Private Equity and Debt in Real Estate

Transcription

1 MUMBAI SILICON VALLEY BANGALORE SINGAPORE MUMBAI BKC NEW DELHI MUNICH Private Equity and Debt in Real Estate February 2015 Copyright 2015 Nishith Desai Associates

2 Private Equity and Debt in Real Estate About NDA Nishith Desai Associates (NDA) is a research based international law firm with offices in Mumbai, Bangalore, Silicon Valley, Singapore, New Delhi, Munich. We specialize in strategic legal, regulatory and tax advice coupled with industry expertise in an integrated manner. We focus on niche areas in which we provide significant value and are invariably involved in select highly complex, innovative transactions. Our key clients include marquee repeat Fortune 500 clientele. Core practice areas include Fund Formation, Fund Investments, Corporate & Securities Law, Mergers & Acquisitions, Capital Markets, International Tax, International Tax Litigation, Litigation & Dispute Resolution, Employment and HR, Intellectual Property, Competition Law, JVs & Restructuring, General Commercial Law and Succession and Estate Planning. 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4 Private Equity and Debt in Real Estate Contents ABBREVIATIONS PRIVATE EQUITY IN 2014: LESSONS LEARNT AND EXPECTATIONS IN 2015! 03 I. Withholding Taxes 03 II. General Anti-Avoidance Rules ( GAAR ) 03 III. Companies Act, IV. Representation and Warranties Insurance ( R&W Insurance ) 04 V. Structured Debt Transactions 04 VI. RBI s Timeline for Regulatory Approval 05 VII. Shareholder Activism 05 VIII. Diligence 05 IX. Entry and Exit Facilitation 05 X. Externalisation 05 XI. Depository Receipts ( DRs ) 05 XII. Conclusion REGULATORY FRAMEWORK FOR FOREIGN INVESTMENT 07 I. Foreign Direct Investment 07 II. FVCI Route 10 III. FPI Route 11 IV. NRI Route LEGAL FRAMEWORK KEY DEVELOPMENTS 18 I. Shares with Differential Rights 18 II. Listed Company 18 III. Inter-Corporate Loans and Guarantee 18 IV. Deposits 19 V. Insider Trading 19 VI. Squeeze out Provisions 19 VII. Directors 19 VIII. Control and Subsidiary and Associate Company 20 IX. Merger of an Indian Company with Offshore Company TAXATION FRAMEWORK 21 I. Overview of Indian Taxation System 21 II. Specific Tax Considerations for PE Investments EXIT OPTIONS / ISSUES 26 I. Put Options 26 II. Buy-Back 26 III. Redemption 27 IV. Initial Public Offering 27 V. Third Party Sale 27 VI. GP Interest Sale 28

5 Private Equity and Debt in Real Estate VII. Offshore Listing 28 VIII. Flips 28 IX. Domestic REITs DOMESTIC POOLING 30 I. AIF 30 II. NBFC THE ROAD FORWARD 33 I. REITs 33 II. Partner issues 33 III. Arbitration / Litigation 33 IV. Security Enforcement 33 V. Offshore listing allowed for unlisted Indian companies 34 ANNEXURE I Foreign Investment Norms for Real Estate Liberalized 35 ANNEXURE II Foreign Investment Norms in Real Estate Changed 42 ANNEXURE III Specific Tax Risk Mitigation Safeguards for Private Equity Investments 44 ANNEXURE IV Flips and Offshore REITs 46 ANNEXURE V Reits: Tax Issues and Beyond 49 ANNEXURE VI NBFC Structure for Debt Funding 51 ANNEXURE VII Challenges in Invocation of Pledge of Shares 59

6 Private Equity and Debt in Real Estate Abbreviations Abbreviation Meaning / Full Form AAR Authority for Advanced Rulings AIF Alternate Investment Funds AIF Regulations SEBI (Alternative Investment Funds) Regulations, 2012 CBDT Central Board of Direct Taxes CCDs Compulsorily Convertible Debentures CCPS Compulsorily Convertible Preference Shares DCF Discounted Cash Flows DDT Dividend Distribution Tax DIPP Department of Industrial Policy and Promotion DTAA Double Taxation Avoidance Agreements ECB External Commercial Borrowing FATF Financial Action Task Force FDI Foreign Direct Investment FDI Policy Foreign Direct Investment Policy dated April 17, 2014 FEMA Foreign Exchange Management Act FIPB Foreign Investment Promotion Board FII Foreign Institutional Investor FPI Foreign Portfolio Investor FVCI Foreign Venture Capital Investor GAAR General Anti-Avoidance Rules GP General Partner HNI High Net worth Individuals InvIT Infrastructure Investment Trust InvIT Regulations Securities And Exchange Board of India (Infrastructure Investment Trusts) Regulations, IPO Initial Public Offering ITA Income Tax Act, 1961 LP Limited Partner LRS Liberalized Remittance Scheme NBFC Non-Banking Financial Services NCD Non-Convertible Debenture NRI Non-Residential Indian PE Permanent Establishment PIO Person of Indian Origin PIS Portfolio Investment Scheme PN2 Press Note 2 of 2005 Press Note 10 Press note 10 of 2014 issued by the Ministry of Commerce and Industry dated December 03, 2014 Press Release Press release issued by the Ministry of Commerce and Industry dated October 29,

7 Abbreviations Provided upon request only QFI RBI REITs REIT Regulations REMF Rs./INR Qualified Foreign Investor Reserve Bank of India Real Estate Investment Trusts Securities And Exchange Board of India (Real Estate Investment Trusts) Regulations Real Estate Mutual Fund Rupees SEZ Act Special Economic Zones Act, 2005 SBT SEBI SPV TISPRO Regulations Singapore Business Trust Securities and Exchange Board of India Special Purpose Vehicle Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations,

8 Private Equity and Debt in Real Estate 1. Private Equity in 2014: Lessons Learnt and Expectations in 2015! Just as we gear up to the transformational Budget 2015 as promised by the Modi Government, we bring to you a crisp summary of how private equity ( PE ) performed in 2014, what were the lessons learnt and what lies ahead. India witnessed an increase in the number and size of PE investments made in 2014 aggregating to around $11.5 billion, which is 17% higher in terms of the total investment value as compared to the same period last year. 1 E-commerce (led by Flipkart with two major rounds of funding) 2 followed by financial services, power and energy and engineering drove most of the activity with renewed interest in real estate sector as well. In the past years, exit routes have always remained one of the key deterrents for investors to invest into India, however last year we saw as many as 221 exits (including partexit tranches) amounting to around $3.8 billion. 3 Following are some of transaction trends / issues that gained significance in 2014, and which may be talked about more in 2015: I. Withholding Taxes Notwithstanding the fact that the seller was an eligible tax resident of Mauritius or Singapore or other treaty jurisdiction, buyers in almost all secondary transactions insisted on withholding full capital gains taxes, and typically negotiated for a host of alternatives such as NIL withholding certificate, tax escrow, tax insurance, tax opinions and specific tax indemnities. With tax insurance not being available in all cases, deals were seen being done typically on the back of tax opinion and tax indemnity. Please see our article on such safeguards. With Cyprus notified as a non-cooperative jurisdiction under Section 94A of the Income Tax Act, we saw increased applications being made to tax authorities under Section 197 of the IT Act for nil withholding. II. General Anti-Avoidance Rules ( GAAR ) Though the government has promised to provide tax predictability, GAAR continues to remain a concern. Please click here 4 for our detailed article on GAAR. Even in 2015, though there are strong indications that GAAR may be deferred, the ability of the tax department to bring any income generating from impermissible avoidance arrangements post August 30, 2010 may remain a concern. III. Companies Act, also saw the implications of the new Companies Act, 2013 ( 2013 Act ) replacing the Companies Act 1956 ( 1956 Act ) as majority of provisions of the 2013 Act were notified only in As of this date, 1956 Act has not been completely repealed and some of the major portions continue to be in force along with the provisions of the 2013 Act. We have analysed the changes brought in by the 2013 Act in detail, please click here 5 for our analysis. Some of the important provisions of the 2013 Act which gained significance last year are: A. Directors liability For the first time ever, the duties of the directors have been codified and a monetary punishment has been prescribed in case the directors act in contravention of their prescribed duties. Further, under the 2013 Act, any director who becomes aware of any contravention of the provisions of the 2013 Act by way of his participation in the board meeting or receipt of information under any proceedings etc. but does not object to such contravention is termed as an officer in default and the concerned director is subject to the punishment prescribed under the 2013 Act. Such liability also

9 Private Equity in 2014: Lessons Learnt and Expectations in 2015! Provided upon request only extends to the non-executive directors in addition to the executive directors. Notification of these provisions last year made the investors re-think about the board position, and many investors in practice appointed an observer even when they had a right to appoint a director. Directors and Officers Liability Insurance (D&O Insurance) was seen as a necessity, even though in some cases such insurance has been found to be inadequate. B. Insider trading Insider trading provisions do exist for listed companies and very recently the Securities Exchange Board of India ( SEBI ) has notified the new regulations (please click here 6 to read our analysis on the same). However, the 2013 Act has also introduced an insider trading provision, which in addition to public listed companies, also applies to unlisted companies (whether public or private). Please click here 7 for our article on the new insider trading regulations. C. Voting arrangements commercials. IV. Representation and Warranties Insurance ( R&W Insurance ) R&W insurance gained popularity in 2014, especially in secondaries between PE players. Since in such deals, (i) the original promoter or the company may not directly benefit, (ii) the selling investor is typically not involved in the day to day management of the company, and (iii) the selling investor is not in a position to give business related warranties, R&W Insurance was seen as an important risk and liability mitigation tool at a rather reasonable premium. This also is the case, where the fund life of the selling investor is going to end soon. The costs for such R&W Insurance could be borne completely by the seller, or shared between the buyer and the seller. In cases where the promoter may not have the financial wherewithal to honor his / its representations and warranties, R&W Insurance offered an ideal prospect in deal making. Under 1956 Act, concept of different classes of shares i.e. equity shares and preference shares was not applicable to private companies, and hence such companies were allowed to issue shares (whether equity or preference) with differential rights. For instance, preference shares with voting rights on as if converted basis, etc. However under the 2013 Act, (i) the provision relating to different classes of shares has been made applicable to both private and public companies; (ii) no separate exemption has been provided to private companies for the issuance of shares (whether equity or preference) with differential rights; and (iii) it has been specifically provided that preference shares cannot have voting rights; therefore, private companies now cannot issue preference shares with voting rights. Since, preference shares continue to be the preferred instrument of investment because of certain other benefits such as better enforcement of anti-dilution and liquidation preference, we have seen more voting rights arrangements being entered into between the shareholders, to give effect to the V. Structured Debt Transactions Structured debt, mostly listed non-convertible debentures with payable-when-able structures or variable-linked-coupon structures gained credence in 2014 as well. Such structures were also seen in promoter funding structures where the promoter entity issues structured debt to acquire shares in their listed company with the return on these debt instruments linked to performance of the listed stock with some downside protection. As these are debt instruments, PE investors derived comfort from: (i) guaranteed returns plus equity upside depending upon the company s EBIDTA, stock prices, cash flows, etc.; and (ii) security creation in the form of mortgage, pledge, guarantee etc. For the promoters, such instruments offered tax optimization without equity dilution. Please click here 8 for our research paper on Private Equity and Private Debt Investments in India for a more detailed analysis pdf

10 Private Equity and Debt in Real Estate VI. RBI s Timeline for Regulatory Approval In July last year, RBI came out with certain timelines for different kinds of regulatory approvals. Under these timelines, RBI has made its departments answerable in case they exceed the prescribed timeline. The investor community and other stakeholders have always been apprehensive about approaching any regulatory body for any approval and therefore the transactions were typically structured in a way to avoid the requirement of any approvals, at times, by even letting go of certain rights. This was because, in most cases, the regulatory bodies instead of opining on the application would just hold on, leading to unnecessary delays in the project. But now with the RBI s Timelines for Regulatory Approvals, the stakeholders would have more certainty from a timeline perspective, and hence they will be more forthcoming in approaching them for the approvals. VII. Shareholder Activism Shareholder activism has slowly gathered pace in India. Several big conglomerates last year faced the ire of minority shareholders who rejected their various resolutions like setting up of a subsidiary company, related party transactions, increase in the remuneration of the top executives, disposal of an undertaking etc. 9 Some reports suggest that the instances of shareholder activism in India are highest in Asia. 10 Advent of shareholder activism in India is a welcome change and is being appreciated by global investors as it brings transparency in the system and also helps the minority shareholders to raise their concerns directly with the top management of the company. It also ensures that the interest of the various investors, be it small retail investors or an institutional investor is safeguarded at all times and the companies provide detailed rationale for each resolution proposed and also to address the perceptional issues as well. While shareholder activism may bring in more transparency into the system, if misused it can also lead to hampering of the decision making process in the company. VIII. Diligence 2014 witnessed investors conducting more stringent background checks on the promoters and key managerial personnel. Forensic audits and anticorruption / anti-bribery compliances gained increased importance. 11 IX. Entry and Exit Facilitation RBI relaxed the DCF based pricing for entry and exits to a more liberal internationally accepted pricing methodology. Put options (common mode of exit in certain asset classes like real estate) were legitimized. 12 Capital account controls were also relaxed to allow for partly paid shares and warrants, which were quite helpful in structuring foreign investments within the convoluted and stringent Indian regulatory framework. X. Externalisation Externalization, or setting up of offshore holding companies for Indian assets, continued to attract both private equity players and their portfolio companies, especially in the tech space. Some of the major reasons for doing so include tax benefits at the time of exit, avoiding Indian exchange control issues, mitigating currency fluctuation risk, better enforceability of rights, etc. For a more detailed analysis on externalisation, please click here. 13 XI. Depository Receipts ( DRs ) Ministry of Finance allowed issuance of ADRs / GDRs both sponsored and unsponsored by unlisted companies in India. For further details on the new depository receipt regulation, please click here. 14 This allowed for Indian companies to tap global

11 Private Equity in 2014: Lessons Learnt and Expectations in 2015! Provided upon request only capital markets without first going public in India considering that only a handful of Indian companies went public in DRs also allow a tax optimized entry and exit route for private equity to invest in Indian companies. 15 Please click here 16 to refer to our article on the benefits of issuing DRs. C. Creating vibrant public markets Institutional play in bourses needs to be encouraged, and for that purpose restrictions on insurance companies and pension funds on capital markets exposure need to be relooked at. Conclusion Year 2015 started off with Sensex zooming to an all-time high level, reduction in the lending rates by RBI, controlled inflation, certainty of achieving fiscal targets, RBI allowing an India conglomerate group to give a pre-decided downside protection on equity shares which is reportedly more than 2 time the existing fair market value of the equity shares. All these factors will certainly improve the image of India in the eyes of the international investors. However, there remain certain issues/demands which if accommodated in the Budget 2015 will boost the PE investments in India, such as: D. Defer and Rationalize GAAR While there are reports that the Government is contemplating to defer GAAR, the government should more importantly focus on certainty, fairness and stability in the implementation of GAAR. E. FVCI Investment FVCIs should be permitted to invest in all sectors (except the current negative list), rather than the current nine sectors that FVCIs are eligible to invest in. A. MAT Government should exclude Special Economic Zones (SEZ) and transfers to real estate investment trusts (REITs) from the purview of minimum alternate tax ( MAT ). Even for other sectors the rate at which MAT is imposed should be reduced to around 10%. B. Tax Pass Through Tax pass through should be provided to all the alternative investment funds, and not just Venture Capital Funds. This should not result in any tax leakage for the revenue since anyways either the trust or its beneficiaries can be taxed, but will go a long way in giving tax predictability to investors. F. Transfer Taxes In order to ensure ease of exit, revenue should provide tax certainity on both direct and indirect transfers. On direct transfers, there should be certainty to tax treaty entitlement and attendant capital gains treatment. Such certainty will allay the unnecessary costs of tax insurance and make transfers of Indian assets easier. From an indirect transfer (Vodafone case) perspective, the government should clearly define the scope and extent of the terms such as transfer, interest, substantially in the context of indirect transfers, and accept Shome Committee s recommendation that the term substantially should mean that alteast 50% of the value of the overseas entity derives its value from Indian assets

12 Private Equity and Debt in Real Estate 2. Regulatory Framework for Foreign Investment Foreign investments into India are primarily regulated by primarily three regulators, the Reserve Bank of India ( RBI ), the Foreign Investment Promotion Board ( FIPB ) and the Department of Industrial Policy and Promotion ( DIPP ). In addition to these regulators, if the securities are listed or offered to the public, dealings in such securities shall also be regulated by the Indian securities market regulator, Securities and Exchange Board of India ( SEBI ). Foreign investment into India is regulated under Foreign Exchange Management Act, 1999 ( FEMA ) and the regulations thereunder, primarily Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000 ( TISPRO Regulations ). Keeping in view the current requirements, the DIPP (an instrumentality of the Ministry of Commerce & Industry), and the RBI make policy pronouncements on foreign investment through Press Notes / Press Releases / Circulars which are notified by the RBI as amendments to the TISPRO Regulations. These notifications take effect from the date of issue of Press Notes / Press Releases / Circulars, unless specified otherwise therein. In order to bring clarity and certainty in the policy framework, the DIPP for the first time issued a consolidated policy relating to FDI in India on April 1, 2010, which is now revised annually and represents the current policy framework on FDI. The latest policy as of the date of this paper is dated April 17, 2014 ( FDI Policy ). Foreign investment can be classified into the following investment regimes i. Foreign Direct Investment ( FDI ); ii. Foreign Venture Capital Investment regime, for investments made by SEBI registered Foreign Venture Capital Investors ( FVCI ); iii. Foreign Portfolio Investor regime, for investments made by SEBI registered Foreign Portfolio investor ( FPI ); iv. Non Resident Indian regime, for investments made by non-resident Indians and persons of Indian origin ( NRI ). Separately, Indian entities are not permitted to avail of External Commercial Borrowings ( ECB ), which are essentially borrowings in foreign currency, if the end use of the proceeds of the ECB will be utilized towards investment in real estate. However, recently, the ECB norms were relaxed to allow ECB in low cost housing. This paper does not discuss ECB. We now discuss each of the investment routes together with their attendant regulatory challenges. Tax issues are dealt with later on under a separate taxation head in this paper. I. Foreign Direct Investment Under the FDI Policy, Indian companies with FDI are prohibited from engaging in Real Estate Business, however, the term Real Estate Business was not defined in the FDI Policy. Recently, DIPP issued press note 10 of 2014 ( Press Note 10 ), wherein it defined the term as dealing in land and immoveable property with a view to earning profit or earning income there from and does not include development of townships, construction of residential/ commercial premises, roads or bridges, educational institutions, recreational facilities, city and regional level infrastructure, townships. Over the period of years, Government has liberalized foreign investment in real estate sector. First notable step in this direction was taken in 2005 when DIPP issued the press note 2 of 2005 ( PN2 ). PN2 permitted FDI in townships, housing, builtup infrastructure and construction-development projects (which would include, but not be restricted to, housing, commercial premises, hotels, resorts, hospitals, educational institutions, recreational facilities, city and regional level infrastructure) subject to fulfillment of certain entity level and project level requirements. PN2 required that real estate companies seek foreign investments only for construction and development of projects, and not for completed projects. Last year, finance minister in his budget speech had announced that the investment conditions for FDI in real estate will be liberalized. Thereafter, the Ministry of Commerce and Industry issued a press release ( Press Release ) on October 29th, 2014 outlining the changes proposed in the FDI Policy. This was followed by Press Note 10 and an 7

13 Regulatory Framework for Foreign Investment Provided upon request only RBI circular dated January 22, 2015, which formally notified the relaxations. Though most of the changes proposed in the Press Release have substantially been incorporated in the Press Note, there are certain differences in the Press Note as against Press Release. Following are few of the key changes introduced by the Press Note 10: A. Minimum area for the Project Development has been Changed i. Development of Serviced Plots Minimum land area requirement has been done away with, while earlier the minimum land area of 10 hectares was prescribed for the development of serviced plots. ii. Construction-Development Projects Minimum area has been reduced for the construction development projects. Press Note 10 prescribes that the minimum area for a construction development project shall be 20,000 sq. meters of floor area whereas earlier the minimum area prescribed was 50,000 sq. meters of built-up area. B. Minimum Capitalization The minimum capitalization has been reduced to US $5 million. Further, different minimum capitalization prescribed for wholly owned subsidiaries and joint ventures with the Indian partners has been done away with. C. Affordable Housing An exemption is provided to the real estate projects which allocate 30% of the total project cost towards the affordable housing projects from complying with the minimum land area and minimum capitalization requirements. Press Note defines affordable housing projects as projects where at least 40% of the FAR / FSI is for dwelling unit of floor area of not more than 140 sq. meters, and out of the total FAR / FSI reserved for affordable housing, at least 1/4th (one-fourth) should be for houses of floor area of not more than 60 sq. meters. D. Complete Assets Press Note 10 has clarified that 100 percent FDI under the automatic route is permitted in completed projects for operation and management of townships, malls/ shopping complexes and business centres. It has been long debated whether FDI should be permitted in commercial completed real estate. By their very nature, commercial real estate assets are stable yield generating assets as against residential real estate assets, which are also seen as an investment product on the back of the robust capital appreciation that Indian real estate offers. To that extent, if a company engages in operating and managing completed real estate assets like a shopping mall, the intent of the investment should be seen to generate revenues from the successful operation and management of the asset (just like a hotel or a warehouse) as against holding it as a mere investment product (as is the case in residential real estate). The apprehension of creation of a real estate bubble on the back of speculative land trading is to that naturally accentuated in context of residential real estate. To that extent, operation and management of a completed yield generating asset is investing in the risk of the business and should be in the same light as investment in hotels, hospitals or any asset heavy asset class which is seen as investment in the business and not in the underlying real estate. Even for REITs, the government was favorable to carve out an exception for units of a REIT from the definition of real estate business on the back of such understanding, since REITs would invest in completed yield general real estate assets. The Press Note 10 probably aims to follow the direction and open the door for foreign investment in completed real assets, however the language is not entirely the way it should have been and does seem to indicate that foreign investment is allowed only in entities that are operating an managing completed assets as mere service providers and not necessarily real estate. While it may seem that FDI has now been permitted into completed commercial real estate sector, the Press Note 10 leaves the question unanswered whether these companies operating and managing the assets may own the assets as well. Please refer to Annexure I 17 for our analysis on the Press Release cache=1&chash=aab4287c1bb5517a914df41d068bd6fc 8

14 Private Equity and Debt in Real Estate As mentioned above, though substantial part of the Press Release has been incorporated in the Press Note there are some differences as well, some of which have been highlighted below: i. Lock-in restriction The Press Release proposed that a foreign investor could exit its investment either on completion of the project or completion of three years from the date of final investment, subject to the development of the trunk infrastructure. 18 The Press Note 10 has done away with such restrictions, now a foreign investor can exit its investment only on the completion of the project or after the development of the trunk infrastructure. This will entail both positive and negative consequences. As this will provide stimulus for small projects wherein the project can be completed before three years. But, it will pose practical issues to the projects which are developed in phases, because it is unclear whether a foreign investor can now exit upon completion of any phase of project, when the trunk infrastructure for other phases is not developed. ii. Combination project The Press Release had retained the investment condition for the development of a combination project i.e. a combination project will have to comply with the minimum area requirement proposed for the service plots or construction development projects. However, it seems that the concept of combination project has been done away with as there is no mention of the combination project in the Press Note 10. Please refer to Annexure II 19 for our detailed analysis on the differences in the Press Note as against the Press Release. The liberalization of the FDI in the real estate sector will definitely provide real estate sector with the much needed impetus. However, the following issue may cause concern to the investors at large: Hitherto under the FDI Policy, a condition was imposed that the FDI into a project can only be brought in within 6 months of the commencement of business of the company. However, the term commencement of business was not defined, regulator s view was that the period of 6 months was to be calculated from the earlier of the date on which the investment agreement was signed by the investor, or the date the funds for the first tranche are credited into the account of the company. But, under the Press Note 10 this condition has been changed to 6 months from the commencement of the project, which is defined as the date of approval of the building plan/lay out plan by the relevant statutory authority. This will hinder foreign investment in the brownfield projects and under construction projects which are stalled due to funding requirement. i. Instruments for FDI As per the FDI Policy, FDI can be routed into Indian investee companies by using equity shares, fully, and mandatorily/compulsorily Convertible Debentures ( CCDs ) and fully and Compulsorily Convertible Preference Shares ( CCPS ). 20 Debentures which are not CCDs or optionally convertible instruments are considered to be ECB and therefore, are governed by clause (d) of sub-section 3 of section 6 of FEMA read with Foreign Exchange Management (Borrowing or Lending in Foreign Exchange) Regulations, 2000 as amended from time to time. RBI recently amended the TISPRO Regulation to permit issuance of partly paid shares and warrants to non-residents (under the FDI and the FPI route) subject to compliance with the other provisions of the FDI and FPI schemes. Since, these CCPS and CCDs are fully and mandatorily convertible into equity, they are regarded at par with equity shares and hence the same are permissible as FDI. Further, for the purpose of minimum capitalization, in case of direct share issuance to non-residents, the entire share premium received by the Indian company is included. However, in case of secondary purchase, only the issue price of the instrument is taken into account while calculating minimum capitalization. Herein below is a table giving a brief comparative analysis for equity, CCPS and CCDs: i. Commencement of business vis-à-vis Commencement of project 18. Roads, water supply, street lighting, drainage and sewerage Please refer below to paragraph (3)(1) on put options 9

15 Regulatory Framework for Foreign Investment Provided upon request only Particulars Equity CCPS CCD Basic Character Liability to Pay Participation in governance and risk based returns Dividend can be declared only out of profits Assured Dividend Convertible into Equity Fixed dividend if profits accrue Assured Coupon Convertible into Equity Fixed Interest payment - not dependent on accrual of profits Limits to Payment No cap on dividend Dividend on CCPS cannot exceed 300 basis points over and above the prevailing SBI prime lending rate in the financial year in which CCPS is issued. No legal restriction on interest on CCD, however in practice it is benchmarked to CCPS limits. Tax Efficiency No tax deduction, dividend payable from post-tax income - Dividend 15% 21 in the hands of the company Liquidation Preference Others Interest expense deductible Withholding tax as high as 40% but it can be reduced to 5% if investment done from favourable jurisdiction CCD ranks higher than CCPS in terms of liquidation preference. Equity gets the last preference. Buy-back or capital reduction permissible CCPS and CCDs need to be converted to equity before they can be bought back or extinguished by the Indian company. ii. Pricing Requirements TISPRO Regulations regulate the price at which a foreign direct investor invests into an Indian company. Recently, RBI amended the TISPRO Regulations wherein it rationalized the pricing guidelines from the hitherto Discounted Cash Flows ( DCF ) / Return on Equity (RoE) to internationally accepted pricing methodologies. Accordingly, shares in an unlisted Indian company may be freely issued or transferred to a foreign direct investor, subject to the following conditions being satisfied: i. The price at which foreign direct investor subscribes to / purchases the Indian company s shares is not lower than the floor price computed on the basis of the internationally accepted pricing method. However, if the foreign investor is subscribing to the memorandum of the company, the internationally accepted pricing methodologies does not apply 22 ; ii. The consideration for the subscription / purchase is brought into India prior to or at the time of the allotment / purchase of shares to / by the foreign direct investor. If any of the above conditions is not complied with, then the prior approval of the FIPB and / or the RBI would be required. If the foreign investor is an FVCI registered with the SEBI, then the pricing restrictions would not apply. In addition, if the securities are listed, the appropriate SEBI pricing norms become applicable. II. FVCI Route SEBI introduced the SEBI (Foreign Venture Capital Investors) Regulations, 2000 ( FVCI Regulations ) to encourage foreign investment into venture capital undertakings. 23 The FVCI Regulations make it mandatory for an offshore fund to register itself with SEBI. FVCIs have the following benefits: 21. All tax rates mentioned herein are exclusive of surcharge and education cess. 22. RBI clarified in its A.P. (DIR Series) Circular No. 36 dated September 26, 2012, that shares can be issued to subscribers (both non-residents and NRIs) to the memorandum of association at face value of shares subject to their eligibility to invest under the FDI scheme. The DIPP inserted this provision in the FDI Policy, providing that where non-residents (including NRIs) are making investments in an Indian company in compliance with the provisions of CA 1956, by way of subscription to its Memorandum of Association, such investments may be made at face value subject to their eligibility to invest under the FDI scheme. This addition in the FDI Policy is a great relief to non-resident investors (including NRIs) in allowing them to set up new entities at face value of the shares and in turn reduce the cost and time involved in obtaining a DCF valuation certificate for such newly set up companies. 23. Venture capital undertaking means a domestic company:- (i) whose shares are not listed in a recognised stock exchange in India; (ii) which is engaged in the business of providing services, production or manufacture of articles or things, but does not include such activities or sectors which are specified in the negative list by the Board, with approval of Central Government, by notification in the Official Gazette in this behalf. 10

16 Private Equity and Debt in Real Estate A. Free Pricing The entry and exit pricing applicable to FDI regime do not apply to FVCIs. To that extent, FVCIs can subscribe, purchase or sell securities at any price. B. Instruments Unlike FDI regime where investors can only subscribe to only equity shares, CCDs and CCPS, FVCIs can also invest into Optionally Convertible Redeemable Preference Shares ( OCRPS ), Optionally Convertible Debentures ( OCDs ) and even Non-Convertible Debenture ( NCDs ). C. Lock-in Under the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 ( ICDR Regulations ) the entire pre-issue share capital (other than certain promoter contributions which are locked in for a longer period) of a company conducting an initial public offering ( IPO ) is locked for a period of 1 year from the date of allotment in the public issue. However, an exemption from this requirement has been granted to registered FVCIs, provided, the shares have been held by them for a period of at least 1 year as on the date of filing the draft prospectus with the SEBI. This exemption permits FVCIs to exit from investments immediately post-listing. D. Exemption under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 Takeover Code ( Takeover Code ) SEBI has also exempted promoters of a listed company from the public offer provisions in connection with any transfer of shares of a listed company, from FVCIs to the promoters, under the Takeover Code. E. QIB Status FVCIs registered with SEBI have been accorded qualified institutional buyer ( QIB ) status and are eligible to subscribe to securities at an IPO through the book building route. However, the RBI while granting the permission/ certificate mandates that an FVCI can only invest in the following sectors, viz. infrastructure sector, biotechnology, IT related to hardware and software development, nanotechnology, seed research and development, research and development of new chemical entities in pharma sector, dairy industry, poultry industry, production of bio-fuels and hotelcum-convention centers with seating capacity of more than three thousand. III. FPI Route Last year SEBI introduced the SEBI (Foreign Portfolio Investment) Regulation 2014 ( FPI Regulations ). FPI is the portfolio investment regime. The Foreign Institutional Investor ( FII ) and Qualified Foreign Investor ( QFI ) route have been subsumed into the FPI regime. Exiting FIIs, or sub-account, can continue, till the expiry of the block of three years for which fees have been paid as per the SEBI (Foreign Institutional Investors) Regulations, 1995, to buy, sell or otherwise deal in securities subject to the provisions of these regulations. However, FII or subaccount shall be required to pay conversion fee of USD 1, on or before the expiry of its registration for conversion in order to buy, sell or otherwise deal in securities under the FPI Regulations. In case of QFIs, they may continue to buy, sell or otherwise deal in securities subject to the provisions of these regulations, for a period of one year from the date of commencement of FPI Regulations, or until he obtains a certificate of registration as FPI, whichever is earlier. Under the new regime SEBI has delegated the power to designated depository participants ( DDP ) who will grant the certificate of registration to FPIs on behalf of SEBI. A. Categories Each investor shall register directly as an FPI, wherein the FPIs have been classified into the following three categories on the basis of risk-based approach towards know your customer. i. Category I FPI Category I includes Government and governmentrelated investors such as central banks, Governmental agencies, sovereign wealth funds or international and multilateral organizations or agencies. 24. Specified in Part A of the Second Schedule of the FPI Regulations 11

17 Regulatory Framework for Foreign Investment Provided upon request only ii. Category II FPI Category II includes the following: i. Appropriately regulated broad based funds; ii. Appropriately regulated persons; iii. Broad-based funds that are not appropriately regulated but their managers are regulated; iv. University funds and pension funds; and v. University related endowments already registered with SEBI as FIIs or sub-accounts The FPI Regulations provide for the broad-based criteria. To satisfy the broad-based criteria two conditions should be satisfied. Firstly, fund should have 20 investors even if there is an institutional investor. Secondly, both direct and underlying investors i.e. investors of entities that are set up for the sole purpose of pooling funds and making investments shall be counted for computing the number of investors in a fund. iii. Category III FPI Category III includes all FPIs who are not eligible under Category I and II, such as endowments, charitable societies, charitable trusts, foundations, corporate bodies, trusts, individuals and family offices. B. Investment Limits The FPI Regulations states that a single FPI or an investor group shall purchase below ten percent of the total issued capital of a company. The position under the FII Regulations was that such shareholding was not to exceed ten percent of the share capital. Under the FPI Regulations ultimate beneficial owners investing through the multiple FPI entities shall be treated as part of the same investor group subject to the investment limit applicable to a single FPI. C. ODIs/P Note An offshore derivative instrument ( ODIs ) means any instrument, by whatever name called, which is issued overseas by a foreign portfolio investor against securities held by it that are listed or proposed to be listed on any recognized stock exchange in India, as its underlying units. Participatory Notes ( P-Notes ) are a form of ODIs. 25 P-notes are, by definition a form of ODI including but not limited to swaps 26, contracts for difference 27, options 28, forwards 29, participatory notes 30, equity linked notes 31, warrants 32, or any other such instruments by whatever name they are called. Below is a diagram that illustrates the structure of an ODI. 25. Section 2(1)(j) of the FPI Regulations 26. A swap consists of the exchange of two securities, interest rates, or currencies for the mutual benefit of the exchangers. In the most common swap arrangement one party agrees to pay fixed interest payments on designated dates to a counterparty who, in turn, agrees to make return interest payments that float with some reference rate. 27. An arrangement made in a futures contract whereby differences in settlement are made through cash payments, rather than the delivery of physical goods or securities. At the end of the contract, the parties exchange the difference between the opening and closing prices of a specified financial instrument. 28. An option is a financial derivative that represents a contract sold by one party to another party. It offers the buyer the right, but not the obligation, to call or put a security or other financial asset at an agreed-upon price during a certain period of time or on a specific date. 29. A forward contract is a binding agreement under which a commodity or financial instrument is bought or sold at the market price on the date of making the contract, but is delivered on a decided future date. It is a completed contract as opposed to an options contract where the owner has the choice of completing or not completing. 30. Participatory notes (P-notes) are a type of offshore derivative instruments more commonly issued in the Indian market context which are in the form of swaps and derive their value from the underlying Indian securities. 31. An Equity-linked Note is a debt instrument whose return is determined by the performance of a single equity security, a basket of equity securities, or an equity index providing investors fixed income like principal protection together with equity market upside exposure. 32. A Warrant is a derivative security that gives a holder the right to purchase securities from an issuer at a specific price within a certain time frame. 12

18 Private Equity and Debt in Real Estate Returns on underlying portfolio Investment holdings to hedge exposures under the ODI as issued Eligible FPI s Distributions including dividends and capital gains Fixed or variables payments. Eg: LIBOR plus a margin on a sum equivalent to a loan on the value of the underlying portfolio of the issued ODI Counterparty (holder of ODI) Portfolio of listed securities on any recognized stock exchange in India Fig 1: Investment through ODIs. The position of the holder of an ODI is usually that of an unsecured counterparty to the FPI. Under the ODI (the contractual arrangement with the issuing FPI), the holder of a P-note is entitled only to the returns on the underlying security with no other rights in relation to the securities in respect of which the ODI has been issued. ODIs have certain features that prevent the holder of such instruments from being perceived as the beneficial owner of the securities. These features include the following aspects: (i) whether it is mandatory for the FPI to actually hedge its underlying position (i.e. actually hold the position in Indian securities), (ii) whether the ODI holder could direct the voting on the shares held by the FPI as its hedge, (iii) whether the ODI holder could be in a position to instruct the FPI to sell the underlying securities and (iv) whether the ODI holder could, at the time of seeking redemption of that instrument, seek the FPI to settle that instrument by actual delivery of the underlying securities. From an Indian market perspective, such options are absent considering that the ownership of the underlying securities and other attributes of ownership vest with the FPI. Internationally, however, there has been a precedence of such structures, leading to a perception of the ODI holder as a beneficial owner albeit only from a reporting perspective under securities laws. 33 The FPI Regulations provide that Category I FPIs and Category II FPIs (which are directly regulated by an appropriate foreign regulatory authority) are permitted to issue, subscribe and otherwise deal in ODIs. 34 However, those Category II FPIs which are not directly regulated (which are classified as Category-II FPI by virtue of their investment manager being appropriately regulated) and all Category III FPIs are not permitted to issue, subscribe or deal in ODIs. On November 24, 2014, SEBI issued a circular1 ( Circular ) aligning the conditions for subscription of offshore derivative instruments ( ODIs ) to those applicable to FPIs. The Circular makes the ODI subscription more restrictive. As per the Circular, read with the FPI Regulations, to be eligible to subscribe to ODI positions, the subscriber should be regulated by an IOSCO member regulator or in case of banks subscribing to ODIs, such bank should be regulated by a BIS member regulator. It states that an FPI can issue ODIs only to those subscribers who meet certain eligibility criteria mentioned under regulation 4 of the FPI Regulations (which deals with eligibility criteria for an applicant to obtain registration as an FPI) in addition to meeting the eligibility criteria mentioned under regulation 22 of the FPI Regulations. Accordingly, ODIs can now only be issued to those persons who (a) are regulated by an appropriate foreign regulatory authority ; (b) are not resident of a jurisdiction that has been identified by Financial Action Task force ( FATF ) as having strategic Anti- Money Laundering deficiencies; (c) do not have opaque structures (i.e. protected cell companies ( PCCs ) / segregated portfolio companies ( SPCs ) 33. CSX Corporation v. Children s Investment Fund Management (UK) LLP. The case examined the total return swap structure from a securities law perspective, which requires a disclosure of a beneficial owner from a reporting perspective. 34. Reference may be made to Explanation 1 to Regulation 5 of the FPI Regulations where it is provided that an applicant (seeking FPI registration) shall be considered to be appropriately regulated if it is regulated by the securities market regulator or the banking regulator of the concerned jurisdiction in the same capacity in which it proposes to make investments in India. 13

19 Regulatory Framework for Foreign Investment Provided upon request only or equivalent structural alternatives); and (d) comply with know your client norms. The Circular clarifies that opaque structures (i.e. PCCs / SPCs or other ring-fenced structural alternatives) would not be eligible for subscription to ODIs. The Circular further requires that multiple FPI and ODI subscriptions belonging to the same investor group would be clubbed together for calculating the below 10% investment limit. The existing ODI positions will not be affected by the Circular until the expiry of their ODI contracts. However, the Circular specifies that there will not be a rollover of existing ODI positions and for any new ODI positions, new contracts will have to be entered into, in consonance with the rules specified in the Circular. 35 FPIs shall have to fully disclose to SEBI any information concerning the terms of and parties to ODIs entered into by it relating to any securities listed or proposed to be listed in any stock exchange in India (Fig 1). Please refer to our research paper Offshore Derivate Instruments: An Investigation into Tax Related Aspects 36, for further details on ODIs and their tax treatment. D. Listed Equity The RBI has by way of Notification No. FEMA. 297/2014-RB dated March 13, 2014 amended the TISPRO Regulations to provide for investment by FPIs. Under the amended TISPRO Regulations, the RBI has permitted Registered Foreign Portfolio Investors ( RFPI ) to invest on the same footing as FIIs. A new Schedule 2A has been inserted after Schedule 2 of the TISPRO Regulations to provide for the purchase / sale of shares / convertible debentures of an Indian company by an RFPI under the Foreign Portfolio Investment Scheme ( FPI Scheme ). The newly introduced Schedule 2A largely mirrors Schedule 2 of TISPRO which provides for investments in shares / convertible debentures by FIIs under the portfolio investment scheme ( PIS ). Accordingly, an FPI can buy and sell listed securities on the floor of a stock exchange without being subjected to FDI restrictions. Since, the number of real estate companies that are listed on the stock exchange are not high, direct equity investment under erstwhile FII route was not very popular. FPI investors are also permitted to invest in the real estate sector by way of subscription / purchase of Non-Convertible Debenture ( NCD ), as discussed below. E. Listed NCDs Under Schedule V of the amended TISPRO Regulations, read with the provisions of the FPI Regulations, FPIs are permitted to invest in, inter alia, listed or to be listed NCDs issued by an Indian company. FPIs are permitted to hold securities only in the dematerialized form. Currently, there is an overall limit of USD 51 Billion on investment by FPIs in corporate debt, of which 90% is available on tap basis. Further, FPIs can also invest up to USD 30 Billion in government securities. Listing of non-convertible debentures on the wholesale debt market of the Bombay Stock Exchange is a fairly simple and straightforward process which involves the following intermediaries: i. Debenture trustee, for protecting the interests of the debenture holders and enforcing the security, if any; ii. Rating agency for rating the non-convertible debentures (there is no minimum rating required for listing of debentures); and iii. Registrar and transfer agent ( R&T Agent ), and the depositories for dematerialization of the NCDs. The entire process of listing, including the appointment of the intermediaries can be completed in about three weeks. The typical cost of intermediaries and listing for an issue size of INR One Billion is approximately INR One Million. Herein below is a structure chart detailing the steps involved in the NCD route: Offshore Derivate Instruments: An Investigation into Tax Related Aspects 14

20 Regulatory Framework for Foreign Investment Private Equity and Debt in Real Estate FPI Offshore Buy India Stock Exchange (WDM) Step 3: Trading of NCDs on the floor of stock exchange Step 2 Listing of NCDs Issuing Company NCDs Cash Step 1: Issuance of NCDs Warehousing Entity Fig 2: Investment through NCDs Recently, the RBI and SEBI permitted direct subscription of to be listed NCDs by the FII (now FPIs), thus doing away with the requirement of warehousing entity. These to be listed NCDs have to listed on a recognized stock exchange within 15 days of issuance, else, the FPI shall be required to disposeoff the NCDs to an Indian entity / person. Under this route, any private or public company can list its privately placed NCDs on the wholesale debt market segment of any recognized stock exchange. An FPI entity can then purchase these NCDs on the floor of the stock exchange from the warehousing entity. For an exit, these debentures may be sold on the floor of the stock exchange 37, but most commonly these NCDs are redeemed by the issuing company. So long as the NCDs are being offered on private placement basis, the process of offering and listing is fairly simple without any onerous eligibility conditions or compliances. The NCDs are usually redeemed at a premium that is usually based on the sale proceeds received by the company, with at least 1x of the purchase price being assured to the NCD holder. Whilst creation of security interest 38 is not permissible with CCDs under the FDI route, listed NCDs can be secured (by way of pledge, mortgage of property, hypothecation of receivables etc.) in favor of the debenture trustee that acts for and in the interest of the NCD holders. Also, since NCDs are subscribed by an FPI entity under the FPI route and not under the FDI route, the restrictions applicable to FDI investors in terms of pricing are not applicable to NCD holders. NCDs, in fact, are also in some situations favored by developers who do not want to share their equity interest in the project. Further, not only are there no interest caps for the NCDs (as in the case of CCDs or CCPS), the redemption premium on the NCDs can also be structured to provide equity upside to the NCD holders, in addition to the returns assured on the coupon on the NCD. Separately, purchase of NCDs by the FPI from the Indian company on the floor of the stock exchange is excluded from the purview of ECB and hence, the criteria viz. eligible borrowers, eligible lenders, end-use requirements etc. applicable to ECBs, is not applicable in the case of NCDs. The table below gives a brief comparative analysis for debt investment through FDI (CCDs) and FPI (NCDs) route: 37. There have been examples where offshore private equity funds have exited from such instruments on the bourses. 38. Security interest is created in favour of the debenture trustee that acts for and on behalf of the NCD Holders. Security interest cannot be created directly in favour of non-resident NCD holders. 15

21 Regulatory Framework for Foreign Investment Provided upon request only Particulars CCD FDI NCD - FPI Equity Ownership Initially debt, but equity on conversion Mere lending rights; however, veto rights can ensure certain degree of control. ECB Qualification Assured returns on FDI compliant instruments, or put option granted to an investor, may be construed as ECB. Coupon Payment Interest pay out may be limited to SBI PLR basis points. Interest can be required to accrue and paid only out of free cash flows. Purchase of NCDs by the FPI from the Indian company on the floor of the stock exchange is expressly permitted and shall not qualify as ECB. Arm's length interest pay out should be permissible resulting in better tax efficiency. Higher interest on NCDs may be disallowed. Interest can be required to accrue only out of free cash flows. Redemption premium may also be treated as business expense. Pricing Internationally accepted pricing methodologies DCF Valuation not applicable Security Interest Sectoral conditionalities Equity Upside Administrative expenses Creation of security interest is not permissible either on immoveable or movable property Only permissible for FDI compliant activities Investor entitled to equity upside upon conversion. No intermediaries required Listed NCDs can be secured (by way of pledge, mortgage of property, hypothecation of receivables etc.) in favor of the debenture trustee who acts for and in the interest of the NCD holders Sectoral restrictions not applicable. NCDs are favorable for the borrower to reduce book profits or tax burden. Additionally, redemption premium can be structured to provide equity upside which can be favourable for lender since such premium may be regarded as capital gains which may not be taxed if the investment comes from Singapore. NCD listing may cost around INR lakh including intermediaries cost. In case of FPI, additional cost will be incurred for registration with the DDP and bidding for debt allocation limits, if required. IV. NRI Route A. Investment in Listed Securities Similar to FPIs, the NRIs can also purchase the shares of a real estate developer entity under the PIS. Under Schedule 3 of the TISPRO Regulations, NRIs are permitted to invest in shares and convertible debentures on a stock exchange subject to various conditions prescribed therein. The regulations prescribe the following limits on the investment by NRIs: i. The total investment in shares by an NRI cannot exceed 5% of the total paid up capital of the company and the investment in convertible debentures cannot exceed 5% of the paid up value of each series of convertible debentures issued by the company concerned; and ii. The aggregate of the NRI investments in the company cannot exceed 10% of the paid up capital of the company. However, this limit could be increased up to the sectoral cap prescribed under the FDI policy with a special resolution of the company. B. Direct Investment in Unlisted Securities i. Investment on repatriation basis Investment by NRI in unlisted securities on repatriation basis is in a manner similar to any 16

22 Private Equity and Debt in Real Estate other investment allowed under Schedule 1 of TISPRO Regulations; however, as stated earlier the onerous requirements of minimum area, minimum capitalization, lock-in etc. applicable for FDI in construction development projects are not required to be met by NRIs per paragraph ii. Investment on Non-repatriation Basis Under Schedule 4 of TISPRO Regulations, NRIs on a non-repatriation basis are permitted to purchase shares or convertible debentures of an unlisted Indian company without any limit and permission to purchase. The above permission is not available to NRIs for certain prohibited companies. 39 C. Direct Acquisition of Immovable Property The Foreign Exchange Management (Acquisition and Transfer of Immovable Property in India) Regulations, 2000, deal with direct acquisition of immovable property by a person resident outside India. Under the regulations a person resident outside India has been classified into two sections: i. A person resident outside India, who is a citizen of India i.e. an NRI. ii. A person resident outside India, who is of Indian origin i.e. a person of Indian Origin 40 ( PIO ) Both NRI s and PIO s have been under the regulations allowed to directly purchase or sell immovable property other than agricultural property, plantation or a farm house in India. However there are certain conditions imposed under the regulations on the payment of the purchase price and on repatriation of the sale consideration received. i. Purchase Price Conditions The payment of the purchase price can be made only by the following means: Funds received in India through normal banking channels by way of inward remittance from any place outside India; or Funds held in any non-resident account maintained in accordance with the provisions of the FEMA and the regulations framed by RBI from time to time. ii. Repatriation of Sale Proceeds NRIs/ PIOs are allowed to freely repatriate the sale proceeds provided: The immovable property was acquired in accordance with the regulations; The amount remitted outside India does not exceed the amount paid for the acquisition of the immovable property; In case of residential property, the repatriation is not for the amount received on sale of more than two residential properties. However, any upside that is obtained on sale of such property after being subject to applicable capital gains tax and withholding can be remitted outside India through a Non-Resident Ordinary Rupee Account. However, the amount so repatriated cannot exceed USD 1 (One) million a year. 39. Prohibited companies means - company which is a chit fund or a nidhi company or is engaged in agricultural/plantation activities or real estate business or construction of farm houses or dealing in transfer of development rights 40. A PIO means an individual (not being a citizen of Pakistan or Bangladesh or Sri Lanka or Afghanistan or China or Iran or Nepal or Bhutan) who 1. at any time, held an Indian Passport or 2. who or either of whose father or mother or whose grandfather or grandmother was a citizen of India by virtue of the Constitution of India or the Citizenship Act, 1955 (57 of 1955). 17

23 Provided upon request only 3. Legal Framework Key Developments CA 2013 recently replaced CA CA 2013 introduces several new concepts and modifies several existing ones. Some of the relevant new provisions introduced by CA 2013 are as follows: i. Shares with Differential Rights ii. Listed Company iii. Inter-Corporate loans iv. Deposits v. Insider trading vi. Squeeze out provisions vii. Directors viii. Subsidiary and Associate Company ix. Merger of an Indian company with offshore company. I. Shares with Differential Rights Under CA 1956, private companies were allowed to issue shares with differential rights for their contractual agreements because of an exemption available to them. 41 However, with the replacement of CA 1956 with CA 2013, this flexibility is no longer available to private companies. Now, private Companies, like public companies, can issue only equity and preference shares and shares with differential rights subject to certain conditions, as discussed below. 42 Accordingly, preference shares with voting rights on an as-if-converted basis may not be permitted now. The Companies (Share Capital and Debentures) Rules, 2014 for issuance of equity share capital 43 prescribe several conditions for any company issuing equity shares with differential voting rights to adhere to, such as: i. Share with differential rights shall not exceed 26% (twenty six per cent) of the total post issue paid up equity share capital, including equity shares with differential rights issued at any point of time; ii. The company shall have a consistent track record of distributable profits for the last 3 (three) years; iii. The company should not have defaulted in filing financial statements and annual returns for the preceding 3 (three) financial years. With this change, structuring different economic rights for different class of equity shareholders may become difficult given the conditions that companies have to comply with under the Companies (Share Capital and Debentures) Rules, For instance, investors in real estate expecting a preferred IRR could earlier take their preferred returns by way of dividends on different class of equity, which may be difficult now. Any returns on preference shares will be capped at a dividend of around 13% (SBI prime lending rate basis points). II. Listed Company CA 2013 defines listed company as a company which has any of its securities listed on any recognized stock exchange. 44 Even private companies with their NCDs listed on any recognized stock exchange will be considered as a listed company. CA 2013 places a whole gamut of obligations on listed companies, such as: i. Returns to be filed with the registrar of companies if the promoter stake changes; ii. Onerous requirements relating to appointment of auditors; iii. Formation of audit committee, nomination and remuneration committee and stakeholders relationship committee; iv. Secretarial audit. III. Inter-Corporate Loans and Guarantee Under CA 1956, loans made to or security provided or guarantee given in connection with loan given 41. Section 90(2) of CA 1956 exempts applicability of Sections 85 to 89 to a private company unless it is a subsidiary of a public company 42. Sections 43 and 47 of CA Chapter IV, Share Capital and Debentures, Rules under CA Section 2(52), CA

24 Private Equity and Debt in Real Estate to the director of the lending company and certain specified parties required previous approval of the Central Government. However, section 185 of CA 2013 which has by far been the most debated section of CA 2013, imposes a total prohibition on companies providing loans, guarantee or security to the director or any other person in whom the director is interested, unless it is in the ordinary course of business of the company to do so. Whilst the restriction contained in CA 1956 applied only to public companies, CA 2013 has extended this restriction to even private companies. Such restriction would create significant difficulties for companies which provide loans, or guarantee/ security to their subsidiaries or associate companies for operational purposes. IV. Deposits Under CA 2013, acceptance of deposits by an Indian company is governed by stricter rules. Securities application money that is retained for more than 60 days without issuance of securities shall be deemed as a deposit. CA 2013 lays down stringent conditions for issuance of bonds and debentures unsecured optionally convertible debentures are treated as deposits. CA 2013 also specifies additional compliances for deposits accepted prior to the commencement of CA V. Insider Trading CA 2013 now has an express provision for insider trading wherein insider trading of securities of a company by its directors or key managerial personnel is prohibited. 45 SEBI had notified the SEBI (Prohibition of Insider Trading) Regulations, 1992 to govern public companies. The provision governs both public and private companies. Hence, nominee director appointed by a private equity investor may also be subjected to insider trading provisions. However, the practical application of section 195 of CA 2013, with respect to a private company remains to be ambiguous. VI. Squeeze out Provisions Under CA 2013 an acquirer or person acting in concert, holding 90% of the issued equity share capital has a right to offer to buy the shares held by the minority shareholders in the Company at a price determined on the basis of valuation by a registered valuer in accordance with prescribed rules. 46 The corresponding provision under the 1956 Act was permissive and not mandatory in nature. 47 In this regard, private equity investors may want to exercise some caution while the majority shareholders approach the 90% shareholding threshold in a company. Interestingly, there is no provision that minority shareholders will be bound to transfer their shares to an acquirer or person acting in concert and the section lacks the teeth required to enforce a classic squeeze up. VII. Directors CA 2013 introduces certain new requirements with respect to directors 48 such as: i. Independent Director: Independent Directors have been formally introduced by CA 2013, earlier the listing agreements 49 provided for appointment of independent directors. CA 2013 provides that Every listed public company shall have at least one-third director of the total number of directors as independent directors. The term every listed public company is ambiguous as it is the only instance in CA 2013 which applies to the listed public company and not just listed company. This is relevant because under CA 2013, a listed company also includes a private company which has its NCDs listed on the stock exchange. ii. Resident Director: Every company to have a director who was resident in India for a total period of not less than 182 days in the previous calendar year. iii. Women Director: Prescribed class of companies shall have atleast one woman director. CA 2013 has for the first time, laid down specific duties of directors, as follows: 45. Section 195, CA Section 236, CA Section 395, CA Section 149, CA Listing agreements set out the conditions that a company or issuer of share has to abide. Clause 49 19

25 Legal Framework Key Developments Provided upon request only i. To act in accordance with the articles of the company; ii. To act in good faith in order to promote the objects of the company for the benefit of its members as a whole and in the best interests of the company, its employees, the shareholders, and the community and for the protection of environment; iii. To exercise his duties with due and reasonable care, skill and diligence and shall exercise independent judgment; iv. Not to involve himself in a situation in which he may have a direct or indirect interest that conflicts or possibly may conflict, with the interest of the company; v. Not to achieve or attempt to achieve any undue gain or advantage either to himself or his relatives, partners, or associates and if such director is found guilty of such, he shall be liable to pay an amount equal to that gain to the company; vi. Not to assign his office and any such assignment shall be void. Having said the above, the liability of an independent director and non-executive director has been restricted to such acts of omission or commission which had occurred with his knowledge, attributable through board processes, and with his consent or connivance or where he had not acted diligently. VIII. Control and Subsidiary and Associate Company CA 2013 defines the term control and the definition of subsidiary and associate company has changed: i. According to CA 2013, control, 50 shall include the right to appoint majority of the directors or to control the management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholders agreements or voting agreements or in any other manner. It is for the first time that the control has been defined in the company law. ii. Subsidiary Company: An entity will be subsidiary of the holding company, if holding company controls the composition of the board of directors of the company or controls (directly or indirectly) more than one half of the total share capital. 51 iii. Associate Company: An entity will be an associate of the company, if the company has a significant influence over the entity, but it is not the subsidiary company of the company. 52 The concept of control as provided in the definition of subsidiary company is narrower than what is provided in the definition of the control. IX. Merger of an Indian Company with Offshore Company Section 234 of CA 2013 permits mergers and amalgamations of Indian companies with foreign companies. However, the provisions of Section 234 go on to say that such mergers and amalgamations are permitted only with companies incorporated in the jurisdictions of such countries notified from time to time by the Central Government. Hitherto, only inbound mergers were permitted, whereby a company incorporated outside India could merge with an Indian company. 50. Section 2(27), CA Section 2(87), CA Section 2(6), CA

26 Private Equity and Debt in Real Estate 4. Taxation Framework I. Overview of Indian Taxation System Income tax law in India is governed by the Income Tax Act, 1961 ( ITA ). Under the ITA, individuals and entities, whether incorporated or unincorporated, if resident for tax purposes in India, shall be taxed on their worldwide income in India. Companies are held to be resident in India for tax purposes a) if they are incorporated in India; or b) if they are controlled and managed entirely in India. Therefore, it is possible for companies incorporated outside India to be considered to be resident in India if they are wholly controlled in India. Non-residents are taxed only on income arising from sources in India. India has entered into more than 80 Double Taxation Avoidance Agreements ( DTAAs or tax treaties ). A taxpayer may be taxed either under domestic law provisions or the DTAA to the extent that it is more beneficial. In order to avail benefits under the DTAA, a non-resident is required furnish a tax residency certificate ( TRC ) from the government of which it is a resident in addition to satisfying the conditions prescribed under the DTAA for applicability of the DTAA. Further, the non-resident should also file tax returns in India and furnish certain prescribed particulars to the extent they are not contained in the TRC. For the purpose of filing tax returns in India, the non-resident should obtain a tax ID in India (called the permanent account number PAN ). PAN is also required to be obtained to claim the benefit of lower withholding tax rates, whether under domestic law or under the DTAA. If the nonresident fails to obtain a PAN, payments made to the non-resident may be subject to withholding tax at the rates prescribed under the ITA or 20%, whichever is higher. A. Corporate Tax Resident companies are taxed at 30%. A company is said to be resident in India if it is incorporated in India or is wholly controlled and managed in India. A minimum alternate tax ( MAT ) is payable by companies at the rate of around 18.5%. Non-resident companies are taxed at the rate of 40% on income derived from India, including in situations where profits of the non-resident entity are attributable to a permanent establishment in India. B. Tax on Dividends and Share Buy-back Dividends distributed by Indian companies are subject to a distribution tax (DDT) at the rate of 15%, payable by the company. However, the domestic law requires the tax payable to be computed on a grossed up basis; therefore, the shareholders are not subject to any further tax on the dividends distributed to them under the ITA. An Indian company would also be taxed at the rate of 20% on gains arising to shareholders from distributions made in the course of buy-back or redemption of shares. C. Capital Gains Tax on capital gains depends upon the holding period of a capital asset. Short term capital gains ( STCG ) may arise if the asset has been held for less than three years (or in the case of listed securities, less than one year) before being transferred; and gains arising from the transfer of assets having a longer holding period than the above are characterized as long term capital gains ( LTCG ). The 2014 Finance Budget proposes a minimum holding period of 3 years for LTCG with respect to unlisted securities. LTCG earned by a non-resident on sale of unlisted securities may be taxed at the rate of 10% or 20% depending on certain considerations. LTCG on sale of listed securities on a stock exchange are exempt and only subject to a securities transaction tax ( STT ). STCG earned by a non-resident on sale of listed securities (subject to STT) are taxable at the rate of 15%, or at ordinary corporate tax rate with respect to other securities. Foreign institutional investors or foreign portfolio investors are also subject to tax at 15% on STCG and are exempt from LTCG (on the sale of listed securities). The 2014 Budget also proposes to treat all income earned by Foreign Institutional Investors or Foreign Portfolio Investors as capital gains income. In the case of earn-outs or deferred consideration, Courts have held that capital gains tax is required to be withheld from the total sale consideration (including earn out) on the date of transfer of the securities / assets. India has also introduced a rule to tax non-residents on the transfer of foreign securities the value of which may be substantially (directly or indirectly) derived from assets situated in India. Therefore, 21

27 Legal Framework Key Developments Provided upon request only the shares of a foreign incorporated company can be considered to be a situate in India and capable of yielding capital gains taxable in India, if the company s share derive their value substantially 53 from assets located in India. However, income derived from the transfer of P-notes and ODIs derive their value from the underlying Indian securities is not considered to be income derived from the indirect transfer of shares in India because holding such derivative instruments which are linked to underlying shares in India does not constitute an interest in the Indian securities. Tax is levied on private companies and firms that buy/ receive shares of a private company for less than their fair market value. Therefore, where the consideration paid by a private company or firm is less than the fair market value of the shares, the purchaser would be taxed on the difference under these provisions. D. Interest Interest earned by a non-resident may be taxed at a rate between 5% to around 40% depending on the nature of the debt instrument. While a concessional withholding tax rate of 5% for interest on long term foreign currency denominated bonds is available until July 1, 2017, the eligibility of rupeedenominated non-convertible debentures for the same benefit expires on June 1, E. Minimum Alternate Tax Where the tax payable by the investee company is less than 18.5 percent of its book profits, due to certain exemption such company is still required to pay atleast 18.5 percent (excluding surcharge and education cess) as Minimum Alternate Tax. F. Safe Harbor Rules Safe harbour rules have been recently notified with the aim of providing more certainty to taxpayers and to address growing risks of transfer pricing litigation in India. Under this regime, tax authorities will accept the transfer price set by the taxpayer if the taxpayer and transaction meet eligibility criteria specified in the rules. Key features of these rules are: i. The rules will be applicable for 5 years beginning assessment year A taxpayer can opt for the safe harbor regime for a period of his choice but not exceeding 5 assessment years. Once opted for, the mutual agreement procedure would not be available. ii. Safe harbor margins have been prescribed for provision of: (i) IT and ITeS services; (ii) Knowledge Process Outsourcing services; (iii) contract R&D services related to generic pharmaceutical drugs and to software development; (iv) specified corporate guarantees; (v) intra-group loan to a non-resident wholly owned subsidiary; (vi) manufacture and export of core and non-core auto components. iii. For provision of IT and ITeS services, KPO and contract R&D services, the rules would apply where the entity is not performing economically significant functions. iv. Taxpayers and their transactions must meet the eligibility criteria. Each level of the authority deciding on eligibility (i.e. the Assessing Officer, the Transfer Pricing Officer and the Commissioner) must discharge their obligations within two months. If the authorities do not take action within the time allowed, the option chosen by the taxpayer would be valid. v. Once an option exercised by the taxpayer has been held valid, it will remain so unless the taxpayer voluntarily opts out. The option exercised by the assessee can be held invalid in an assessment year following the initial assessment year only if there is change in the facts and circumstances relating to the eligibility of the taxpayer or of the transaction. G. Wealth Tax Buildings, residential and commercial premises held by the investee company will be regarded as assets as defined under Section 2(ea) of the Wealth Tax Act, 1957 and thus be eligible to wealth tax in the hands of the investee company at the rate of 1 percent on its net wealth in excess of the base exemption of INR 30,00,000. However, commercial and business assets are exempt from wealth tax. H. Service Tax The service tax regime was introduced vide Chapter 53. Although, substantial has not been defined under ITA, as per draft DTC 2013, substantial is proposed to be 20% 22

28 Private Equity and Debt in Real Estate V to the Finance Act, Subsequent Finance Acts, (1996 to 2003) have widened the service tax net by way of amendments to Finance Act, Service tax is levied on specified taxable services at the rate of percent on the gross amount charged by the service provider for the taxable services rendered by him. The Finance Act, 2004 has introduced construction services as a taxable service and thus such services provided by the investee company would be subject to service tax in India. Further, the Finance Act, 2007, has brought services provided in relation to renting of immovable property, other than residential properties and vacant land, for use in the course or furtherance of business or commerce under the service tax regime. I. Stamp Duty and Other Taxes The real estate activities of the venture capital undertaking would be subject to stamp duties and other local/municipal taxes, property taxes, which would differ from State to State, city to city and between municipals jurisdictions. Stamp duties may range between 3 to 14 percent. II. Specific Tax Considerations for PE Investments A. Availability of Treaty Relief Benefits under a DTAA are available to residents of one or both of the contracting states that are liable to tax in the relevant jurisdiction. However, some fiscally transparent entities such as limited liabilities companies, partnerships, limited partnerships, etc. may find it difficult to claim treaty benefits. For instance, Swiss partnerships have been denied treaty benefits under the India-Switzerland DTAA. However, treaty benefits have been allowed to fiscally transparent entities such as partnerships, LLCs and trusts under the US and UK DTAAs, insofar as the entire income of the entity is liable to be taxed in the contracting state; or if all the beneficiaries are present in the contracting state being the jurisdiction of the entity. On the other hand, Swiss partnerships have been denied treaty benefits under the India-Switzerland. Benefits under the DTAA may also be denied on the ground of substance requirements. For instance, the India-Singapore DTAA denies benefits under the DTAA to resident companies which do not meet the prescribed threshold of total annual expenditure on operations. The limitation on benefits ( LoB ) clause under the India-Luxembourg DTAA permits the benefits under the DTAA to be overridden by domestic anti-avoidance rules. India and Mauritius are currently in the process of re-negotiating their DTAA to introduce similar substance based requirements. B. Permanent Establishment and Business Connection Profits of a non-resident entity are typically not subject to tax in India. However, where a permanent establishment is said to have been constituted in India, the profits of the non-resident entity are taxable in India only to the extent that the profits of such enterprise are attributable to the activities carried out through its permanent establishment in India and are not remunerated on an arm s length basis. A permanent establishment may be constituted where a fixed base such as a place of management, branch, office, factory, etc. is available to a non-resident entity; or where a dependent agent habitually exercises the authority to conclude contracts on behalf of the non-resident entity. Under some DTAAs, employees or personnel of the non-resident entity furnishing services for the non-resident entity in India may also constitute a permanent establishment. The recent Delhi High Court ruling in e-funds IT Solutions/ e-funds Corp vs. DIT 55 laid down the following principles for determining the existence of a fixed base or a dependent agent permanent establishment: i. The mere existence of an Indian subsidiary or mere access to an Indian location (including a place of management, branch, office, factory, etc.) does not automatically trigger a permanent establishment risk. A fixed base permanent establishment risk is triggered only when the offshore entity has the right to use a location in India (such as an Indian subsidiary s facilities); and carries out activities at that location on a regular basis. ii. Unless the agent is authorized to and has habitually exercised the authority to conclude contracts, a dependent agent permanent establishment risk may not be triggered. Merely 54. Excluding currently applicable education cess of 3 percent on service tax 55. TS-63-HC-2014 (DEL); MANU/DE/0373/

29 Legal Framework Key Developments Provided upon request only assigning or sub-contracting services to the Indian subsidiary does not create a permanent establishment in India. iii. An otherwise independent agent may, however, become a permanent establishment if the agent s activities are both wholly or mostly wholly on behalf of foreign enterprise and that the transactions between the two are not made under arm s length conditions. Where treaty benefits are not available, the concept of business connection, which is the Indian domestic tax law equivalent of the concept of permanent establishment, but which is much wider and has been defined inclusively under the ITA, would apply to non-resident companies deriving profits from India. C. Indirect Transfer of shares in India No explanation has been given under the ITA as to when such securities may be considered to have derived value substantially from assets located in India. However, such transfers may be subject to relief available under the relevant DTAA. As discussed, these provisions should not impact p-notes or ODI holders. As mentioned earlier, substantial has not been defined under ITA, based on the recommendation of high level government committee, draft DTC 2013, provides for a threshold of 20% or more assets are situated in India. However, given the ambiguity of the provisions governing indirect transfer of shares in India, the impact of these provisions have to be examined on a case-by-case basis and necessary risk mitigation strategies have to be adopted to address the concerns of buyers or sellers. Please refer to Annexure III for a detailed analysis. D. General Anti-Avoidance Rule India has introduced general anti-avoidance rules ( GAAR ) which provide broad powers to tax authorities to deny a tax benefit in the context of impermissible avoidance agreements, i.e., structures (set up subsequent to August 30, 2010) which are not considered to be bona fide or lack commercial substance. GAAR will come into effect from April 1, 2015 and would override DTAAs signed by India. Therefore, the transfer of any investment made subsequent to August 30, 2010 shall be subject to the GAAR from April 1, The applicability of the GAAR is subject to a de minimis threshold of INR 3 crore. GAAR is not attracted in the case of a foreign institutional investor which is not claiming benefits under the DTAA and has invested in in listed or unlisted securities in compliance with the law. The option of obtaining an advance ruling is available even in the context of GAAR structures. Care has to be taken while developing and implementing structures to address GAAR and in this context, it is important to document the business and strategic rationale for each step in a structure. E. Transfer Pricing Regulations Under the Indian transfer pricing regulations, any income arising from an international transaction is required to be computed having regard to the arm s length price. There has been litigation in relation to the mark-up charged by the Indian advisory company in relation to services provided to the offshore fund / manager. In recent years, income tax authorities have also initiated transfer pricing proceedings to tax foreign direct investment in India. In some cases, the subscription of shares of a subsidiary company by a parent company was made subject to transfer pricing regulations, and taxed in the hands of the Indian company to the extent of the difference in subscription price and fair market value. F. Withholding Obligations Tax would have to be withheld at the applicable rate on all payments made to a non-resident, which are taxable in India. The obligation to withhold tax applies to both residents and non-residents. Withholding tax obligations also arise with respect to specific payments made to residents. Failure to withhold tax could result in tax, interest and penal consequences. Therefore, often in a cross-border the purchasers structure their exits cautiously and rely on different kinds of safeguards such as contractual representations, tax indemnities, tax escrow, nil withholding certificates, advance rulings, tax insurance and legal opinions. Such safeguards have been described in further detail under Annexure V. G. Structuring Through Intermediate Jurisdictions Investments into India are often structured through holding companies in various jurisdictions for number of strategic and tax reasons. For instance, US investors directly investing into India may face 24

30 Private Equity and Debt in Real Estate difficulties in claiming credit of Indian capital gains tax on securities against US taxes, due to the conflict in source rules between the US and India. In such a case, the risk of double taxation may be avoided by investing through an intermediary holding company. While choosing a holding company jurisdiction it is necessary to consider a range of factors including political and economic stability, investment protection, corporate and legal system, availability of high quality administrative and legal support, banking facilities, tax treaty network, reputation and costs. India has entered into several BITs and other investment agreements with various jurisdictions, most notably, Mauritius. It is important to take advantage of structuring investment into India, may be the best way to protect a foreign investor s interest. Indian BITs are very widely worded and are severally seen as investor friendly treaties. Indian BITs have a broad definition of the terms investment and investor. This makes it possible to seek treaty protection easily through corporate structuring. BITs can also be used by the investors to justify the choice of jurisdiction when questioned for GAAR. Over the years, a major bulk of investments into India has come from countries such as Mauritius, Singapore and Netherlands, which are developed and established financial centers that have favorable tax treaties with India. Cyprus was also a popular investment holding jurisdiction, but due to a recent blacklisting by India due to issues relating to exchange of information, investments from Cyprus could result in additional taxes and disclosure till this position changes. The following table summarizes some of the key advantages of investing from Mauritius, Singapore and Netherlands: HEAD OF TAXATION MAURITIUS SINGAPORE NETHERLANDS Capital gains tax on sale of Indian securities Tax on dividends Withholding tax on outbound interest Withholding tax on outbound royalties and fees for technical services Other comments Mauritius residents not taxed. No local tax in Mauritius on capital gains. Indian company subject to DDT at the rate of 15%. No relief. Taxed as per Indian domestic law. 15% (for royalties). FTS 56 may be potentially exempt in India. Mauritius treaty in the process of being renegotiated. Possible addition of substance rules. Singapore residents not taxed. Exemption subject to satisfaction of certain substance criteria and expenditure test by the resident in Singapore. No local tax in Singapore on capital gains (unless characterized as business income). Indian company subject to DDT at the rate of 15%. 15% 10% 10% 10% There are specific limitations under Singapore corporate law (e.g. with respect to buyback of securities). Dutch residents not taxed if sale made to non-resident. Exemption for sale made to resident only if Dutch shareholder holds lesser than 10% shareholding in Indian company. Local Dutch participation exemption available in certain circumstances. Indian company subject to DDT at the rate of 15%. To consider anti-abuse rules introduced in connection with certain passive holding structures. 56. Fees for Technical Services 25

31 Provided upon request only 5. Exit Options / Issues One of the largest issues faced by private equity investors investing in real estate under the FDI route is exit. Following are some of the commonly used exit options in India, along with attendant issues / challenges: I. Put Options Put options in favour of a non-resident requiring an Indian resident to purchase the shares held by the non-resident under the FDI regime were hitherto considered non-compliant with the FDI Policy by the RBI. RBI has legitimized option arrangements 57 through an amendment in the TISPRO Regulations. The TISPRO Regulations now permit equity shares, CCPS and CCDs containing an optionality clause to be issued as eligible instruments to foreign investors. However, the amendment specifies that such an instrument cannot contain an option / right to exit at an assured price. The amendment, for the first time, provides for a written policy on put options, and in doing that sets out the following conditions for exercise of options by a non-resident: i. Shares/debentures with an optionality clause can be issued to foreign investors, provided that they do not contain an option/right to exit at an assured price; ii. Such instruments shall be subject to a minimum lock-in period of one year; iii. The exit price should be as follows: a. In case of listed company, at the market price determined on the floor of the recognized stock exchanges; b. In case of unlisted equity shares, at a price not exceeding that arrived on the basis of internationally accepted pricing methodologies c. In case of preference shares or debentures, at a price determined by a Chartered Accountant or a SEBI registered merchant banker per any internationally accepted methodology. II. Buy-Back In this exit option, shares held by the foreign investor, are bought back by the investee company. Buy-back of securities is subject to certain conditionalities as stipulated under Section 68 of CA A company can only utilize the following funds for undertaking the buy-back (a) free reserves (b) securities premium account, or (c) proceeds of any shares or other specified securities. However, buy-back of any kind of shares or other specified securities is not allowed to be made out of the proceeds of an earlier issue of the same kind of shares or same kind of other securities. Further, a buy back normally requires a special resolution 58 passed by the shareholders of the company unless the buyback is for 10% or less of the total paid-up equity capital and free reserves of the company. Additionally, a buy back cannot exceed 25% of the total paid up capital and free reserves of the company in one financial year, and post buy-back, the debt equity ratio of the company should not be more than 2:1. Under CA 1956, it was possible to conduct two buy-backs in a calendar year, i.e., one in the financial year ending March 31 and a subsequent offer in the financial year commencing on April 1. However, in order to counter this practice, the CA 2013 now requires a cooling off period of one year between two successive offers for buy-back of securities by a company. From a tax perspective, traditionally, the income from buyback of shares has been considered as capital gains in the hands of the recipient and accordingly the investor, if from a favourable treaty jurisdiction, could avail the treaty benefits. However, in a calculated move by the Government to undo this current practice of companies resorting to buying back of shares instead of making dividend payments, the government, vide Budget levied a tax of 20% 59 on domestic unlisted companies, when such companies make distributions pursuant to a share repurchase or buy back. The said tax at the rate of 20% is imposed on a domestic company on consideration paid by it which is above the amount received by the company at the Under CA 2013, a Special Resolution is one where the votes cast in favor of the resolution (by members who, being entitled to do so, vote in person or by proxy, or by postal ballot) is not less than three times the number of the votes cast against the resolution by members so entitled and voting. (The position was the same under CA 1956). 59. Exclusive of surcharge and cess. 26

32 Legal Framework Key Developments Private Equity and Debt in Real Estate time of issuing of shares. Accordingly, gains that may have arisen as a result of secondary sales that may have occurred prior to the buy-back will also be subject to tax now. The proposed provisions would have a significant adverse impact on offshore realty funds and foreign investors who have made investments from countries such as Mauritius, Singapore, United States of America and Netherlands etc. where buy-back of shares would not have been taxable in India due to availability of tax treaty benefits. Further, being in the nature of additional income tax payable by the Indian company, foreign investors may not even be entitled to a foreign tax credit of such tax. Additionally, in the context of the domestic investor, even the benefit of indexation would effectively be denied to such investor and issues relating to proportional disallowance of expenditure under Section 14A of the ITA (Expenditure incurred in relation to income not includible in total income) may also arise. This may therefore result in the buyback of shares being even less tax efficient than the distribution of dividends. As an alternative to buy-back, the investor could approach the courts for reduction of capital under the provisions of section 66 of CA 2013; however, the applications for such reduction of capital need to be adequately justified to the court. From a tax perspective, the distributions by the company to its shareholders, for reduction of capital, would be regarded as a dividend to the extent to which the company possesses accumulated profits and will be taxable in the hands of the company at the rate of 15% 60 computed on a grossed up basis, distribution over and above the accumulated profits (after reducing the cost of shares) would be taxable as capital gains. 61 III. Redemption In recent times, NCDs have dominated the market. NCDs can be structured as pure debt or instruments delivering equity upside. The returns on the NCDs can be structured either as redemption premium or as coupon, the tax consequences of the same is set out earlier in this paper. The redemption premium in certain structured equity deals can be pegged to the cash flows or any commercially agreed variable, enabling such debentures to assume the character of payable when able kind of bonds. A large amount of foreign investment into real estate has been structured through this route. However, not much data is available on how many such bonds have been redeemed and at what IRRs. The instances of default are few and it does seem that in most cases such debentures are indeed providing returns and exits to the investors as contemplated. IV. Initial Public Offering Another form of exit right which an investor may have is in the form of an Initial Public Offering ( IPO ). However, looking at the number of real estate companies which have listed in the previous decade in India, this may not be one of viable exit options. The reason why real estate companies do not wish to go public in India is manifold. For instance, real estate companies are usually selfliquidating by nature. Thus, unless the flagship or the holding company goes public, there may not be enough public demand for and interest in such project level SPVs. There is also some reluctance in going for an IPO due to the stringent eligibility criteria (for instance 3 year profitability track record etc.) and the level of regulatory supervision that the companies (usually closely held) will be subjected to post listing. V. Third Party Sale In this option, the investor sells its stake to a third party. If the sale is to another non-resident, the lockin of 3 years would start afresh and be applicable to such new investor. Also, since FDI in completed assets is not permitted, the sale to a non-resident can only be of an under-construction project. In a third party sale in real estate sector, it may also be important to negotiate certain contractual rights such as drag along rights. For instance, if the sale is pursuant to an event of default, and the investor intends to sell the shares to a developer, it is likely that the new developer may insist on full control over the project, than to enter a project with an already existing developer. In such cases, if the investor has the drag along rights, he may be able to force the developer to sell its stake along with the investor s stake. 60. Exclusive of surcharge and cess 61. CIT v G. Narasimhan, (1999)1SCC510 27

33 Exit Options / Issues Provided upon request only VI. GP Interest Sale 62 A private equity fund is generally in the form of a limited partnership and comprises two parties, the General Partner ( GP ) and the Limited Partner ( LP ). The GP of a fund is generally organized as a limited partnership controlled by the fund manager and makes all investment decisions of the fund. In a GP interest sale, the fund manager sells its interest in the limited partnership ( GP Interest ) to another fund manager or strategic buyer. While technically sale of GP Interest does not provide exits to the LPs as they continue in the fund with a new fund manager, it provides an effective exit to fund managers who wish to monetize their interests in the fund management business. VII. Offshore Listing The raising of capital abroad shall be in accordance with the extant foreign FDI Policy, including the sectoral caps, entry route, minimum capitalization norms and pricing norms; The number of underlying equity shares offered for issuance of ADRs/GDRs to be kept with the local custodian shall be determined upfront and ratio of ADRs/GDRs to equity shares shall be decided upfront based on applicable FDI pricing norms of equity shares of unlisted company; The funds raised may be used for paying off overseas debt or for operations abroad, including for the funding of acquisitions; In case the money raised in the offshore listing is not utilized overseas as described, it shall be remitted back to India within 15 days for domestic use and parked in AD category banks. The Ministry of Finance ( MoF ) by a notification 63 has permitted Indian unlisted companies to list their ADRs, GDRs or FCCBs abroad on a pilot basis for two years without a listing requirement in India. In pursuance to this, the Central Government amended 64 the Foreign Currency Convertible Bonds and Ordinary Shares (Through Depositary Receipt Mechanism) Scheme, 1993 ( FCCB Scheme ). RBI also directed 65 the authorized dealers towards the amendment to the FCCB Scheme. Regulation 3(1)(B) of the FCCB Scheme, prior to the amendment restricted unlisted Indian companies from issuing GDRs/FCCBs abroad as they were required to simultaneously list in Indian stock exchanges. The notification amended the regulation 3(1)(B) to permit Indian unlisted companies to issue GDRs/ FCCBs to raise capital abroad without having to fulfill the requirement of a simultaneous domestic listing. But it is subject to following conditions: The companies will be permitted to list on exchanges in IOSCO/FATF compliant jurisdictions or those jurisdictions with which SEBI has signed bilateral agreements (which are yet to be notified). The Central Government has recently prescribed that SEBI shall not mandate any disclosures, unless the company lists in India. VIII. Flips Another mode of exit could be by way of rolling the real estate assets into an offshore REIT by flipping the ownership of the real estate company to an offshore company that could then be listed. Examples of such offshore listings were seen around 2008, when the Hiranandani Group set up its offshore arm Hirco PLC building on the legacy of the Hiranandani Group s mixed use township model. Hirco was listed on the London Stock Exchange s AIM sub-market. At the time of its admission to trading, Hirco was the largest ever real estate investment company IPO on AIM and the largest AIM IPO in Another example is Indiabulls Real Estate that flipped some of its stabilized and developing assets into the fold of a Singapore Business Trust ( SBT ) that got listed on the Singapore Exchange ( SGX ). However, both Hirco and Indiabulls have not been particularly inspiring stories and to some extent disappointed investor sentiment. Based on analysis of the listings, it is clear that there may not be a market for developing assets on offshore bourses, but stabilized assets may receive 62. Reaping the Returns: Decoding Private Equity Real Estate Exits in India, available at the_returns_decoding_private_equity_real_estate_exits_in_india.pdf 63. The Press Release is available on: 64. Notification no. GSR 684(E) [F.NO.4/13/2012-ECB], dated RBI A.P. (Dir Series) Circular No. 69 of November 8,

34 Private Equity and Debt in Real Estate good interest if packaged well and have the brand of a reputed Indian developer. Hence, stabilized assets such as educational institutions, hospitals, hotels, SEZs, industrial parks et al may find a market offshore. Please refer to Annexure IV for a detailed note on exit by rolling assets to offshore REITs. IX. Domestic REITs Recently, SEBI introduced the REIT Regulations. REITs would serve as an asset-backed investment mechanism where an Indian trust is set up for the holding of real estate assets as investments, either directly or through an Indian company set up as a Special Purpose Vehicle ( SPV ). However, there was no clarity on the proposed tax regime, which is a key element for enabling a successful REIT regime. The Finance Act, 2014 has made certain amendments to the Income Tax Act, 1961 ( ITA ) to clarify the income tax treatment of REITs and InvITs. These provisions have been incorporated depending on the stream of income that the REIT would be earning and distributing. The Finance Act, 2014 introduced the definition of business trust in the Income Tax Act, 1961 which includes REITs. REITs will have a tax pass through status for income received by way of interest or receivable from the SPV as per s. 10 (23FC), 10 (23FD) and 115UA of the Income Tax Act, Long term capital gains on sale of units as well as dividends received by REITs and distributed to the investor shall be tax exempt. Interest income received by the REIT is tax exempt and foreign investors shall be subject to a low withholding tax of 5% on interest payouts. Thanks to clarity in tax treatment, global investors can soon participate in core real estate assets in India. The regime for InvITs would provide a massive boost to infrastructure growth and development in India. Even though the REITs Regulations have been released, so far the regime has not taken off on account of non-tax and tax issues. Please refer to Annexure V for our article published in Live Mint on the tax and non-tax issues that make the Indian REIT unattractive. 29

35 Provided upon request only 6. Domestic Pooling Domestic pools of capital may be structured primarily in two ways: I. AIF In 2012, SEBI notified the (Alternative Investment Funds) Regulations, 2012 ( AIF Regulations ) to regulate the setting up and operations of alternate investment funds in India. As provided in the AIF Regulations, it replaces and succeeds the erstwhile SEBI (Venture Capital Funds) Regulations, The AIF Regulations further provide that from commencement of such regulations, no entity or Person shall act as an AIF unless it has obtained a certificate of registration from the SEBI. The AIF Regulations define Alternative Investment Funds as any fund established or incorporated in India in the form of trust, company, a limited liability partnership or a body corporate which is a privately pooled investment vehicle which collects funds from investors, whether Indian or foreign, for investing in accordance with a defined investment policy for the benefit of investors, and is not covered under the SEBI regulations to regulate fund management. The real estate funds shall be registered with SEBI as a Category II Alternate Investment Fund and shall be governed by the provisions of the AIF Regulations. The AIF Regulations prescribe that the raising of commitments should be done strictly on a private placement basis and the minimum investment that can be accepted by a fund from an investor is INR 1,00,00,000 (Rupees One Crore Only). The AIF Regulations also prescribe that a placement memorandum detailing the strategy for investments, fees and expenses proposed to be charged, conditions and limits on redemption, risk management tools and parameters employed, duration of the life cycle of the AIF should also be issued prior to raising commitments and be filed with the SEBI prior to launching of a fund. Further, the AIF Regulations also prescribe that the manager or a sponsor of an AIF shall have a continuing interest in the AIF of not less than 2.5% of the corpus or INR 5,00,00,000 (Rupees Five Crore Only), whichever is lower, in the form of investment in the AIF and such interest shall not be through the waiver of management fees. The AIF Regulations provide that a close ended AIF may be listed only after the final closing of the fund or scheme on a stock exchange subject to a minimum tradable lot of INR 1,00,00,000 (Rupees One Crore Only). Accordingly, the Fund will not be in a position to list its securities without complying with the above conditions. The AIF Regulations lay down several investment restrictions on category II AIFs. These restrictions are as follows: i. A Category II AIF cannot invest more than 25 percent of its corpus in any one investee company. ii. A Category II AIF may invest in units of Category I and II AIFs but not in the units of fund of funds. iii. An AIF may not invest in its Associates except with the approval of 75% of the investors by value of their investments in the AIF. For this purpose Associates means a company or a limited liability partnership or a body corporate in which a director or trustee or partner or sponsor or manager of the AIF or a director or partner of the manager or sponsor holds, either individually or collectively, more than 15% of its paid-up equity share capital or partnership interest, as the case may be. An investee company has been defined to mean any company, special purpose vehicle or limited liability partnership or body corporate in which an AIF makes an investment. A registered AIF will be subject to investigation/inspection of its affairs by an officer appointed by SEBI, and in certain circumstances the SEBI has the power to direct the AIF to divest its assets, to stop launching any new schemes, to restrain the AIF from disposing any of its assets, to refund monies or assets to Investors and also to stop operating in, accessing the, capital market for a specified period. However, a Category II AIF is not permitted to receive foreign investment under the extant exchange control regulations without prior approval of the FIPB. Though in a few cases, such approval has been granted in cases where the investment was required for the purposes of making the sponsor commitment, no approval has thus far been granted for LPs willing to invest in the AIF. Based on reports, SEBI is in discussions with the RBI and FIPB to allow foreign investment beyond sponsor commitment in AIFs, but as we understand the RBI and the FIPB are not yet comfortable with such permissions on a policy level. 30

36 Private Equity and Debt in Real Estate II. NBFC In light of the challenges that the FDI and the FPI route are subjected to, there has been a keen interest in offshore realty funds to explore the idea of setting up their own NBFC to lend or invest to real estate. An NBFC is defined in terms of Section 45I(c) of the RBI Act, 1934, as a company engaged in granting loans/advances or in the acquisition of shares/ securities, etc. or hire purchase finance or insurance business or chit fund activities or lending in any manner provided the principal business of such a company does not constitute any non-financial activities such as (a) agricultural operations (b) industrial activity (c) trading in goods (other than securities) (d) providing services (e) purchase, construction or sale of immovable property. Every NBFC is required to be registered with the RBI, unless specifically exempted. Following are some of the latest changes with respect to NBFC: A. Transfer of Shares from Resident to Non-resident 66 Earlier there was only a requirement of giving 30 thirty days written notice 67 prior to effecting a change of control of non-deposit NBFC (the term control has the same meaning as defined in the SEBI Takeover Code), and a separate approval was not required; and unless the RBI restricted the transfer of shares or the change of control, the change of control became effective from the expiry of thirty days from the date of publication of the public notice. However, recently, the RBI vide its circular dated May 26, , has prescribed that in order to ensure that the fit and proper 69 character of the management of NBFCs is continuously maintained for both, deposit accepting and non-deposit accepting NBFCs, its prior written permission has to be obtained for any takeover or acquisition of control of an NBFC, whether by acquisition of shares or otherwise. This RBI circular requires prior approval in the following situations also: i. any merger/amalgamation of an NBFC with another entity or any merger/amalgamation of an entity with an NBFC that would give the acquirer / another entity control of the NBFC; ii. any merger/amalgamation of an NBFC with another entity or any merger/amalgamation of an entity with an NBFC which would result in acquisition/transfer of shareholding in excess of 10 percent of the paid up capital of the NBFC; iii. for approaching a court or tribunal under Section of CA 1956 or Section of CA 2013 seeking order for mergers or amalgamations with other companies or NBFCs. The abovementioned RBI approval is sought from the DNBS (Department of Non-Banking Supervision) division of the RBI. Separately, earlier, any transfer of shares of a financial services company from a resident to a non-resident required prior approval of the Foreign Exchange Department of the Reserve Bank of India ( FED ), which took anywhere in the region of 2 4 months. In a welcome move, as per a recent RBI circular dated November 11, 2013, the requirement to procure such an approval was removed if: i. any fit and proper/ due diligence requirement as regards the non-resident investor as stipulated by the respective financial sector regulator shall have to be complied with; and ii. The FDI policy and FEMA regulations in terms of sectoral caps, conditionalities (such as minimum capitalization, etc.), reporting requirements, documentation etc., are complied with. B. Only Secured Debenture can be Issued 70 NBFCs can only issue whether by way of private placement of public issue fully secured debentures The public notice had be published in one English and one vernacular language newspaper, copies of which were required to be submitted to the RBI. 68. DNBS (PD) CC.No.376/ / Under the Master Circular on Corporate Governance dated July 1, 2013, RBI had emphasized the importance of persons in management who fulfil the fit and proper criteria. The Master Circular provides as follows: it is necessary to ensure that the general character of the management or the proposed management of the non-banking financial company shall not be prejudicial to the interest of its present and future depositors. In view of the interest evinced by various entities in this segment, it would be desirable that NBFC-D with deposit size of Rs 20 crore and above and NBFC-ND-SI may form a Nomination Committee to ensure fit and proper status of proposed/existing Directors. 70. RBI/ /560 DNBD(PD) CC No. 330/ / and RBI/ /115 DNBS(PD) CC No.349/ /

37 Domestic Pooling Provided upon request only The security has to be created within a month from the date of issuance. If the security cover is inadequate, the proceeds have to be placed in an escrow account, till the time such security is created. C. Private Placement 71 As per Section 67(2) of CA 1956, private placement means invitation to subscribe shares or debenture from any section of public whether selected as members or debenture holders of the company concerned or in any other manner. Section 67(3) prescribes that shares or debenture under such offer can be offered to maximum of fifty persons. However, NBFCs where excluded from Section 67(3). But RBI has now restricted private placement to not more than 49 investors, in line of the private companies which are to be identified upfront by the NBFC. D. Deployment of Funds and Miscellaneous i. NBFCs can issue debentures only for deployment of the funds on its own balance sheet and not to facilitate requests of group entities/ parent company/ associates. Core Investment Companies have been carved out from the applicability of this restriction. ii. NBFCs have been restricted from extending loans against the security of its own debentures, whether issued by way of private placement or public issue. Please refer to Annexure VI 72 for detailed investment note on investment through NBFCs. 71. Ibid

38 Private Equity and Debt in Real Estate 7. The Road Forward The Indian real estate industry is at a stage where the private equity players have seen a lot of exits, with some making excellent multiples while others burning their fingers deep. However, a larger chunk of exits are expected to be witnessed in the next 2-3 years when the sector completes its first full cycle, which is where the key challenge lies. Some of the challenges that Indian real estate sector faces are as follows: II. Partner Issues Uncooperative partner has been the largest issue for private equity players. Promoter - investor expectation mismatch are now increasingly seen. Enforceability of tag along rights, drag along rights, put options or even 3rd party exits clearly hinge on the cooperation of the local partner. I. REITs The Budget has put REITs back on the fast track by proposing to take steps to bring clarity in tax treatment of REITs, including a partial tax pass-through regime for REITs. This will result in the REIT not being subject to any tax in respect of such interest income, whereas the investors will be subject to tax on the same. The much awaited framework for REITs has also been announced and thanks to the present clarity in tax treatment, global investors can soon participate in core real estate assets in India. Long term capital gains on sale of units as well as dividends received by the REIT and distributed to the investor shall be tax exempt. Interest income received by the REIT is tax exempt and foreign investors shall be subject to a low withholding tax of 5% on interest payouts. In spite of the positive proposals brought forward by the government to establish an investment-friendly regime, there still remain certain issues with respect of taxation of REITs. It should be noted that almost all countries provide for a complete pass through regime for REITs if the prescribed regulatory criteria is met and a move towards that will further increase interest in this space. It is hoped that the Finance Ministry would address the above issues going forward and possibly simplify the REIT taxation regime. Please refer to Annexure V for our article published in Live Mint on the tax and non-tax issues that make the Indian REIT unattractive. III. Arbitration / Litigation Indian courts have been known for their lackadaisical approach to dispute resolution. Hitherto, even international arbitration was not free from the involvement of the Indian courts, which was a concern for offshore investors. Now, with the decision of the Supreme Court in the Balco case, the jury is out that parties in an international arbitration can agree to exclude the jurisdiction of the Indian courts. In India, any dispute may be set to comprise of two stages. The first being the liability crystallization process, and other being the award enforcement process. The liability crystallization that typically took several decades sometimes, can now be shorted to less than a year as well where the process is referred to institutional arbitration under the auspices of LCIA etc. Once an award has been delivered, the enforcement process is rather straightforward. IV. Security Enforcement Enforcement of security interest is still a challenge in India. For instance, enforcing a mortgage in India is a court driven process and can take long sometimes even extending beyond couple of years. The situation was better in case of pledge of listed shares which was considered the most liquid security, as it could be enforced without court involvement. However, the court stay on the invocation of pledge of shares of Unitech 73, in spite of a breach of the terms, has raised questions on this form of security as well Court saves promoter pledge, last visited on April 8, For the first time, a High Court (highest court of law in a state in India) stayed the invocation of a pledge and that too via an ex-parte (without the defending party being present or heard) injunction handed out on a Sunday. 33

39 The Road Forward Provided upon request only Please see Annexure VII 75 for an article on challenges in invocation of pledge. V. Offshore listing allowed for unlisted Indian companies Hitherto unlisted companies in India were prohibited from issuing American / Global Depositary Receipts (ADRs / GDRs) and Foreign Currency Convertible Bonds ( FCCB ) without a simultaneous or prior listing on a domestic exchange in India. However, RBI and the Central Government have now removed this requirement of prior or simultaneous listing on a domestic exchange, reverting to the position pre-2005, when the requirement was introduced. Private companies can now list their ADRs / GDRs / FCCB in an overseas stock exchange. The Central Government has recently prescribed that SEBI shall not mandate any disclosures, unless the company lists in India. IV for articles analyzing the reasons why Indian companies are being driven to list offshore and raise funds abroad

40 Private Equity and Debt in Real Estate Annexure I Foreign Investment Norms for Real Estate Liberalized Minimum area threshold reduced from 50,000 sq ft. to 20,000 sq ft. No minimum area threshold, if 30% project cost is contributed towards development of affordable housing. Are investments in completed yield generating real estate assets allowed? meeting dated October 29, 2014 ( Press Release ), the Union Cabinet has cleared the further liberalization of Foreign Direct Investment ( FDI ) in construction-development sector, in line with the announcements in the Finance Minister s budget speech for I. Changes The changes sought to be made by the Press Release are set out below. 1 In a recent press release issued in relation to its Provisions Revised policy pursuant to Press Release Existing Policy Minimum Land Requirements Minimum Capitalization Requirements Timing of investment Minimum area to be developed under each project would be: i. Development of serviced plots: No minimum land requirement; ii. Construction-development projects: Minimum floor area of 20,000 sq. meters; iii. Combination project: Any of the above two conditions need to be complied with Minimum capitalization of USD 5 million. The funds would have to be brought in within 6 months of commencement of the project. Commencement of the project has been explained to mean date of approval of the building plan/ lay out plan by the relevant statutory authority. Subsequent tranches can be brought in till the earlier of: i. Period of 10 years from the commencement of the project; or ii. The completion of the project. Minimum area to be developed under each project would be as under: i. Development of serviced housing plots: Minimum land area of 10 hectares; ii. Construction-development projects: Minimum builtup area of 50,000 sq. meters; iii. Combination project: Any of the above two conditions need to be complied with. For wholly owned subsidiary: minimum capitalization of USD 10 million; For joint ventures with Indian partners: minimum capitalization of USD 5 million. The funds would have to be brought in within 6 months of commencement of business of the Company. No such concept of 10 years from commencement of business earlier. 1. The changes brought in by the Amendment are expected to be formalized in the form of a Press Note or by way of inclusion in the FDI Policy, and till such time the changes do not have the binding force of law. 35

41 Foreign Investment Norms for Real Estate Liberalized Provided upon request only Lock-in Sale of developed plots only Minimum development Exemption Affordable Housing Certificate from architect Completed projects Responsibility for obtaining all necessary approvals The investor is permitted to exit from the investment at (i) 3 years from the date of final installment, subject to development of trunk infrastructure, or (ii) on the completion of the project. Trunk infrastructure has not been defined, but is explained to include roads, water supply, street lighting, drainage and sewerage. Repatriation of FDI or transfer of stake by a non-resident investor to another non-resident investor would require prior FIPB approval. Only developed plots are permitted to be sold. Developed plots would mean plots where trunk infrastructure is developed, including roads, water supply, street lighting, drainage and sewerage. The requirement of completion certificate has been done away with No requirement of any such minimum development. They are no longer exempt from the sale of undeveloped plots. Projects which allocate 30% of the project cost for low cost affordable housing are exempt from the minimum land area, and minimum capitalization requirements. The investee company required to procure an architect empanelled by any authority authorized to sanction building plan to certify that the minimum floor area has been complied. It has been clarified that 100% FDI permitted in completed projects for operation and management of townships, malls/ shopping complexes and business centers. Investee Company. The investor is permitted to exit from the investment at expiry of 3 years from the date of completion of minimum capitalization. For investment in tranches: The investor is permitted to exit from the investment at the later of (a) 3 years from the date of receipt of each tranche/ installment of FDI, or (b) at expiry of 3 years from the date of completion of minimum capitalization. Prior exit of the investor only with the prior approval of FIPB Sale of undeveloped plots prohibited. Undeveloped plots would mean plots where roads, water supply, street lighting, drainage and sewerage, and other conveniences, as applicable under prescribed regulations, have not been made available. The investor was required to provide the completion certificate from the concerned regulatory authority before disposal of serviced housing plots. At least 50% of the project must be developed within a period of 5 years from date of obtaining all statutory clearances. Certain investments were exempt from complying with the following requirements: (i) minimum land area; (ii) minimum capitalization, (iii) lock-in, (iv) 50% development within 5 year requirements and (v) sale of undeveloped plots. No such exemption. No such requirement. No such provision/ clarification Investor/ Investee company. 36

42 Private Equity and Debt in Real Estate II. Analysis Provisions Minimum Land Requirements Revised policy pursuant to Press Release Minimum area to be developed under each project would be: i. Development of serviced plots: No minimum land requirement; ii. Construction-development projects: Minimum floor area of 20,000 sq. meters; iii. Combination project: Any of the above two conditions need to be complied with. Existing Policy Minimum area to be developed under each project would be as under: i. Development of serviced housing plots: Minimum land area of 10 hectares; ii. Construction-development projects: Minimum built-up area of 50,000 sq. meters; iii. Combination project: Any of the above two conditions need to be complied with A. Serviced plots and combination projects Removal of minimum land requirements for serviced plots is a substantial relaxation. It appears that in case of combination projects as well, there shall be no minimum land requirement. Such relaxation could attract creative structuring for foreign investments in smaller areas. B. Construction- development projects In case of construction-development projects, the minimum land requirement has been reduced from 50,000 sq. meters of built-up area to 20,000 sq. meters of floor area. The introduction of floor area concept, as against the earlier benchmark of built-up area may need to be examined. Floor area has been stated to be defined as per the local laws/ regulations of the respective state governments / union territories. Definitions of floor area vary from state to state. While floor area is defined for some areas, other areas do not have any definition of the term, such as the regulations for Greater Mumbai. It is to be seen whether floor area in these regions would be equivalent to built-up area or floor space index (FSI), though in some cases, floor area is close to built-up area. Provisions Minimum Capitalization Requirements Revised policy pursuant to Press Release Minimum capitalization of USD 5 million. Existing Policy For wholly owned subsidiary: minimum capitalization of USD 10 million; For joint ventures with Indian partners: minimum capitalization of USD 5 million. In a market largely driven by debt such as listed non-convertible debentures, a lower minimum capitalization would be helpful considering minimum capitalization can only consist of equity and compulsorily convertible instruments. This will also be helpful in tax structuring and optimization of returns for investors. 37

43 Foreign Investment Norms for Real Estate Liberalized Provided upon request only Provisions Timing of investment Revised policy pursuant to Press Release The funds would have to be brought in within 6 months of commencement of the project. Commencement of the project has been explained to mean date of approval of the building plan/ lay out plan by the relevant statutory authority. Subsequent tranches can be brought in till the earlier of: i. Period of 10 years from the commencement of the project; or ii. The completion of the project. Existing Policy The funds would have to be brought in within 6 months of commencement of business of the company. No such concept of 10 years from commencement of business earlier. C. Commencement of business of company to commencement of project Commencement of business of the company had not been defined in the FDI Policy. It was seen practically that the regulator s view was that the period of 6 months was to be calculated from the earlier of the date on which the investment agreement was signed by the investor, or the date the funds for the first tranche are credited into the account of the company. However, the criterion has now been changed to 6 months from the commencement of the project of the company, which has been explained to mean the date of the approval of the building plan/ lay out plan by the relevant authority. This is a welcome move since this brings clarity as against dependence on interpretation of commencement of business. D. Period for subsequent tranches The FDI Policy did not have any restriction on the maximum period till which the investor could infuse funds. However, the Amendment states that subsequent tranches of investment can only by brought in till a period of 10 years from the commencement of the project, which seems to imply that the regulator is reluctant towards real estate projects which have extremely long gestation periods. Provisions Lock-in Revised policy pursuant to Press Release The investor is permitted to exit from the investment at (i) 3 years from the date of final installment, subject to development of trunk infrastructure, or (ii) on the completion of the project. Existing Policy The investor is permitted to exit from the investment at expiry of 3 years from the date of completion of minimum capitalization. Trunk infrastructure has not been defined, but is explained to include roads, water supply, street lighting, drainage and sewerage. Repatriation of FDI or transfer of stake by a non-resident investor to another non-resident investor would require prior FIPB approval. For investment in tranches: The investor is permitted to exit from the investment at the later of (a) 3 years from the date of receipt of each tranche/ installment of FDI, or (b) at expiry of 3 years from the date of completion of minimum capitalization. Prior exit of the investor only with the prior approval of FIPB. 38

44 Private Equity and Debt in Real Estate E. Exit on completion A welcome change is permitting investors to exit on the completion of the project. Hitherto, each tranche of investments were locked-in for a period of 3 years, even if the project was completed. This posed a major challenge for last-mile funding for projects, since the investment was stuck even on the completion of the project. F. Lock-in of 3 years from final instalment The lock-in for ongoing or non-completed projects for 3 years from the final tranche may need to be examined. The earlier regulations required any tranche to be locked in for a period of 3 years from the date of receipt of such tranche only. G. 50% in 5 years Another positive move is the removal of the minimum development of 50% in 5 years from the date of obtaining all statutory clearances. Earlier, there some ambiguity in relation to when the 50% development requirement would trigger, since it was unclear what all statutory approvals meant. To remove this ambiguity, the requirement for the minimum development of 50% in 5 years has been removed. However, in spirit, the same has been introduced by requiring trunk infrastructure to be developed before any exit. H. Trunk infrastructure last tranche, trunk infrastructure (explained to include roads, water supply, street lighting and drainage and sewerage) must be developed. This requirement did not exist previously, and has been a recent introduction. This has also removed all ambiguities in relation to the 50% development requirement, since this is no longer linked to the obtaining of statutory clearances. I. Grandfathering It is unclear whether existing investment, on the anvil of exit currently would be required to satisfy the trunk infrastructure requirements. This may be a major barrier for investors who have completed the 3 year period from their investment, and are seeking exit, although trunk infrastructure has not been developed. It is also unclear whether existing tranches of investment would be locked in till the end of 3 period from any future tranches, if any. Grandfathering of the existing investments from the requirements to comply with trunk infrastructure and the lock-in period would be important for existing investments. J. Sale of stake from non-resident to non-resident While the exit of a foreign investor earlier required FIPB approval, transfer of a non-resident investor s stake to another non-resident investor was not expressly included. The Press Release now confirms this. To be eligible to exit at the end of 3 years from the Provisions Revised policy pursuant to Press Release Existing Policy Requirement of commencement certificate for serviced plots The requirement of commencement certificate has been done away with. The investor was required to provide the completion certificate from the concerned regulatory authority before disposal of serviced housing plots. A major relaxation which has now been introduced is the removal of the completion certificate requirement. Since these were service plots, a completion certificate was not forthcoming. Addressing this concern, this is no longer required as long as trunk infrastructure is developed. 39

45 Foreign Investment Norms for Real Estate Liberalized Provided upon request only Provisions Minimum development Revised policy pursuant to Press Release No requirement of any minimum development. Existing Policy At least 50% of the project must be developed within a period of 5 years from date of obtaining all statutory clearances. Earlier, there some ambiguity in relation to when the 50% development requirement would trigger, since it was unclear what all statutory approvals meant. To remove this ambiguity, the requirement for the minimum development of 50% in 5 years has been removed. However, in spirit, the same has been introduced by requiring trunk infrastructure to be developed before any exit Provisions Revised policy pursuant to Press Release Existing Policy Affordable Housing Projects which allocate 30% of the project cost for low cost affordable housing are exempt from the minimum land area, and minimum capitalization requirements. No such exemption. Affordable housing projects have been defined to mean projects which allot at least 60% of the FAR/ FSI for dwelling units of carpet area not being more than 60 sq. meters. Out of the total dwelling units, at least 35% should be of carpet area sq. meters for economically weaker section category. intent clearly is to encourage investment into affordable housing and housing for the economically weaker section, the equilibrium between luxury housing and affordable housing remains to be seen. This would encourage creative structuring of investments into affordable housing. While the Provisions Completed projects Revised policy pursuant to Press Release It has been clarified that 100% FDI permitted in completed projects for operation and management of townships, malls/ shopping complexes and business centers. Existing Policy No such provision/ clarification It has been long debated whether FDI should be permitted in commercial completed real estate. By their very nature, commercial real estate assets are stable yield generating assets as against residential real estate assets, which are also seen as an investment product on the back of the robust capital appreciation that Indian real estate offers. To that extent, if a company engages in operating and managing completed real estate assets like a shopping mall, the intent of the investment should be seen to generate revenues from the successful operation and management of the asset (just like a hotel or a warehouse) as against holding it as a mere investment product (as is the case in residential real estate). The apprehension of creation of a real estate bubble on the back of speculative land trading is to that naturally accentuated in context of residential real estate. To that extent, operation and management of a completed yield generating asset is investing in the risk of the business and should be in the same light as investment in hotels, hospitals or any asset heavy asset class which is seen as investment in the business and not in the underlying real estate. Even for REITs, the government was favorable to carve out an exception for units of a REI from the definition of real estate business on the back of such understanding, since REITs would invest in completed yield general real estate assets. The Press Release probably aims to follow the direction and open the door for foreign investment in completed real assets, however the language is not entirely the way it should have been and does seem to indicate that foreign investment is allowed only in entities that are operating an managing completed 40

46 Private Equity and Debt in Real Estate assets as mere service providers and not necessarily real estate. While it may seem that FDI has now been permitted into completed commercial real estate sector, the Press Release leaves the question unanswered whether these companies operating and managing the assets may own the assets as well. Provisions Responsibility for obtaining all necessary approvals Revised policy pursuant to Press Release Investee Company. Existing Policy Investor/ Investee company. K. Analysis The obligation to obtain all necessary approvals, including the business plans has now been clarified to be that of the investee company in India, doing away with the unnecessary hassles around this for investor III. Conclusion The changes introduced by way of the Press Release are along expected lines after the Budget Speech earlier this year. The minimum land requirement was an impediment for foreign investment, since it was difficult to find large tracts of land for development to satisfy the minimum land requirements in Tier-I cities. Further, the demand was inadequate for such investment to be made in Tier-II cities, where minimum land requirements could be met. Reducing or removal of minimum land requirements, along with removal of the requirement to obtain a completion certificate for sale of such plots would encourage foreign investment into this space. While the final press note is still awaited to clarify certain aspects, this seems to be a positive move by the government to attract further investment. Abhinav Harlalka & Ruchir Sinha You can direct your queries or comments to the authors 41

47 Provided upon request only Annexure II Foreign Investment Norms in Real Estate Changed i. Analysis 3 year lock-in restriction removed Criteria for affordable housing projects relaxed Whether investments are now possible in brownfield real estate projects? In line with the announcements in the Finance Minister s budget speech for 2014, the Union Cabinet in a recent press release issued pursuant to its meeting dated October 29, 2014 ( Press Release ), proposed certain relaxations for Foreign Direct Investment ( FDI ) in construction-development sector. This was followed by press note 10 of 2014 ( Press Note ) on December 3 rd, 2014 and an RBI circular dated January 22, 2015 to formally notify the relaxations. Though most of the changes proposed in the Press Release have substantially been incorporated in the Press Note, there are certain differences in the Press Note as against Press Release. For a detailed analysis of the Press Release, please refer to our previous hotline Foreign investment norms for real estate liberalized. In this hotline, we are covering only the differences in the Press Note as against the Press Release. I. Changes A. Lock-in restriction The Press Release proposed that a foreign investor can exit from its investment only on (i) the completion of the project, or (ii) completion of three years from the date of final investment, subject to the development of the trunk infrastructure, i.e., roads, water supply, street lighting, drainage and sewerage. The Press Note has done away with the requirement of 3 (three) years from the date of final investment, and hence, an investor can now exit from the project once it is completed or after the development of the trunk infrastructure. a). No minimum lock-in period As per the earlier FDI Policy, each tranche of investment was locked in for a period of 3 years. Though this was intended to provide some long term commitment to the project by a foreign investor, even if the project was completed, some later tranches of foreign investment, especially the last mile funding could still be locked-in. By removing the 3 year (three) lock-in now, the government has encouraged foreign investments in shorter projects (also applicable as the minimum area requirements have now been relaxed), and removed deterrence for a foreign investor to provide subsequent funding in case of longer projects. b). Ambiguity in exit from multi-phase projects Previously if a project was developing in phases, a foreign investor could exit from the project upon completion of the initial phase, provided the 3 (three) year lock-in period had expired. However now, since the exit is linked to either project completion or development of trunk infrastructure, it is unclear whether a foreign investor can exit (whether partly or completely) upon completion of any phase of the project, when the trunk infrastructure for later phases is not developed. B. Affordable housing project The Press Note has relaxed the criteria for determining affordable housing projects than as proposed in the Press Release. As per the Press Release, affordable housing projects were defined to mean projects which allot at least 60% of the floor area ratio ( FAR ) / floor space index ( FSI ) for dwelling units of carpet area not being more than 60 sq. meters, and out of the total dwelling units, at least 35% should be of carpet area sq. meters for economically weaker section category. Press Note defines affordable housing projects as 42

48 Private Equity and Debt in Real Estate projects where at least 40% of the FAR / FSI is for dwelling unit of floor area of not more than 140 sq. meters, and out of the total FAR / FSI reserved for affordable housing, at least 1/4 th (one-fourth) should be for houses of floor area of not more than 60 sq. meters i. Analysis This relaxation is a welcome move, since projects which qualify for affordable housing will not be required to comply with certain conditionalities like minimum area requirements and minimum investment requirements. Having said the above, since the area requirements is relaxed to as high as 140 sq. meters (approx sq. feet), and only 1/4th of the affordable housing portion needs to be 60 sq. meters (approx. 645 sq. feet), whether the purpose for which this relaxation is introduced will be met or not is not clear. C. Combination project The Press Release retained the provision that in case of combination projects (mix of serviced plots and construction development), either of the condition for minimum area requirement can be satisfied. However, since now the minimum area restriction (being 25 acres) for serviced plots has been removed, to avoid any misuse, the concept of combination projects has been removed in the Press Note. D. Grandfathering The Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) (Sixteenth Amendment) Regulations, 2014, dated December 8, 2014 ( Amendment Regulations ) which amends the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 to include the changes introduced by the Press Note, provides that (i) the Amendment Regulations shall be deemed to have come into force from December 3, 2014, and (ii) no person will be adversely affected as a result of the retrospective effect being given to the Amendment Regulations. II. Conclusion estate sector. The relaxations in the minimum land area requirements will bring a lot of projects under the FDI compliant fold, especially in Tier I cities, where project sizes are typically small. Having said the above, there are two issues which may cause a concern: i. as now it has been clarified that the minimum investment will have to be infused within 6 months of commencement of the project i.e., the date of approval of building plan / lay out plan by the relevant statutory authority, and not 6 (six) months of commencement of business, which was understood to mean the date of investment agreement with the investor or the date of first infusion by the investor, it appears that investment in brownfield projects may be a challenge, which could be a major dampener. This may also hinder investments in under construction projects which are stalled due to funding requirements; and ii. though, the government has relaxed the capital account restrictions in real estate sector over the last few years, certain changes have created hindrance in exits for existing foreign investments; for instance, press note 2 of 2005 permitted a foreign investor to exit upon completion of 3 (three) years from the date of investment, which was then later extended to 3 (three) years from the date of each tranche of investment. So, if an investor made a subsequent investment in the 4 th (fourth) year from the date of initial investment, its 4 th (fourth) year investment got suddenly locked in for another 3 (three) years, which the investor had not contemplated at the time of making investment. Also now, the Press Note prescribes that an investor can exit only on completion of the entire project or development of the trunk infrastructure. To that extent, in the absence of grandfathering, existing investors who had completed 3 (three) years and could have exited, are now left high and dry. It remains to be seen if they will now be given approvals for exit prior to completion or development of trunk infrastructure. Dipanshu Singhal, Deepak Jodhani & Nishchal Joshipura You can direct your queries or comments to the authors The changes introduced by the Press Note are expected to provide a much need fillip to the real 43

49 Provided upon request only Annexure III Specific Tax Risk Mitigation Safeguards for Private Equity Investments In order to mitigate tax risks associated with provisions such as those taxing an indirect transfer of securities in India, buy-back of shares, etc., parties to M&A transactions may consider or more of the following safeguards. These safeguards assume increasing importance, especially with the GAAR coming into force from April 1, 2015 which could potentially override treaty relief with respect to tax structures put in place post August 30, 2010, which may be considered to be impermissible avoidance arrangements or lacking in commercial substance. I. Nil Withholding Certificate Parties could approach the income tax authorities for a nil withholding certificate. There is no statutory time period prescribed with respect to disposal of applications thereof, which could remain pending for long without any clarity on the time period for disposal. In the last few years, there have not been many instances of such applications that have been responded to by the tax authorities. However, recently, in January 2014, an internal departmental instruction was issued requiring such applications to be decided upon within one month. The extent to which the instruction is adhered to remains yet to be seen. II. Advance Ruling Advance rulings obtained from the Authority for Advance Rulings ( AAR ) are binding on the taxpayer and the Government. An advance ruling may be obtained even in GAAR cases. The AAR is statutorily mandated to issue a ruling within six months of the filing of the application, however due to backlog of matters, it is taking about 8-10 months to obtain the same. However, it must be noted that an advance ruling may be potentially challenged in the High Court and finally at the Supreme Court. There have been proposals in the Budget to strengthen the number of benches of the AAR to relieve this burden. III. Contractual Representations Parties may include clear representations with respect to various facts which may be relevant to any potential claim raised by the tax authorities in the share purchase agreement or such other agreement as may be entered into between the parties. IV. Escrow Parties may withhold the disputed amount of tax and potential interest and penalties and credit such amount to an escrow instead of depositing the same with the tax authorities. However, while considering this approach, parties should be mindful of the opportunity costs that may arise because of the funds getting blocked in the escrow account. V Tax insurance A number of insurers offer coverage against tax liabilities arising from private equity investments. The premium charged by such investors may vary depending on the insurer s comfort regarding the degree of risk of potential tax liability. The tax insurance obtained can also address solvency issues. It is a superior alternative to the use of an escrow account. VI. Legal Opinion Parties may be required to obtain a clear and comprehensive opinion from their counsel confirming the tax liability of the parties to the transaction. Relying on a legal opinion may be useful to the extent that it helps in establishing the bona fides of the parties to the transaction and may even be a useful protection against penalties associated with the potential tax claim if they do arise. 44

50 Private Equity and Debt in Real Estate VII. Tax indemnity Tax indemnity is a standard safeguard used in most M&A transactions. The purchasers typically seek a comprehensive indemnity from the sellers for any tax claim or notice that may be raised against the purchaser whether in relation to recovery of withholding tax or as a representative assessee. The following key issues may be considered by parties while structuring tax indemnities: A. Scope The indemnity clause typically covers potential capital gains tax on the transaction, interest and penalty costs as well as costs of legal advice and representation for addressing any future tax claim. B. Period Indemnity clauses may be applicable for very long periods. Although a limitation period of seven years has been prescribed for reopening earlier tax cases, the ITA does not expressly impose any limitation period on proceedings relating to withholding tax liability. An indemnity may also be linked to an advance ruling. C. Ability to indemnify The continued ability and existence of the party providing the indemnity cover is a consideration to be mindful of while structuring any indemnity. As a matter of precaution, provision may be made to ensure that the indemnifying party or its representatives maintain sufficient financial solvency to defray all obligations under the indemnity. In this regard, the shareholder/s of the indemnifying party may be required to infuse necessary capital into the indemnifying party to maintain solvency. Sometimes back-toback obligations with the parent entities of the indemnifying parties may also be entered into in order to secure the interest of the indemnified party. D. Conduct of proceedings The indemnity clauses often contain detailed provisions on the manner in which the tax proceedings associated with any claim arising under the indemnity clause may be conducted. E. Dispute Resolution Clause Given that several issues may arise with respect to the interpretation of an indemnity clause, it is important that the dispute resolution clause governing such indemnity clause has been structured appropriately and covers all important aspects including the choice of law, courts of jurisdiction and/or seat of arbitration. The dispute resolution mechanism should take into consideration urgent reliefs and enforcement mechanisms, keeping in mind the objective of the parties negotiating the master agreement and the indemnity. 45

51 Provided upon request only Annexure IV Flips and Offshore REITs One of the means of exit for shareholders of a real estate company and also a way of accessing global public capital is by way of flipping the assets of the real estate company into the fold of an offshore REIT vehicle. adopted for flipping the assets into REIT vehicle structured as a Singapore business trust that could be listed on the Singapore stock exchange. Herein below, is a typical structure that may be Investors Investors Offshore Units in the trust SBT Investors Singapore India 100% owner Trust Management Company Promoter Singapore SPV 100% Equity / Listed NCDs Real Estate Company Indian SPV Real Estate Project In this structure the promoter flips its interest in the real estate asset in India offshore which can then be utilized to raise global capital offshore or to give an exit to offshore investors. I. In this Structure i. The individual shareholders of the Promoter entity acquires an interest in the management company in Singapore under the liberalized remittance scheme ( LRS ) which sets up the Singapore business trust ( SBT ). LRS permits an Indian resident individual to remit upto USD 125,000 in any financial year for most capital / current account transactions. ii. SBT in turn sets up an SPV in Singapore to invest in India. This is because a trust is not eligible to treaty benefits under the Indian Singapore tax treaty. iii. The SPV then sets up the Indian SPV. iv. The Indian SPV can then either purchase the real estate project on a slump sale basis on deferred consideration. v. SBT can then raise monies by way of private placement or through listing of its units on the Singapore stock exchange. These monies can then be utilized to settle the deferred purchase consideration or purchase the real estate project. vi. The proceeds from the sale of the real estate 46

52 Private Equity and Debt in Real Estate project may then be utilized to provide an exit to the shareholders in India, in particular the foreign investor in the real estate company. II. Key Considerations Some of the key considerations that may be considered while flipping assets into an offshore entity are as follows i. Jurisdiction of the offshore entity and amenability to public markets ii. Choice of Yield generating stabilized assets vs. developing assets as most offshore markets favor yield generating assets iii. Need for on the ground presence and domestic sponsor and track record iv. Appetite for Indian assets v. Tax Challenges vi. Regulatory Challenges III. Tax and Regulatory Challenges A. FDI Policy A foreign company or a subsidiary of a foreign company is not permitted under the FDI Policy to acquire completed real estate assets, and can only invest in developmental assets as set out earlier in this paper. To that extent, either the SBT can acquire under construction real estate assets or other FDI Compliant assets such as SEZs, industrial parks, hospital etc. as provided in the FDI Policy and set out above. Also, other restrictions of FDI in real estate as set out earlier such as 3 year lock-in, DCF valuation and other issues as set out earlier in this paper also become applicable. B. Holding of the Trustee Manager Under the extant Indian exchange control regulations, only an Indian financial services company can invest in another financial services only with prior approval of the Indian financial services regulator (department of non-banking financial services in case of an NBFC investing overseas) and the overseas financial services regulator. However, based on our experience, such approval from the Indian regulator may be difficult to come through if the purpose of the overseas investment is to reinvest the proceeds in India, or manage a trust that is entrusted with investing India. Accordingly, whilst an Indian real estate company will find it impossible to invest in the asset management company overseas (referring to the trustee-manager), even if the investment were through an affiliated Indian NBFC, regulatory approval may be challenging. Accordingly, the promoters of the Indian Promoter entity may subscribe to units of the trustee manager under the LRS, which permits an Indian resident individual to remit upto USD 125,000 in any financial year to acquire shareholding in the trusteemanager. In our experience, Sponsor brand name typically is necessary for marketing the SBT. C. Need for Indian SPV Typically, any fundraise initiative by the SBT may not be received well by the investors unless the SBT has the real estate project in its fold. Since the SBT may not have adequate funds to purchase the real estate project initially, it may like to purchase the real estate project on a deferred consideration basis. However, since purchase of Indian securities on a deferred consideration is not permitted, the SPV may setup the Indian SPV, which could purchase the real estate project on deferred consideration basis, which shall be discharged in manner set out above. D. Transfer Taxes on Flips Any transfer of immoveable property is subject to stamp duty to be paid to state government where the property is located. The extent of stamp duty varies from state to state usually ranging from 5-8% on the market value of property or the actual sale consideration whichever is higher. To determine the market value, the local authorities have prescribed the reckoner / circle rates for each area which are generally revised on an annual basis. In addition to the stamp duty, the Seller is obligated to pay tax on the capital gains received by it from the sale of the immovable property. If however, the sale consideration is lower than the reckoner rate, per Section 50C of the ITA the reckoner rate shall be deemed to be the consideration for the transfer of immovable property and the seller shall be taxed 47

53 Flips and Offshore REITs Provided upon request only accordingly. Having said that, Section 50C is not applicable to immovable property which is held as stock-in-trade and not capital asset however, the Finance Bill, has inserted section 43CA (Special provision for full value of consideration for transfer of assets other than capital assets in certain cases) in the ITA which is a provision similar to Section 50C but applicable for assets other than capital assets, and since most developers record the real estate project as stock-in-trade, to that extent also unlike before, the seller would now be taxed on the value adopted/assessed/assessable by any authority of a state Government for the purpose of payment of stamp duty on such transfer, thus denying the tax advantage of allowing the sale of the immoveable property at book value. the limited asset classes that can be rolled into an offshore REIT (being only FDI Compliant assets), SBT may consider investing in the Indian SPV by way of acquiring listed NCDs of the Indian SPV or the real estate company under the FPI route as set out earlier in this paper. In addition to the above, NCDs may also be issued where the investors are offered assured regular returns and exit. This is because, the interest on compulsorily convertible debentures may be capped at SBI PLR basis points and any returns beyond that may have to be structured by way of buy-back or dividends which entails a higher tax rate. E. Structured Debt Instruments Considering the restrictions of FDI in real estate (minimum area requirement, lock - in etc.) and 48

54 Private Equity and Debt in Real Estate Annexure V REITs: Tax Issues and Beyond APART FROM THE TAX CHALLENGES, THERE ARE NON-TAX ISSUES ALSO THAT MAKE THE INDIAN REIT UNATTRACTIVE The Securities and Exchange Board of India (Sebi) recently introduced the final regulations for real estate investment trusts (REITs) and infrastructure investment trusts (InvITs). These regulations come on the back of recent tax initiatives introduced in the budget this year. While the initiative is indeed a positive step, the tax measures governing REITs or business trusts (as they are referred to in the Incometax Act) do not offer much encouragement, neither to the sponsor nor the unit holders. From a sponsor s perspective, capital gains tax benefit has been given only in cases where shares of the special purpose vehicle (SPV) holding the real estate are transferred to a REIT against units of a REIT, and not when real estate is directly transferred to a REIT. By doing so, there is an unnecessary corporate layer imposed between the REIT and the real estate asset, which could result in a tax leakage of about 45% (corporate taxes of 30% at the SPV level and distribution tax of 15% on dividends, exclusive of surcharge and cess). To the sponsor, there is no tax benefit (but mere deferral) because she gets taxed when the REIT units are ultimately sold on the floor at a much more appreciated value, even though the units of a REIT would be listed and exempt from capital gains tax if held by other unit holders for more than three years. While capital gains tax incidence may still be avoided by relying on principles of trust taxation, there will still be no respite from minimum alternate tax (MAT), which could become applicable on transfer of shares to the REIT. Considering that sponsors would like to transfer the shares at higher than book value to ensure commensurate fund raising for the REIT, the issue of MAT seems to be most critical. From a REIT taxation perspective, although a passthrough of tax liability to investors for REIT income was promised, since the SPV is required to pay full corporate and dividend distribution taxes, where is the pass-through? What is even worse is that no foreign tax credit may be available for such taxes paid in India. The only way to achieve tax optimization seems to be by way of infusion of debt into the SPV by a REIT. In such a situation, interest from the SPV to the REIT will be a deductible for the SPV, thus allaying both distribution taxes and corporate taxes. Interest from the SPV would be tax exempt at the REIT level and only a 5% withholding will be applicable on distributions by the REITs to the foreign unitholders. This should help neutralize REIT taxation at India level, considering that the 5% withholding tax paid in India should also be creditable offshore. The critical question that would then come up is how the SPV would use this debt. The debt can either be used to retire existing debt, or be structured to retire promoter equity in the SPV. If the debt is used for retiring equity, the risk of deemed dividend characterization would need to be carefully considered. Though other creative structures may be devised to minimize tax exposure for the sponsor, it will be critical to dress up the SPV appropriately with the right amount of debt and equity, before the SPV is transferred to the REIT. Apart from the tax challenges set out above, there are also several non-tax issues that make the Indian REIT story unattractive. The requirement for a sponsor to have a real estate track record is likely to rule out a substantial portion of yield generating assets. This eliminates the possibility of non-real estate players such as hotels, hospitals, banks and others (such as Air India) becoming sponsors of REITs. Most importantly, the marketability of Indian REITs compared with other fixed-income products remains weak since the expected yield on REITs may not exceed 5-6% compared with an around-8% yield offered by government securities. Though REITs may offer a higher return considering the capital appreciation, offshore investors seem reluctant to buy the cap rate story attached to a REIT. Having said that, REITs are likely to offer monetization opportunities to private equity funds and developers, which have till now been unable to find institutional buyers for completed real estate assets. As the appetite for developmental projects has reduced, REITs will offer opportunities to foreign investors to invest in rent generating assets, an asset 49

55 REITs: Tax Issues and Beyond Provided upon request only class otherwise prohibited for foreign investments. It, however, remains to be seen how the Indian REIT story matches up to the Singapore REIT structure for Indian assets, or the more trending lease-rentaldiscounting structure, or the even more innovative commercial mortgage-backed security structure, which seem to be more appealing to potential sponsors. This article was published in Livemint dated October 21, The same can be accessed from the link article/reits-tax-issues-and-beyond-1.html?no_cache= 1&cHash=a bb5bc1969d720fba3cad33a Sriram Govind & Ruchir Sinha You can direct your queries or comments to the authors 50

56 Private Equity and Debt in Real Estate Annexure VI NBFC Structure for Debt Funding In light of the challenges that the FDI and the FPI route are subjected to, there has been a keen interest in offshore funds to explore the idea of setting up their own NBFC to lend or invest in Indian companies. An NBFC is defined in terms of Section 45I(c) of the RBI Act, 1934 ( RBI Act ) as a company engaged in granting loans/advances or in the acquisition of shares/securities, etc. or hire purchase finance or insurance business or chit fund activities or lending in any manner provided the principal business of such a company does not constitute any non-financial activities such as (a) agricultural operations, (b) industrial activity, (c) trading in goods (other than securities), (d) providing services, (e) purchase, construction or sale of immovable property. Every NBFC is required to be registered with the RBI, unless specifically exempted. The Act has however remained silent on the definition of principal business and has thereby conferred on the regulator, the discretion to determine what is the principal business of a company for the purposes of regulation. Accordingly, the test applied by RBI to determine what is the principal business of a company was articulated in the Press Release 99/1269 dated April 8, 1999 issued by RBI. As per the said press release, a company is treated as an NBFC if its financial assets are more than 50 per cent of its total assets (netted off by intangible assets) and income from these financial assets is more than 50 per cent of its gross income. Both these tests ( 50% Tests ) are required to be satisfied in order for the principal business of a company to be determined as being financial for the purpose of RBI regulation. Recommendation of the Working Group on the Issues and Concerns in the NBFC Sector chaired by Usha Thorat has been issued by RBI in the form of Draft Guidelines ( Draft Guidelines ). Draft Guidelines 1 provide that the twin criteria of assets and income for determining the principal business of a company need not be changed. However, the minimum percentage threshold of assets and income should be increased to 75 per cent. Accordingly, the financial assets of an NBFC should be 75 per cent or more (as against more than 50 per cent) of total assets and income from these financial assets should be 75 per cent or more (as against more than 50 percent) of total income. The NBFC could be structured as follows. Structure diagram Off-shore Fund Non-Banking Financial Company Off-shore India Indian Company 1. The Working Group report was published by the RBI in the form of Draft Guidelines on its website 12 th December

57 NBFC Structure for Debt Funding Provided upon request only The Offshore Fund sets up an NBFC as a loan company, which then lends to Indian companies. The NBFC may either lend by way of loan or through structured instruments such as NCDs which have a protected downside, and pegged to the equity upside of the company by way of redemption premium or coupons. I. Advantages of the NBFC Route A. Assured Returns The funding provided through NBFCs is in the form of domestic loans or NCDs, without being subjected to interest rate caps as in the case of CCDs. These NCDs can be structured to provide the requisite distribution waterfall or assured investors rate of return ( IRR ) to the offshore fund. B. Regulatory Uncertainty but since the NBFC will be owned by the foreign investor itself, the foreign investor is no longer dependent on the Indian company as would have been the case if the investment was made directly into the Indian entity. E. Tax Benefits to the Investee Company As against dividend payment in case of shares, any interest paid to the NBFC will reduce the taxable income of the investee company. However, an NBFC may itself be subjected to tax to the extent of interest income so received, subject of course to deductions that the NBFC may be eligible for in respect of interest pay-outs made by the NBFC to its offshore parent. II. Challenges Involved in the NBFC Route The greatest apprehension for funds has been the fluid regulatory approach towards foreign investment, for instance put options. The NBFC being a domestic lending entity is relatively immune from such regulatory uncertainty C. Security Creation Creation of security interest in favour of nonresidents on shares and immoveable property is not permitted without prior regulatory approval. However, since the NBFC is a domestic entity, security interest could be created in favour of the NBFC. Enforceability of security interests, however, remains a challenge in the Indian context. Enforcement of security interests over immovable property, in the Indian context, is usually a time consuming and court driven process. Unlike banks, NBFCs are not entitled to their security interests under the provisions of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act. D. Repatriation Comfort Even though repatriation of returns by the NBFC to its offshore shareholders will still be subject to the restrictions imposed by the FDI Policy (such as the pricing restrictions, limits on interest payments etc.), A. Setting up The first challenge in opting for the NBFC route is the setting up of the NBFC. Obtaining a certificate of registration from the RBI for an NBFC is a time consuming process. This process used to take anywhere in the region of months earlier, which wait period has now significantly reduced, but it may still take as much as 6 months, or in some cases, even longer. Draft Guidelines provide that NBFCs with asset size below Rs crore and not accessing any public funds shall be exempted from registration. NBFCs, with asset sizes of Rs.1000 crore and above, need to be registered and regulated, even if they have no access to public funds. Draft Guidelines also provide that small nondeposit taking NBFCs with asset of Rs. 50 crores or less should be exempt from the requirement of RBI registration. Not being deposit taking NBFCs and being small in size, no serious threat perception is perceived to emanate from them. Due to the elaborate time period involved in setting up the NBFC, one of the common alternatives 52

58 Private Equity and Debt in Real Estate adopted, especially in case of non-deposit taking NBFCs was to purchase an existing NBFC. This was because earlier there was only a requirement of giving 30 thirty days written notice 2 prior to effecting a change of control of non-deposit NBFC (the term control has the same meaning as defined in the SEBI Takeover Code), and a separate approval was not required; and unless the RBI restricted the transfer of shares or the change of control, the change of control became effective from the expiry of thirty days from the date of publication of the public notice. However, recently, the RBI vide its circular dated May 26, , has prescribed that in order to ensure that the fit and proper 4 character of the management of NBFCs is continuously maintained for both, deposit accepting and non-deposit accepting NBFCs, its prior written permission has to be obtained for any takeover or acquisition of control of an NBFC, whether by acquisition of shares or otherwise. This RBI circular requires prior approval in the following situations also i. any merger/amalgamation of an NBFC with another entity or any merger/amalgamation of an entity with an NBFC that would give the acquirer / another entity control of the NBFC; ii. any merger/amalgamation of an NBFC with another entity or any merger/amalgamation of an entity with an NBFC which would result in acquisition/transfer of shareholding in excess of 10 percent of the paid up capital of the NBFC; iii. for approaching a court or tribunal under Section of the Companies Act, 1956 or Section of Companies Act, 2013 seeking order for mergers or amalgamations with other companies or NBFCs. The abovementioned RBI approval is sought from the DNBS (Department of Non-Banking Supervision) division of the RBI. Separately, earlier, any transfer of shares of a financial services company from a resident to a non-resident required prior approval of the Foreign Exchange Department of the Reserve Bank of India ( FED ), which took anywhere in the region of 2 4 months. In a welcome move, as per a recent RBI circular dated November 11, 2013, the requirement to procure such an approval was removed if: i. any fit and proper/ due diligence requirement as regards the non-resident investor as stipulated by the respective financial sector regulator shall have to be complied with ; and ii. The FDI policy and FEMA regulations in terms of sectoral caps, conditionalities (such as minimum capitalization, etc.), reporting requirements, documentation etc., are complied with. Since, the requirement of obtaining RBI approval in case of change in control even for non-deposit taking NBFC is relatively very new, only time will tell how forthcoming RBI is in granting such approvals and to that extent, how favourable is this option of purchasing NBFC. B. Capitalization The NBFC would be subject to minimum capitalization requirement which is pegged to the extent of foreign shareholding in the NBFC as set out in the FDI Policy. Considering the need for capitalization, it is not uncommon to see non residents holding less than 75% stake in the NBFC even though a significant portion of the contribution comes from nonresidents. Premium on securities is considered for calculating the minimum capitalization. In addition to the above, every NBFC is required to have net owned funds 5 of INR 20 million (INR 2.5 million provided application for NBFC registration is 2. The public notice had be published in one English and one vernacular language newspaper, copies of which were required to be submitted to the RBI 3. DNBS (PD) CC.No.376/ / Under the Master Circular on Corporate Governance dated July 1, 2013, RBI had emphasized the importance of persons in management who fulfil the fit and proper criteria. The Master Circular provides as follows: it is necessary to ensure that the general character of the management or the proposed management of the non-banking financial company shall not be prejudicial to the interest of its present and future depositors. In view of the interest evinced by various entities in this segment, it would be desirable that NBFC-D with deposit size of Rs 20 crore and above and NBFC-ND-SI may form a Nomination Committee to ensure fit and proper status of proposed/existing Directors. 5. Net Owned Funds has been defined in the RBI Act 1934 as (a) the aggregate of paid up equity capital and free reserves as disclosed in the latest balance sheet of the company, after deducting there from (i) accumulated balance of loss, (ii) deferred revenue expenditure and (iii) other intangible asset; and (b) further reduced by the amounts representing (1) investment of such company in shares of (i) its subsidiaries; (ii) companies in the same group; (iii) all other NBFCs and (2) the book value of debentures, bonds, outstanding loans and advances (including hire-purchase and lease finance) made to and deposits with (i) subsidiaries of such company and (ii) companies in the same group, to the extent such amounts exceed ten percent of (a) above 53

59 NBFC Structure for Debt Funding Provided upon request only filed on or before April 20,1999). 6 C. The Instrument Before we discuss the choice of an instrument for the NBFC, let s discuss the instruments that are usually opted for investment under the FDI route CCDs essentially offer three important benefits. Firstly, any coupon paid on CCDs is a deductible expense for the purpose of income tax. Secondly, though there is a 40% withholding tax that the nonresident recipient of the coupon may be subject to, the rate of withholding can be brought to as low as 10% if the CCDs are subscribed to by an entity that is resident of a favorable treaty jurisdiction. Thirdly, coupon can be paid by the company, irrespective of whether there are profits or not in the company. Lastly, being a loan stock (until it is converted), CCDs have a liquidation preference over shares. And just for clarity, investment in CCDs is counted towards the minimum capitalization. Percentage of Holding in the NBFC Up to 51% FDI More than 51% FDI More than 75% FDI Minimum Capitalisation USD 0.5 million, with entire amount to be brought upfront. USD 5 million with entire amount to be brought upfront. USD 50 million, with USD 7.5 million to be brought upfront and the balance in 24 months. CCDs clearly standout against CCPS on at least the following counts. Firstly, while any dividend paid on CCPS is subject to the same dividend entitlement restriction (300 basis points over and above the prevailing State Bank of India Prime Lending Rate at the time of the issue), dividends can only be declared out of profits. Hence, no tax deduction in respect of dividends on CCPS is available. To that extent, the company must pay 30% 7 corporate tax before it can even declare dividends. Secondly, any dividends can be paid by the company only after the company has paid 15% 8 dividend distribution tax. In addition, unlike conversion of CCDs into equity, which is not regarded as a transfer under the provisions of the Income-tax Act, 1961, conversion of CCPS into equity may be considered as a taxable event and long term or short term capital gains may be applicable. Lastly, CCPS will follow CCDs in terms of liquidation preference. However, unlike other companies, a combination of nominal equity and a large number of CCDs may not be possible in case of NBFCs. Though all nondeposit accepting NBFCs are subjected to NBFC (Non-Deposit Accepting or Holding) Companies Prudential norms (Reserve Bank) Directions (the Prudential Norms ), once such NBFC has total assets in excess of INR 1 billion (USD 20 million approximately) 9, the NBFC is referred to as a systemically important NBFC. Unlike other NBFCs, a systemically important NBFC is required to comply with Regulation 15 (Auditor s Certificate), Regulation 16 (Capital Adequacy Ratio) and Regulation 18 (Concentration of Credit / Investment) of the Prudential Norms. The choice of instrument is largely dependent on the capital adequacy ratio required to be maintained by the NBFC for the following reason. Regulation 16 of the Prudential Norms restricts a systemically important NBFC from having a Tier II Capital larger than its Tier I Capital. Tier I Capital = Owned funds 10 + Perpetual debt instruments (upto15% of Tier I Capital of previous accounting year) -Investment in shares of NBFC and share/ debenture/bond/ loans / deposits with subsidiary and Group company (in excess of 10% of Owned Fund) Tier II Capital = Non-convertible Preference shares 6. Although the requirement of net owned funds presently stands at INR 20 million, companies that were already in existence before April 21, 1999 are allowed to maintain net owned funds of INR 2.5 million and above. With effect from April 1999, the RBI has not been registering any new NBFC with net owned funds below INR 20 million. 7. Exclusive of surcharge and cess. 8. Exclusive of surcharge and cess. 9. Note that an NBFC becomes a systemically important NBFC from the moment its total assets exceed INR 100 crores. The threshold of INR 1 billion need not be reckoned from the date of last audited balance sheet as mentioned in the Prudential Norms. 10. Owned Fund means Equity Capital + CCPS + Free Reserves +Share Premium + Capital Reserves (Accumulated losses + BV of intangible assets + Deferred Revenue Expenditure) 54

60 Private Equity and Debt in Real Estate / OCPS + Subordinated debt + General Provision and loss reserves (subject to conditions) + Perpetual debt instruments (which is in excess of what qualifies for Tier I above) + Hybrid debt capital instruments + revaluation reserves at discounted rate of fifty five percent; instruments to be in the nature of investments rather than just loan instruments. Once the nature of the instrument changed, then nature of the NBFC automatically changed from lending to investment, and FIPB approval was immediately required in respect of foreign investment in an NBFC engaged in investment activity. Thus, CCDs being hybrid debt instruments which fall in Tier II cannot be more than Tier I Capital. This disability in terms of capitalization is very crucial for the NBFC and its shareholder as it not only impedes the ability of the NBFC to pay out interests to the foreign parent in case of inadequate profits, but is also tax inefficient. There is currently an ambiguity on whether NCDs are to be included in Tier II Capital as they do not qualify in any of the heads as listed above for Tier II Capital. D. No Ability to Make Investments Having discussed the funding of the NBFC itself, let s discuss how the NBFC could fund the investee companies. Under the FDI Policy, an NBFC with foreign investment can only engage in certain permitted activities 11 under the automatic route, and engaging in any financial services activity other than such activities will require prior approval of the Foreign Investment Promotion Board ( FIPB ), an instrumentality of the Ministry of Finance of the Government of India. While lending qualifies as one of the permitted categories ( leasing and finance ), investment is not covered in the list above. Therefore, any FDI in an NBFC that engages in investments will require prior approval of the FIPB. Such an approval though discretionary is usually granted within 3 months time on a case to case basis. Therefore, an NBFC with FDI can only engage in lending but not in making investments. 12 We are given to understand that in a few cases where the redemption premium of the NCDs was linked to the equity upside, RBI qualified such Core Investment Companies A core investment company ( CIC ) is a company which satisfies the following conditions as on the date of the last audited balance sheet (i) it holds not less than 90% of its net assets in the form of investment in equity shares, preference shares, bonds, debentures, debt or loans in group companies; (ii) its investments in the equity shares (including instruments compulsorily convertible into equity shares within a period not exceeding 10 years from the date of issue) in group companies constitutes not less than 60% of its net assets ; (iii) it does not trade in its investments in shares, bonds, debentures, debt or loans in group companies except through block sale for the purpose of dilution or disinvestment; and (iv) it does not carry on any other financial activity referred to in Section 45 I (c) and 45 I (f) of the Reserve Bank of India Act, 1934 except for granting of loans to group companies, issuing of guarantees on behalf of group companies and investments in bank deposits, money market instruments etc. A CIC is not required to register with the RBI, unless the CIC accepts public funds AND has total financial assets in excess of INR 1 billion. Public funds for the purpose of CIC include funds raised either directly or indirectly through public deposits, Commercial Papers, debentures, intercorporate deposits and bank finance but excludes funds raised by issue of instruments compulsorily convertible into equity shares within a period not exceeding 10 years from the date of issue. 11. The activities permitted under the automatic route are: (i) Merchant Banking, (ii) Under Writing, (iii) Portfolio Management Services, (iv) Investment Advisory Services, (v) Financial Consultancy, (vi) Stock Broking, (vii) Asset Management, (viii) Venture Capital, (ix) Custodian Services, (x) Factoring, (xi) Credit Rating Agencies, (xii) Leasing & Finance, (xiii) Housing Finance, (xiv) Forex Broking, (xv) Credit Card Business, (xvi) Money Changing Business, (xvii) Micro Credit, (xviii) Rural Credit and (xix) Micro Finance Institutions 12. The FDI Policy however under paragraph (1) provides that: (iv) 100% foreign owned NBFCs with a minimum capitalisation of US$ 50 million can set up step down subsidiaries for specific NBFC activities, without any restriction on the number of operating subsidiaries and without bringing in additional capital. (v) Joint Venture operating NBFCs that have 75% or less than 75% foreign investment can also set up subsidiaries for undertaking other NBFC activities, subject to the subsidiaries also complying with the applicable minimum capitalisation norms. 55

61 NBFC Structure for Debt Funding Provided upon request only E. Deployment of Funds NBFCs can issue debentures only for deployment of the funds on its own balance sheet and not to facilitate requests of group entities/ parent company/ associates. Core Investment Companies have been carved out from the applicability of this restriction. F. Credit Concentration Norms A systemically important NBFC is not permitted to lend or invest in any single company exceeding 15% of its owned fund, or single group 13 of companies exceeding 25% of its owned fund. If however the systemically important NBFC is investing and lending, then these thresholds stand revised to 25% and 40% respectively. Exemption from such concentration norms may be sought and has been given in the past where the NBFC qualified the following two conditions firstly, the NBFC did not access public funds 14, and secondly, the NBFC did not engage in the business of giving guarantees. Interestingly, public funds include debentures, and to that extent, if the NBFC has issued any kind of debentures (including CCDs), then such relaxation may not be available to it. In the absence of such exemption, it may be challenging for loan or investment NBFCs to use the leverage available to them for the purpose of making loans or investments. G. Only Secure Debentures can be Issued NBFCs can only issue fully secured debentures whether by way of private placement or public issue. The security has to be created within a month from the date of issuance. If the security cover is inadequate, the proceeds have to be placed in an escrow account, till the time such security is created. H. Enforcing Security Interests NBFCs, unlike banks, are not entitled to protection under the SARFAESI Act. This is a major handicap for NBFCs as they have to undergo through the elaborate court process to enforce their security interests, unlike banks which can claim their security interests under the provisions of SARFAESI Act without the intervention of the courts. Representations were made by industry associations seeking inclusion of NBFCs within the ambit of SARFAESI Act, especially in the current times when NBFCs are fairly regulated. We understand that the then RBI Governor D. Subbarao responded to the exclusion of NBFCs on the ground that their inclusion under the SARFAESI Act would distort the environment for which Securitisation Companies (SCs)/ Reconstruction Companies (RCs) were set up by allowing more players to seek enforcement of security rather than attempting reconstruction of assets. Subbarao mentioned that SARFAESI Act was enacted to enable banks and financial institutions to realise long-term assets, manage problem of liquidity, asset liability mis-matches and improve recovery by exercising powers to take possession of securities, sell them and reduce nonperforming assets by adopting measures for recovery or reconstruction, through the specialised SCs/RCs, which would be registered with the RBI and purchase the NPAs of the banks and FIs. According to him, two methodologies were envisaged - first, the strategy for resolution of the assets by reconstructing the NPAs and converting them into performing assets, and second, to enforce the security by selling the assets and recovering the loan amounts Subbarao further mentioned that SARFAESI Act is not merely a facilitator of security enforcement without the intervention of Court. It is a comprehensive approach for restructuring the assets and make it work and only when it does not work, the recovery mode was envisaged. He was apprehensive that since NBFCs have followed the leasing and hire purchase models generally for extending credit and they enjoy the right of repossession, the only benefit SARFAESI Act would extend to the NBFCs will be for enforcement of security interest without the intervention of the court, which may distort the very purpose for which SCs/RCs were created, namely, reconstruction and the inclusion would simply add a tool for forceful recovery through the Act. 13. The term group has not been defined in the Prudential Norms 14. Public funds includes funds raised either directly or indirectly through public deposits, Commercial Papers, debentures, inter-corporate deposits and bank finance. 56

62 Private Equity and Debt in Real Estate Draft Guidelines provide that NBFCs should be given the benefit under SARFAESI Act, 2002, since there is an anomaly that unlike banks and public financial institutions ( PFIs ), most NBFCs (except those registered as PFIs under Section 4A of the Companies Act) do not enjoy the benefits deriving from the SARFAESI Act even though their clients and/or borrowers may be the same. I. Exit Exit for the foreign investor in an NBFC is the most crucial aspect of any structuring and needs to be planned upfront. The exits could either be by way of liquidation of the NBFC, or buy-back of the shares of the foreign investor by the NBFC, or a scheme of capital reduction (where the foreign investor is selectively bought-back), or the sale of its shares in the NBFC to another resident or non-resident, or lastly, by way of listing of the NBFC. 15 Unlike most countries, liquidation in the Indian context is a time consuming and elaborate process in India, sometimes taking in excess of 10 years. Buyback of securities is another alternative, however, CCDs cannot be bought back. CCDs must be converted into the underlying equity shares to be bought back. Buy-back of securities is subjected to certain conditionalities as stipulated under Section 68 of the Companies Act, A buyback of equity shares can happen only out of free reserves, or proceeds of an earlier issue or out of share premium. 16 In addition to the limited sources that can be used for buy-back, there are certain other restrictions as well that restrict the ability to draw out the capital from the company. For instance, only up to a maximum of 25% of the total paid up capital and free reserves of the company can be bought in one financial year, the debt equity ratio post buyback should not be more than 2:1 etc. Buy-back being a transfer of securities from a non-resident to a resident cannot be effected at a price higher than the price of the shares as determined by the discounted cash flows method. Although, buy back from the existing shareholders is supposed to be on a proportionate basis, there have been certain cases such as Century Enka where the court approved a scheme for selective buy-back of 30% of its shareholding from its non-resident shareholders. From a tax perspective, traditionally, the income from buyback of shares has been considered as capital gains in the hands of the recipient and accordingly the investor, if from a favourable treaty jurisdiction, could avail the treaty benefits. However, in a calculated move by the Government to undo this practice of companies resorting to buying back of shares instead of making dividend payments the Budget has now levied a tax of 20% 17 on domestic unlisted companies, when such companies make distributions pursuant to a share repurchase or buy back. The said tax at the rate of 20% is imposed on a domestic company on consideration paid by it which is above the amount received by the company at the time of issuing of shares. Accordingly, gains that may have arisen as a result of secondary sales that may have occurred prior to the buy-back will also be subject to tax now. The proposed provisions would have a significant adverse impact on offshore realty funds and foreign investors who have made investments from countries such as Mauritius, Singapore, United States of America and Netherlands etc. where buy-back of shares would not have been taxable in India due to availability of tax treaty benefits. Further, being in the nature of additional income tax payable by the Indian company, foreign investors may not even be entitled to a foreign tax credit of such tax. Additionally, in the context of the domestic investor, even the benefit of indexation would effectively be denied to such investor and issues relating to proportional disallowance of expenditure under Section 14A of the ITA (Expenditure incurred in relation to income not includible in total income) may also arise. This may therefore result in the buyback of shares being even less tax efficient than the distribution of dividends. As an alternative to buy-back, the investor could approach the courts for reduction of capital under the provisions of section 68 of the Companies Act, 2013; however, the applications for such reduction of capital need to be adequately justified to the court. 15. The forms of exit discussed here are in addition to the ability of the foreign investor to draw out interest / dividends from the NBFC up to 300 basis points over and above the State Bank of India prime lending rate. 16. As a structuring consideration, the CCDs are converted into a nominal number of equity shares at a very heavy premium so that the share premium can then be used for buy-back of the shares. 17. Exclusive of surcharge and cess. 57

63 NBFC Structure for Debt Funding Provided upon request only From a tax perspective, the distributions by the company to its shareholders, for reduction of capital, would be regarded as a dividend to the extent to which the company possesses accumulated profits and will be taxable in the hands of the company at the rate of 15%. 18 Any, distribution over and above the accumulated profits (after reducing the cost of shares) would be taxable as capital gains. Sale of shares of an NBFC or listing of the NBFC could be another way of allowing an exit to the foreign investor; however, sale of shares cannot be effected at a price higher than the price of the shares determined by the discounted cash flow method. Listing of NBFCs will be subject to the fulfillment of the listing criterion and hinges on the market conditions at that point in time. 18. Exclusive of surcharge and cess 58

64 Private Equity and Debt in Real Estate Annexure VII Challenges in Invocation of Pledge of Shares Promoters of Unitech obtained the injunction due to the unreasonable notice period given to them, the company said in an release. Outstanding loan amount was repaid in full by the promoters within a few days of obtaining the injunction and ahead of the schedule. The pledged shares got released nearly three months ago. The pledging of shares is a mechanism through which an investor or a lender can ensure a company or a borrower delivers a promised return or repays a loan within the stipulated period. When the company defaults on the pledge, the shares are sold. PE funds that focus on real estate have got such pledged shares from their portfolio companies. The Unitech case has raised concerns among PE investors about the enforceability of the pledge, said Ruchir Sinha, co-head, real estate investments practice, at law firm Nishith Desai Associates. Many funds are looking to enforce the pledge today, but are concerned if the company can take them to court and obtain a stay order. Realty valuations have been declining as some companies have been facing allegations of wrongdoing relating to bribes given for loans and the allocation of telecom spectrum, besides falling home sales and rising interest rates. On 30 January, Unitech s promoters approached the Delhi high court and secured an injunction against a move by debenture trustee Axis Trustee Services Ltd to sell pledged shares. The promoters of Unitech had raised Rs 250 crore from high networth individuals (HNIs) in 2010 through the issue of non-convertible debentures and had pledged their shares in the firm as security to raise these funds. However, on 28 January, Unitech s stock price dropped to Rs 51 per share, marking a 38% decline since November 2009 and triggering the default. The same day Axis Trustee Services informed the promoters that it would sell the pledged shares on the next working day, as per their agreement. Unitech moved the high court, which said that if the stay was not granted, the company would suffer irreparable loss. Invoking a pledge can be challenging even in a publicly traded company, since the law requires that a fund must immediately sell the shares upon invocation; funds are often faced with the dilemma of whether to invoke the pledge or not, said Sinha. If they invoke the pledge, then they must ensure that the shares are sold, which may, apart from hammering the stock, earn a bad name for the fund, he said. If they don t, and the share value falls, an argument can be made that they suffered the loss due to their failure to exercise their rights on time. The situation is even worse in a private company as there is generally no market for such shares, Sinha said. Any lender who has pledged shares as collateral runs the risk of ending up in court, said a fund manager at one of the large domestic real estate funds, who declined to be identified as it was a legal issue. Ideally, in a case where the lender decides to invoke the pledge even before the company defaults because of weak market conditions, the company should immediately provide for adequate additional security to avoid legal proceedings, he said. There are three major forms of security that are available to lenders mortgages, guarantees and share pledging. Realty funds are increasingly making investments through structured debt instruments and are looking at stringent security mechanisms and stock pledges are one of the most liquid form of security. This is a strong tool being employed by institutional investors today who are worried about their returns from their investment, said Amit Goenka, national director of capital transactions at Knight Frank (India) Pvt. Ltd. According to him, what is prompting investors to enforce pledging of shares is that the risk associated with real estate has risen and investors don t believe they can get their returns on time. There have been 10 investments worth $514 million (Rs 2, crore today) in real estate this year, according to VCCEdge, a financial research platform. Last year, there were 34 investments worth $1.16 million compared with 28 investments worth $870 million in the year earlier. 59

65 Challenges in Invocation of Pledge of Shares Provided upon request only Some of the big investments in the sector include $450 million investment in DLF Assets Ltd by Symphony Capital Partners Ltd, $296 million invested in Phoenix Mills SPV by MPC Synergy Real Estate AG and $200 million invested in Indiabulls Real Estate Ltd by TPG Capital. Unfortunately, it is true that real estate funds want to invoke pledges, said the general counsel of a local PE fund that has raised foreign money. He declined to be identified considering the sensitivity of the issue. If you see all the real estate companies, the extent to which shares have been pledged is increasing day by day, he said. In some of those companies, it has reached the limit and they have nothing else to leverage. So, there is no other choice for those lenders, but to invoke the pledge. However, Sinha of Nishith Desai cautioned that enforcing a pledge will affect the reputation of the company as borrowers will become apprehensive of taking PE money. 60

66 Provided upon request only The following research papers and much more are available on our Knowledge Site: Fund Structuring and Operations E-Commerce in India The Curious Case of the Indian Gaming Laws January 2015 January 2015 January 2015 Corporate Social Responsibility & Social Business Models in India Joint-Ventures in India Outbound Acquisitions by India-Inc March 2015 November 2014 September 2014 Internet of Things: The New Era of Convergence Doing Business in India Private Equity and Private Debt Investments in India September 2014 July 2014 February 2015 NDA Insights TITLE TYPE DATE Thomas Cook Sterling Holiday Buyout M&A Lab December 2014 Reliance tunes into Network18! M&A Lab December 2014 Sun Pharma Ranbaxy, A Panacea for Ranbaxy s ills? M&A Lab December 2014 Jet Etihad Jet Gets a Co-Pilot M&A Lab May 2014 Apollo s Bumpy Ride in Pursuit of Cooper M&A Lab May 2014 Diageo-USL- King of Good Times; Hands over Crown Jewel to Diageo M&A Lab May 2014 Copyright Amendment Bill 2012 receives Indian Parliament s assent IP Lab September 2013 Public M&A s in India: Takeover Code Dissected M&A Lab August 2013 File Foreign Application Prosecution History With Indian Patent Office IP Lab April 2013 Warburg - Future Capital - Deal Dissected M&A Lab January 2013 Real Financing - Onshore and Offshore Debt Funding Realty in India Realty Check May 2012 Pharma Patent Case Study IP Lab March 2012 Patni plays to igate s tunes M&A Lab January 2012 Vedanta Acquires Control Over Cairn India M&A Lab January 2012 Corporate Citizenry in the face of Corruption Yes, Governance Matters! September 2011 Funding Real Estate Projects - Exit Challenges Realty Check April 2011

67 Private Equity and Debt in Real Estate NDA Research is the DNA of NDA. In early 1980s, our firm emerged from an extensive, and then pioneering, research by Nishith M. Desai on the taxation of cross-border transactions. The research book written by him provided the foundation for our international tax practice. Since then, we have relied upon research to be the cornerstone of our practice development. Today, research is fully ingrained in the firm s culture. Research has offered us the way to create thought leadership in various areas of law and public policy. Through research, we discover new thinking, approaches, skills, reflections on jurisprudence, and ultimately deliver superior value to our clients. Over the years, we have produced some outstanding research papers, reports and articles. Almost on a daily basis, we analyze and offer our perspective on latest legal developments through our Hotlines. These Hotlines provide immediate awareness and quick reference, and have been eagerly received. We also provide expanded commentary on issues through detailed articles for publication in newspapers and periodicals for dissemination to wider audience. Our NDA Insights dissect and analyze a published, distinctive legal transaction using multiple lenses and offer various perspectives, including some even overlooked by the executors of the transaction. We regularly write extensive research papers and disseminate them through our website. Although we invest heavily in terms of associates time and expenses in our research activities, we are happy to provide unlimited access to our research to our clients and the community for greater good. Our research has also contributed to public policy discourse, helped state and central governments in drafting statutes, and provided regulators with a much needed comparative base for rule making. Our ThinkTank discourses on Taxation of ecommerce, Arbitration, and Direct Tax Code have been widely acknowledged. As we continue to grow through our research-based approach, we are now in the second phase of establishing a four-acre, state-of-the-art research center, just a 45-minute ferry ride from Mumbai but in the middle of verdant hills of reclusive Alibaug-Raigadh district. The center will become the hub for research activities involving our own associates as well as legal and tax researchers from world over. It will also provide the platform to internationally renowned professionals to share their expertise and experience with our associates and select clients. We would love to hear from you about any suggestions you may have on our research reports. Please feel free to contact us at [email protected]

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