project of the company, which has been explained to mean the date of the approval of the building plan/ lay out plan by the relevant authority. This is a welcome move since this brings clarity as against dependence on interpretation of ‘commencement of business’.

D. Period for subsequent tranches

The FDI Policy did not have any restriction on the maximum period till which the investor could infuse funds. However, the Amendment states that subsequent tranches of investment can only by

In a market largely driven by debt such as listed non-convertible debentures, a lower minimum capitalization would be helpful considering minimum capitalization can only consist of equity and compulsorily convertible instruments. This will also be helpful in tax structuring and optimization of returns for investors.

the regulations for Greater Mumbai. It is to be seen whether floor area in these regions would be equivalent to built-up area or floor space index (FSI), though in some cases, floor area is close to built-up area.


Minimum Capitalization Requirements

Minimum capitalization of USD 5 million. For wholly owned subsidiary: minimum capitalization of USD 10 million;

For joint ventures with Indian partners: minimum capitalization of USD 5 million.


Timing of investment

The funds would have to be brought in within 6 months of commencement of the project.

‘Commencement of the project’ has been explained to mean ‘date of approval of the building plan/ lay out plan by the relevant statutory authority’.

Subsequent tranches can be brought in till the earlier of:

(iii) Period of 10 years from the commencement of the project; or

(iv) The completion of the project.

The funds would have to be brought in within 6 months of ‘commencement of business of the company’.

No such concept of 10 years from commencement of business earlier.




E. Exit on completion

A welcome change is permitting investors to exit on the completion of the project. Hitherto, each tranche of investments were locked-in for a period of 3 years, even if the project was completed. This posed a major challenge for last-mile funding for projects, since the investment was stuck even on the completion of the project.

F. Lock-in of 3 years from final instalment

The lock-in for ongoing or non-completed projects for 3 years from the final tranche may need to be examined. The earlier regulations required any tranche to be locked in for a period of 3 years from the date of receipt of such tranche only.

G. 50% in 5 years

Another positive move is the removal of the minimum development of 50% in 5 years from the date of obtaining all statutory clearances. Earlier, there some ambiguity in relation to when the 50% development requirement would trigger, since it was unclear what all statutory approvals meant. To remove this ambiguity, the requirement for the minimum development of 50% in 5 years has been removed. However, in spirit, the same has been introduced by requiring ‘trunk infrastructure’ to be developed before any exit.

H. Trunk infrastructure

To be eligible to exit at the end of 3 years from the last tranche, trunk infrastructure (explained to include roads, water supply, street lighting and drainage and sewerage) must be developed. This requirement did not exist previously, and has been a recent introduction. This has also removed all


Lock-in The investor is permitted to exit from the investment at (i) 3 years from the date of final installment, subject to development of trunk infrastructure, or (ii) on the completion of the project.

‘Trunk infrastructure’ has not been defined, but is explained to include roads, water supply, street lighting, drainage and sewerage.

Repatriation of FDI or transfer of stake by a non-resident investor to another non-resident investor would require prior FIPB approval.

The investor is permitted to exit from the investment at expiry of 3 years from the date of completion of minimum capitalization.

For investment in tranches: The investor is permitted to exit from the investment at the later of (a) 3 years from the date of receipt of each tranche/ installment of FDI, or (b) at expiry of 3 years from the date of completion of minimum capitalization.

Prior exit of the investor only with the prior approval of FIPB.

brought in till a period of 10 years from the commencement of the project, which seems to imply that the regulator is reluctant towards real estate projects which have extremely long gestation periods.



A major relaxation which has now been introduced is the removal of the completion certificate requirement. Since these were service plots, a completion certificate was not forthcoming. Addressing this concern, this is no longer required as long as trunk infrastructure is developed.

ambiguities in relation to the 50% development requirement, since this is no longer linked to the obtaining of statutory clearances.

I. Grandfathering

It is unclear whether existing investment, on the anvil of exit currently would be required to satisfy the trunk infrastructure requirements. This may be a major barrier for investors who have completed the 3 year period from their investment, and are seeking exit, although trunk infrastructure has not been developed. It is also unclear whether existing tranches of investment would be locked in till the end of 3 period from any future tranches, if any.

Grandfathering of the existing investments from the requirements to comply with trunk infrastructure and the lock-in period would be important for existing investments.

J. Sale of stake from non-resident to non-resident

While the exit of a foreign investor earlier required FIPB approval, transfer of a non-resident investor’s stake to another non-resident investor was not expressly included. The Press Release now confirms this.


Requirement of commencement certificate for serviced plots

The requirement of commencement certificate has been done away with.

The investor was required to provide the completion certificate from the concerned regulatory authority before disposal of serviced housing plots.

Earlier, there some ambiguity in relation to when the 50% development requirement would trigger, since it was unclear what all statutory approvals meant. To remove this ambiguity, the requirement for the minimum development of 50% in 5 years has been removed. However, in spirit, the same has been introduced by requiring ‘trunk infrastructure’ to be developed before any exit.


Minimum development

No requirement of any minimum development.

At least 50% of the project must be developed within a period of 5 years from date of obtaining all statutory clearances.


Affordable Housing

Projects which allocate 30% of the project cost for low cost affordable housing are exempt from the minimum land area, and minimum capitalization requirements.

No such exemption.




It has been long debated whether FDI should be permitted in commercial completed real estate. By their very nature, commercial real estate assets are stable yield generating assets as against residential real estate assets, which are also seen as an investment product on the back of the robust capital appreciation that Indian real estate offers. To that extent, if a company engages in operating and managing completed real estate assets like a shopping mall, the intent of the investment should be seen to generate revenues from the successful operation and management of the asset (just like a hotel or a warehouse) as against holding it as a mere investment product (as is the case in residential real estate). The apprehension of creation of a real estate bubble on the back of speculative land trading is to that naturally accentuated in context of residential real estate. To that extent, operation and management of a completed yield generating asset is investing in the risk of the business and should be in the same light as investment in hotels, hospitals or any asset heavy asset class which is seen as investment in the business and not in the underlying real estate. Even for REITs, the government was favorable to carve out an exception for units of a REI from the definition of real estate business on the back of such understanding, since REITs would invest in completed yield general real estate assets. The Press Release probably aims to follow the direction and open the door for foreign investment in completed real assets, however the language is not entirely the way it should have been and does seem to indicate that foreign investment is allowed only in entities that are operating an managing completed assets as mere service providers and not necessarily real estate. While it may seem that FDI has now been permitted into completed commercial real estate sector, the Press Release leaves the question unanswered whether these companies operating and managing the assets may own the assets as well.

Affordable housing projects have been defined to mean projects which allot at least 60% of the FAR/ FSI for dwelling units of carpet area not being more than 60 sq. meters. Out of the total dwelling units, at least 35% should be of carpet area 21-27 sq. meters for economically weaker section category.

This would encourage creative structuring of investments into affordable housing. While the intent clearly is to encourage investment into affordable housing and housing for the economically weaker section, the equilibrium between luxury housing and affordable housing remains to be seen.


Completed projects

It has been clarified that 100% FDI permitted in completed projects for operation and management of townships, malls/ shopping complexes and business centers.

No such provision/ clarification


Responsibility for obtaining all necessary approvals

Investee Company. Investor/ Investee company.

K. Analysis

The obligation to obtain all necessary approvals, including the business plans has now been clarified to be that of the investee company in India, doing away with the unnecessary hassles around this for investor.



III. Conclusion

The changes introduced by way of the Press Release are along expected lines after the Budget Speech earlier this year. The minimum land requirement was an impediment for foreign investment, since it was difficult to find large tracts of land for development to satisfy the minimum land requirements in Tier-I cities. Further, the demand was inadequate for such investment to be made in Tier-II cities, where minimum land requirements could be met. Reducing or removal of minimum land requirements, along with removal of the requirement to obtain a completion certificate for sale of such plots would encourage foreign investment into this space.

While the final press note is still awaited to clarify certain aspects, this seems to be a positive move by the government to attract further investment.

This article was published as our Hotline dated November 07, 2014

Abhinav Harlalka & Ruchir Sinha

You can direct your queries or comments to the authors




2. Foreign Investment Norms In Real Estate Changed

￭ 3 year lock-in restriction removed

￭ Criteria for ‘affordable housing projects’ relaxed

￭ Whether investments are now possible in brownfield real estate projects?

In line with the announcements in the Finance Minister’s budget speech for 2014, the Union Cabinet in a recent press release issued pursuant to its meeting dated October 29, 2014 (“Press Release”), proposed certain relaxations for Foreign Direct Investment (“FDI”) in ‘construction-development sector’. This was followed by press note 10 of 2014 (“Press Note”) on December 3rd, 2014 and an RBI circular dated January 22, 2015 to formally notify the relaxations. Though most of the changes proposed in the Press Release have substantially been incorporated in the Press Note, there are certain differences in the Press Note as against Press Release. For a detailed analysis of the Press Release, please refer to our previous hotline ‘Foreign investment norms for real estate liberalized’. In this hotline, we are covering only the differences in the Press Note as against the Press Release.

I. Changes

A. Lock-in restriction

The Press Release proposed that a foreign investor can exit from its investment only on (i) the completion of the project, or (ii) completion of three years from the date of final investment, subject to the development of the trunk infrastructure, i.e., roads, water supply, street lighting, drainage and sewerage. The Press Note has done away with the requirement of 3 (three) years from the date of final investment, and hence, an investor can now exit from the project once it is completed or after the development of the trunk infrastructure.

B. Analysis

No minimum lock-in period : As per the earlier FDI Policy, each tranche of investment was locked in for a period of 3 years. Though this was intended to provide some long term commitment to the project by a foreign investor, even if the project was completed, some later tranches of foreign investment, especially the last mile funding could still be locked-in. By removing the 3 year (three) lock-in now, the government has encouraged foreign investments in shorter projects (also applicable as the minimum area requirements have now been relaxed), and removed deterrence for a foreign investor to provide subsequent funding in case of longer projects.



Ambiguity in exit from multi-phase projects : Previously if a project was developing in phases, a foreign investor could exit from the project upon completion of the initial phase, provided the 3 (three) year lock-in period had expired. However now, since the exit is linked to either project completion or development of trunk infrastructure, it is unclear whether a foreign investor can exit (whether partly or completely) upon completion of any phase of the project, when the trunk infrastructure for later phases is not developed.

C. Affordable housing project

The Press Note has relaxed the criteria for determining ‘affordable housing projects’ than as proposed in the Press Release. As per the Press Release, ‘affordable housing projects’ were defined to mean projects which allot at least 60% of the floor area ratio (“FAR”) / floor space index (“FSI”) for dwelling units of carpet area not being more than 60 sq. meters, and out of the total dwelling units, at least 35% should be of carpet area 21-27 sq. meters for economically weaker section category.

Press Note defines ‘affordable housing projects’ as projects where at least 40% of the FAR / FSI is for dwelling unit of floor area of not more than 140 sq. meters, and out of the total FAR / FSI reserved for affordable housing, at least 1/4th (one-fourth) should be for houses of floor area of not more than 60 sq. meters

D. Analysis

This relaxation is a welcome move, since projects which qualify for ‘affordable housing’ will not be required to comply with certain conditionalities like minimum area requirements and minimum investment requirements. Having said the above, since the area requirements is relaxed to as high as 140 sq. meters (approx. 1510 sq. feet), and only 1/4th of the affordable housing portion needs to be 60 sq. meters (approx. 645 sq. feet), whether the purpose for which this relaxation is introduced will be met or not is not clear.

E. Combination project

The Press Release retained the provision that in case of combination projects (mix of serviced plots and construction development), either of the condition for minimum area requirement can be satisfied. However, since now the minimum area restriction (being 25 acres) for ‘serviced plots’ has been removed, to avoid any misuse, the concept of combination projects has been removed in the Press Note.

F. Grandfathering

The Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) (Sixteenth Amendment) Regulations, 2014, dated December 8, 2014 (“Amendment Regulations”) which amends the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 to include the changes introduced by the Press Note, provides that (i) the Amendment Regulations shall be deemed to have come into force from December 3, 2014, and (ii) no person will be adversely affected as a result of the retrospective effect being given to the Amendment Regulations.

Foreign Investment Norms In Real Estate Changed



II. Conclusion

The changes introduced by the Press Note are expected to provide a much need fillip to the ‘real estate sector’. The relaxations in the minimum land area requirements will bring a lot of projects under the FDI compliant fold, especially in Tier I cities, where project sizes are typically small. Having said the above, there are two issues which may cause a concern:

i. as now it has been clarified that the minimum investment will have to be infused within 6 months of ‘commencement of the project’ i.e., the date of approval of building plan / lay out plan by the relevant statutory authority, and not 6 (six) months of ‘commencement of business’, which was understood to mean the date of investment agreement with the investor or the date of first infusion by the investor, it appears that investment in brownfield projects may be a challenge, which could be a major dampener. This may also hinder investments in under construction projects which are stalled due to funding requirements; and

ii. though, the government has relaxed the capital account restrictions in real estate sector over the last few years, certain changes have created hindrance in exits for existing foreign investments; for instance, press note 2 of 2005 permitted a foreign investor to exit upon completion of 3 (three) years from the date of investment, which was then later extended to 3 (three) years from the date of each tranche of investment. So, if an investor made a subsequent investment in the 4th (fourth) year from the date of initial investment, its 4th (fourth) year investment got suddenly locked in for another 3 (three) years, which the investor had not contemplated at the time of making investment. Also now, the Press Note prescribes that an investor can exit only on completion of the entire project or development of the trunk infrastructure. To that extent, in the absence of grandfathering, existing investors who had completed 3 (three) years and could have exited, are now left high and dry. It remains to be seen if they will now be given approvals for exit prior to completion or development of trunk infrastructure.

This article was published as our Hotline dated February 06, 2015

Dipanshu Singhal, Deepak Jodhani & Nishchal Joshipura




3. FDI in Real Estate Construction and Development

In line with the finance minister’s promise to boost the investment climate in the real estate sector, the Ministry of Commerce through Press Note 10 of 2014 (“PN 10”) provided certain important relaxations for Foreign Direct Investment (“FDI”) in the ‘construction-development’ sector. While the said relaxations made a significant attempt to attract foreign investment, representations were made by industry participants for further clarity on the import of certain provisions introduced by PN 10. To this end, the Department of Industrial Policy and Promotion earlier this year issued clarifications (“DIPP Clarifications”) in relation to several aspects of PN 10. However, despite the clarifications, ambiguities still prevail, which is not just detrimental to the investor community but also counter-productive to the positive efforts made by the new government. Set forth below are our observations on certain ambiguous DIPP Clarifications and our recommendations to address the same.

Sl. No. Issue Clarification/ Com-ment

Observations Proposed Recommenda-tions

1. Whether period of six months from the commencement of project means first approval of the building plan/ layout plan or subsequent approvals also?

Reckoning date would be the commencement of the project which is the date of approval of the building plan/lay out plan by the relevant statutory authority. Further approvals are just addendum/modification to the first approval.

As ‘commencement of project’ has been clarified to mean the date of obtaining the first approval of the building plan/ layout plan, and not the date of obtaining subsequent approvals, first time FDI in brownfield project would now be a major challenge. The developers who intend to partner with a foreign investor will now have to do so at the time of inception of the project, and only then will they be able to bring in further foreign investment. In case a project without FDI has already been started but is stuck for want of funds, then no new foreign investment can be brought in. This is a major dampener for the real estate sector; also, considering the large number of projects which are stuck mid-way, the ramifications will be significant.

While the government’s intent of attracting long-term stable capital in the real estate sector can be appreciated, barring brownfield investments in a sector which is highly capital intensive and cash-flow dependent would be a major problem for developers. Instead of placing a blanket prohibition on brownfield investments, a balance could be struck by imposing a 2-3 year lock-in on brownfield investments.



2. Whether FDI can be brought if the minimum capitalization was not completed within the period of six months of the commencement of the project?

No new FDI can be brought in the project if the minimum capitalization of US $ 5 million has not been achieved within six months of commencement of the project. If such minimum capitalization was achieved, FDI can be brought in till the period of 10 years or the completion of the project, whichever is earlier.

Due to the absence of a clear-cut definition for the term “Project”, it is not clear whether a multi-phase project spread over 5 - 10 years would be considered as a single project or whether each phase would be considered as a difference project. If the former interpretation is adopted by the regulators, due to the previous clarification, the project will have to attract all the FDI within 6 (six) months from its inception. As a result, in case of long term-projects, if there is a cash-crunch due to steep escalations and overheads, the developer will not be in a position to bring in foreign investment. In addition, since the unused land of a project cannot be sold without prior FIPB approval, value realization for existing foreign investors would be extremely difficult.

In order to clarify the scope of this clarification, the term “Project” would have to be objectively defined, and multi-phase projects must be permitted to attract brownfield investments.

3. Whether the past investments made as per the earlier FDI policy on the sector will be adversely impacted?

Press Note 10 of 2014 which provides more liberal FDI regime supersedes the earlier FDI policy on Construction Development sector contained in the FDI Policy Circular of 2014.

The import of this clarification is far-reaching, and could considerably affect the investments/ investment strategy of existing investors. As an illustration, under the erstwhile FDI regime, an investor was permitted to exit after the expiry of 3 years from the date of completion of minimum capitalization. Assuming the date of completion of minimum capitalization was January 2013 for a particular project, the foreign investor under the erstwhile regime would have been allowed to automatically exit after January 2016.

In order to avoid disconcerting issues arising out of the retrospective effect of PN 10, the government should explicitly clarify that all investments made under the earlier FDI regime will stand grandfathered.



However, based on the DIPP Clarifications, PN 10 will be applicable even for investments made in January 2013. As a result, the investor will not be permitted to automatically exit from its investment until trunk infrastructure is developed or the project itself is completed.

4. Whether foreign investor can acquire possession of the completed projects in townships, malls, shopping complexes and business centres?

FDI is permitted in completed projects for operation and management of townships, malls/ shopping complexes and business centres as long as they do not get into the realm of real estate business. Definition of “Real Estate Business” for the purposes of FDI policy is as provided in FEMA Notification No. 1/2000-RB dated May 03, 2000 read with RBI Master Circular i.e. dealing in land and immovable property with a view to earning profit or earning income therefrom and does not include development of townships, construction of residential/ commercial premises, roads or bridges, educational institutions, recreational facilities, city and regional level infrastructure, townships.

It has been long debated whether FDI should be permitted in commercial completed real estate. By their very nature, commercial real estate assets are stable yield generating assets as against residential real estate assets, which are also seen as an investment product on the back of the robust capital appreciation that Indian real estate segment offers. To that extent, if a company engages in operating and managing completed real estate assets like a shopping mall, the intent of the investment should be viewed as one to generate revenues from the successful operation and management of the asset (just like a hotel or a warehouse) as against regarding it as a mere investment product (as is the case of residential real estate). Further, operation and management of a completed yield generating asset involves investing in the risk of the business and should therefore be viewed in the same light as investment in hotels, hospitals or any asset heavy class which is seen as investment in the business and not in the underlying real estate.

FDI in completed commercial real estate should be permitted so long as the operation and management remains the responsibility of the Company (which may be done through sub contracting) and there are multiple tenants occupying the premises.

FDI in Real Estate Construction and Development



PN 10 probably aims to open the doors for FDI in completed commercial real estate; however, the language used in PN 10 does not unequivocally state this.

Our recommendation made to APREA



4. Government Tightens Norms For Foreign Investment In Corporate Bonds

￭ Foreign portfolio investors (“FPIs”) restricted from investing in corporate bonds with residual maturity of less than 3 years

￭ FPIs not subject to any lock-in restrictions on holding of bonds, and are free to sell

In a major blow to foreign investment in bonds issued by corporates in India (“Bonds”), the Reserve Bank of India (“RBI”), by way of a circular dated February 3, 2015 (“RBI Circular”) and the Securities Board of India, by way of a circular dated 3, 2015 (“SEBI Circular”, and together with RBI Circular, the “Circulars”), has restricted the ability of foreign portfolio investors (“FPI”) to invest in Bonds having residual maturity of less than 3 (three) years.

I. BackgroundFPIs are permitted to invest in government securities (“G-Sec”) and Bonds. To encourage more patient capital, the RBI had restricted FPIs from investing in G-Sec having a minimum residual maturity of less than 3 (three) years. No such restriction was previously imposed on Bonds issued by corporates. However, the RBI Governor in the Sixth Bi-Monthly Monetary Policy, dated February 3, 2015, announced that to harmonize the conditionalities, FPIs would henceforth be permitted to invest in Bonds only with a minimum residual maturity of 3 (three) years. The Circulars are introduced in line with the abovementioned policy. This was succeeded by a clarification dated February 6, 2015 (“Clarification”) with respect to the investment by FPIs in Bonds.

II. Changes ￭ FPIs are now permitted to invest in / purchase corporate Bonds only with a minimum residual

maturity of 3 (three) years. This applies to for all future investments by FPIs into Bonds;

￭ FPIs however do not have any lock-in for such investments, and are free to sell it any time; provided however, if less than 3 (three) years is pending to maturity, FPIs can sell the Bonds only to persons resident in India;

￭ FPIs are now not permitted to invest in liquid and money market mutual fund schemes;

￭ FPIs cannot invest in Bonds with maturity over 3 (three) years but having optionality clauses exercisable within 3 (three) years.

III. Analysis

A. Contractual arrangements difficult

Imposition of 3 year residual maturity requirement would not only impact shorter term loans, it



would also restrict various contractual arrangements like call / put option vis-à-vis the issuing company, part redemptions etc. to be exercised prior to the expiry of 3 years. For an issuer company which is contemplating having a prepayment clause in the terms of the Bonds, this may be a major deterrent for them to raise monies from FPIs. Also, in many cases, especially in real estate sector, where payments are linked to agreed distribution waterfall, or where Bonds where structured from a tax perspective in a manner that payments on them are attributed towards principal in the beginning and the premium is back-ended, this new requirement would majorly hinder such structures.

B. Optionality Clauses

The Clarification has also made it clear that any investment into Bonds, having residual maturity above 3 (three) years, but having optionality clauses exercisable prior to 3 (three) years would also not be permitted for investment by FPIs. This would prevent structuring by FPIs to exercise put option and sell the Bonds. This may be against the intent of RBI to bring in patient lasting capital and accordingly seems to be prohibited.

C. Default

The Circulars do not clarify whether in case of default, the Bonds can be redeemed prior to 3 years upon enforcement of security. In the absence of such clarification, even redemption upon enforcement prior to 3 years would require regulatory approvals. However, if the application for approval is coupled with court order, regulatory approvals for prior redemption may be granted. Alternatively, the FPI may also transfer the Bonds to a domestic counter-party prior to enforcement, in which case this 3 year condition would not apply.

D. Grandfathering

The requirement of minimum 3 year residual maturity is only for fresh investments by FPIs. Existing holdings of Bonds by FPIs can continue to have call / put options and be redeemed prior to 3 years.

E. Possible structures

Considering that principal moratorium of more than 18 months may not be amenable, warehousing in India by FPIs and sale to promoter without any optionality clauses in the terms of the document of the Bond issuance seem to be possible structuring options open to the FPIs. However, each of these options would have their own set of regulatory and tax considerations which may need to be analyzed in detail on a case to case basis.

IV. Conclusion

The Indian corporate bond market is a highly underdeveloped market in comparison to other countries. It lags behind China (USD 1,651 billion), South Korea (USD 1,014 billion) and Japan (USD 786 billion) at approximately USD 242 billion.1 In 2013, the government had substantially

1. http://www.careratings.com/upload/NewsFiles/Studies/Indian%20Bond%20Market-%20Striking%20a%20Chord%20with%20Asian%20Peers.pdf



reduced the withholding tax for corporate NCDs, which seemed to indicate that it intends to encourage foreign debt. However, the introduction of minimum 3 years residual maturity requirement is a major dampener for FPIs and corporates. Though the aggregate limit for all corporate NCDs is USD 51 billion of which 90% is available on-tap basis, still a substantial portion is yet to be utilized. The Circulars and the Clarification do not augur well with the intention of the government to encourage debt.

Abhinav Harlalka , Deepak Jodhani & Ruchir Sinha


Government Tightens Norms For Foreign Investment In Corporate Bonds

This article was published as our Hotline dated February 10, 2015



5. Recommendations on FPI Investment in Corporate Bonds

I. Background

The Reserve Bank of India (“RBI”), by way of a circular dated February 3, 2015 (“RBI Circular”) and the Securities Board of India, by way of a circular dated 3, 2015 (“SEBI Circular”, and together with RBI Circular, the “Circulars”), has restricted the ability of foreign portfolio investors (“FPI”) to invest in bonds issued by corporates in India (“Bonds”) having residual maturity of less than 3 (three) years. This was followed by a clarification dated February 6, 2015 (“Clarification”) with respect to the investment by FPIs in Bonds

This is a major blow to foreign investment in Bonds. As it is, the Indian corporate bond market is a highly underdeveloped market in comparison to other countries. It lags behind China (USD 1,651 billion), South Korea (USD 1,014 billion) and Japan (USD 786 billion) at approximately USD 242 billion.1 Further, though the aggregate limit for all corporate NCDs is USD 51 billion of which 90% is available on-tap basis, still a substantial portion is yet to be utilized.

In 2013, the government had substantially reduced the withholding tax for corporate NCDs, which seemed to indicate that it intends to encourage foreign debt. The introduction of this minimum 3 years residual maturity requirement will be a major dampener for FPIs and corporates.

Though, the restriction has been imposed to rationalize the investment restrictions for FPI investment in Bonds, along the lines of government securities, the dynamics and commercials in these two instruments are completely different. In light of the above, we suggest the following recommendations / clarifications, to increase the vibrancy of FPI investment in Indian Bonds.

II. Recommendations

A. Residual maturity versus initial maturity

Currently, as per the Circulars, FPIs can invest in Bonds having a residual maturity of 3 (three) years.

i. Recommendation

Instead of residual maturity, the restriction should be linked to initial maturity.

ii. Rationale

It appears that the intention of the regulators is to encourage more patient capital. So long as the initial maturity of Bonds is 3 years and above, it ensures sufficient safeguard against volatile monies. Linking it to residual maturity majorly affects secondary transaction between two FPIs, which does not affect the company or the flow of foreign monies in India. [G-sec]

1. http://www.careratings.com/upload/NewsFiles/Studies/Indian%20Bond%20Market-%20Striking%20a%20Chord%20with%20Asian%20Peers.pdf



B. Average maturity

The Clarification provides that FPIs can invest in amortised debt instruments provided the duration of the instrument is three years and above, however, it is not clear whether FPIs can invest in Bonds having minimum average maturity period of 3 years.

i. Recommendation

It should be clarified that FPIs can invest in Bonds having minimum average maturity period of 3 years, and the method of calculating average maturity shall be the same as given in External

Commercial Borrowing (“ECB”) policy (reproduced below for quick reference)

Calculate of Average Maturity – an Illustration

ABCD Ltd. Loan Amount = USD 2 Million

Date of drawal/repayment(MM/DD/YYYY)

Drawal Repayment Balance No of days** balance with the borrower

Product=(Col 1 * Col5) / Loan amount * 360)

Col 1 Col 2 Col 3 Col 4 Col 5 Col 6

05/11/2007 0.75 0.75 24 0.0250

06/11/2007 0.50 1.25 85 0.1476

08/31/2007 0.75 2.00 477 1.3250

12/27/2008 0.20 1.80 180 0.4500

06/27/2009 0.25 1.55 180 0.3875

12/27/2009 0.25 1.30 180 0.3250

06/27/2010 0.30 1.00 180 0.2500

12/27/2010 0.25 0.75 180 0.1875

06/27/2011 0.25 0.50 180 0.1250

12/27/2011 0.25 0.25 180 0.0625

06/27/2012 0.25 0.00 180

Average Maturity = 3.2851

**Calculated by = DAYS360 (firstdate, seconddate, 360)

Recommendations on FPI investment in Corporate Bonds



ii. Rationale

There are many transactions where the stakeholders require repayment of part principal prior to 3 years. This restriction imposes a major hindrance in such transactions. So long as the average maturity is more than 3 years, it should suffice the intention of the regulators to encourage patient capital. Further, to avoid any ambiguity in the determination of average maturity, and to ensure consistency across regulations, it is best linked to the mechanism in ECB policy.

C. Optionality clauses vis-à-vis third party

The Circulars and the Clarification provide that FPIs cannot invest in Bonds where optionality clause is exercisable within three years. As we understand from various custodians, the regulatory view is that this restriction would also apply where the optionality clause exists vis-à-vis third parties (let’s say, the promoter) and not against the issuer.

i. Recommendation

It should be clarified that optionality clause vis-à-vis third parties (i.e., not against the issuer) is permitted even if exercisable within three years

ii. Rationale

Currently, the Circulars and the Clarification do not restrict an FPI from selling a three year Bond to a resident after, let’s say 2 years. Since, an optionality clause vis-à-vis the promoter only results in a sale of Bonds to the promoter and does not affect the issuer, to that extent, such optionality clause vis-à-vis third parties should be permissible.

D. Early redemption in case of default

Currently, the Circulars and Clarification restrict the redemption of Bonds within 3 years. However, it is not clear whether such Bonds can be redeemed in case of event of default or out of the enforcement proceeds.

i. Recommendation

It should be clarified that redemption of Bonds in case of events of default or out of enforcement proceeds is permitted even if done within 3 years.

ii. Rationale

One of the primary concerns for any investor in a debt investment is its ability to force an early redemption in case of an event of default, and exit. Any ambiguity in the enforceability of such right due to any regulatory restriction causes a lot of apprehension for FPIs, as a result of which many FPIs are shying away from making investments in Bonds. It should be clarified that early redemption in case of default, even within 3 years is permitted. Since, FPIs can only subscribe to listed Bonds, and any default by the issuer is disclosed publicly, any misuse of such relaxation is unlikely.

Our recommendation made to ASIFMA



6. Foreign Investment Structure Seen As A ‘Colorable Device’ And Held Illegal

￭ Bombay High Court evaluates a downstream FDI structure to rule that investment in the holding company was a ‘sham’ structured to invest downstream by way of redeemable instruments.

￭ Court would not provide assistance in enforcement of transactions which are not compliant with the FDI Policy and FEMA Regulations.

￭ Courts follow the regulatory approach and scrutinize the various steps in a transaction to hold that such transaction as intended to provide assured return which is not permitted under the FDI Policy and FEMA Regulations.

I. Introduction

The recent ruling of the Bombay High Court sets out the approach of the courts to scrutinize transactions to ascertain if the objective of the transaction or the series of connected transactions are compliant with the law. The Court in IDBI Trusteeship Services Limited (“IDBI” or “Petitioner”) v. Hubtown Limited (“Hubtown” or “Respondent”) declared an investment of INR 418 crores in the holding company as colorable device used to circumvent the Foreign Direct Investment Policy (“FDI Policy”) and the regulations framed under the Foreign Exchange Management Act, 1999 (“FEMA Regulations”) to provide an assured return.

Off - Shore

India

FMO

HUBTOWN VINCA / HOLD CO

AMEZIA / Subsidiary RUBIX / Subsidiary

1

2

3

II. Background And Factual Matrix



A. FMO invested into Hold Co. through subscription of CCDs

￭ Nederlandse Financierings- Maatschappiji Voor Ontwikkelingslandeo N.V. (“FMO”) is a corporation formed under the laws of Netherlands. FMO held 10 percent of the shareholding in Vinca Developers Private Limited (“Vinca” or “Hold Co.”) and 3 Compulsorily Convertible Debentures (“CCDs”) issued by Vinca.

￭ The CCDs were convertible within a period of 60 months and upon conversion FMO would hold 99% of Vinca’s equity.

￭ Vinca was involved in the construction development sector and had an FDI eligible township project.

B. Hubtown/Promoters hold the balance shares of the Hold Co.

￭ Hubtown and individual promoters held the balance 90 percent shareholding in Vinca which was to be diluted upon conversion of the CCDs.

C. Hold Co. invested in the subsidiaries through subscription of OCDs

￭ Vinca had contractually agreed that the investment by FMO would be used to purchase Optionally Convertible Debentures (“OCDs”) issued by Amazia Developers Private Limited (“Amazia”) and Rubix Trading Private Limited (“Rubix”), who are wholly owned subsidiaries of Vinca. Accordingly, the amounts invested by FMO were infused into Amazia and Rubix (together referred to as “Subsidiaries”).

￭ The Petitioner is the Debenture Trustee in regard to the OCDs.

￭ The Articles of Association (“AoA”) of Vinca/Hold Co. were amended such that FMO Nominee Directors on Vinca’s Board of Directors would alone be entitled to take all decisions regarding the OCDs and the Debenture Trustee.

￭ Hubtown provided a guarantee in favour of Vinca for the performance of the obligations by the Subsidiaries with respect to the OCDs.

Upon failure by the Subsidiaries to make the payments on the OCDs, the guarantee provided by Hubtown was invoked. Subsequently, upon failure of Hubtown to make the payments pursuant to the invocation of the guarantee, the Debenture Trustee filed a petition for winding up Hubtown and also a summary suit for recovery of the dues.

In both the proceedings, it was contended by Hubtown that the structure was itself in violation of the FDI Policy and hence the guarantee being part of the transaction is also unenforceable. It was argued that by interposing the Hold Co. in the middle and arranging the contractual and shareholder rights in such manner, FMO was looking to obtain an assured return on its investment which was not permitted under the FDI Regulations/FDI Policy.

III. Judicial Reasoning

The Bombay High Court applied the principle laid down in Vodafone International Holdings BV v.



Union of India1 wherein it was held that the Court must look at the entire transaction as a whole and not adopt a dissecting approach while ascertaining whether a transaction is being used as a colorable device. The court also relied on precedents to hold that Court’s assistance could not be taken to enforce prohibited/illegal transactions and that the exchange control regulations formed part of the public policy of India.

In this backdrop, the Court examined the adopted investment structure for the transaction and noted the following points with respect to the structuring of the investment:

i. FDI received by the Hold Co was mandated to be only invested downstream by way of subscription of OCDs.

The Court rejected the contention of the Petitioner that the investment by FMO in the Hold Co. was in accordance with Press Note 2 of 2005 as the Hold Co. has a township project which is an FDI eligible project.

The court took note of the fact that the agreements required the Hold Co. to immediately pass the FDI received from FMO to the Subsidiaries against subscription of OCDs. Hold Co. was not allowed to retain the FDI amount or to utilize the same in any of its projects. Press Note 2 of 2005 permits FDI investment in the real estate sector only if it is for township/construction project. Accordingly, the court held that the investment in the Hold Co. cannot be said to be in accordance with Press Note 2 of 2005 and is not FDI compliant.

It was contended by the Petitioner that the Hold Co. being a separate legal entity, there was no bar on it to invest the amount received from FMO in OCDs of the Subsidiaries and the investment by the Hold Co. could not be treated as an investment by FMO. The Court rejected the contention on the same ground that the agreements established that the Hold Co. did not have an option but to route the funds to the Subsidiaries.

ii. Investment by the Hold Co. in the Subsidiaries was through subscription of OCDs as opposed to instruments considered as equity under the FDI Regime

The Court rejected the contention of the Petitioner that FMO could have directly invested in the Subsidiaries by CCDs and obtained a fixed rate of return as there in no prohibition against CCDs bearing interest under the FDI Policy.

FDI Policy restricts investment through redeemable (whether in part or full) instruments, and obtaining assured returns. It was noted by the Court that FDI Policy & FEMA Regulations permits equity investment i.e. where equity risk is taken by the foreign investor. CCDs are compulsorily convertible into equity and are treated as an equity instrument under the FDI Regime. However, the instrument used was OCDs which allowed FMO to ensure that the Hold Co. obtains the investment amount along with the interest. Thus, the equity risk was not borne by the investors.

iii. The cash up streamed would belong to FMO since the CCDs issued by Hold Co. to FMO could convert into 99% of the capital of the Hold Co.

It was also argued that the investment by FMO was ultimately in form of CCDs in the Hold Co, sale of which would be subject to the pricing guidelines and would not be able obtain a price higher than that stipulated by the RBI.

1. (2012) 70 Com Cases 369

Foreign Investment Structure Seen As A ‘Colorable Device’ And Held Illegal



However, the Court noted that structure was designed in such a manner to ensure that on receipt by the Hold Co. of the principal amount invested in the Subsidiaries along with the interest, FMO on conversion of its CCDs would become the owner of the Hold Co. and thereby receive/become entitled to the amounts received by the Hold Co. The Court observed that FMO could then sell the shares of Hold Co. at fair value which would necessarily include the value/benefit of the assured return through the OCDs.

The Court also took note of how Articles of Association of the Hold Co. had been amended such as to ensure that the decisions pertaining to matters relating to the OCDs and the enforcement thereof by the Hold Co. are made by the nominee directors of FMO on board of the Hold Co.

Accordingly, the Court held that:

“I am prima facie of the view that the structure/device of routing FMO’s FDI amount of Rs. 418 crores to Amazia and Rubix through the newly interposed Vinca (as the nominal recipient of the FDI) was a colourable device structured only to enable FMO to secure repayment (through Vinca) of its FDI amount and interest thereon at 14.75%, contrary to the statutory FEMA Regulations and the FDI Policy embodied therein, which only permit FDI investment in townships/real estate development sector to be made in the form of equity (including Compulsorily Convertible Debentures) and preclude any assured return. I am also prima facie of the view that the Company’s Guarantee (which is the basis of the Company Petition) though ostensibly in favour of Vinca, an Indian Company, was part of the aforesaid illegal structure/scheme and was given to ensure that FMO received back its FDI amount with interest as aforesaid through Vinca. The Guarantee was therefore part of the aforesaid illegal structures/scheme and therefore prima facie illegal and unenforceable.”

However, it is to be noted that observations made by the court in context of the facts and finding that the structure is a colorable device are prima facie in nature and not based on detailed adjudication considering the nature of the legal proceedings which were initiated by the Petitioner.

IV. Analysis

i. The judgments2 resonate the regulatory outlook towards foreign transaction and sets out to scrutinize the substance of the transaction rather than the form of it.

ii. The Supreme Court in Vodafone International Holdings BV v. Union of India (“Vodafone”) has held that it is the task of the Court to ascertain the legal nature of the transaction and while doing so it has to look at the entire transaction as a whole and not to adopt a dissecting approach. While doing so, if the Court came to a conclusion that it was a colorable device, it had to be treated as non-est in the eyes of law.

iii. While the ‘look at’ test was adopted by the court, the judgments reflects that under such approach the courts are willing to scrutinize the transaction and its various elements to ascertain if the structure is in spirit compliant with the FDI Policy & FEMA Regulations. This willingness to re-characterize the transaction despite the individual steps in isolation seemingly being in compliance with the regulations on the basis of the defense raised by the non-compliant party highlights the need for high caution to be exercised while adopting certain investment structures.

2. Separate judgments were passed in the two proceedings i.e. the petition for winding up and the summary suit.



iv. Further, Press Note 2 of 2005 or the FDI Policy did not impose any end use requirements for the FDI received by a Company. However, the findings of the Court with regard to the investment not being in compliance with Press Note 2 of 2005 seems to indicate that FDI received is required to be utilized in the FDI eligible projects of the Company and connected requirements and cannot be used for other purposes.

v. The Court has rejected the contention of the Petitioner that even after conversion of the CCDs and FMO becoming 99 percent shareholder of Vinca, FMO will have to follow Reserve Bank of India’s (“RBI”) pricing guidelines and hence the transaction should not be treated as a colourable device. However, the Court has not expressly stated how the equity risk is not on FMO as the Hold Co. was not a shell entity. Thus, while Vinca would obtain the returns on the amounts invested in Amazia and Rubix and derive benefits thereof, price received by FMO upon exit from Vinca would also be affected by loss if any incurred by Vinca in its existing business. It appears that the extent of Hold Co.’s business and its potential impact on valuation at which FMO may exit from Hold Co. thereby being considered as an investment wherein equity risk is taken by the foreign investor may be a question which may be determined post a detailed adjudication.

vi. Lastly, the Court has relied upon the observations of the Supreme Court in Renusagar Power Sugar Company Limited v General Electric Company3, to hold that the foreign exchange related enactments are enacted to safeguard the economic interest of India and are therefore part of the public policy of India. Hence, arbitral awards challenged or objected to under Section 34 and Section 48 of the Arbitration and Conciliation Act, 1996 for similar structures may also be subject to such court scrutiny to ascertain if the transaction was in compliance with the extant exchange control regulations. Therefore such objections may also lead to delay in final enforcement of the arbitral awards. Thus, serious caution ought to be exercised by Investors while considering various modes whereby they may invest.

This article was published as our Hotline dated June 09, 2015

Satish Padhi, Ashish Kabra, & Ruchir Sinha


3. AIR 1994 SC 860

Foreign Investment Structure Seen As A ‘Colorable Device’ And Held Illegal



1. BUDGET UNLIKELY TO GIVE ANY FILLIP TO REITS 29

2. TAX AND NON-TAX ISSUES 31

3. TAX PROVISIONS INTRODUCED IN THE BUDGET 2014 33

4. WORLD SECURITIES LAW REPORT 38

Contents



1. Budget unlikely to give any fillip to REITs

After many failed attempts by the Government to introduce REITs, REITs came up last year and was seen as game changer for unlocking the commercial real estate in India. Notwithstanding the tax initiatives introduced in Budget 2014, REITs received lackluster response from both the developer and the investor community. Whilst there are a host of commercial reasons for Indian REITs not to have taken off, taxation was clearly one of the biggest reasons.

I. Current Regime

From a sponsor perspective, the biggest issues were capital gains tax (CGT) and minimum alternate tax (MAT) on transfer of the shares by the sponsor of the real estate owning company (SPV) to the REIT. The current regime provides that if a sponsor transfers shares of the SPV in exchange for REIT units, then the sponsor shall only be taxed when he sells the REIT units and not when he transfers the SPV shares. However, this deferment was seen only as a hogwash since the sponsor ends up paying CGT when such units are sold on the floor. As a double whammy, even though the sponsor pays CGT when he monetizes the REIT units, he is subjected to MAT on book profits at the time of transfer of shares of the SPV to the REIT. Further, there is no exemption from CGT or MAT available to a sponsor on direct transfer of real estate to the REIT.

From an investor perspective, the REIT taxation made the yield unattractive. Capital gains tax exemption on transfer of the shares to the REIT and huge stamp duty on transfer of real estate encourages REITs to acquire SPVs and not real estate directly. If SPVs were held by the REIT, then the REIT was subjected to almost 33% income tax and a further 17% tax on dividend up streaming to the REIT. Issue of foreign tax credits was also critical since the foreign investors of a REIT could not claim any tax credit in most cases since it was the SPV that paid the taxes, not the REIT.

II. Budget 2015 Proposals

To revive REITs in India, the sponsors were expecting the following tax treatment in Budget 2015

i. exemption from MAT when the sponsor transfers shares of the SPV or real estate to the REIT considering the fact that the sponsor would want to transfer the shares of SPV at a premium to its book value

ii. deferment of capital gains tax on transfer of shares of SPV or real estate to REIT till the time the sponsor monetises the REIT units and

iii. sponsors getting the same tax exemption available to other REIT unitholders at the time of monetising the REIT units. Further, exemption from dividend distribution tax (DDT) for upstreaming income by the SPV to the REIT was expected by the investors considering the fact that distribution of income is mandatory as per SEBI REIT regulations unlike a listed real estate company where the Board can decide the timing and quantum of dividend payment to its shareholders.

From a sponsor perspective, although deferment of capital gains tax was addressed partially by Budget 2014 and equitable treatment with other unit holders has been addressed by Budget



2015, the much needed exemption from MAT at the time of transfer of SPV shares or real estate to the REIT has not been addressed. Even a simple proposal of deferment of MAT till the monetisation of REIT units would have been fair for the sponsors since they would have been required to pay MAT on transfer of SPV shares and on monetization of REIT units only at the time of monetising their REIT units as compared to the current regime where the MAT has to be paid both at the time of exchange of SPV shares for REIT units and at the time of monetisation of REIT units.

From an investor perspective, Budget 2015 proposal to provide pass through on rental income on real estate held directly by the REIT is practically redundant since stamp duty and capital gains tax/MAT make it prohibitive for the sponsors to transfer the real estate directly to the REIT. Further, no exemption from DDT will continues to reduce the net returns earned by the investors unless the REIT inherits a tax efficient debt structure.

Overall, Budget 2015-16 is unlikely to give any fillip to REITs, which will continue to grapple with its own challenges. The sponsors and the investors will continue exploring Singapore REIT structures and LRD structures till the tax issues are addressed satisfactorily.

This article was published in Economic Times on March 01, 2015

Nishchal Joshipura & Ruchir Sinha,

Budget unlikely to give any fillip to REITs


Real EstateCompendiumReal Estate Update

.........................................................................................................................................................................................

October 27, 2014

REITS: TAX ISSUES AND BEYOND

APART FROM THE TAX CHALLENGES, THERE ARE NON-TAX ISSUES ALSO THAT MAKE THE

INDIAN REIT UNATTRACTIVE

The Securities and Exchange Board of India (Sebi) recently introduced the final regulations for real

estate investment trusts (REITs) and infrastructure investment trusts (InvITs). These regulations

come on the back of recent tax initiatives introduced in the budget this year. While the initiative is

indeed a positive step, the tax measures governing REITs or business trusts (as they are referred to

in the Income-tax Act) do not offer much encouragement, neither to the sponsor nor the unit holders.

From a sponsor’s perspective, capital gains tax benefit has been given only in cases where shares of

the special purpose vehicle (SPV) holding the real estate are transferred to a REIT against units of a

REIT, and not when real estate is directly transferred to a REIT. By doing so, there is an unnecessary

corporate layer imposed between the REIT and the real estate asset, which could result in a tax

leakage of about 45% (corporate taxes of 30% at the SPV level and distribution tax of 15% on

dividends, exclusive of surcharge and cess). To the sponsor, there is no tax benefit (but mere

deferral) because she gets taxed when the REIT units are ultimately sold on the floor at a much more

appreciated value, even though the units of a REIT would be listed and exempt from capital gains tax

if held by other unit holders for more than three years.

While capital gains tax incidence may still be avoided by relying on principles of trust taxation, there

will still be no respite from minimum alternate tax (MAT), which could become applicable on transfer

of shares to the REIT. Considering that sponsors would like to transfer the shares at higher than

book value to ensure commensurate fund raising for the REIT, the issue of MAT seems to be most

critical.

From a REIT taxation perspective, although a pass-through of tax liability to investors for REIT income

was promised, since the SPV is required to pay full corporate and dividend distribution taxes, where

is the pass-through? What is even worse is that no foreign tax credit may be available for such taxes

paid in India.

The only way to achieve tax optimization seems to be by way of infusion of debt into the SPV by a REIT.

In such a situation, interest from the SPV to the REIT will be a deductible for the SPV, thus allaying

both distribution taxes and corporate taxes. Interest from the SPV would be tax exempt at the REIT

level and only a 5% withholding will be applicable on distributions by the REITs to the foreign unit-

holders. This should help neutralize REIT taxation at India level, considering that the 5% withholding

tax paid in India should also be creditable offshore.

The critical question that would then come up is how the SPV would use this debt. The debt can either

be used to retire existing debt, or be structured to retire promoter equity in the SPV. If the debt is used

for retiring equity, the risk of ‘deemed dividend’ characterization would need to be carefully

considered. Though other creative structures may be devised to minimize tax exposure for the

sponsor, it will be critical to ‘dress up’ the SPV appropriately with the right amount of debt and equity,

before the SPV is transferred to the REIT.

Apart from the tax challenges set out above, there are also several non-tax issues that make the

Indian REIT story unattractive. The requirement for a sponsor to have a real estate track record is

likely to rule out a substantial portion of yield generating assets. This eliminates the possibility of non-

real estate players such as hotels, hospitals, banks and others (such as Air India) becoming

sponsors of REITs.

Most importantly, the marketability of Indian REITs compared with other fixed-income products

remains weak since the expected yield on REITs may not exceed 5-6% compared with an around-8%

yield offered by government securities. Though REITs may offer a higher return considering the

capital appreciation, offshore investors seem reluctant to buy the ‘cap rate story’ attached to a REIT.

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2. Tax and Non-Tax issues



Having said that, REITs are likely to offer monetization opportunities to private equity funds and

developers, which have till now been unable to find institutional buyers for completed real estate

assets. As the appetite for developmental projects has reduced, REITs will offer opportunities to

foreign investors to invest in rent generating assets, an asset class otherwise prohibited for foreign

inves tments. It, however, remains to be seen how the Indian REIT story matches up to the Singapore

REIT structure for Indian assets, or the more trending lease-rental-discounting structure, or the even

more innovative commercial mortgage-backed security structure, which seem to be more appealing

to potential sponsors.

This article was published in Livemint dated October 21, 2014. The same can be accessed from

the link.

– Sriram Govind & Ruchir Sinha


DISCLAIMER

The contents of this hotline should not be construed as legal opinion. View detailed disclaimer.

This Hotline provides general information existing

at the time of preparation. The Hotline is intended

as a news update and Nishith Desai Associates

neither assumes nor accepts any responsibility

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Real Estate Update

.........................................................................................................................................................................................

October 27, 2014

REITS: TAX ISSUES AND BEYOND

APART FROM THE TAX CHALLENGES, THERE ARE NON-TAX ISSUES ALSO THAT MAKE THE

INDIAN REIT UNATTRACTIVE

The Securities and Exchange Board of India (Sebi) recently introduced the final regulations for real

estate investment trusts (REITs) and infrastructure investment trusts (InvITs). These regulations

come on the back of recent tax initiatives introduced in the budget this year. While the initiative is

indeed a positive step, the tax measures governing REITs or business trusts (as they are referred to

in the Income-tax Act) do not offer much encouragement, neither to the sponsor nor the unit holders.

From a sponsor’s perspective, capital gains tax benefit has been given only in cases where shares of

the special purpose vehicle (SPV) holding the real estate are transferred to a REIT against units of a

REIT, and not when real estate is directly transferred to a REIT. By doing so, there is an unnecessary

corporate layer imposed between the REIT and the real estate asset, which could result in a tax

leakage of about 45% (corporate taxes of 30% at the SPV level and distribution tax of 15% on

dividends, exclusive of surcharge and cess). To the sponsor, there is no tax benefit (but mere

deferral) because she gets taxed when the REIT units are ultimately sold on the floor at a much more

appreciated value, even though the units of a REIT would be listed and exempt from capital gains tax

if held by other unit holders for more than three years.

While capital gains tax incidence may still be avoided by relying on principles of trust taxation, there

will still be no respite from minimum alternate tax (MAT), which could become applicable on transfer

of shares to the REIT. Considering that sponsors would like to transfer the shares at higher than

book value to ensure commensurate fund raising for the REIT, the issue of MAT seems to be most

critical.

From a REIT taxation perspective, although a pass-through of tax liability to investors for REIT income

was promised, since the SPV is required to pay full corporate and dividend distribution taxes, where

is the pass-through? What is even worse is that no foreign tax credit may be available for such taxes

paid in India.

The only way to achieve tax optimization seems to be by way of infusion of debt into the SPV by a REIT.

In such a situation, interest from the SPV to the REIT will be a deductible for the SPV, thus allaying

both distribution taxes and corporate taxes. Interest from the SPV would be tax exempt at the REIT

level and only a 5% withholding will be applicable on distributions by the REITs to the foreign unit-

holders. This should help neutralize REIT taxation at India level, considering that the 5% withholding

tax paid in India should also be creditable offshore.

The critical question that would then come up is how the SPV would use this debt. The debt can either

be used to retire existing debt, or be structured to retire promoter equity in the SPV. If the debt is used

for retiring equity, the risk of ‘deemed dividend’ characterization would need to be carefully

considered. Though other creative structures may be devised to minimize tax exposure for the

sponsor, it will be critical to ‘dress up’ the SPV appropriately with the right amount of debt and equity,

before the SPV is transferred to the REIT.

Apart from the tax challenges set out above, there are also several non-tax issues that make the

Indian REIT story unattractive. The requirement for a sponsor to have a real estate track record is

likely to rule out a substantial portion of yield generating assets. This eliminates the possibility of non-

real estate players such as hotels, hospitals, banks and others (such as Air India) becoming

sponsors of REITs.

Most importantly, the marketability of Indian REITs compared with other fixed-income products

remains weak since the expected yield on REITs may not exceed 5-6% compared with an around-8%

yield offered by government securities. Though REITs may offer a higher return considering the

capital appreciation, offshore investors seem reluctant to buy the ‘cap rate story’ attached to a REIT.

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Tax and Non-Tax issues



3. Tax Provisions Introduced in the Budget 2014

Real Estate Update

.........................................................................................................................................................................................

July 15, 2014

BUDGET 2014: A GAME CHANGER FOR REITS?

Budget 2014-15 (“Budget”) has introduced tax incentives for the real estate investment trusts

(“REITs”) regime, and also provided for relaxations in foreign direct investment (“FDI”) regime. With the

tax incentives in place, the Securities and Exchange Board of India (“SEBI”) is likely to formally

announce the REIT regulations that are currently in draft form. In this hotline, we discuss some of the

key changes and its Budget 2014 impact on the real estate sector. For a detailed analysis of the

impact of Budget 2014-15 on other aspects as well, please refer to our hotline “India Budget 2014:

New Beginnings and New Direction”.

CHANGES IN RELATION TO REITS

1. Background

As a background, the Securities and Exchange Board of India (“SEBI”) had released the draft

regulations on REITs (“Draft Regulations”) for comments on October 10, 2013. The Draft Regulations

as released are available here. Though the Draft Regulations were received positively, it was

imperative that attendant tax and regulatory incentives were also announced. Now, with the tax

incentives announced and effective from October 1, 2014, it seems almost certain that the SEBI will

put in place an operating framework for REITs by October 2014. Please refer to our article titled “REIT

Regime In India: Draft REIT Regulations Introduced” for a detailed analysis of, and our suggestions

on, the Draft Regulations.

2. Structure of REIT

Before we move on the tax incentives proposed in the Budget, we set out below a quick snapshot of

the REIT structure as contemplated under the Draft Regulations. REITs in India are required to be set

up as private trusts under the purview of the Indian Trusts Act, 1882.

(i) Parties: The parties in the REIT include the sponsor, the manager, the trustee, the principal valuer

and the investors / unit holders. Sponsor sets up the REIT, which is managed by the manager. The

trustee holds the property in its name on behalf of the investors. The roles, responsibilities, minimum

eligibility criteria and qualification requirements for each of the abovementioned parties are detailed

in the Draft Regulations. Sponsors are required to hold a minimum of 15% (25% for the first 3 years)

of the total outstanding units of the REIT at all times to demonstrate skin-in-the-game.

(ii) Use of SPV: REITs may hold assets directly or through an SPV. All entities in which REITs control

majority interest qualify as an SPV for the purpose of the Draft Regulations.

(iii) Investment and Listing: Units of a REIT are compulsorily required to be listed on a recognized

stock exchange.

(iv) Potential income streams: REITs are principally expected to invest in completed assets. Income

would consist of rental income, interest income or capital gains arising from sale of real assets /

shares of SPV.

(v) Distribution: 90% of net distributable income after tax of the REIT is required to be distributed to

unit holders within 15 days of declaration.

The illustration below gives the typical REIT structure:

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February 09, 2015



3. Proposed tax regime under the Budget

The Finance Bill, 2014 (“Bill”) proposes to amend the Income Tax Act (“ITA”) to provide for the income

tax treatment of REITs. These provisions have been incorporated depending on the stream of income

that the REIT is earning and distributing:

(i) Units of REIT akin to listed shares

The Bill proposes that when a unit holder disposes off units of a REIT, long term capital gains

(“LTCG”) (units held for more than 36 months) would be exempt from tax and short term capital gains

(“STCG”) would be taxed at 15% since units would be treated as listed securities under the ITA. In

addition to the above, the Bill has also proposed that securities transaction tax is to be payable on

transfer of units of a REIT.

Analysis

Treatment of listed REITs unit akin to listed shares with respect to rates for LTCG and STCG is a

major relaxation for the unit holders, and will give a major impetus to the REIT regime. Though the

requirement of holding the units for at least 36 months for characterization as long term capital

gains, unlike 12 months in case of listed shares, is understandable since REITs are meant to be

akin to holding real estate directly which is any ways subject to 36 months holding period, this may

be a disincentive to invest in REITs.

(ii) Tax treatment of the sponsor - The Bill proposes to make the transfer of shares of the SPV into a

REIT in exchange for issue of units of the REIT to the transferor (or the sponsor) exempt from capital

gains tax under the ITA. However, although the units of a REIT would be listed on a recognized stock

exchange, specific amendments are proposed to exclude units of REITs from the exemption of tax on

LTCG / STCG if sold by the sponsor; and the cost of acquisition of the shares of the SPV by the

sponsor shall be deemed to be the cost of acquisition of the units of the REIT in his hands.

Analysis

Although the Draft Regulations allow REITs to hold real estate assets either directly or through an

SPV, the tax benefit for a sponsor to set up a REIT has been extended only to cases where real

estate assets are held by the REIT through an SPV. This can be a substantial dampener for

sponsors looking to set up REITs holding direct assets since transfer of real estate assets instead

of an SPV to a REIT may involve a tax leakage.

An additional issue that is outstanding is in cases where assets are held in a partnership or a

limited l iability partnership and on the tax treatment in order to transfer the partnership interest to

the REIT.

(iii) Income in the nature of interest - The Bill provides for a pass through treatment in respect of any

interest income that is received by the REIT from an SPV. This will result in the REIT not being subject

to any tax in respect of such interest income, whereas the investors will be subject to tax on the same.

However, there would be a levy of withholding tax that would be imposed on distribution by the REIT to

its unit holder. This withholding tax would be at the rate of 10% if paid to resident unit holders and 5%

if paid to non-resident unit holders.1 In case of non-resident unit holders, the 5% tax would be the final

tax payable by the non-resident, while in case of residents, they will be subject to tax as per the tax

rate applicable to them.

Analysis

To avail the tax pass through on interest income, the sponsor would have to trade-off by paying tax

on transfer of the SPV / assets. This is so because, (a) the REIT cannot acquire any debt securities



Powers

February 09, 2015

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January 15, 2015




January 14, 2015

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Analysis













Analysis







limited liability partnership and on the tax treatment in order to transfer the partnership interest to

the REIT.









Analysis





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February 09, 2015

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January 27, 2015




January 15, 2015




January 14, 2015

NDA Connect



NDA Hotline


Video



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Takes A U-Turn?




Real Estate Update

.........................................................................................................................................................................................

July 15, 2014

BUDGET 2014: A GAME CHANGER FOR REITS?

Budget 2014-15 (“Budget”) has introduced tax incentives for the real estate investment trusts

(“REITs”) regime, and also provided for relaxations in foreign direct investment (“FDI”) regime. With the

tax incentives in place, the Securities and Exchange Board of India (“SEBI”) is likely to formally

announce the REIT regulations that are currently in draft form. In this hotline, we discuss some of the

key changes and its Budget 2014 impact on the real estate sector. For a detailed analysis of the

impact of Budget 2014-15 on other aspects as well, please refer to our hotline “India Budget 2014:

New Beginnings and New Direction”.

CHANGES IN RELATION TO REITS

1. Background

As a background, the Securities and Exchange Board of India (“SEBI”) had released the draft

regulations on REITs (“Draft Regulations”) for comments on October 10, 2013. The Draft Regulations

as released are available here. Though the Draft Regulations were received positively, it was

imperative that attendant tax and regulatory incentives were also announced. Now, with the tax

incentives announced and effective from October 1, 2014, it seems almost certain that the SEBI will

put in place an operating framework for REITs by October 2014. Please refer to our article titled “REIT

Regime In India: Draft REIT Regulations Introduced” for a detailed analysis of, and our suggestions

on, the Draft Regulations.

2. Structure of REIT

Before we move on the tax incentives proposed in the Budget, we set out below a quick snapshot of

the REIT structure as contemplated under the Draft Regulations. REITs in India are required to be set

up as private trusts under the purview of the Indian Trusts Act, 1882.

(i) Parties: The parties in the REIT include the sponsor, the manager, the trustee, the principal valuer

and the investors / unit holders. Sponsor sets up the REIT, which is managed by the manager. The

trustee holds the property in its name on behalf of the investors. The roles, responsibilities, minimum

eligibility criteria and qualification requirements for each of the abovementioned parties are detailed

in the Draft Regulations. Sponsors are required to hold a minimum of 15% (25% for the first 3 years)

of the total outstanding units of the REIT at all times to demonstrate skin-in-the-game.

(ii) Use of SPV: REITs may hold assets directly or through an SPV. All entities in which REITs control

majority interest qualify as an SPV for the purpose of the Draft Regulations.

(iii) Investment and Listing: Units of a REIT are compulsorily required to be listed on a recognized

stock exchange.

(iv) Potential income streams: REITs are principally expected to invest in completed assets. Income

would consist of rental income, interest income or capital gains arising from sale of real assets /

shares of SPV.

(v) Distribution: 90% of net distributable income after tax of the REIT is required to be distributed to

unit holders within 15 days of declaration.

The illustration below gives the typical REIT structure:

Interesting Reads











Proud Moments






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February 09, 2015

Tax Provisions Introduced in the Budget 2014



without a tax incidence for the sponsor (the exemption is only for shares); and (b) if the monies are

raised by REIT from the public, and infused into a newly created SPV by way of debt, which acquires

the asset from the sponsor, there is no tax exemption for the sponsor in such case. To that extent,

the benefit of this relaxation is highly questionable.

(iv) Income in the nature of dividend - Where dividends are distributed by the SPV to the REIT, the

existing provision dealing with Dividend Distribution Tax (“DDT”) under Section 115-O of the ITA would

apply and the SPV would face a 15% tax on distribution with no further liability on the REIT as a

shareholder. Further, the Bill proposes that any income distributed by the REIT to its unit holder that is

not in the nature of interest or capital gains is exempt from income tax. Therefore, distributions of

dividends received from the SPV by the REIT to the unit holders would be exempt from tax in India.

Analysis

Though distribution of monies received by the REIT as dividend to the until holders is exempt from

tax in the hands of the unit holders, still the applicability of both, the corporate tax and dividend

distribution tax, in the hands of SPV makes this route of distribution tax inefficient. Since, unlike

listed developers, REITs are mandatorily required to distribute 90% of net distributable income after

tax to investors, the applicability of dividend distribution tax is a major dampner. To ensure real

pass through, it would have been better if the government had dispensed with the dividend

distribution tax in case of REITs.

(v) Income in the nature of business profits/lease rentals/management fee - Chapter XII-FA is

proposed to be added to the ITA by which Section 115UA is to be included for dealing with the taxation

of income earned by a REIT that is not in the nature of capital gains, interest income or dividend. All

such income is proposed to be taxed in the hands of the REIT at the maximum marginal rate i.e. 30%.

Such income, while distributed by the REIT to the unit holders would be exempt in the hands of the

unit holders.

Analysis

This would apply in a situation where the REIT is holding the assets directly or in situations where

they are charging fees to the SPV. There is no relaxation in such case, as even under the existing

tax regime, tax once paid by a trust would have been exempt in the hands of the unit holders. To

ensure true pass through to REIT, the gains should have been tax exempt in the hands of REIT and

should have rather been taxed in the hands of the unit holders.

(vi) Income in the nature of capital gains - Where the REIT earns income by way of capital gains by

sale of shares of the SPV, the REIT would be taxed as per regular rates for capital gains i.e. 20% for

LTCG and slab rates for STCG. However, further distribution of such gains by the REIT to the unit

holder is proposed to be exempt from tax liability.

Analysis

Please refer to our analysis in point (v) above.

RELAXATION IN THE FDI REGIME

In line with the commitment of the government to have housing for all by 2022, and also to promote

the Prime Minister’s vision of ‘one hundred Smart Cities’, the Finance Minister in the Budget has

proposed key reforms for foreign investment in the real estate and development sector.

1. Relaxation in minimum area and minimum capitalization

The Finance Minister has proposed to reduce the requirement of minimum project size from 50,000

square metres to 20,000 square metres, and the capitalization requirement (for a wholly owned

subsidiary) from USD 10 million to USD 5 million respectively.

Analysis

Previously, in order to qualify for FDI, the project size had to be a minimum of 50,000 square metres

and at least USD 10 million had to be infused for a wholly owned subsidiary. This was a major

challenge since in Tier I cities which formed a bulk of the demand demography, finding such a

large project was difficult, whereas in Tier II and III cities where such projects were available, the

demand was not sufficient enough to warrant investor interest. This relaxation has partially

addressed the long standing demand of the industry, which was expecting a reduction to 10,000

square metres, since even 20,000 square metres could be difficult for some Tier I cities (ex –

Mumbai).

The relaxation is a positive step towards providing impetus to development of smart cities providing

habitation for the neo-middle class, as contemplated in the Budget.

2. Promoting affordable housing

The Budget has proposed introduction of schemes to incentivize the development of low cost housing

and has also allocated this year a sum of INR 40 billion for National Housing Bank for this purpose.

In addition to the above relaxation, to further encourage this segment, projects which commit at least

30% of the total project cost for low cost affordable housing have been proposed to be exempted from

minimum built-up area and capitalisation requirements under FDI. The Finance Minister has also

proposed to include slum development in the statutory list of corporate social responsibility (“CSR”)

activities.











Analysis













Analysis







limited liability partnership and on the tax treatment in order to transfer the partnership interest to

the REIT.









Analysis





Powers

February 09, 2015

Audio



in 2015

January 27, 2015




January 15, 2015




January 14, 2015

NDA Connect



NDA Hotline


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in 2015


Takes A U-Turn?






without a tax incidence for the sponsor (the exemption is only for shares); and (b) if the monies are

raised by REIT from the public, and infused into a newly created SPV by way of debt, which acquires

the asset from the sponsor, there is no tax exemption for the sponsor in such case. To that extent,

the benefit of this relaxation is highly questionable.

(iv) Income in the nature of dividend - Where dividends are distributed by the SPV to the REIT, the

existing provision dealing with Dividend Distribution Tax (“DDT”) under Section 115-O of the ITA would

apply and the SPV would face a 15% tax on distribution with no further liability on the REIT as a

shareholder. Further, the Bill proposes that any income distributed by the REIT to its unit holder that is

not in the nature of interest or capital gains is exempt from income tax. Therefore, distributions of

dividends received from the SPV by the REIT to the unit holders would be exempt from tax in India.

Analysis

Though distribution of monies received by the REIT as dividend to the until holders is exempt from

tax in the hands of the unit holders, still the applicability of both, the corporate tax and dividend

distribution tax, in the hands of SPV makes this route of distribution tax inefficient. Since, unlike

listed developers, REITs are mandatorily required to distribute 90% of net distributable income after

tax to investors, the applicability of dividend distribution tax is a major dampner. To ensure real

pass through, it would have been better if the government had dispensed with the dividend

distribution tax in case of REITs.

(v) Income in the nature of business profits/lease rentals/management fee - Chapter XII-FA is

proposed to be added to the ITA by which Section 115UA is to be included for dealing with the taxation

of income earned by a REIT that is not in the nature of capital gains, interest income or dividend. All

such income is proposed to be taxed in the hands of the REIT at the maximum marginal rate i.e. 30%.

Such income, while distributed by the REIT to the unit holders would be exempt in the hands of the

unit holders.

Analysis

This would apply in a situation where the REIT is holding the assets directly or in situations where

they are charging fees to the SPV. There is no relaxation in such case, as even under the existing

tax regime, tax once paid by a trust would have been exempt in the hands of the unit holders. To

ensure true pass through to REIT, the gains should have been tax exempt in the hands of REIT and

should have rather been taxed in the hands of the unit holders.

(vi) Income in the nature of capital gains - Where the REIT earns income by way of capital gains by

sale of shares of the SPV, the REIT would be taxed as per regular rates for capital gains i.e. 20% for

LTCG and slab rates for STCG. However, further distribution of such gains by the REIT to the unit

holder is proposed to be exempt from tax liability.

Analysis

Please refer to our analysis in point (v) above.

RELAXATION IN THE FDI REGIME

In line with the commitment of the government to have housing for all by 2022, and also to promote

the Prime Minister’s vision of ‘one hundred Smart Cities’, the Finance Minister in the Budget has

proposed key reforms for foreign investment in the real estate and development sector.

1. Relaxation in minimum area and minimum capitalization

The Finance Minister has proposed to reduce the requirement of minimum project size from 50,000

square metres to 20,000 square metres, and the capitalization requirement (for a wholly owned

subsidiary) from USD 10 million to USD 5 million respectively.

Analysis

Previously, in order to qualify for FDI, the project size had to be a minimum of 50,000 square metres

and at least USD 10 million had to be infused for a wholly owned subsidiary. This was a major

challenge since in Tier I cities which formed a bulk of the demand demography, finding such a

large project was difficult, whereas in Tier II and III cities where such projects were available, the

demand was not sufficient enough to warrant investor interest. This relaxation has partially

addressed the long standing demand of the industry, which was expecting a reduction to 10,000

square metres, since even 20,000 square metres could be difficult for some Tier I cities (ex –

Mumbai).

The relaxation is a positive step towards providing impetus to development of smart cities providing

habitation for the neo-middle class, as contemplated in the Budget.

2. Promoting affordable housing

The Budget has proposed introduction of schemes to incentivize the development of low cost housing

and has also allocated this year a sum of INR 40 billion for National Housing Bank for this purpose.

In addition to the above relaxation, to further encourage this segment, projects which commit at least

30% of the total project cost for low cost affordable housing have been proposed to be exempted from

minimum built-up area and capitalisation requirements under FDI. The Finance Minister has also

proposed to include slum development in the statutory list of corporate social responsibility (“CSR”)

activities.

Tax Provisions Introduced in the Budget 2014



Analysis

The INR 40 billion allocated for NHB will increase the flow of cheaper credit for affordable housing

to the urban poor and lower income segment. Further, the relaxation of 20,000 square metres

requirements in case of projects committing at least 30% project cost to low cost affordable

housing, would provide a major fillip to affordable housing projects where the size of the project is

less than 20,000 square metres.

A critical element however will be the way ‘affordable housing’ is defined. The Budget does not lay

down the criteria for classification of affordable housing. Under external commercial borrowing

regulations, the criteria for affordable housing includes units having maximum carpet area of 60

square metres, and cost of such individual units not exceeding INR 30 lakh.

The Companies Act, 2013 has introduced CSR provisions which are applicable to companies with

an annual turnover of INR 10 billion and more, or a net worth of INR 5 billion and more, or a net

profit of INR 0.05 billion or more during any financial year. Companies that trigger any of the

aforesaid conditions are required to spend least two per cent (2%) of their average net profits made

during the three immediately preceding financial years on CSR activities and/or report the reason

for spending or non-expenditure. The proposition of the Finance Minister to include slum

development in the statutory list of corporate social responsibility activities is quite encouraging, as

it not only provides developers an avenue to meet their CSR requirements, but also at the same

time could give a huge impetus to this segment.

CONCLUSION

REITs are beneficial not only for the sponsors but also the investors. It provides the sponsor (usually

a developer or a private equity fund) an exit opportunity thus giving liquidity and enable them to invest

in other projects. At the same time, it provides the investors with an avenue to invest in rental income

generating properties in which they would have otherwise not been able to invest, and which is less

risky compared to under-construction properties.

For a REIT regime to be effectively implemented, complete tax pass through is essential, as is the

case in most countries having effective REIT regimes. Though the tax incentives for REITs introduced

in the Budget is definitively a positive move, however, the tax incentives only result in partial tax pass

through to REIT, at the maximum. It is hoped that the Finance Minister would address the issues as

mentioned in this piece going forward and possibly simplify the REIT taxation regime.

Before REITs actually takes off, few other changes need to be introduced, especially from securities

and exchange control laws perspective. Currently, units of a REIT may not even qualify as a 'security'.

Since, units of a REIT have to be mandatorily listed, the first step will be to define units of a REIT as a

security under the SCRA. The next step will be to amend exchange control regulations to allow foreign

investments in units of a REIT. Capital account transaction rules will also need to be amended to

exclude REITs from the definition of 'real estate business', as any form of foreign investment is

currently not permitted in real estate business. Under current exchange control laws, investment in

yield generating assets may qualify as 'real estate business'.

The relaxations proposed in the Budget pertaining to affordable housing is a really positive move as

there is a major demand for housing in this segment. All in all, the Budget represents the new

government’s positive attitude and willingness to follow through on its message of growth and

development, especially in the real estate sector.

– Prasad Subramanyan, Deepak Jodhani & Ruchir Sinha


1 This provision would be effective only as of 1 October, 2014.

DISCLAIMER






















Analysis

The INR 40 billion allocated for NHB will increase the flow of cheaper credit for affordable housing

to the urban poor and lower income segment. Further, the relaxation of 20,000 square metres

requirements in case of projects committing at least 30% project cost to low cost affordable

housing, would provide a major fillip to affordable housing projects where the size of the project is

less than 20,000 square metres.

A critical element however will be the way ‘affordable housing’ is defined. The Budget does not lay

down the criteria for classification of affordable housing. Under external commercial borrowing

regulations, the criteria for affordable housing includes units having maximum carpet area of 60

square metres, and cost of such individual units not exceeding INR 30 lakh.

The Companies Act, 2013 has introduced CSR provisions which are applicable to companies with

an annual turnover of INR 10 billion and more, or a net worth of INR 5 billion and more, or a net

profit of INR 0.05 billion or more during any financial year. Companies that trigger any of the

aforesaid conditions are required to spend least two per cent (2%) of their average net profits made

during the three immediately preceding financial years on CSR activities and/or report the reason

for spending or non-expenditure. The proposition of the Finance Minister to include slum

development in the statutory list of corporate social responsibility activities is quite encouraging, as

it not only provides developers an avenue to meet their CSR requirements, but also at the same

time could give a huge impetus to this segment.

CONCLUSION

REITs are beneficial not only for the sponsors but also the investors. It provides the sponsor (usually

a developer or a private equity fund) an exit opportunity thus giving liquidity and enable them to invest

in other projects. At the same time, it provides the investors with an avenue to invest in rental income

generating properties in which they would have otherwise not been able to invest, and which is less

risky compared to under-construction properties.

For a REIT regime to be effectively implemented, complete tax pass through is essential, as is the

case in most countries having effective REIT regimes. Though the tax incentives for REITs introduced

in the Budget is definitively a positive move, however, the tax incentives only result in partial tax pass

through to REIT, at the maximum. It is hoped that the Finance Minister would address the issues as

mentioned in this piece going forward and possibly simplify the REIT taxation regime.

Before REITs actually takes off, few other changes need to be introduced, especially from securities

and exchange control laws perspective. Currently, units of a REIT may not even qualify as a 'security'.

Since, units of a REIT have to be mandatorily listed, the first step will be to define units of a REIT as a

security under the SCRA. The next step will be to amend exchange control regulations to allow foreign

investments in units of a REIT. Capital account transaction rules will also need to be amended to

exclude REITs from the definition of 'real estate business', as any form of foreign investment is

currently not permitted in real estate business. Under current exchange control laws, investment in

yield generating assets may qualify as 'real estate business'.

The relaxations proposed in the Budget pertaining to affordable housing is a really positive move as

there is a major demand for housing in this segment. All in all, the Budget represents the new

government’s positive attitude and willingness to follow through on its message of growth and

development, especially in the real estate sector.

– Prasad Subramanyan, Deepak Jodhani & Ruchir Sinha


1 This provision would be effective only as of 1 October, 2014.

DISCLAIMER






















This article was published as our Hotline dated July 15, 2014.



Reproduced with permission from World Securities Law Report, null, 12/06/2013. Copyright � 2013 by The Bureauof National Affairs, Inc. (800-372-1033) http://www.bna.com

The Securities and Exchange Board of India’sDraft Regulations on Real Estate InvestmentTrustsBy Ruchir Sinha and Prasad Subramanyan, of NishithDesai Associates.

The Securities and Exchange Board of India (‘‘SEBI’’)finally released the draft Securities and ExchangeBoard of India (Real Estate Investment Trusts) Regula-tions, 2013 (‘‘Draft REIT Regulations’’) on October 10,2013. The Draft REIT Regulations were open for pub-lic comment until October 31, 2013, and SEBI shouldbe formally introducing the regime soon.

The Draft REIT Regulations are the third initiative bythe securities regulator to bring about a REIT regimein India, after a failed attempt to bring in REITs in2008 (see report by Mansi Seth and Nishchal Joshipura, ofNishith Desai Associates, Mumbai, at WSLR, January 2008,page 10) and a subsequent initiative to bring in a REITregime in the form of real estate mutual funds(‘‘REMFs’’), which also did not find any takers.1 SEBIhas finally sought to encourage investments in real es-tate as an asset class, and, in doing so, the regulator hasclearly done a commendable job taking into accountinternational models and the views of stakeholders.

REITs should likely emerge as a preferred form of as-set backed investment with established revenuestreams, and will go a long way in protecting the inter-ests of investors seeking exposure in real estate as anasset class. More importantly, REITs may infuse addi-

tional transparency and liquidity into the Indian realestate market. With Indian players showing an in-creased keenness to list Indian real asset listings off-shore, especially on the Singapore Exchange, SEBI’smove is likely to attract such markets onshore and in-crease the depth of Indian real estate capital markets.

From a private equity in real estate perspective, REITswill also create exit opportunities for developers and fi-nancial investors, allowing them to move completed as-sets to REITs and provide much needed liquidity in themarket.

Although the Draft REIT Regulations indicate a posi-tive step forward on the part of SEBI, several issuesconcerning taxation, stamp duty and foreign participa-tion remain.

In this Special Report, we analyze some of the most im-portant provisions of the REIT regime and what addi-tional steps need to be taken to ensure efficacious uti-lization of the REIT regime in India.

Investment Restrictions

The Draft REIT Regulations have taken cognizance ofglobal standards on REIT regimes, and accordinglySEBI appears to have generally followed the 90 percent

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rule on investment and distribution. This means thatREITs are required to mandatorily invest in such a man-ner that:

s 90 percent of the value of the assets of the REIT areinvested in ‘‘completed’’ (defined to mean propertieswhich have received occupancy certificates) and ‘‘rentgenerating properties’’ (defined to mean propertiesnot less than 75 percent of whose area has beenrented/leased out);

s the remaining 10 percent may be invested in develop-mental properties, listed/unlisted debt of companies,mortgage backed securities, government securitiesand money market instruments/cash equivalents,among others;2 and

s developmental properties have been defined to meanproperties that are under construction (i.e., for whichan occupancy certificate has not been received). Forinvestment in such developmental properties, REITsinvestment must be locked in for a minimum periodof three years after completion.

Suggestions

s Investing in limited liability partnerships (‘‘LLPs’’):REITs can invest through special purpose vehicles(‘‘SPVs’’), which are defined to mean only bodies cor-porate as defined under the Companies Act, 2013.That definition defines a body corporate to includecompanies incorporated in India and outside India.LLPs are classified as bodies corporate under theLimited Liability Partnership Act, 2008, and thereforeshould qualify as SPVs under the Draft REIT Regula-tions. However, restrictions on investment activities ofREITs would come under Regulation 18(1), whichstates that REITs are allowed to invest only in securi-ties or properties in India. The definition of securities(as per Section 2(h) of the Securities Contracts(Regulation) Act, 1956 (‘‘SCRA’’)) does not include apartnership interest. Therefore, Regulation 18(1) willhave to be modified to the extent of allowing REITsto also make investments in partnership interests.

s Instruments in which REITs can invest: A supple-mentary issue to the modification suggested in rela-tion to LLPs and Regulation 18(1) is the restrictionon REITs to investment only in securities and proper-ties in India. Typically, all undefined terms draw theirreference from the SCRA, which defines securities tomean marketable securities. Since a REIT will be in-vesting mostly in private companies, the shares ofsuch companies may not qualify as ‘‘securities’’ as de-fined under the SCRA.

s The 75 percent rental limit: The requirement to haveat least 75 percent of the area to be leased out at alltimes appears currently to be seen on a continuousbasis. This should be revised to be seen at the time ofthe valuation, and there should be a 12 month cor-rection period to allow for some headroom in opera-tions, as against the current six month (valuation up-date) period. Internationally, the focus is more on

completed assets and not as much on the extent ofrentals, which is driven by markets.

s Developmental property: Investment in developmen-tal property is only allowed to a maximum of 10 per-cent of the value of the assets of the REIT. This 10percent flexibility was provided to allow a REIT tocapitalize on capital appreciation benefits that comewith investment in assets under construction. Whilethe three year lock-in following completion is under-standable to prevent speculative trading in land, therequirement to lease it out may be done away with.Further, such developmental assets should, at the op-tion of the manager, be considered in the 90 percentbucket from the time they are completed and be-come rent generating.

Listing and Other Ancillary Issues

The Draft REIT Regulations mandate listing of the unitsof the REIT within 15 days of the closure of the initialoffer. The initial offer requires filing the draft letter ofoffer with SEBI at least 30 days prior to filing the finalletter of offer, and then making available publicly theletter of offer for public comments for 10 days, and thenproviding a five day notice after the filing of the final let-ter of offer before issuing such units to the public.

Some material requirements of note are as follows:

s A REIT must hold (and not merely propose to hold)real estate assets worth INR 1,000 crore (approxi-mately U.S.$160 million) prior to making the initialoffer;3

s A REIT can offer its units to the public only by way ofan initial public offer or a follow-on offer;4

s Trading of units of a REIT is permitted only on thefloor;5

s The minimum public float shall be 25 percent,6 andany initial offer of its units to the public shall be forthe value of units not less than 25 percent of the valueof the REIT; and

s SEBI has prescribed the minimum ticket size of aREIT unit at INR 100,000 (approximately U.S.$1,600)and further by requiring each applicant to purchaseat least two units (i.e., a minimum investment of INR200,000 (approximately U.S.$3,200)).

Suggestions

s Listing proceeds: The value of REIT assets should beINR 1,000 crore (approximately U.S.$160 million)not prior to the offer, but at the time of listing. Thiswill help the REIT to acquire real estate assets fromthe proceeds of the offer. A requirement to haveidentified property tied in by way of definitive docu-ments and limitation on utilization of the offeringmonies may be provided for.

s Preferential allotment/rights issue: There is no pro-vision for a rights issue or preferential allotment. Thismay be added, especially as the sponsor will be di-luted if the units are only offered to the public.

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s Off market deals: The trading of REIT units may alsobe permitted off the market by way of negotiateddeals, just as in the case of listed shares. This will al-low for greater investor participation.

s Failure to maintain minimum public float: Currently,failure to maintain a minimum public shareholdingmandates a trustee to apply for delisting of the REIT.There should ideally be a cure period providedwithin which the sponsor could divest its sharehold-ing to bring up the minimum public shareholding.

Valuations, Transparency and Disclosures

SEBI has prescribed extensive valuation, transparencyand disclosure requirements for REITs in the Draft REITRegulations:

s net asset value (‘‘NAV’’) to be calculated on a bian-nual basis;

s full valuation required once a year, including a physi-cal inspection of the real estate site, followed by anupdate on any developments every six months; spe-cific valuation requirements for the occurrence ofany material events;

s purchase or sale of a property to require full valua-tion by two independent valuers, the average ofwhose valuation shall be the determined price forpurchase/sale;

s event based disclosures will also be required to bemade to the stock exchange and unit holders; and

s valuation undertaken by any valuer shall abide by in-ternational valuation standards and valuation stan-dards as may be prescribed by the Institute of Char-tered Accountants of India (ICAI) for the valuation ofreal estate, provided that, in case of any conflict, stan-dards prescribed by the ICAI shall prevail.

Observations/Suggestions

s No over-arching valuation requirements: Extensivevaluation requirements have been notified, includingthe requirement to carry out a full valuation of theassets of a REIT by the principal valuer to the REIT.7

SEBI has taken a practical steps towards valuation(unlike in previous regimes, such as the REMF prod-uct), requiring that the REIT conduct a full valuationonce in a year, with physical site visits and a six monthupdate valuation.8

s ICAI norms for real estate valuation: Requiring thevaluation of REITs to conform with both interna-tional valuation standards and valuation standardsprescribed by the ICAI, and valuation standards pre-scribed by the ICAI to prevail in case of conflict, maypose some challenges. This is because real estate hasits own peculiarities, and the ICAI’s ability to valuereal estate remains to be seen. SEBI’s preference forthe ICAI may have been based on an accountabilityperspective, since an Indian regulator would providecomfort to SEBI regarding valuations carried out. Itmight be helpful to suggest international valuation

standards to prevail in case of a conflict with ICAIprescribed standards.

s Encumbrances on real estate assets — disclosuresversus prohibition: A key improvement (and anothersignificant departure from the REMF/2008 REIT re-gime) is the manner in which encumbrance on titleshas been perceived. It is common knowledge that le-gal proceedings against any real estate asset can be in-stituted which may not significantly affect the owner-ship or marketability of the real estate asset. Accord-ingly, SEBI has allowed for such properties to beacquired by the REIT, provided that adequate disclo-sures are made considering the sophisticated natureof the investors. In contrast, the REMF regime ex-pected investee real estate assets to be ‘‘free of all en-cumbrances and not be a subject matter of any litiga-tion.’’9 This resulted in severe restrictions on invest-ment in real estate, especially when many largeprojects were the subjects of fraudulent and mala fidelitigation. The current draft of the REIT Regulationsappears to have addressed this satisfactorily, only re-quiring the trustee to a REIT to ensure that the realassets held by it have a proper legal and marketabletitle and for adequate disclosure of any material liti-gation to be disclosed in the valuation reports to in-vestors of the REIT. This will allow REITs to make in-vestments in real estate properties previously inacces-sible to investment vehicles.

Leverage

In general, SEBI is uncomfortable with leverage in in-vestment vehicles. However, considering that globallyREITs have significant leverage, SEBI has allowed lever-age (on a consolidated basis) to a maximum of 50 per-cent of the value of its assets. In this regard, the REITcan avail leverage up to 25 percent without requiringany additional approvals. Beyond 25 percent, a creditrating and approval of 75 percent of the unit holders ofthe REIT (by value and number) is required to avail anyfurther leverage.

Sponsor and Manager Obligations

Sponsors Held Accountable

SEBI has also sought to ensure that accountability isclearly levied on managers seeking to set up REITs. Fol-lowing is a brief summary of the obligations imposed onsponsors:

s A ‘‘sponsor’’ to the REIT must hold at least 15 per-cent of the value of the REIT assets at all times.10

s Additionally, in order to ensure adequate ‘‘skin-in-the-game,’’ sponsors will be required to hold at least25 percent of the value of the REIT assets for threeyears from the date of listing of the units of theREIT.11

s Further, if the REIT holds any assets over and abovethe 25 percent limit outlined above, that holding willbe locked in for a period of one year from the date oflisting as well.12

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s If a sponsor looks to move out of the REIT (i.e., sellits mandatory 15 percent holding in a REIT), it willhave to first obtain approval from 60 percent of theunit holders (in value and numbers) and require thatthe redesignated sponsor also agree to hold the mini-mum 15 percent.

Eligibility Criteria for REIT Managers

A recent feature in SEBI issued regulations has been therequirement for both manager entities and employeesof such managers to be adequately qualified. In theDraft REIT Regulations, SEBI has set out the followingas eligibility criteria:

s for the REIT manager: minimum net worth criteria(for INR 5 crore (approximately U.S.$800,000)), andexperience (of at least five years) in propertymanagement/fund management/advisory services orexperience in real estate development; and

s for employees of REIT managers: in addition to themanager level experience, employees of the managerare also required to have at least two key personnelwho have at least five years’ experience in propertymanagement/fund management/advisory services orexperience in real estate development.

Suggestion

s Manager experience should be waived initially: It islikely that many of the new entities looking to set upREITs will not have the requisite experience at theREIT manager level. Hence, the manager level expe-rience requirement should be waived, as long as theemployee level experience requirement is adequatelymet.

Related Party Transactions

The Draft REIT Regulations have taken an extremelybalanced approach to related party transactions. The fol-lowing is a brief description of the restrictions on relatedparty transactions that can be undertaken by a REIT:

Restrictions on Leasing

The leasing of REIT properties to related parties is sub-ject to the following restrictions:13

s The area leased to a related party should not exceed20 percent of the underlying area of the assets;

s The value of assets under such lease should not ex-ceed 20 percent of the value of the total underlyingassets;

s Rental income obtained from such leased assetsshould not exceed 20 percent of the value of the to-tal rental income derived from the underlying assets;

s A fairness opinion is required to be obtained by theREIT manager and submitted to the trustee of theREIT in relation to such related party transactions;

s Additionally, all related party transactions, whetherentered into prior to or after the initial offering, shall

require a full valuation of the property being pur-chased, with the average of the two valuations beingthe purchase price; and

s Full valuations of the property must be provided,along with the relationship and other ancillary detailsrelating to the relationship of the parties concerned.

Unit Holder Approval for Related PartyTransactions

Any transaction sought to be entered into by a REIT sub-sequent to the initial offer whose value exceeds 5 per-cent of the value/rental income/borrowings of theREIT requires the positive approval of 75 percent of theunit holders of the REIT by value and number, exclud-ing the interested parties.

Suggestion

s Unit holder approval threshold: Although it is neces-sary for unit holder approvals in relation to relatedparty transactions that a REIT proposes to enter into,the threshold to obtain 75 percent unit holder ap-proval (by value and number) in case of a transaction,i.e., 5 percent of the value/rental income/borrowings, appears low. With the 20 percent limit al-ready in place for related party transactions, coupledwith other restrictions in the context of related partytransactions, the 5 percent limit should be reconsid-ered.

Voting Thresholds

The Draft REIT Regulations require unit holder ap-proval in many potentially material transactions that theREIT may carry out. The thresholds for unit holder ap-proval have been measured on the basis of value andnumber:

s Matters which require the approval of 60 percent ofthe unit holders (by value and number) include mat-ters such as removal or appointment of a newtrustee/manager/sponsor or principal valuer, changein control of the sponsor, as well as a requirement todelist the units of the REIT; and

s Matters which require the approval of 75 percent ofthe unit holders (by value and number) include mat-ters such as any related party transactions, borrowingsin excess of 25 percent of the value of the REIT as-sets, change in investment strategy, proposal by thesponsor or manager to delist units of the REIT, and ifany unit holder (or associated persons) seeks to ac-quire more than 50 percent of the units of the REITby value.

Suggestions

s Voting requirements by value and number: All ac-tions relating to REITs as outlined in Clause 22 re-quire approval from unit holders constituting a 60percent or 75 percent consensus both by value and bynumber. It may be preferable to require approvalonly of unit holders present and voting. The thresh-olds should also be based on value and not number.

4




s Exclusion of interested parties: Regulation 22(12) ofthe Draft REIT Regulations excludes the votes of anyrelated person (and associates of such person) to agiven transaction from being considered for the issueat hand. Therefore, since interested parties are ex-cluded from participating in the vote, the voting re-quirement for the 60 percent matters should be re-duced to 51 percent (instead of 60 percent).

Delisting and Termination

Currently, Regulation 17 of the Draft REIT Regulationsoutlines the provisions for delisting of the units of aREIT. Delisting may be carried out in the situations out-lined below. Upon the occurrence of such an event, theREIT will be required to apply to SEBI and to the stockexchange for permission to delist:

s the minimum public float falls below 25 percent ofthe total units of the REIT;

s the number of unit holders in the REIT (other thanrelated parties) falls below 20;

s SEBI or a stock exchange requires the delisting of theREIT for violation of the listing agreements/any pro-vision of law or in the interests of unit holders;

s the sponsor or the manager applies for delisting ofunits and receives the relevant approval from the unitholders; and

s the unit holders apply for delisting of units.

Suggestion

s Clarifying the delisting and termination process forREITs: In the case of listed securities of a company inIndia, delisting entails a buyout of the securities ofthe company by the promoter by way of a book build-ing process. However, in the case of a REIT, it mustbe clarified that, in conjunction with the delisting ofthe REIT, its termination should also occur. Essen-tially, the delisting and the termination should hap-pen simultaneously, and in such an event the REITshould sell off the assets of the REIT, which moniesshould be distributed to the unit holders. The exist-ing delisting applicable for companies cannot andshould not be made applicable to REITs.

Perpetual Investment Vehicles for REITs

In our experience, in the past, SEBI has insisted on aterm being fixed for venture capital funds/alternativeinvestment funds, even when the relevant regulationswere silent in that respect. However, we understand that,in the present instance, SEBI may be comfortable withREITs being conceived as perpetual investment vehicleswhich can be terminated only in accordance with itsterms, and, accordingly, SEBI may not insist on a fixedterm maturity. This would be in line with the globalpractice, where REITs are structured as perpetual invest-ment vehicles which do not have a fixed term of matu-rity.

The Road Ahead

Several issues need to be addressed to ensure optimumutilization of the regime:

Taxes on Transfer

Currently, most completed real estate assets will behoused in SPVs, and, due to substantial costs, the pro-moters of such SPVs (who will also likely be the sponsorsof the REIT) may not be able to transfer such assets toREITs for investment purposes. Such costs will include1) stamp duty on the transfer of land in the region of 6percent to 8 percent; and 2) capital gains tax on thetransfer. Promoters would not be able to transfer thereal estate asset of the SPV at nominal value, as the readyreckoner value will be deemed to be the sale price re-ceived (under Section 50 C if the asset is held as a capi-tal asset, or under 43CA if the asset is held as stock intrade). To that extent, stamp duty on such transfer tothe REIT should be exempt. On the topic of capitalgains, similar to the merger provisions (under Indiantax laws), insofar as the seller/promoter receives units ofthe REIT, tax should not be levied on the receipt of theunits themselves. Capital gains tax can then be levied atthe time of sale/redemption of the units of the REIT.

Tax on Acquisition of SPV

If the promoters were to transfer their shares in the SPVto the REIT, then in all likelihood such transfer wouldhappen for a combination of cash and in kind (units ofthe REIT). We suggest that capital gains on the transferof shares for the units of a REIT should not be treatedas a ‘‘transfer,’’ and that capital gains tax be levied onlywhen the units of the REIT are transferred. This is be-cause there is no monetization on the receipt of theunits of the REIT, especially considering that the pro-moter will be locked in to the extent of 25 percent forthree years.

Tax on Distribution of Income from REITs

If the REIT holds the SPV, any distributions would besubject to corporate level tax at the rate of 30 percent(exclusive of surcharge and cess) plus a dividend distri-bution tax of 15 percent if the SPV seeks to distributedividends. Hence, we suggest that the SPV (if held by aREIT) should be exempt from all corporate level taxes,distribution taxes and minimum alternate tax. Further,the REIT should be given a pass through status (in thesame manner as venture capital funds as outlined in Sec-tion 10(23FB) of the Income Tax Act, 1961), ensuringonly a single level of tax at the hands of the unit holder.

Tax on Trading in the Units of the REIT

Additionally, since REITs are required to be mandatorilylisted on the stock exchange, the same lower rate ofcapital gains tax (between zero percent and 15 percent)should be afforded to the sale and purchase of units ofa REIT (on payment of the securities transaction tax) ina stock exchange as provided to listed shares and unitsof mutual funds. Amendments will have to be made tothe Income Tax Act, 1961 and Chapter VII of the Fi-

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nance Act, 2004 (which set up the securities transactiontax regime in India).

Foreign Investments

For units of a REIT to be mandatorily listed, the firststep will be to define units of a REIT as a security underthe SCRA. Currently, units of a REIT may not evenqualify as a ‘‘security.’’ The second step will be to amendSEBI’s foreign institutional investor (‘‘FII’’) and quali-fied foreign investor (‘‘QFI’’) regulations to allow port-folio investments in units of a REIT. The third step willbe to amend the exchange control regulations to facili-tate FIIs/QFIs to subscribe to units of a REIT. Capital ac-count transaction rules will also need to be amended toexclude REITs from the definition of ‘‘real estate busi-ness,’’ as even foreign portfolio investment is not permit-ted in real estate business. Investment in yield generat-ing assets may qualify as ‘‘real estate business.’’

Conclusion

As REITs develop, health care, infrastructure and otherstabilized yield generating assets may also be rolled intoREITs. Such a framework was initially considered by theSEBI and will likely be the next progressive step.

However, the immediate need of the hour is to addressthe issues relating to tax and foreign investments, with-out which the REIT regime may not take off as contem-plated.

NOTES1 Subsequently, SEBI instead sought to bring REITs through the SEBImutual funds regime as a real estate mutual fund (‘‘REMF’’). However,the REMF could not take off due to issues relating to tax, restrictiveinvestment and asset criteria and certain other conditions. Please seeNishith Desai Associates’ Hotline analyzing the REMF regime when itwas introduced, titled ‘‘Will REMFs Outshine REITs?’’2 Regulation 18 of the Draft REIT Regulations.3 Clause 14(b) of the Draft REIT Regulations.4 Clause 14(2) of the Draft REIT Regulations.5 Regulation 16(4) of the Draft REIT Regulations.6 Regulation 18(6) of the Draft REIT Regulations.7 Regulation 21(4) of the Draft REIT Regulations.8 Regulation 21(5) of the Draft REIT Regulations.9 Regulations 49A(a)(v) and (vi) of the Mutual Funds Regulations.10 Regulation 11(2)(b) of the Draft REIT Regulations.11 Regulation 11(2)(a)(i) of the Draft REIT Regulations.12 Regulation 11(2)(a)(ii) of the Draft REIT Regulations.13 Regulation 19(7) of the Draft REIT Regulations.

The text of the draft Securities and Exchange Board of India(Real Estate Investment Trusts) Regulations, 2013 is avail-able on the SEBI website at http://www.sebi.gov.in/cms/sebi_data/attachdocs/1381398382013.pdf.

Ruchir Sinha is Head of private equity and debt in real estateat Nishith Desai Associates, Mumbai. Prasad Subramanyan isan Associate at Nishith Desai Associates, Bangalore. Theymay be contacted at [email protected] [email protected].

6




The following research papers and much more are available on our Knowledge Site: www.nishithdesai.com

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Reliance tunes into Network18! M&A Lab December 2014

Sun Pharma –Ranbaxy, A Panacea for Ranbaxy’s ills? M&A Lab December 2014

Jet Etihad Jet Gets a Co-Pilot M&A Lab May 2014

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Diageo-USL- ‘King of Good Times; Hands over Crown Jewel to Diageo M&A Lab May 2014

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Public M&A’s in India: Takeover Code Dissected M&A Lab August 2013

File Foreign Application Prosecution History With Indian Patent Office IP Lab April 2013

Warburg - Future Capital - Deal Dissected M&A Lab January 2013

Real Financing - Onshore and Offshore Debt Funding Realty in India Realty Check May 2012

Pharma Patent Case Study IP Lab March 2012

Patni plays to iGate’s tunes M&A Lab January 2012

Vedanta Acquires Control Over Cairn India M&A Lab January 2012

Corporate Citizenry in the face of Corruption Yes, Governance Matters!

September 2011

Funding Real Estate Projects - Exit Challenges Realty Check April 2011

Joint-Ventures in India

November 2014

The Curious Case of

the Indian Gaming

Laws

September 2015

Fund Structuring and Operations

June 2015

Private Equity and Private Debt Investments in India

June 2015

E-Commerce in India

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Corporate Social

Responsibility &

Social Business

Models in India

March 2015

Doing Business in India

June 2015

Convergence:Internet of Things

July 2015

Outbound Acquisitions by India-Inc

September 2014



Research is the DNA of NDA. In early 1980s, our firm emerged from an extensive, and then pioneering, research by Nishith M. Desai on the taxation of cross-border transactions. The research book written by him provided the foundation for our international tax practice. Since then, we have relied upon research to be the cornerstone of our practice development. Today, research is fully ingrained in the firm’s culture.

Research has offered us the way to create thought leadership in various areas of law and public policy. Through research, we discover new thinking, approaches, skills, reflections on jurisprudence, and ultimately deliver superior value to our clients.

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As we continue to grow through our research-based approach, we are now in the second phase of establishing a four-acre, state-of-the-art research center, just a 45-minute ferry ride from Mumbai but in the middle of verdant hills of reclusive Alibaug-Raigadh district. The center will become the hub for research activities involving our own associates as well as legal and tax researchers from world over. It will also provide the platform to internationally renowned professionals to share their expertise and experience with our associates and select clients.

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