Global investors’ appetite for commercial properties in India has been increasing in recent times; with the liberalisation in the foreign direct investment (FDI) policy, a wider spectrum of commercial real estate space, including malls and city-centric commercial properties, is now available for foreign investors. And investors are lapping it up - FDI in commercial real estate during 2015 was about $850 million, according to a Cushman and Wakefield report.
Like in any other transaction, income-tax and regulatory considerations are unavoidable bedfellows for investors, and peculiarities of commercial property acquisitions accentuate them somewhat. We discuss a few aspects:
1. Acquisition:
Depending on the property location, direct property acquisition could attract a 5 per cent to 10 per cent stamp duty cost, in addition to the pain of securing approvals, if the underlying land is leasehold. Acquisitions, therefore, tend to be in the form of acquisition of the property holding company itself.
If such company is a Special Purpose Entity (SPE) this shouldn’t pose any challenge. However, it is not uncommon for the seller to hold several assets in a single entity. In such cases, demergers could be explored to carve out the target property into an SPE which could be acquired by the investor. Demergers are income-tax neutral; but they usually attract stamp duty at a concessional rate. However, demergers require court approvals as well as approvals from creditors and could take six to nine months to consummate, significantly pushing back the acquisition timelines.
In a number of cases, this requires interim arrangements to be worked out such that, pending the demerger, whole or part consideration could be paid over to the seller, while the investor could get de-facto control over the target property.
2. Income-tax:
The SPE’s rental income may be taxed as ‘Property’ or ‘Business’ income. While ‘Business’ income taxation is largely based on accounting profits, ‘Property’ taxation substitutes allowance for actual expenses and depreciation with an ad-hoc deduction of 30 per cent of rent received; plus, deduction is allowed for interest paid on ‘construction/ acquisition’ loans, which could have an impact for leveraged acquisitions (see below).
Since the taxation approach initially selected is difficult to change subsequently, a thorough analysis of the likely annual tax outgo from the rental income is a must-do for investors.
3. Leveraged acquisitions and capital structures:
Efficiency of cash throughput from a SPE (i.e., ratio of pre-tax rentals earned by the SPE to post-tax returns received by the investor) is principally determined by the SPE’s capital structure. Equity-based capital structures distort efficiency as dividend distributions attract additional taxes.
Leveraged acquisitions provide an attractive tool in this regard as cash flows generated in the SPE can be used for servicing the acquisition loan, thereby obviating the need for cash takeout to the investor (and the associated tax leakages). Investor returns are then primarily a function of the capital appreciation upon exit.
Further, acquisition loans taken for stabilised properties against discounting of future lease rentals tend to be at lower interest rates, thereby further boosting returns on equity.
A key issue with leveraged acquisitions, however, is the manner in which acquisition loans may be used to pay the seller. If the acquired SPE has been initially capitalised using shareholder loans, the acquisition loan can be drawn-down into the SPE and be used to repay such shareholder loans. However, in the absence of shareholder loans, paying the seller (who is a shareholder in the SPE), may be difficult and achieving this may require some degree of SPE-level restructuring.
Another significant issue could be the tax deductibility of interest paid on acquisition loans. Very strictly, interest on any loan other than the initial loan taken to construct/ acquire the property and the first refinancing thereof is not a tax deductible item, where rental income has been offered to tax as ‘Property’ income. Investors need to be mindful of this aspect.
4. Liabilities and tax advances:
A direct fallout of an SPE acquisition is that the SPE’s tax assessments of earlier years are completed post it being acquired by the investor, and could render the investor liable to incremental tax liabilities arising from there. The law also entitles tax authorities recourse against the Investor for pre-existing tax liabilities of the seller, and, where the seller is a non-resident, for recovery of taxes arising in the seller’s hands on sale of the SPE.
Robust tax diligence, appropriate tax withholding and indemnities therefore form an essential prerequisite for such acquisitions. Separately, the SPE may also be entitled to refunds of excess taxes paid in the past, and a key negotiating point is the value that the acquirer needs to pay for such refunds. Vagaries in timelines for getting tax refunds make this negotiation tricky.
The labyrinth of tax and regulatory issues that an investor looking at acquisition of commercial properties deepens if the commercial asset is also entitled to any tax incentives (such as Special Economic Zones); where, in addition to determination of whether the claim for tax incentive suffers from any infirmities, the investor also needs to carefully consider the impact that an unforeseen change in government policies could have on the investment.
Exciting as the opportunity to bite into the Indian commercial property space may seem, the cost of getting investment structures wrong could be punitive. Investors will be well advised to tread cautiously.
(With inputs from Anand Laxmeshwar and Jinesh Jobalia.)
Rajeshree Sabnavis is partner, Anand Laxmeshwar is director and Jinesh Jobalia is senior associate at BMR & Associates LLP.