FPIs in a bind over higher tax on interest income from REIT investments

If an REIT distributes interest income received from SPV, it is taxable as 'interest income' in the hands of the unit holder at 20% plus surcharge and education cess

Foreign portfolio investors (FPIs) are in a spot over the tax to be paid for interest income earned from investments in real estate investment trusts (REITs).

Several FPIs have taken a conservative view and started paying a higher tax of 20 per cent for such income. This is because of the amendment in the definition of ‘securities’ in the Securities Contracts Regulation Act with effect from April 1, 2021, which now extends to the units of REITs as well.

FPIs have the highest institutional holding in all the three REITs listed on the bourses currently. Experts reckon that higher taxes may dissuade future investment in REITs and the government will need to step in to clarify on the tax that needs to be paid.

The tax conundrum

If an REIT distributes interest income that is received from the special purpose vehicle (SPV), the same is taxable in the hands of the unit holder as ‘interest income’.

Section 115AD of the Income Tax Act deals with taxation of FPIs for income earned from securities. It prescribes a tax rate of 20 per cent plus surcharge and education cess with respect to income in respect of securities.

Certain tax treaties do provide relief from the higher rate of tax. However, many of the funds cannot access the tax treaty because of the way they are set up and therefore have to refer back to the domestic tax rates, said experts.

Distribution of interest income by REITs to other non-resident unitholders, however, is governed by Section 115A read with section 194LBA, which prescribes a 5 per cent tax rate plus surcharge and education cess.

“The section that governs FPI taxation talks about securities to be taxed at 20 per cent and does not carve an exception of lower tax at 5 per cent for interest from units of REIT unlike the section which governs taxation for non-residents. This has created confusion in the minds of investors on the quantum of tax that needs to be paid,” said Sunil Badala, partner and national leader of BFSI tax and regulatory, KPMG India.

According to him, investors will have to factor in the higher tax and may back out if they don’t feel the investment is commercially viable. So, the government should clarify on the tax to be applied at the earliest.

“Even today it can be argued that the 5 per cent tax is applicable on interest income from REIT units. FPI investments in other securities such as government and corporate bonds are taxed at lower rates as per section 194 LD, so there is no justification for taxing interest income on REITs at 20 per cent, especially when other non-residents are eligible for lower tax rate of 5 per cent,” Badala said.

"Earlier, FPIs were able to take a view that since income is not in respect of securities, the rate of 20 per cent did not apply and they could apply the lower rate of 5 per cent, which was available in Section 115A," added another person who deals with FPIs.

REITs have become a popular instrument for investment among FPIs like pension funds, superannuation funds, sovereign wealth funds and overseas mutual funds as they offer a steady stream of income on their investments, according to experts.

A REIT typically pays out at least 90 per cent of its net taxable income to its unitholders in the form of dividends and interest.

When a realty firm decides to form a REIT, it becomes the sponsor and appoints a trustee, which holds the real estate assets of the trust in its trusteeship and appoints a manager to manage the assets and make investment decisions. A REIT may control its real estate holdings either directly or through a SPV, which is a domestic company.