New tax on distribution income, a budget loss for REITs, InvITs

Blame it on a budget proposal that sought to bring one of the income components of these trusts – loan repayments – into the tax net. Finance Minister Nirmala Sitharaman announced that ‘repayment of loan’ – or ‘amortisation of loan’ – should be taxable in the hands of unitholders under ‘Income from other sources’ at the slab rates of an investor.

Reits and InvITs, which invest in income-generating commercial real estate assets and infrastructure assets, respectively, have been mandated by markets regulator SEBI to distribute at least 90% of available cash to unitholders. Thus, distributive income—which comes in the form of dividends, interest, rental income or loan repayments to unitholders—makes up a significant portion of the return from these trusts. If the budget proposal takes effect, after-tax distribution income from these trusts would decrease by 100 basis points. A basis point is one hundredth of a percentage point.

The distribution yield, which is calculated by dividing the annual distributed income by the current market price, gives a fair picture of the returns one can expect from their investment. Currently, the distribution yield of these trusts has been in the range of 6-7.5%.

What happened now?

Reits and InvITs invest in Special Purpose Vehicles (SPVs) through equity or debt instruments. Any income distributed by these trusts to its unit holders should be of the same nature and in the same proportion as that distributed by the SPV to the business trust.

That is, if the SPV pays interest amount to the trust for the loan taken, the same amount is to be passed on by the trust to the unitholders as interest income. Since trusts are given a pass-through structure, such income is taxable to the unit holders.

In most cases, dividend income is exempt for unitholders. However, if the SPV has opted for the lower tax regime, the dividend along with the interest will be taxable at the slab rates, while the interest/rental income is taxed at the slab rates applicable to the investor.

The ‘loan repayment’ component of the distributed income was till now not attracting any tax in the hands of the business trusts as well as the unitholders.

The Finance Minister plugged this loophole by proposing that such income should be taxed as part of the ‘Income from other sources’ of the unitholders, which is taxed at the slab rates of a person. With this, the attractiveness of these trusts – which had gained traction over the past few years, especially among high-net-worth individuals – as a yield product has been affected.

There are three listed REITs in India – Brookfield India Real Estate Trust (Brookfield REIT), Embassy Office Park REIT (Embassy REIT), and Mindspace Business Park REIT (Mindspace REIT).

The loan repayment component is a significant part of the disbursements made by Embassy and Brookfield. Post-Budget, the taxable (at slab rate) component of distribution of these companies will be 76% and 97% respectively.

Mindspace, which has almost zero allocation to debt repayment in distribution, looks attractive among the three REITs from a tax perspective.

Embassy saw the highest drop of 8% in prices after the budget. Vishal Chandirmani, chief operating officer, TrustPlutus, said that with the fall in share price, Embassy REIT’s distribution yield has started looking attractive even after tax (view graphic). As the price falls, the yield rises.

There are around 18 SEBI-registered InvITs. Of these, only three are public and listed on the stock exchange: IndiGrid InvIT and PowerGrid InvIT invest in electricity transmission assets, while IRB InvIT invests in a portfolio of road assets to collect tolls during the concession period.

InvITs are generally highly leveraged companies as compared to REITs and thus the ‘debt repayment’ component in its distribution is higher. Post-Budget, almost 100% of distributions held by both IndiGRID and IRB trusts may be taxable at the individual’s slab rates.

Industry experts are of the view that the ‘loan repayment’ amount should be treated as capital gain which attracts 10% tax if held for a long period (36 months) and not as ‘other income’ which attracts tax at slab rates. “It is not appropriate to treat income by way of capital gains as ‘other income’, which is at the higher level of 39% (including surcharge and cess under the new tax regime) for high-net-worth individuals. This proposal will make investors shy away from investing in Indian infrastructure assets,” said Nitan Chatwal, managing director-investment manager, Shrim InvIT.

Note that these tax rules apply to unlisted REITs and InvITs as well.

see for an explanation

Experts say that the budget proposal has been included in the Finance Bill, 2023 in such a way that it has sought clarification from the government.

Apart from highlighting that ‘loan repayment’ would be charged under the head ‘Income from other sources’, it also added a provision (a condition) in the relevant section in the Income-tax Act – if the amount received by the unitholder under ‘loan repayment’ represents redemption of the unit, then the amount received should be reduced by the cost of acquisition, which is nothing but capital gains tax treatment.

Industry experts are unsure of how to interpret this provision. Also, tax experts and trusts are trying to understand the definition of redemption in the current context. They also want to know whether the income will be treated as capital gain in the year of receipt or in the year of final sale of units and how to determine the cost of acquisition.

Embassy, ​​in a recent press release, states that “the announcement affects approximately 40% of our current distribution. In addition, REIT growth is a total return product with stable distribution due to capital appreciation driven by leverage. We , along with other industry participants, are currently evaluating next steps, including appropriate representation given the attractiveness and success of the product to date, particularly to retail investors.”

Nevertheless, with this proposal, trusts will have to disclose information about distribution to their unitholders in a more detailed manner, Chandirmani said.

What should investors do?

Those looking to better predict the post-tax returns on their investments in these trusts may wait for the clarifications to be issued.

Apart from taxation, the rationale for investing in Reits and InvITs and the quality of the underlying assets remain intact.

Vishal Dhawan, founder and CEO of Plan Ahead Wealth Advisors, believes that investors should not alter their investment strategy in any form, as taxation will be introduced on the principal repayment component.

“The underlying concept and value of commercial real estate (in the case of REITs) and gaining access to a pool of assets is as relevant as it was before the Budget. The benefits of using REITs as an investment vehicle as an alternative to owning and managing physical commercial real estate and finding high-quality tenants still remain,” he added.

REITs currently offer no significant premium compared to the yield from the 10-year G-Sec instrument, for which the risk of default is practically nil. Having said that, experts say that the actual yield in the hands of investors of REITs could increase in future years if the renewal of leases happens at a higher rate due to inflation than the current rate. Another important component of the return from REITs is the capital appreciation of the investment if the share price does not decline.