Decoding Finance Bill 2012

Jayesh Kariya, Partner - Tax & Regulatory Services, Infrastructure, Government & Healthcare, KPMG
Is Realty Sector Blessed by the Union Budget? – Reality vs. Myth

April 3rd, 2012
The year passed by saw a continued slow down in the Global and Indian economy and the Indian real estate was no exception.  Despite the slowdown, the sector still continued to contribute more than 5% to the overall GDP and remained the second largest employment provider next to the agricultural sector.  Besides its contribution to the economy, employment and other economic aspects, the sector also caters to one of the basic needs of human being, the house. 
The sector has been gearing up to the newer challenges and adopting the newer approaches to the business namely corporatisation of businesses, adoption of latest construction technology, innovative products and multi-facet projects, partnering with the Government and involvement of Private Equity players. However, some of the external factors like lack of industry status, pricing pressure, liquidity and shortage of low cost funding, land acquisition related challenges, cost escalations, long drawn and time consuming approval process especially obtaining multiple approvals, unclear and frequent policy changes, etc. have contributed to the sluggishness in the sector.    
Amidst this scenario, the sector represented before the Government to express its concerns and sought relaxations on various matters among other are – 
  • Granting of industry status for ‘Real Estate Sector’;
  • Introduction of ‘Real Estate Regulatory Authority’ to enhance transparency in the sector and increase investor and customer confidence;
  • Development friendly regulations for acquisition of land to facilitate easy availability of land;
  • Single-window clearance for real estate development projects to reduce hassles in obtaining multiple and varied nature of project clearances;
  • Interest subvention for one more year and also increase the threshold for eligibility limit;
  • Introduction of tax sops for developers;
  • Allowing ECB for the sector especially for township projects, affordable housing projects;
  • Eliminate multiple levy of taxes on the real estate development;  

As usual the Finance Minister (FM) disappointed the fraternity and did not provide much needed fillip for the sector except for some policy measures – 
  • Issuance of tax free bonds worth Rs. 60,000 crores, out of which Rs. 10,000 crores would be issued by National Housing Authority of India and Rs. 5000 crores would be issued by National Housing Bank. In other words, Rs. 15,000 crores worth of the investment augmentation for the sector;
  • Opening up of External Commercial Borrowings (ECB) route for the low cost affordable housing projects;
  • Setting up of Credit Guarantee Trust Fund to ensure better flow of institutional credit for housing loans;
  • Increased allocation to the Rural Housing Fund from Rs. 3000 crores to Rs. 4000 crores;
  • Extension of 1% interest subvention on housing loan up to Rs. 15 lakhs where cost of the house does not exceed Rs. 25 lakhs by one more year; and
  • Opening up of the FDI in retail sector will be considered by the Government 

While the above policy reforms are welcome, among others, the long awaited expectations of sector have not been met with. 
If we talk about tax proposals, the FM did not tweak the corporate tax, surcharge and MAT rates, but silently introduced Alternate Minimum Tax (AMT) on partnership firms and other non corporate entities availing benefits under specific provisions of Chapter VIA and section 10AA of the Act. Further, the FM has proposed several provisions that could have far reaching ramifications for foreign as well as domestic players. Some of them are tax withholding from property transactions, stringent criteria for claiming benefits under tax treaty, introduction of the General Anti Avoidance Rules (GAAR), taxability of excess premium in the hands of private companies, withholding of tax on payments made by one non-resident to another non-resident where the income is subject to Indian tax and more importantly, expanding the coverage of transfer pricing regulations to the domestic transactions between related parties. The provisions giving unfettered powers to the tax authorities to apply GAAR coupled with applicability of transfer pricing provisions to the domestic transactions would severely impact the various business arrangements including intra group transactions especially when the sector is so inter-twined. 
We have analysed some of the important proposals in more detail. 
Benefits for Affordable housing – A Reality or a Myth? 
Affordable housing gained prominence in the Budget 2012. Apart from allowing the External Commercial Borrowing ("ECB") for the affordable housing segment, the proposal to lower the withholding tax rate on interest on ECB taken during the specified three year period at a much lower rate of 5% as compared to the normal rate of 20% is a welcome move. Secondly, investment linked deduction for capital expenditure (other than land) incurred for affordable housing segment at the enhanced rate of 150% is perceived to be a beneficial tax proposition. However, if one looks at the real estate business model, the developers have light asset base and most of the capital cost on capital asset is borne by the construction contractors thereby virtually no real and significant benefit of this proposal to the developers. In fact, the benefit is a “myth”. Certainly, service tax exemption for construction services relating to specified infrastructure, residential dwelling, and low-cost mass housing up to an area of 60 square meters will be helpful for the sector.
Domestic Transfer Pricing made applicable:
Introduction of transfer pricing regulations and determination of arm’s length price for the specified domestic transactions between two related persons or two units of the same entity having transaction value exceeding INR 50 million, in a year is not being debated much and the impact thereof is not being fully apprehended by the sector. However, these provisions with enhanced coverage of related party transactions will impact the sector adversely. 
The proposal states that all the provisions of transfer pricing regulations (including procedural and penal provisions) would be applicable to such domestic transactions, which will increase the burden for the realty players. Further, these provisions will severely impact real estate transactions as the expenditure such as construction charges, management fees, development fees, marketing and personnel provisioning services, etc. to related parties would be disallowed if it is found be excessive or unreasonable having regard to the arm’s length price. More importantly, the scope of applicability has been widened whereby indirect relationship could also get covered which will bring in many more transactions within the ambit of disallowance. Further, the way the industry is structured, related party transactions are inevitable and applicability of transfer pricing regulations to such transactions will hamper the growth of the sector. 
GAAR introduced – A draconian regime? 
Budget 2012 introduced comprehensive GAAR provisions providing wide powers to the tax authorities in treating the transaction as ‘impermissible avoidance arrangement’ and taxing them. These powers are very wide including the power to disregard entities in a structure, , alter the tax residence of such entities reallocate income and expenditure between parties to the arrangement and the legal sites of assets involved, treat debt as equity and lifting of corporate veil. The way the provisions have been crafted, it appears that the tax payer is required to justify its every act and establish that the transaction has not been entered into with the main motive of obtaining tax benefits. The obligation is onerous and cumbersome. Some of the regular business transactions that could be impacted by GAAR are –  
  • Structuring of funding through hybrid and debt instruments; 
  • Transfer of shares of the company having immovable property rather than transferring the immovable property;
  • Genuine transactions of bulk sale of apartments to group companies and many more; 
  • Business reorganization like slump sale, mergers and demergers. 

As per the GAAR provisions, if the tax authorities believe that the holding company has been interposed mainly for tax benefits, then the treaty benefits can be denied. Further, in case the debt transaction is re-characterization into equity, it could lead to double taxation and that it would work as “Thin capitalization norms” with open ended powers. Further, there are many Specific Anti Avoidance Rules (SAAR) in the Income-tax Act and a question arises, whether GAAR will override such SAAR provisions having limited scope and coverage? 
The introduction of GAAR in line with some of the developed countries is not a bone of contention, but the real challenge is in it’s implementation and approach of the tax authorities. If these provisions are not implemented rightly, then it could create chaos and significant litigations. The Government should revisit its decision of introducing the GAAR in the same manner as in the Budget and also consider it introducing in a phased manner by diluting the proposed regime.
Be that as it may be, these provisions will become the statute and the industry needs to prepare itself to tackle these provisions. Proactive approach needs to be adopted and proactive measures such as building substance, documenting business decisions, documenting arm’s length arrangement, etc will be critical to defend any allegations of the tax authorities.
Tax withholding from immovable property transactions 
These provisions require that the transferee shall withhold tax @1% from sale consideration paid or credited, whichever is earlier, on transfer of immovable property (other than agricultural land) and deposit it with the Government in relation to transactions exceeding specified threshold limited for different areas. Albeit, the compliance provisions are simple and hassle free, the implementation of this provision will create significant practical difficulties and will create a “BIG question mark” on its implementation. It is not possible to fathom how these provisions can be practically implemented in cash less transactions such as transfer of land under JDA arrangement for area sharing, transfer of property without consideration under re-organization, slump sale of business having immovable property, long term land lease transaction, transaction of TDR sale, transactions which are exempt from tax under section 47, etc.
Negative list of services 
The “Negative List” approach of levy of service tax has widened the tax net significantly, albeit with some sector specific exemptions from levy of service tax. This has almost made most of the services to be taxable unless specifically excluded from the tax net. Further increase in the rate by 2% has increased the overall construction cost including ability to claim rebate/refund. 
Apart from the above, there are many proposals which could have negative impact on the sector such as taxability of share premium in excess of fair market value, relaxation from DDT in multi-layer structure given the word “paid” used in the section, denial of tax treaty benefits, Tax Residential Certificate (TRC) not being satisfactory evidence to claim treaty benefits, enhancing the time limit for reopening of assessment, plethora of retrospective amendments, etc, 
All this will result in increased cost of housing thereby making housing costlier for the ultimate buyers resulting in rippling effect on the sector. 
Clearly, the Budget 2012 has not met with some of the important expectations of the sector. While, the favorable policy announcements are welcome, but the Budget has not addressed many areas namely, granting of industry status to the sector, infrastructure status to some of the projects like IT Parks and townships, introduction of the Real Estate Regulatory Bill, Land Acquisition Bill and the Land Titling Bill, introduction of a Real Estate Investment Trust (REIT) regime to facilitate liquidity. The expectation gap will always remain and ignoring the unsatisfied demands of the sector for a moment, the authors hope that the policy initiatives, specifically for the affordable housing proposed by the FM are implemented properly and effectively to ensure that they deliver the desired fillip to the sector.  Further, the Government should implement some of the anti-avoidance provisions with the right mind set and approach to achieve the desired result rather than creating a negative impact on the sector.