Non-Resident Indians, Persons of Indian Origin, Foreign Nationals and Indian residents involved in real estate transactions are all affected by exchange control regulations, succession laws and taxes. Real estate investments involve emotional as well as financial decisions. In a rapidly shrinking world it has become common for individuals to have close connections with more than one country, which means that cross-border real estate investments are quickly becoming the norm. However, the ability to make such investments and the choice of structure depend on the legal and tax requirements of the relevant countries. Where India-focused investments are involved, exchange control regulations, community and region-specific succession laws and a complex tax system can complicate the available options for purchasing/transferring real estate. This article attempts to introduce some of the available options and their potential consequences.
What are the relevant Indian laws?
Although India’s economic development has resulted in relaxation of policy and more freedom to parties to conduct cross-border transactions, the exchange control laws are still relatively restrictive. India’s exchange control regime is primarily governed by the Foreign Exchange Management Act, 1999 (“FEMA”) and the rules, regulations and other administrative guidance issued under the FEMA. Together, these regulate all inbound and outbound transactions which involve foreign exchange. The primary regulatory bodies are the Reserve Bank of India, India’s central bank (the “RBI”) and the Foreign Investment Promotion Board (the “FIPB”). Depending on the kind of asset, sector-specific regulatory authorities may also be involved in processing the transaction, e.g. the Securities and Exchange Board of India (“SEBI”) who is the securities markets regulator.
Broadly, FEMA’s regulatory framework requires permitted activities involving foreign exchange to be carried out through the general or special permission of the RBI. The FEMA classifies foreign exchange transactions into two categories: (i) capital account transactions; and (ii) current account transactions. A capital account transaction alters the assets or liabilities, including contingent liabilities outside India, of persons resident in India or the assets or liabilities in India of persons resident outside India. Transactions involving Indian real estate are capital account transactions (other than a lease for a period of five years or less). Therefore, the acquisition or transfer of such property, whether outside or within India, is a regulated transaction under the FEMA.
Indian tax regime
India taxes persons (such as individuals, companies, partnerships, etc.) on the basis of residence, not citizenship. Taxation of income is governed by the Income Tax Act, 1961, (“Tax Act”). Indian residents are subject to tax in India on their worldwide income, while non-residents are taxed only on Indian source income. Determination of residence is based on days of physical presence (for natural persons) and location of control and management (for non-natural persons). Where a non-resident is a resident of a jurisdiction with which India has signed a double tax avoidance agreement (commonly called a DTAA or tax treaty), the non-resident has the option of being taxed either under the tax treaty or the Tax Act, whichever is more beneficial.
Can residents invest in foreign real estate?
The scope for making investments in foreign real estate by Indian residents has been significantly limited by a 2013 RBI circular which was aimed at checking the declining value of the Indian Rupee by introducing several capital controls on the outflow of foreign exchange.
One of the key amendments was to the Liberalised Remittance Scheme (“LRS”), a regulatory route that enabled resident Indians to make offshore investments up to a specified limit of USD 200,000, in every financial year (April – March). These funds were usable for any permitted transaction including the funding of acquisition of real estate. While Indian currency controls certainly posed a challenge, the evolution of the offshore trust structure addressed these issues.
Under this structure the LRS funds of all family members were pooled to provide the initial capital for the property, following which loans were taken by the trust. These loan amounts were secured against the trust property and the loans were serviced out of annual LRS remittances. An offshore trust also provided additional advantages such as flexibility with succession planning and tax benefits. This was particularly attractive considering that the domestic tax and regulatory consequences imposed by various countries could affect the commercial viability of directly purchasing such real estate. Certain jurisdictions such as Jersey, the Cayman Islands, Luxembourg were preferred as robust trust law regimes which provided for different structures to meet specific objectives of settlors.
While a private foundation is a popular vehicle in many countries for estate planning purposes, in India it is neither recognized under law nor prevalent in practice. A private foundation “is an independent self-governing legal entity, set up and registered or recorded by an official body within the jurisdiction of where it is set up, in order to hold an endowment provided by the Founder and/or others for a particular purpose for the benefit of Beneficiaries and which usually excludes the ability to engage directly in commercial operations, and which exists without shares or other participation.” In some countries, the foundation acts as a substitute for a Will. However, since India does not recognize the concept of a foundation, foundations may be considered a hybrid of a trust and a company under Indian law, depending on the issues under examination. It is this uncertainty and unfamiliarity with the foundation structure which has led to a preference for trusts, whose popularity is a consequence of India’s British heritage and the flexibility they provide.
Recent regulatory amendments
The 2013 RBI Circular discussed above: (i) reduced the limit for outward remittances by Indian residents to USD 75,000 in one financial year; and (ii) expressly prohibited acquisition of real estate, either directly or indirectly, under the LRS. This means that funds remitted under the LRS route cannot be used for the purchase of real estate, even if such purchase is undertaken through an intermediate trust, company or other entity. Therefore, investment into offshore real estate is no longer possible by individuals resident in India.
It is hoped that the above measures are only of a temporary nature as they were introduced for the limited purpose of reducing the Current Account Deficit and the depreciation of the Indian Rupee. Although these measures restrict the ability of resident individuals to purchase real estate offshore, they do not restrict existing loans being serviced out of LRS funds. Further, it is relevant to note that assets acquired by resident individuals in the following situations do not come under the purview of the LRS and therefore are permitted without any restriction: (i) assets acquired when non-resident in India; (ii) assets gifted by a non-resident; or (iii) assets inherited from a non-resident.
Can individuals resident outside India invest in Indian real estate?
A non-Indian resident is permitted to hold, own, transfer or invest in Indian real estate if he purchased, held or owned such property when he was resident in India. An offshore resident may also inherit property from a person who was an Indian resident. However, this only applies to residential or commercial property. Offshore residents are not permitted to acquire agricultural property, plantation property or farm houses in India, by way of purchase or gift, but are allowed to inherit such property.
Here it is important to mention that non-residents are classified into different categories by the FEMA, namely:
- non-resident Indians (“NRIs”)
- foreign nationals who are of Indian origin (“PIOs”)
- foreign nationals who are not of Indian origin (“Foreign Nationals”).
Far more restrictive exchange control rules apply to investments by Foreign Nationals, as compared to NRIs and PIOs who are grouped together in the FEMA for the purposes of investment into India. There are more restrictions on direct acquisition of Indian immoveable property by Foreign Nationals than on NRIs/PIOs, which are discussed in further detail below.
All three categories enjoy a relatively level-playing field when it comes to indirect holding routes, although Foreign Nationals are subject to investment limits which are not applicable in all cases to NRIs/PIOs. Investments may be routed through jurisdictions such as Mauritius or Singapore so as to make use of tax treaty provisions. These jurisdictions offer beneficial taxation on returns structured as capital gains and interest.
How can NRIs/PIOs acquire Indian real estate?
Option 1: Direct acquisition
Under this option, the individual is the direct owner of property. While this brings with it all the benefits of property ownership, including the personal satisfaction of having property held in one’s name, it may create difficulties in taxation and succession. Recently, there has been a drive globally to increase the marginal rates of taxation on high net-worth individuals, which has made NRIs/PIOs reconsider the comparative advantages of having property held through an intermediary vehicle. One must be particularly aware of the exchange control consequences of such an investment.
(a) Direct purchase
An NRI or PIO is permitted to directly purchase certain types of Indian real estate. There is no restriction on the number of properties that may be acquired but there are restrictions on the type of property that may be acquired and on the mode of payment of purchase price. NRIs and PIOs cannot purchase agricultural property, plantation or a farm house. Further, payment of purchase price can be made only through: (i) funds received in India through normal banking channels by way of inward remittance from any place outside India; or (ii) funds held in any non-resident account maintained as per FEMA and RBI regulations. In India, any income earned by the NRI/PIO from the Indian real estate will be liable to taxation at 30% on income above INR 10,00,000 lakhs (1 million) with an additional surcharge (i.e. tax on tax) at 10% for incomes exceeding INR1 Crore (10 million).
Indian real estate may be gifted from a resident to an NRI/PIO or between NRIs/PIOs. Such gifts are permitted under the exchange control regime via the automatic route. Stamp taxes are applicable on the transfer. Further, under the ITA, where the stamp duty value of the real estate gifted is above INR50000, the stamp duty value is considered as chargeable to income under the category of ‘income from other sources’. However, the charge to tax will not be imposed where the gift is made between relatives or received on the occasion of the recipient’s marriage or received under a will.
NRIs and PIOs may inherit Indian real estate from a resident or a non-resident (i.e. another NRI/PIO or Foreign National) so long as the deceased had acquired the property as per the exchange control regulations in force at that time. The charge to tax described above is inapplicable where real estate is received by way of inheritance.
How can NRIs/PIOs sell/transfer Indian real estate?
It is important to keep in mind that where Indian real estate is to be transferred, the eligibility of the transferee depends on the type of property involved. Residential/commercial property may be sold or gifted to an Indian resident, NRI or PIO, with the additional condition that a sale between PIOs requires prior RBI permission. Where an NRI/PIO owns/holds agricultural property, plantations or a farm house, such property may be sold or gifted only to an Indian resident who is also an Indian citizen. Payment received by an NRI/PIO from the sale of Indian residential/commercial property may be repatriated outside India subject to certain conditions, namely that the amount remitted outside India must not exceed the amount paid for acquisition and repatriation of sale proceeds on residential property must not be for the amount received on sale of more than two residential properties.
Transfers (other than by way of Will) attract stamp duty in India, with the rate of stamp duty dependent upon the state/province in which the property is situated. The rate usually ranges from 5%-8% of the market value of the property or actual sale consideration (whichever is higher). To determine the market value, authorities publish reckoner/circle rates for each area which are usually revised annually.
Gains made on sale/transfer of real estate are chargeable to income tax. Under the Tax Act, capital gains are classified as short-term and long-term depending upon the holding period. Holdings greater than 36 months are treated as long-term capital gains, which have a beneficial tax rate. If the payment for transfer is lower than the reckoner rate, then the latter is deemed to be the actual payment and tax is calculated accordingly. The stamp duty and tax consequences described above will apply to transfers made in the other options discussed below.
Option 2: Indirect holding
Recent market reports suggest that the trend with respect to Indian real estate has shifted from direct acquisition to investing through pooling vehicles. Investing through an intermediate entity means that value is captured in a different entity/form, along with timing receipt of distributions and having the tax being borne at rates applicable to a non-natural person. Some standard structures are considered below:
(i) Settlement of Indian trusts by NRIs/PIOs:
With certain exceptions, FEMA regulations do not permit investment in Indian trusts by non-resident persons. Where the investment in Indian real estate is intended for a business purposes (i.e. to generate revenue), then NRIs/PIOs are strictly barred from settling property into an Indian trust.
However, if settlement is with a view for asset protection or succession planning, i.e. in the context of a private family trust and for the benefit of family members, it may be possible to take a view that the above prohibition should not be applicable because the settlement is not an ‘investment’ as such. In that case, the reach of the exchange control regulations should be limited to specifying permissible deposits into and outgoings from the NRIs/PIOs bank account for the purposes of settling the trust. Under the relevant regulations, Indian (i.e. local) disbursements from the Non-Resident Ordinary Account are allowed. Therefore, it should be possible for an NRI/PIO to settle an Indian trust using funds from the Non-Resident Ordinary (NRO) bank account. NRIs/PIOs may also settle Indian real estate, whether received as gift or as inheritance, into Indian trusts.
A real estate trust must be declared, i.e. the trust deed must be a registered written instrument. Such a trust can have either all NRI beneficiaries or a mix of NRI and resident Indian beneficiaries.
The tax consequences of using a trust depend on the type of trust chosen which in turn depend on the objectives of the settlor. Settling an irrevocable trust enables the property to be ring-fenced from the settlor’s creditors while a discretionary trust enables the property to be held at the trust level and potentially ring-fenced from the beneficiary’s creditors.
If an irrevocable determinate trust is settled, i.e. where the beneficiaries and their shares are identifiable, a trustee is assessed to tax as a representative assessee. That is to say, tax is levied and recovered from him in the same manner and to the same extent as it would be from the person represented by him, i.e. the beneficiary. The trustee would generally be able to avail all the benefits / deductions, etc. available to the beneficiary, with respect to that beneficiary’s share of income. There is no further tax in the hands of the beneficiary on the distribution of income from a trust. On the other hand, if an irrevocable discretionary trust is settled, i.e. when the beneficiaries and their shares are not ascertained, a trustee will be regarded as the representative assessee of the beneficiaries and subject to tax at the maximum marginal rate of 30%.
Income distributions from the Indian trust to its NRI beneficiaries may be repatriated entirely (without any limit or any prior approval) either in their offshore accounts directly or be credited to their non-resident accounts in India. The trust must maintain separate accounts in respect of income and capital to demarcate income distributions from capital distributions because repatriation of capital is restricted to USD 1 million in every financial year, which can be made through NRO accounts only. It must be borne in mind that the USD 1 million limits applies to repatriations done from the NRO account and not separately for any distribution received from the trust.
(ii) Holding property through an Indian trust with a subsidiary Indian company
Under this option direct ownership of Indian real estate is with the Indian company, instead of the trust which holds shares of the Indian company. In a company structure, tax leakage arises because of the dividend distribution tax imposed on distributions made by a company to its shareholders. Indian companies must pay a tax of 15% on the distribution of dividends to their shareholders, with such dividends being tax-exempt in the hands of shareholders (resident or non-resident). The only advantage would be if we prefer to hold property in separate special purpose vehicles rather than directly.
(iii) Investing in listed and unlisted shares of a real estate company
As such, NRIs and PIOs are not permitted to trade in the secondary market in debt and equity of Indian companies. However, the Portfolio Investment Scheme enables NRIs and PIOs to diversify their investments into equity shares, debentures and convertible debentures of Indian companies on recognized stock exchanges by allowing them to route such portfolio investments through designated bank branches authorized for such transactions. With respect to the real estate sector, NRIs and PIOs are permitted to purchase listed shares of a real estate entity under the Portfolio Investment Scheme. Dealing in foreign securities is also a regulated capital account transaction, so the following limits are imposed on such investments:
- An NRI or a PIO can purchase shares up to a maximum of 5% of the paid up capital of an Indian company and purchase convertible debentures up to a maximum of 5% of the paid up value of each series of convertible debentures issued by a company.
- All NRIs/PIOs taken together cannot purchase more than 10% of the paid up capital of an Indian company. However, this limit could be increased up to the sectoral cap prescribed under the Foreign Direct Investment policy with a special resolution of that company.
NRIs and PIOs also have the option of directly investing in unlisted securities of real estate companies on either a repatriation basis or a non-repatriation basis.
What are the investment options for Foreign Nationals?
Unlike NRIs and PIOs, the direct acquisition route (either by way of purchase or gift) is not permitted for Foreign Nationals, even for residential and commercial property, nor can they be joint owners along with NRIs and PIOs. So the only possible options for a Foreign National to directly acquire Indian real estate are where:
- Indian real estate is acquired on lease for a period of five years or less
- The Foreign National inherits such property from an Indian resident
- The Foreign National acquires Indian real estate when he is an Indian resident as defined in the FEMA.
The RBI has clarified that a foreign national resident in India who is a citizen of Pakistan, Bangladesh, Sri Lanka, Afghanistan, China, Iran, Nepal and Bhutan (‘Restricted Countries’) would require prior approval of the RBI if such person intends to acquire Indian real estate.
Foreign Nationals, including those from Restricted Countries, are permitted to sell or gift residential/commercial property only to an Indian resident, an NRI or PIO with prior RBI approval. Such approval is also required to sell agricultural land/plantation property/ farm house in India. Further, while there are options available to invest into real estate linked securities through the FDI route and Foreign Portfolio Investor (FPI) route, these are subject to conditions and apply more to the economic value of the underlying property than a purchase of real estate. This may change if the regulatory regime opens up at some point, but the currency controls continue to restrict the manner in which these investments can take place.
What other considerations must be kept in mind?
We began this note with a discussion of how investments in real estate in India and abroad are complicated by the applicable exchange control regime, tax laws and succession laws. The first two have been discussed above. It is equally important to keep in mind that succession laws in India are community and region specific and that this may influence the choice of a real estate structure. Under Indian conflict of law principles, the law applicable to an intestate succession (i.e. when a person dies without leaving a will) of real estate is the law of the place where the property is located. Therefore, if an NRI holds property in India at the time of intestate succession, it would devolve as per Indian succession laws. This makes it important to ensure, particularly where there is a possibility of contest, that the holding structure contemplates the possibilities that may arise upon death. For example, under Sharia law, gifts in anticipation of death can be nullified. Therefore, even though the gift from one NRI to another may be valid under Indian exchange controls and neutral from a tax perspective if made to a close relative, they may not satisfy the succession law requirements if the donor dies within a year of the gift and the bequeathal limits are not met. Anticipation and planning in advance can protect from such situations.