27 Feb 2008

Changing Tax treatment of Real Estate Investment Trusts and Regulation of Art Markets: Sneek peak into upcoming changes in India

Well looks like this blog is evolving all the time and now we are posting exclusive news (well it will be hot news soon enough) contents for India now. The latest updates from the security and capital markets are the two major changes to be brought in soon enough; (i) changing the methodology and structure of taxation of Real Estate Investment Trusts (or simply REITs) and (ii) the proposal to regulate hitherto unregulated art markets in India, reveals a government official (and a close friend of mine) who wishes to be unnamed. We shall deal with both of them in some details, as told to us.

(i) Tax treatment of Real Estate Investment Trusts in
India: Expecting concessions

A REIT is not a different species but a corporation in the business of investing in real estate and having a special treatment of tax. The premise from this starts (despite the economists arguing about 'economic double taxation') from the practice of taxing both the corporation profits and the receipt of dividends in the hands of the shareholders. To illustrate, lets us suppose that there is a corporation with $100 of income. Now the rate of both corporation tax and individual income tax is 30%. Therefore the income available for distribution is $70 only ($100 - $30). Now when these $70 are distributed to the shareholders, the law considers this to be income in the hands of the shareholder and therefore this $70 would be subject to tax again. Thus the individual shareholder would be liable to pay $21 ($70 x 30%) as taxes and the net income from dividends available in the hands of the shareholder is only $49. Thus more than half the corporate income goes in taxes despite the rate of tax being only 30%.

In this situation, while legally there is just one taxation in the hands of the tax-payers (the corporation and individual shareholders being different entities, they are liable to pay tax differently on their incomes) and thus there is no case of double taxation. However speaking in economic terms, the same income is being subjected to tax twice and thus what the government collects as tax is more than the rate of tax it prescribes. Thus economists argue that this is a case of double taxation and thus the tax system should be such to tax the income only at one stage (either in the hands of the corporation or the shareholder) and not at both the stages. While some countries pay heed to this argument and have a taxation system which taxes corporate income only at one stage, most countries are quiet satisfied to see their revenue coffers flushed with money by taxing the same income twice.

A Real Estate Investment Trust, similar to make other structures that law gives recognition to, is one method of avoiding this economic double taxation. The premise of this form of relief given to the REIT is the condition attached with the REIT that it would distribute a significant part of its income and profits (if you consider 90% as a 'significant' and not 'almost everything') to its shareholders or beneficiaries. With this condition attached to the REIT, they are taxed only at one stage (i.e. either in the hands of REIT of in the hands of the shareholders of REIT), thus avoiding economic double taxation. The percentage of distribution as a qualifying criterion and the methodology of taxation of REITs varies in different jurisdictions but then the essence remains the same.

As regards the taxation in
India of such REITs (which forms the crux of this update), there is no distinct position of REITs i.e. no special advantage is given to these REITs meaning thereby that they are subject to economic double taxation.

The update that we have got is that in the coming budget (i.e. three days from now), the Finance Minister might announce such an exemption scheme for REIT from the upcoming Financial Year. The aim would be to enhance and development the yet languishing real estate markets in
India. And therefore not just this benefit, a plethora of other exemptions are also expected. For illustration, income from investment in REITs may be totally exempted from tax within the taxable caps. In fact the market regulator SEBI has already come out with Draft Regulations in REITs (click here for the draft regulations) but without ensuing tax benefits which REITs generally carry, the market might not develop at all.

So keep your ears open for the Finance Minister can surely come out (unless there are some last minute hiccups) with tax exemption scheme for REITs in
India, accentuating the real estate markets to take off in India.

(ii) Regulating Art Markets in
India: Some policy perspectives expected

The market for arts and artistic products has been facing a boom for sometime now. This might have very well slipped from our coverage but for the word of our friendly source. But looking back, I find three credible financial papers writing on it (1. Financial Times, 2. International Herald Tribune, 3. BusinessWeek).
India has not been an exception to it and its art market is estimate to be near the Rs. 1000 crore mark at the last wild guess by various experts covering the field. But the only problem is that it is unregulated.

The modus operandi for operations in this field have been coming together of private funds to invest in works of art that are later sold on at profitable returns, thereby giving value for money to the investors. Something very similar on the lines of private equity but for the fact that the funds are purely for investment in artistic products alone. These private investments are known as 'art funds'.

Perhaps bothered by the size of the market and the potential fallouts of non-regulation, it was only recently that SEBI (in its capacity as market regulator of sorts) came out with a caution note for the investors and players in the market. SEBI announced that technically these 'art funds' are characteristically the same as 'collective investment schemes', a term defined under Section 11AA(2) of the SEBI Act, 1992 and therefore they fall within the regulatory arena of SEBI. Consequently therefore, as SEBI announced, these funds are liable to registration under the 'SEBI (Collective Investment Schemes) Regulations, 1999' and thus art funds operating without registration are liable for criminal actions, thereby giving a serious blow to the hitherto unfazedly operating art funds in India. [click here for the full message from SEBI]

The move has been welcomed by almost all cross-sections associated with the arts market [msn news, sify news] and though this is a recent move by SEBI (12th February), there is aggressive murmurs within the financial corridors of there being a policy statement coming out from the FM in this budget to cast more light on the future and working of these art funds in India. Though the ET has already come out with a prediction to this regard but we are told that this is not a mere possibility but a serious one. Keep your ears clear for this one as well.

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