Developers in no mood to embrace REIT despite FII boost

Developers are uncomfortable with the long-term capital gains tax on REIT

While the government may have moved a step closer to the launch of Real Estate Investment Trust, or REITs, with the Securities and Exchange Board of India making some major changes in its final regulations with respect to foreign investments, developers still feel not enough has been done to boost investment in the sector.

They are unhappy that their long-standing demand for more concessions in the "tax pass-through" status for REITs was left untouched in the final regulations cleared by the market regulator on Sunday. Developers say REITs in their present format attract too many taxes at various levels that make them unviable as an investment option.

REITs are publically-traded instruments that pool investor money to buy real estate such as office buildings, shopping malls and residential complexes. A "pass-through" status for the instrument means that the income generated would be taxed in the hands of the investor, while the fund itself would remain tax-exempt. Pioneered in the US, REITs are already quite popular in several countries including the UK, Singapore and Australia. Several India-focused developers such as Indiabulls and Ascendas have also listed their own REITs on the Singapore Stock Exchange.

Many believe REITs have the potential to become a game-changer for the Indian real estate sector as they can lower the developers' dependency on banks for funds. According to realty consultancy Jones Lang LaSalle, 80-100 million sq ft of office space worth at least Rs 60,000 crore may qualify to be included under REITs. These assets could together generate rentals of Rs 6,000 crore annually.

"When REITs buy large assets from property developers, it helps developers to repay loans. Almost all developers have residential projects stuck for want of money," says Maadhav Poddar, associate director (real estate practice), EY. "It will increase liquidity in the sector as a whole."

This means REITs could particularly help builders such as DLF, Prestige and Phoenix Mills that have a large portfolio of leased assets and investors such as Blackstone and Brookfield that are keen to invest into the country's property market. However, there are many who believe the current tax structure for REITs is unviable.

"It does not make sense to float REITs because there is too much tax leakage. It will not be remunerative for investors, and sponsors will be hit by capital gains tax," says Sunil Hingorani, director (finance) at K Raheja Corp, one of the largest owners of commercial properties in the country. "It makes more sense to list the company straightaway as there are multiple points of tax on REITs."

Tax experts say developers are uncomfortable with the long-term capital gains tax they would have to pay once they sell their units in a REIT. Unlike retail investors, who are exempt from the tax, developers need to pay long-term capital gains tax of 20 per cent if they hold their REIT units for longer than 12 months. However, developers don't have to pay any tax when they are transferring their property to a REIT.

Developers find this tax structure irksome. "Their logic is that if they sell stake through an IPO, they need not pay any tax, but in the case of REITs, they need to pay 20 per cent tax. They want REITs to be given the same treatment as IPOs," says Gautam Mehra, executive director (tax and regulatory services), PricewaterhouseCoopers.

Analysts point out another dichotomy. They say while the government has proposed a pass-through on distribution tax when a REIT pays dividend to its unit holders, it has subjected the special purpose vehicle that owns the project to corporate tax and the dividend paid by the special purpose vehicle to REIT to dividend distribution tax.

Another sore point with developers is the issue of stamp duty on transfer and purchase of properties. They say exemption from the duties would have helped in making REITs more attractive. But resolving the vexed issue of stamp duty won't be easy.

"Stamp duty is a state subject. The Centre has to work with the states to resolve this matter. The states may not agree on this," says Tushar Sachade, head of private equity tax at BBSR & Co.

According to a report by Kotak Institutional Equities, stamp duty charges vary between 6 and 9 per cent in five states-Maharashtra, Karnataka, Haryana, Uttar Pradesh and Tamil Nadu-which have the majority of the assets that could potentially qualify for REITs.

"Direct holding of a property by REITs will eventually save some tax leakage in the form of dividend distribution tax. Separate representations will have to be made to the states for this," says Samar Sarda, an analyst with Kotak Institutional Equities in the report.

Given the slew of taxes, many don't see why a developer would want to invest in REITs. Adhidev Chattopadhyay, an analyst with HDFC Securities, says developers would rather prefer to take loans from banks at 10 to 11 per cent than invest in REITs if the latter only gives them 10 per cent return.