Another investment avenue rendered unattractive by taxes

Return on Investment for any instrument is highly sensitive to the effective tax leakage. Tax framework of an investment avenue, therefore, determines its success. However, this fact is often ignored while introducing amendments to the tax laws which may unintentionally render an investment avenue unattractive. While the Finance Ministry has also been receptive of the reaction from the capital market participants, but not without a lot of hue and cry and significant damage. This article discusses a recent proposal in the Budget 2023 which is contrary to the Government’s intent of making Business Trusts successful in India.

The change

In the Finance Bill, 2023, the Government has proposed that the ‘repayment of debt/ amortisation of debt’ portion of the distributions from a Business Trust to its unitholders should be taxed in the hands of the unitholders as income from other sources. Such tax would be payable at the applicable slab rates for the unitholder.

What is ‘repayment of debt/ amortisation of debt’?

Business Trusts comprise of Real Estate Investment Trusts and Infrastructure Investment Trusts (‘REITs/ InvITs’). These Business Trusts invest in real estate projects or infrastructure projects such as tolls roads, power projects, warehouses (‘SPVs’) which are highly capital intensive and typically have a long gestation period. This gestation period results in huge book losses in the SPVs which take several years to be recouped and since SPVs are capital intensive, the Business Trusts infuse debt capital to maintain cash extraction flexibility. Debt infusion is often also a result of the debt refinance undertaken by the Business Trusts at the time of acquisition of SPVs. Even after servicing a market appropriate coupon on such debt, these SPVs may turn cash positive after a few years. But this cash is trapped in the SPV since dividends cannot be declared under corporate laws until the SPVs achieve net positive reserves and surplus. It is only logical for the SPVs to repay the debt in order to clear this cash trap.

At Business Trust level, the funding is initially received in the form of equity-like units. However, it is fairly common for the Business Trusts to issue listed debentures (‘NCDs’) in market to further address the debt requirement of the SPVs. It is important to appreciate that the repayment schedule of such NCDs is determined by market forces and these could either have a regular, staggered or a bullet repayment. On the other hand, the repayment schedule of the debt from the SPVs to the Business Trusts depends on the cash availability at the SPV level. It may be virtually impossible for a Business Trust to mirror the debt repayment schedule at both levels. This creates an obvious mismatch and further results in cash accrual at the Business Trust level. As per the relevant SEBI regulations applicable on the Business Trusts, 90% of net distributable cash flows is statutorily required to be distributed to the unitholders. Therefore, when a Business Trust makes distribution in the form of ‘repayment of debt’ it is not a tax evasion strategy but rather a commercial and regulatory compulsion.

Taxation of ‘repayment of debt’

Since the income from the SPVs moves to the unitholders through the Business Trusts, the applicable tax framework provides not only a pass-through status to the Business Trust but also accords the same nature of income in the hands of the unitholder as it were for the Business Trust. In simpler words, it ensures that the all the elements of income are taxed at only one level ie either Business Trust or unitholder and it also ensures that income received by the Business Trust and passed on to the unitholders is taxed in the same nature ie as interest, dividend, capital gains etc. Now ideally, principal repayment of a debt is not an income and therefore debt repayments by SPVs to Business Trusts are not taxable. Therefore, due to the mismatch in repayment schedules at two levels, as discussed above, the principal accrued at Business Trust level is paid to the unitholders and retains the same character and taxability (ie nil).

The Government however looks at this as ‘dual non-taxation’ and ‘tax avoidance’ probably because it seems like a missed revenue opportunity. The increased amount of ‘repayment of debt’ being reported in the income-tax returns in recent years could have been picked up by the ministry and led to this amendment. However, instead of addressing the issue from a business point of view, a half-measure has been introduced to tax this amount as income from other sources. The Finance Ministry may consider the possibility that at times, non-taxable profits and arbitrage result from real commercial factors and tax evasion is not the core intent of investors or businessmen. In fact, while aiming to plug this unintentional arbitrage, the amendment has created a bigger demon.

Issue with the amendment

In the memorandum to the Finance Bill, it has been clarified that ‘dual non-taxation was never the ‘intent’ of the special tax regime. At the same time, the intent of providing a pass-through is conveniently tossed aside to tax ‘repayment of debt’ as income from other sources. It is absurd to consider a real and commercial ‘repayment of debt’, which is not taxable in the hands of the debt investor in any usual scenario, as an income from other sources in the hands of unitholders. This also blatantly disregards the intent behind the special tax regime.

The amendments also fail at providing adequate withholding tax provisions for both resident and non-resident investors. This creates a huge problem for the non-resident investors including sovereign wealth funds and pension funds. As per the present tax provisions, the final applicable tax rate on distributions from Business Trusts to non-resident investors is same as the applicable withholding tax rate. Since there is no withholding tax rate applicable for ‘repayment of debt’, this ‘non-income’ gets taxed as ‘income from other sources’ at whopping 40%. Further, the sovereign wealth funds and pension funds which are provided with a blanket tax exemption on income in the nature of dividend, interest or long-term capital gains from Business Trust, are now taxable at 40% on this amount. This does not seem to be the ‘intent’ of the special tax regime or the amendment. In a similar case, resident investors will now be taxed on ‘repayment of debt’ which otherwise should have been tax free.

How big is the issue?

To give a better context on the effect of the amendment on each of the listed Business Trust, we have provided the breakup of the distributions by each Business Trust in the last 4 quarterly distributions (1):

Business Trust	Repayment of debt	Interest	Dividend	Total distribution	Repayment of debt/ total distribution
Embassy REIT	8.95	2.9	9.51	21.36	41.9%
Mindspace REIT	0	1.42	17.45	18.9	0%
Brookfield REIT	8.87	11.11	0.32	20.3	43.7%
Powergrid InvIT	0.43	7.84	3.70	11.97	3.6%
IRB InvIT (6 quarters)	5.8	7.25	0	13.05	44.4%
Shrem InvIT	9.91	2.54	1.40	13.85	71.5%

It is clear that while varied, a substantial part of distributions is made by way of ‘repayment of debt’ which is not income in commercial sense and is rather a cash pay-out pursuant to a mismatch in debt repayment schedules. Therefore, on an average, 40% of distributions which should not be subject to tax are now taxable in the hands of the unitholders, making it Business Trusts a non-lucrative investment. This has evidently been reflected in the unit prices of the above listed Business Trusts in last couple of days.

Neutralisation of decade long efforts

It is also relevant to note that while the regulatory mechanisms for the Business Trust were introduced in 2014, it took several years and hundreds of amendments to make Business Trusts marketable and attractive for the investors. Such half-thought amendments neutralise almost decade long efforts of the industry. As is the case with most non-resident investors, it is this unpredictable legal policy which makes them apprehensive about investing in India.

We hope that as usual, the industry will lobby to make the ministry understand the repercussions of the amendment and the Finance Act 2023 will correct these errors before more harm is done to the entire investment instrument.

[1] Source: Official Business Trust websites