Collective Investment Schemes

for
Real Estate investments in India







CA Nidhi Jain
nidhijain@vinodkothari.com
Vinod Kothari & Company

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Real estate sector in India is growing and is becoming attractive to various investors. The
growth in real estate market is seen in both commercial as well as residential field. The
attractiveness of the Indian real estate sector is also decorated by a report Emerging
trends in Real Estate in Asia Pacific 2011 published by Price Waterhouse Coopers and
Urban Land Institute
1
. According to this report, India leads the pack of top real estate
investment markets in Asia for 2010. As per a report by Ernst & Young, the long-term
view for the Indian real estate sector is positive since its fundamental demand drivers -
increasing urbanisation, favorable demographics, growth of the services sector and
rising incomes are still intact.
2


The real estate sector is getting more and more organized and transparent witnessing
various regulatory reforms like Government of India supporting the repeal of Urban
Land Ceiling Act, rationalization of property taxes in various states, modifications in Rent
Control Act for greater protection of owners wishing to rent out their properties. This
organization and transparency has added a lot to the development of the sector
including greater demand for residential, commercial and retail real estate all across
India. At the same time, the foreign investments in real estate are also increasing.
According to the Department of Industrial Policy and Promotion India (DIPP), during
April-November 2011-12, the Indian real estate and housing sectors received US$ 509
million in foreign direct investment (FDI) accounting for 7% of total FDI inflows.
3
Further,
the cumulative inflow from April 2000 to November, 2011, on account of FDI in real
estate and housing is US$ 10891 million. Real estate also emerged as the popular sector
for private equity (PE) funds, which witnessed investments worth US$ 1,700 million in
the sector during 2011.

Collective investment schemes are coming up in the mind of various investors for
entering into the real estate industry. Some of the examples which can be quickly cited
are of Sahara India, PACL India Ltd. This article talks about various possible structures
under which a real estate business can be carried out.

Introduction to REITs:

The ideal way to launch any scheme for real estate business would have been a real
estate investment trust (REIT). A REIT is a fund that holds real estate or mortgage using
capital pooled from investors. It is a tax transparent, collective investment device to
channelize investments into income-producing real estate. REITs could be listed on stock
markets or could be unlisted but has to be regulated through a regulatory board.
However, REITs derive their tax transparency from specific legislations. No such

1
http://www.pwc.com/jp/en/tax-global-report/emerging-trends-asia-pacific-2010.jhtml
2
http://m.economictimes.com/markets/real-estate/news-/long-term-view-for-indias-real-estate-sector-
positive/articleshow/11105256.cms
3
http://dipp.nic.in/English/Publications/FDI_Statistics/2011/india_FDI_November2011.pdf

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legislation exists in India. In fact, REITs have been considered on various occasions, but it
seems that the regulators are currently not in favour of permitting REITs.

Hence, there is a need to look up for alternative structures which can run as a REIT.

Constraints and applicable laws:

The constraints/applicable law within which a real estate scheme has to operate are the
following:

1. It is very apparent that there will be commingling of funds, as investment in
properties has to be pooled together to form any practical ticket size. If there is
commingling of funds, apparent implication is the Collective Investment Scheme
regulations of the SEBI.

2. Yet another implication on commingling is the formation of Association of
person (AOP) and loss of tax transparent status to the pool. On prima facie basis,
a pass through or see through treatment is applicable to an investing vehicle
only if the vehicle rateably distributes all that it receives and does not vest any
discretion in the manager of the pool, so that the income of each participant is
nothing but a rateable proportion of the income. However, in most of the cases,
the manager of the scheme will continue to invest and reinvest the funds in a
discretionary manner. Based on recent rulings, particularly in case of M/s
Gammon India Ltd. v. Commissioner of Customs (Civil Appeal No. 5166 of 2003)
4
,
the apparent view is that an AOP will come into existence in the eye of tax
authorities. AOP taxation does not result into double taxation, but one has to
bear in mind an entity-level taxation of the AOP.

The possible forms/ structure for the real estate business are discussed below:
I. Collective Investment Scheme (CIS)
Any scheme or arrangement made or offered by any company under which the
contributions, or payments made by the investors, are pooled and utilised with a view
to receive profits, income, produce or property, and is managed on behalf of the
investors is a CIS. Investors do not have day to day control over the management and
operation of such scheme or arrangement.
The three critical features of a CIS are: (a) pooling of money; (b) entrustment of money
to someone such that the investors are not the ones who are managing their own
money; and (c) sharing of returns from a specified investment.

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http://www.indiankanoon.org/doc/1503622/?type=print

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The Companies whose object is to organise, operate and manage a CIS need to be
registered with SEBI under the SEBI (Collective Investment Schemes) Regulations, 1999
and it will be known as Collective Investment Management Company (CIMC). A
registered CIMC is eligible to raise funds from the public by launching schemes.
Apart from the comprehensive registration and constitutional requirements, the
scheme should be rated by a rating agency and appraised by an appraisal agency. A copy
of the offer document of the scheme has to be filed with SEBI and if no modifications
are suggested by SEBI within 21 days from the date of filing then the CIMC is entitled to
issue the offer document to the public for raising funds from them.
The inflexibility and rigidity of the regulations has made it very difficult for any CIS
schemes to suo-moto come under the SEBI regulations. However, the real estate
schemes floated by many companies which are satisfying the features of CIS have been
mandatorily required by SEBI to be compulsorily registered and prosecution have been
initiated by SEBI against companies that are not complying with its directions in this
regard. As on 31st March, 2011, there are 552 companies against which prosecution
cases were launched for violation of CIS Regulations
5
.
II. Alternate Investment Fund (AIF)
Recently in August, 2011, SEBI has come up with a concept paper on setting up an
Alternate Investment Fund (AIF), however with the regulators it may not be likely that
the final regulations would be published soon. Hence, the funds regulated by SEBI
under this banner may seem futuristic and may not be of immediate relevance.
Once the regulations come into existence, based on the recent concept paper, the
investors can consider setting up a Real Estate Investment Fund as an Alternate
Investment Fund (AIF). In that case, there are certain regulatory requirements as per the
proposed guidelines on AIF; few of them are listed below:
1. Mandatory registration with SEBI.
2. Funds to be formed as Company, trusts, LLP or body corporate. In case of a
company or LLP, the number of shareholders or partners should not be more
than 50.
3. Funds shall be close ended.
4. There is no upward limit for revision of fund size, although this is possible only
after SEBIs permission on the same. But, minimum investment amount would
be specified as 0.1% of fund size subject to a minimum floor of Rs. 1 Crore.
5. The size of units issued will not be less than Rs.10 lakhs.
6. Units may not be transferable immediately or only after lockin period amongst
institutional/HNI investors which may be listed after lockin period or after
specific duration at the choice of the funds.

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http://www.sebi.gov.in/cis/cis_prosecution_data.html

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For Real Estate Funds, investment could be in Real Estate Projects or shares in the SPVs
undertaking Real Estate Projects.

III. Limited Liability Partnership (LLP)
Real estate investment business can be done under the form of LLP. LLP structure is
attractive mainly because of the limitation on the liability of the partners to their
investment in the LLP and not beyond. It is also easier to set up and operate with
relaxed reporting structures unlike the traditional incorporation laws governing
companies under the Companies Act, 1956.
As per the latest data available from the governments site for LLP, 7337 LLPs are
registered as on 20.12.2011, out of which 751 are engaged in real estate activities.
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So,
it can be easily seen that despite of being a new legal structure, people are considering
LLP for investing in real estate. Particularly because of the following benefits:
1. The sponsors can be designated partners; with the investors being limited
partners.
2. The partnership agreement may provide for such manner of sharing the profits
of the partnership as may be fixed therein. That is to say, it is not necessary that
the limited partners will have the same share of profits as designated partners.

Talking about the limitations of this structure,
1. One of the limitations is that the share in partnership is not freely transferable.
However, provisions may be incorporated in the Partnership agreement for:
- Transfer of partnership interest by a partner to a person selected by him,
subject to resolution of managing partners.
- Buy back of partnership interest by the partnership.
2. Another limitation in this structure is that though there is no limit on maximum
number of partners, if investors are to be taken as partners; partnership deed
needs to be amended every time when a new investor comes in.

It can therefore be said that practically, an LLP may virtually be run as a REIT. However,
one needs to look into the other side as well i.e. the applicable laws and regulation.

Applicability of SEBI (Collective Investment Schemes) Regulations, 1999:

A Collective investment scheme is any scheme or arrangement, which satisfies the
conditions, referred to in sub-section (2) of section 11AA of the SEBI Act. Section 11AA

6
http://llp.gov.in/LLPSummary/LLPRegionalReportPage.htm

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(2) of SEBI Act is only applicable for companies and LLP is not a company. Hence, CIS
Regulations will not be applicable on LLPs.

However, since LLP is a new concept in India and there have been regular amendment in
various laws for LLPs, as and when there is an amendment in SEBI Regulations for
incorporating LLPs under its purview, then the compliances under CIS Regulation will be
required.

Taxation of LLP:
LLP is treated as Partnership firms for the purpose of Income Tax and is taxed like a
partnership firm. Alternate Minimum Tax (AMT) will be applicable on LLPs if there is a
taxable loss. The share of a partner in the total income of a LLP shall be exempt from tax
u/s 10(2A) of the Income Tax Act.
So, virtually there will not be any double taxation under LLP structure, but again the
taxes will be levied on entity level and not on investors level.
IV. Issue of redeemable bonds linked with performance return
Issue of bonds linked with performance returns (herein after referred to as Bonds) can
be considered as another option by investors willing to invest in real estate. These
Bonds can carry a floating coupon based on the return on the real estate and can be
redeemed from the sale proceeds of the real estate. The Bonds will become attractive
to investors as they are backed-up with real estate. Moreover, there is always an exit
route for the investor as they can transfer the Bond easily and exit.
The issue of Bonds can be done through private placement or public issue depending on
the number of investors.

1. Private issue of Bonds
If the Bonds are to be issued to less than 50 investors and are not to be listed, no
guidelines have been prescribed as such. However, if the issue is to be listed,
guidelines as applicable to listing of public issue, shall apply.

2. Public issue of Bonds
Along with other compliances as mentioned in SEBI (Issue and Listing of Debt
Securities) Regulations, 2008, public issue of bonds is required to be listed on
one or more recognized stock exchange in terms of the said Regulations.

Further, SEBI through Guidelines on Issue and Listing of Structured Products/Market
Linked Debentures (issued vide circular no. Cir. /IMD/DF/17/2011 dated 28th
September, 2011) has prescribed additional disclosures and other requirements in the
offer documents for issue of structured products/ market linked debentures seeking
listing on stock exchanges for issuers having net worth of at least Rs. 100 Crores.

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The issue of Bonds linked with performance return can be highly beneficial for small
group of investors (i.e. less than 50 investors) particularly because of the following
benefits:
i) If such bonds are issued on private placement basis, no compliance with any
guidelines is required.
ii) No additional tax implication as normal provisions of taxation of bonds will
apply.
iii) There is no question of treating the entire scheme as Collective Investment
Scheme since the Bonds will be secured and hence will not be treated as
deposits.
iv) High level of liquidity as Bonds being a marketable security is easily transferable.
v) Issue of bonds will not attract the provisions of section 58A of the Companies
Act, 1956, if the issue is fully secured by mortgage of immovable property,
provided the amount of such bonds does not exceed the market value of such
asset.
V. Real Estate Mutual Fund Scheme (REMFs)
The keen investors can consider setting up REMFs that will invest directly or indirectly in
real estate assets or other permissible assets in accordance with SEBI (Mutual Funds)
Regulations, 1996 (Regulations). In which case, the highlights of the regulation that
hold relevance are mentioned below:
1. A mutual fund may invest into such real estate assets in India or a special
economic zone which shall:
a) Be in usable form and the construction shall be complete (i.e. which is not under
construction, a vacant or deserted property and is not an agricultural land);
b) Have a legal and valid title document and is legally transferable;
c) Neither be under any dispute or litigation nor shall reserved or attached by the
government or the acquisition of which is otherwise prohibited by the
government; and
d) Not have any encumbrance.

2. There are certain eligibility criteria that requires-
a) The scheme shall be closed-ended.
b) The units of such scheme shall be listed on a stock exchange.
c) Track record of carrying on business in real estate for a period of at least 5 years.

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d) The title deeds pertaining to the real estate assets shall be kept in the custody of
the custodian.
Apart from this, there are certain investment restrictions and conditions, for which one
can refer to the SEBI (Mutual Funds) Regulations, 1996.

Taxation of REMFs:

1. Tax in the hand of MFs:

a) The entire income of the MF registered under SEBI Act, 1992 or any
regulations made thereunder is exempt from income-tax in accordance with
the provisions of section 10(23D) of the IT Act.

Further, as per Section 196(iv) of the IT Act, the income received by such MF
is not liable for deduction of income tax at source.

b) Tax on distribution of income by the Mutual Fund to the Unit holders:

As per section 115R of the IT Act, income distribution by MF will attract
distribution tax at the following rates:

In case of Equity Oriented Fund - Proviso (b) to Section 115R(2) of the IT Act
provides exemption to equity oriented mutual funds from paying distribution
tax on income distributed.

In case of Money Market Mutual Fund or Liquid Fund - @ 25%/ 30% plus
surcharge on such income-tax @ 10% and education cess and secondary and
higher education cess @ 3% on the amount of tax and surcharge in case
income is distributed to individuals and HUFs/ persons other than individuals
respectively.

In case of other than Equity Oriented Fund, not being a Money Market
Mutual Fund or a Liquid Fund - @ 12.5% / 30% plus surcharge on such
income-tax @ 10% and education cess and secondary and higher education
cess @ 3% on the amount of tax and surcharge, in case income is distributed
to individuals and HUFs/ persons other than individuals respectively.

2. Tax in the hand of investors i.e. unit holders:


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a) Under the provisions of section 10(35) of the Act, any income (other than
income arising from transfer of units) received by any person in respect of
the units of the mutual fund is exempt from income tax.
b) Long-term capital gains arising on the transfer of units of an equity oriented
mutual fund is exempt from income tax u/s 10(38) of the IT Act, if the
Securities Transaction Tax (STT) is paid.
c) Short-term capital gains arising on such transactions are taxable at a rate of
15% (plus surcharge as applicable, and education cess of 2% and secondary
and higher education cess of 1%), if STT is paid.
d) If STT is not paid, the long-term capital gain tax rate would be 10% without
indexation or 20% with indexation.
e) Short-term capital gains on such transactions are taxable at normal rates.

We have done a comparative analysis to analyze the most tax transparent structure
among the options discussed above.

Comparative analysis of the options from tax perspective:

Particulars AOP LLP Issue of Bonds REMFs
Tax at entity
level:
Tax on total
income at
MMR.
Tax on total
income at 30%
plus cess.
Interest
expenditure
allowable in the
hands of issuer
company. Tax
on total income
at 30% plus
surcharge plus
cess.
Income
exempted u/s
10(23D) of IT
Act. Income
distribution tax
u/s 115R
@12.5% / 30%.
Tax at
investor level:
Share of profit
exempted as
per proviso to
section 86 of IT
Act.
Share of partner
shall be exempt
u/s 10(2A) of
the IT Act.
Interest income
will be taxable
in the hands of
investors.
Income from
MFs exempted
u/s 10 (35) of IT
Act.
Applicability
of section
14A
expenses
incurred in
relation to
income not
Section 14A will
apply. Interest
on borrowings
will be
disallowed in
the hands of
investors.
Section 14A will
apply. Interest
on borrowings
will be
disallowed in
the hands of
investors.
Section 14A will
not apply.
Investors can
take leverage by
claiming
interest on
borrowings
Section 14A will
apply. Interest
on borrowings
will be
disallowed in
the hands of
investors.

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includible in
total income.
against interest
income.
Our
Comments:
Tax is levied on
total income
and interest
expense cannot
be claimed,
hence not tax
efficient.
Tax is levied on
total income
and interest
expense cannot
be claimed,
hence not tax
efficient.
Tax is on total
income as
compared to
MFs but interest
expense can be
claimed by
investors.
Tax is levied on
distributed
income only.
Highly
beneficial for
investors who
are falling
under the
highest tax
bracket.

Summing up:

The real estate sector has become a lucrative investment sector; hence these options
will be put to test by the market players in the recent times to come.