THE CHANGES IN TAXATION OF INCOME FROM A REIT – WHAT IT MEANS FOR INVESTORS

[Dhanush T]

A part of remittances from REIT’s, which were earlier not taxed in the hands of unit holders of the REIT’s, are now taxable through the amendment brought to the Income Tax Act, 1961, through the finance bill 2023, wherein the Government of India will impose tax on the earlier non–taxed income of ‘debt repayment’ that unit holders derived from a Real Estate Investment Trust (REIT).

In this article, firstly, there will be a brief explanation of what a REIT is. Secondly, there will be a brief note on the earlier taxation regime of an REIT. Thirdly the new structure of taxation of a REIT will be discussed. Fourthly, there will be an opinion on the new regime, ending with a conclusion.

WHAT IS A REIT

A REIT is a business trust that invests in income-generating real estate assets such as buildings and such to earn rental income REIT’s invite people to invest in them, and use this money to invest in real estate projects either directly into the property or indirectly through a Special Purpose Vehicle (SPV). The people, who invest in such REITs, get a unit in the trust indicating the extent of their ownership in the trust, and are referred to as unit holders. .

OLD TAXATION REGIME OF AN REIT

Section 115UA was inserted in the Income Tax Act, 1961 vide Finance Act (no.2), 2014, as a special provision regarding the taxation of a business trust, which includes a REIT under section 2(13A) of the Income Tax Act 1961.

At the first level, sub-section 1 of section 115UA, codifies the principle that when a trust earns any income, it is not considered to be the trust’s income per se, but the income of the unit holder.

The income in the hand of the unit holder will be considered to be of the same nature as it was in the hands of the REIT which disburses the income to the unit holder and in the same proportion as received by the REIT as well.

Next sub section 2 of Section 115UA of the Act deals with how the unit holder should be taxed if they choose to redeem their units. Section 111A provides for tax treatment in case of short term capital gains and Section 112 provides for tax treatment in case of long term capital gains.

Finally, sub section 3 of Section 115UA of the Act deals with how incomes in the hand of a unit holder are to be taxed.

Under Sub section 23FCA and 23FC of Section 10, the rental income, dividend income and interest income in the hands of the REIT is not subject to tax. However, this income is subject to tax when it is received by the unit holders by way of sub section 3. Sub Section 4 is a more procedural provision regarding furnishing statements and is not as relevant to the discussion at hand

THE AMENDMENTS

Two amendments were introduced vide the Finance Act 2023, which inserted a new clause (xii) in Sub Section 2 of Section 56 of the Act, taxing specified sums received by the unit holder and Sub Section 3A to Section 115UA, which essentially exempts the application of Sub Section 1 of Section 115UA of the Act, with respect to sums taxed under Section 56(2)(xii).

In the memorandum to the finance bill 2023, the government has outlined that there are four primary remittances from a REIT does to its unit holders.

1) Rental income

2) Dividend income

3) Interest income

4) Debt repayment

The first three have already been covered in by virtue of Sub-section 3 of Section 115UA. The amendment seeks to make the ‘debt repayment’ component in the hands of the unit holder, taxable as well.

REITs advance loans to the SPV’s they invest in, or set up subsidiaries for the management of the buildings they invest in and advance loans to them. Eventually, the loans are repaid to the REIT. The REIT’s included this when remitting amounts to unit holders, who received income which was characterized as debt repayment by virtue of the principle codified in Section 115UA(1).

The Government has said that this amount is income in the hands of the unit holders and wanted to bring this component within the ambit of taxation and therefore introduced the two amendments that we started off our discussion with.

The addition of sub clause (xii) to Section 56(2) imposes a tax on any specified sum received by the unit holder. In the explanation to the provision, a calculation is given to determine the ‘specified sum’ to be taxed under Section 56(2)(xii).

It involves subtracting a component B and a component C from component A. (A-B-C) Component A essentially includes the aggregate sum received by a unit holder from the business trust, over the years. This component excludes rental income, dividend income, interest income and in case of redemption of shares whether it is long term capital gain or short term capital gain.

Component B, which is to be subtracted from component A, is essentially the cost of acquisition of the unit by the unit holder.

Component C includes any sum that was already taxed under Section 56(2)(xii) in the earlier year.

To illustrate, assuming that the cost of acquisition of a unit is 100 rupees, and the ‘debt repayment’ component over the years has amounted to 80 rupees, there will be no tax as the calculation results in a negative number. But if the ‘debt repayment’ received by unit holders over the years is 120 rupees and the cost of acquisition is 100 rupees, the difference of 20 rupees will be taxable

Assuming further that the total amount received by the unit holder is 140 rupees in the next financial year, the calculation will first reduce the cost of acquisition of 100 rupees and the 20 rupees which was already taxed in the preceding year. The remaining amount of 20 rupees will be taxed in the current financial year.

REASONS FOR ENACTMENT OF AMENDMENT 

The entire controversy at hand arises because the nature of incomes in the hands of the unit holder is deemed to be of the same nature as received by the REIT. But the essential component for Sub-section 1 of Section 115UA to attract is that it must have been income in the hands of the REIT.

Ordinarily speaking, the income in the hands of the unit holder must have been income in the hands of the REIT. But there was no distinction between debt repayment and the other incomes in the hands of the unit holder, and therefore debt repayment component in the hands of the unit holders has enjoyed tax exemption because of the application Sub-section 1 of Section 115UA

The amendments work on two levels. Firstly, Section 3A is enacted to exclude the income taxed under S 56(2)(xii) from receiving the benefit under S. 115UA(1). By excluding this amount, the indication is that debt repayment must be considered as income in the hands of a unit holder, which is a necessary precondition for the application of S. 115UA (1), as discussed above.

Secondly, S 56(2)(xii) provides for the taxation of any sum received by the unit holders, apart from incomes which are already taxed under the ambit of S 115UA (1). This exclusion of incomes in the hands of unit holders already taxed under Section 115UA(1), eliminates all other remittances received by the unit holder, leaving only the debt repayment component which can be taxed under this proviso. This is reflective of the legislative intention, as reiterated in the memorandum to the finance bill that the amendment was to tax the debt repayment component in the hands of unit holders.

Additionally, the government has provided a relief to the unit holders by allowing the debt repayment component to remain tax free, as long as it does not exceed the cost of acquisition of the unit purchased. This ensures that the unit holders who have invested prior to the amendment do not have to assume a huge tax liability by virtue of the calculation of specified sum which includes all aggregate remittances over the years, with the precondition that it must not exceed the cost of acquisition, which is reflected in the calculation of component B in the explanation to Section 56(xii) of the Income Tax Act, 1961.

CONCLUSION

This amendment was enacted to widen the tax base by including debt repayment to ensure that any and all incomes in the hands of the unit holders are taxed, with debt repayment being in the nature of an income in the hands of unit holders. This ensures there is no unreasonable loss of potential tax revenue, while providing partial relief to unit holders who have invested before the amendment was passed.