(This article was first published on Taxsutra on 14 June 2017)
“Disruption” – a term usually associated with the digital age – is also a term increasingly being used to describe the evolving Indian legal landscape. Owing to the seminal nature of the new laws being enacted, India Inc. cannot afford to perfunctorily adopt them, but would be required to embrace a completely new perspective in order to cope up with them.
One such ground-breaking law is the Real Estate (Regulation and Development) Act, 2016 (“RERA”) which will have significant impact on the different players engaged in the real estate sector i.e. real estate developer, land owners (in case of Joint Development Agreements) and strategic investors such as private equity funds, in addition, of course, to the buyers.
RERA and Real Estate Developer
RERA, which was brought into force entirely with effect from 1 May 2017, seeks to disrupt the milieu in which the real estate sector operates. Under the RERA-era, a real estate developer (who is now rechristened and subsumed under a much wider definition of “promoter”) cannot market or offer for sale a “real estate project” before registering the project with RERA. Therefore, a promoter is bound to have requisite approvals and sanctioned plans in place in order for him to file application for registration under RERA[1].
Further, one of the most critical aspects under RERA is lock-in of funds in a separate bank account. Under RERA[2], 70% of the funds received from the allottees would be locked-in in a separate bank account till the time, occupancy or completion certificate is obtained. Such funds can be used only in a phased manner in proportion to the percentage of completion of project (to be certified by an engineer, architect and a chartered accountant) for meeting cost of construction and land cost. Therefore, a developer would be restricted to use the funds received for one project for development of other.
In order to optimize cash flow management, it could be in the interests of a real estate developer that each “building” or a phase of a large real estate project be registered as a separate real estate project under RERA. If so be the case, only the funds received for development of each such building would be locked-in till the time completion certificate of that particular building is received. However, if the entire larger real estate project is registered as a single real estate project, then the entire funds would be locked in till the time the completion certificate for the last phase or building is received.
Under RERA, onerous responsibilities are cast upon a promoter such as restriction of receiving more than 10% of the consideration from an allottee as advance if the agreement for sale is not entered into, non-transferability of majority of rights in a real estate project without approval of 2/3rd of allottees, statutory obligation to hold out to the veracity of the advertisement to the public at large as also to deliver the project within the scheduled time of completion failing which an allottee would be entitled to an interest-bearing refund amount, mandatory prior approval of the allottees in case of alteration to the sanctioned plan, etc.
Very interestingly, RERA has also prescribed the model form of agreement to be entered into between the promoter and the allottee(s) which includes the promoter having to give inspection of all relevant documents to the allottee, the sale price being escalation free, the promoter having the obligation of confirming final carpet area post completion of project, and of course, time of delivery of possession. While not directly tax related, the last aspect is also linked to some extent to the controversy of date of possession vis-à-vis the point of time of acquisition of the property by the allottee, though of course, there are a large number of judicial precedents which provide that the date of allotment will be considered as relevant from a capital gains tax investment perspective. In any case, formalising all these aspects will possibly lead to reduction in the tax controversies.
As such, any real estate developer would need to take up the role of a promoter with utmost seriousness since failure of adhering to the statutory obligations would not only attract penal provisions but also prosecution under RERA; for example, non-registration of real estate project under RERA entails a penalty upto 10% of the estimated project cost. One of the controversies that can arise is whether such penalties are deductible in arriving at the taxability income of a real estate developer. The trend of judicial opinion is negative for such penalty to be deducted. The Supreme Court, in various decisions, has held that any penalty paid cannot be claimed as business loss u/s 28 of the Income-tax Act, 1961 (“ITA”); of course, such penalty would, in any case, not be deductible as business expenditure u/s 37 of the ITA by virtue of Explanation 1 to section 37.
RERA and Joint Development Agreement (“JDA”), including Tax Aspects
Where the land prices are skyrocketing, especially in metro cities, a viable route to develop land has been through JDAs where the land owner land grants development rights to a real estate developer to develop the land against which the land owner either receives a share in the developed area or cash consideration or both, which would typically be received at a later point in time.
Historically, taxation of JDAs has been marred with controversy. Earlier, the Revenue Authorities had contended that when a land owner enters into a JDA with a real estate developer, the point of taxation is the time when such agreement is entered into, despite the fact that the actual sale consideration may only be received at a later point in time, whereas the land owner would typically offer the same to tax as and when he receives consideration.
As a partial relief, Finance Act, 2017 introduced a favorable capital gains tax regime for JDAs. Limiting the regime to only individuals and HUFs, section 45(5A) of the ITA (with effect from Financial Year 2017-18) provides that any capital gains arising to an individual or HUF on transfer of land or building or both under a “specified agreement” shall only be chargeable in the year in which a completion certificate is issued by a competent authority and not earlier; therefore, putting to rest this historical controversy, Section 45(5A) of the ITA defers taxation of capital gains in case of a JDA till the time completion certificate for the same is received.
The concept of JDA poses an interesting interplay between the definition of “promoter” under RERA and the definition of “specified agreement” under the ITA. As noted earlier, a promoter is a person who either constructs or “causes to be constructed” a property. This phraseology would, in the ordinary sense, cover JDAs since it is the land owner who causes his land to be constructed by granting development rights to the real estate developer. Therefore, a land owner could be swept under the definition of “promoter” which would obviously entail the onerous responsibilities cast by RERA upon a real estate developer. Consequently, an indemnity agreement between the land owners and the real estate developer to indemnify the land owners from any liabilities arising on account of negligence of the real estate developers would be the need of the hour. It is to be noted that the Maharashtra RERA Authority has granted relied to a land owner being considered as a promoter in cases of a JDA; however, for other states, a land owner, if treated as a promoter, may be discouraged to enter into a JDA in view of the stringent obligations imposed by RERA (jointly and severally with the real estate developer).
Further, the definition of “specified agreement” under the ITA provides that it is a registered agreement in which the land owner agrees to allow another person to develop a real estate project on such land or building in consideration of a share in such land/ building (“Area Share”) supplemented by cash consideration. Therefore, an agreement with only cash consideration or revenue share as consideration may not enjoy the deferral of capital gains tax.
Further, the said section also provides for deemed full value of consideration accruing to the land owner, being the sum total of stamp duty value of the share in developed property as on the date of completion certificate and any cash consideration received for the same. However, it is also provided that 10% tax shall be deducted at source on the gross cash consideration at the time of payment of such sums to the land owner. Since TDS is on a gross amount (without considering the cost of acquisition of land), a careful analysis of would need to be made to ascertain whether such TDS on cash consideration does not exceed the final capital gains tax liability. If the TDS exceeds the capital gains tax liability, since the credit of such TDS would only be granted at the time of discharging final tax liability, refund of the same would also be deferred till the time completion certificate is received.
Incidentally, in relation to JDAs entered into prior to 1 April 2017, as also JDAs entered by any other person other than an individual or an HUF even after 1 April 2017, one needs to see how the law evolves.
RERA and Private Equity Funds
Under the RERA-era, the deals that would be struck between the private equity funds (“PE”) and the real estate developers would undergo a significant change, fundamentally on account of three aspects viz., a) role of private equity investor in day-to-day dealings, b) risk-return expectation; and c) exit from the real estate projects.
Typically, when a PE fund invests in a Special Purpose Vehicle (“SPV”) which seeks to undertake a real estate project, the PE fund not only enters the SPV as a passive financial investor but also as a strategic investor with certain rights such as step-in rights i.e. PE fund will step-in the shoes of the developer, if the developer were to default, and either run the project through itself or appoint a third-party developer. Even otherwise, an investor-cum-developer model could envisage a significant say of a PE fund in management and administration of the SPV. Therefore, effectively, a PE fund, being an active participant in the SPV, could be classified as a “promoter”, being a person who causes a real estate project to be constructed. If a PE fund is considered as a promoter, it would attract all the onerous obligations as statutorily prescribed under RERA. However, whether the PE fund itself would be classified as a promoter or the SPV (and hence, indirectly, the PE fund) is a question which would depend on facts and will evolve going forward.
Further, as a cardinal rule of finance, with more risks, the rewards that would henceforth be sought by the PE fund would also be higher. Further, with mandatory lock-in of funds (to the extent of 70% of the funds received from the allottee) till the time of receipt of completion certificate, monetizing the stake of PE fund prior to completion would become difficult. Therefore, with the PE fund being mandated to virtually be locked-in till the time of receipt of completion certificate, a PE fund could seek higher returns for the time-risk undertaken by it. However, if a PE fund were to structure the infusion of funds as a structured debt as opposed to a plain vanilla equity, a repayment of principal and interest could be considered as a discharge of debt utilized for cost of construction; thereby, being free to be utilized from the said 70% of the funds received.
Lastly, RERA mandates prior approval of 2/3rd of the allottees, if a promoter were to divest majority of the right/ liabilities in the real estate project. Therefore, a PE fund seeking to exit its rights/ liabilities in the real estate project could require prior approval of the allottees as aforementioned. However, where a PE fund seeks to exit by way of sale of shares of SPV, a view could be taken that the rights/ liabilities in the real estate project legally owned by the SPV, per-se, remain intact and it is only the shares of SPV which are being divested; therefore, such divestment may not require prior approval of the allottees.
Life in the RERA-Era
Disruption – as a concept – per se disrupts the entire ecosystem in which a market segment operates. With RERA kicking in, life is surely to be disrupted not only for the real estate developers but also other players in the market such as the land owners and the PE Investors, with the benefactor being the consumers. With the Goods and Service Tax, as well as, the Income Computation and Disclosure Standards also being enforced, the backdrop in which a real estate transaction is undertaken would have to be carefully scrutinized and analysed from the perspective of tax, regulatory, accounting and, obviously RERA.