Saturday, September 19, 2015

Foreign owned or controlled companies: Is sharing of office infrastructure real estate business?

[The following guest post is contributed by Vinod Kothari of Vinod Kothari & Co.]

If a company wholly or majorly owned by non residents allows group or subsidiary companies to share your photocopier, or server, or staff, are you engaged in “real estate business”? The question itself must have startled most: however, a purported clarification of the Department of Industrial Policy and Promotion (DIPP) may actually create a substantial confusion.

Why the question at all?

The reason why the question arises is as follows: “real estate business” is a prohibited business for foreign direct investment in India. The expression “real estate business” is defined in Foreign Exchange Management (Transfer or Issue of Any Foreign Security) (Amendment) Regulations 2004. The definition has consistently been cited in the Foreign Direct Investment (FDI) Policy documents. The definition of “real estate business” is as follows:

p. 'Real estate business' means buying and selling of real estate or trading in Transferable Development Rights (TDRs) but does not include development of townships, construction of residential/commercial premises, roads or bridges;

In the master circulars on FDI issued every year by the Reserve Bank of India (RBI), the following para appears: “It is clarified that “real estate business” means dealing in land and immovable property with a view to earning profit or earning income therefrom 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.”

Notably, whereas the expression was “buying and selling” in the Notification referred to above, the RBI has used the word “dealing” in land and immovable property. The ambit of the word “dealing” is much wider than buying and selling, as dealing includes doing all such things as are customarily done to engage in a trade with respect to the subject matter, that is, real estate. It is common knowledge that in the real estate business, properties may not be acquired by outright conveyance – they are often acquired by way of long-term leases. Hence, leasing and sub leasing are commercial prevalent devices of transactions in real estate. In certain metropolitan townships, most of the city land is taken on lease – hence, leasing seems to be the only way to deal in real estate.

The intent seems to be quite clear – as FDI in real estate may create an asset bubble on real estate prices, and may therefore, create a systemic crisis in the country, the RBI has been consciously prohibiting FDI in real estate. Escalation of land prices that may follow if there is too much money flowing into real estate may also affect land used for agriculture, and push the country into a food crisis.

Thus, the intent of the DIPP/RBI has consistently been to prevent FDI from coming into an entity which is engaged in buying, selling or dealing in real estate. Therefore, if the entity in question is engaged in leasing or sub leasing of real estate, it may be possible to contend that the entity is engaged in real estate business.

Sharing of office infrastructure: a commercial reality

Sharing of office infrastructure among group companies is a widely-prevalent reality of business. Corporate architecture of entities often involves several legal entities, related to each other as holding companies, subsidiaries, associates or affiliates. These entities typically have an interwoven business model. They normally operate from the same business premises. They may, for sheer practical reasons, share a common office space, common office infrastructure, common facilities, sometimes even common staff or key managerial personnel. It is quite natural that if the entities are running their business from a common address, it is impossible to delineate space used by either entity. Since infrastructure (computers, systems, canteen, utilities, etc) are shared, there is no way to identify what is used by whom.

The office premises are typically taken on lease by one of the group entities. Now, how does this entity allow other entities to use the premises? It would not commonly be a case of sub-leasing of the premises to the group entities, for several reasons. Head lease agreements do not generally permit the lessee to sub-lease. In any case, a sub-lease will entail delineation and earmarking of area being sublet, which is not practical.

Hence, in most cases, companies enter into a facility sharing agreement, called by whatever name. This arrangement does not result in the creation of a sub-lease or leasehold interest – it simply amounts to a permission to use. In legal parlance, such agreement may come close to a license agreement.

Sharing of office infrastructure is a commercial reality which cannot be denied. If there are five companies in a business group, it is outrageous to think they will have five different offices, five different servers, or ERP systems, or key managerial personnel, or legal officers, etc.

The DIPP Circular

These circulars are issued with a benign intent – to clarify matters. However, as it quite often the case, half-spoken intent, or unclearly-spoken intent, muddles the issue altogether. This is the very likely situation with the DIPP Circular.

The document in question is the Circular dated 15 September 2015 on “facility sharing arrangements between group companies”. The Circular states the following: facility sharing arrangements between groups companies in the larger interest of business will not be considered as real estate business provided (a) such arrangement is at arms length price in accordance with the relevant provisions of the Income Tax Act; and (b) annual lease rent earned by the lessor company does not exceed 5% of its total revenue.

Does it occur at arms length price?

Section 92F(ii) of the Income Tax Act, 1961 defines the term arms length price as follows:

"arm's length price" means a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions.

There are several models of arms-length pricing, viz., comparable uncontrolled price method, resale price method, cost plus method, profit split method, transaction net margin method and so on [Sec 92C of the Income Tax Act]. Arguably, the appropriate method in the present case may be cost plus method, or transaction net margin method.

However, the key issue is: should the company charge any margin on its cost on the sharing of infrastructure? Or should it simply go by a pure reimbursement? Needless to emphasise, the purpose of the infrastructure sharing is not to engage in the business of letting or subletting, or to make proper use of surplus resources, or to minimise costs. The sharing is done purely for reasons of practicality.

If the company starts charging a margin on its costs, there may be several issues. It will then amount to a business transaction, and therefore, one will get into an issue whether the business of providing office infrastructure amounts to a “business”, and hence, are there enabling powers in the Memorandum of Association? The transaction will be a related party transaction[1], and not being in the ordinary course of business, it may require approval under section 188 of the Companies Act, 2013, disclosing in the directors’ report, etc.

If it is not a pure reimbursement, it may also amount to a service, chargeable to service tax.

In any case, if the intent of the transaction is mere mutual facilitation, is it expected that the company enabling the sharing must make a margin? It is almost like saying, if I am going to buy coffee for myself, and looking at the queue at the coffee vendor, my friend asks to get one coffee for him as well, does the law expect I must expect a margin on the coffee I am getting for my friend?

The limits of lease rentals

 

Not only does the DIPP Circular expect arms length pricing of the facilitation, it also imposes a limit of 5% of total revenue on the facility provider. This stipulation will also result in multiple difficulties. First, there are several companies where the head lease is signed with one of the operationally-less-active companies. This may be  an investment company in the group, or any other company, not engaged in the core operations. Therefore, the amount charged for the sharing may actually be in excess of 5% of the total revenues.


The facilitating company may not be the recipient of FDI directly – it may either be a subsidiary of a company having FDI, or the collective foreign holding in the company may be exceeding 50%.

Note, also, that the limit of 5% of revenues seems unreasonable, as it is unlikely that the charges for sharing of facilities bear any nexus with the revenues. Revenues may be volatile; it is not possible for the facilitating company to reduce what it is charging from the sharing companies, if the revenues have gone down in a particular year. Doing so will be counter-intuitive, particularly in a year when the revenues of the first company are anyway down.

Likely confusion

The DIPP Circular will, in all likelihood, lead to major confusion. The foremost question is – does the Circular necessarily imply that all sharing of infrastructure has to be on arms-length pricing? For domestic transactions, arms length pricing as per income tax law is  applicable on a very limited number of transactions, enumerated in section 92BA of the Income Tax Act.

If arm’s length pricing is not applicable, and the company is simply sharing the infrastructure on actual reimbursement basis (based on an estimated proportion utilised by the sharing company), does that mean there is any violation of the terms of FDI?

It needs to be noted that the DIPP circular does not, by itself, impose a condition that the sharing of infrastructure has to be on arms length basis. The circular is in context of the definition of “real estate business”. Sharing of infrastructure is, by no means, a business activity, and hence, cannot be any business at all, not to speak of “real estate business”.

However, if the entity is at all engaged on sub-leasing of space, then there is a question of limitation of the lease rentals, and arms length pricing.

Conclusion

There are thousands of companies with FDI in business in India, and the Prime Minister’s lofty targets of “Make in India” and “Ease of Doing Business” in India may envisage substantial further foreign investment into India.

Not only companies with FDI, there are lots of our home grown, fully Indian companies, which are regarded as “foreign owned or controlled companies” by virtue of a regulatory definition of “indirect foreign investment”.

The present Circular will cause existing infrastructure sharing arrangements of most of such companies to be reexamined. We are of the view that the Circular creates more issues than it resolves.

- Vinod Kothari




[1] In case of a pure reimbursement, it is possible to argue that there is no transaction at all, as there is no transfer of resources, obligations or services.

2 comments:

vswami said...


“...The present Circular will cause existing infrastructure sharing arrangements of most of such companies to be re-examined. We are of the view that the Circular creates more issues than it resolves.”
OFFHAND:
The concluding observations are quite well-reasoned ; and , if viewed in proper light, is noted to sum up the hidden perils , inherent in, and entailing, the freshly mooted idea, mindlessly gone ahead with though, of treating / authoritatively recognising the activity of ‘sharing of office infrastructure’ as part of ‘real estate business’ – obviously contradicting the thus far understood ‘realty business’ , both for taxation and other purposes as well.
Apart from the mentioned problem of ‘arms length pricing’ (ref. sec 92 BA of the IT Act), certain other issues could arise; for instance, the ‘head of income’ to apply for taxation. Further, it is envisaged, the idea seemingly intended to primarily attract FDI investment, could give rise to, in fact add to the already existing, accounting and audit problems.
In a manner of visualizing, one can instantly think of such issues as have surfaced in the past and had to be taken on in court litigation; that is, in regard to a similar so-called idea of ‘sale and lease back’ transaction , which came to be devised and resorted to mainly as a ‘tax planning ‘ measure.
Incidentally , this might, in any case , call for suitable amendments of the wording in objects clause of the memorandum and articles of association of a real estate company ; of course, subject to/conditional upon the ROC ‘s approval , before being acted upon.

Back to the learned writer suggesting further deliberation of such other related aspects as indicated above.

(May have more to add)

vswami said...

To add:
May be, for suggested further deliberation/in-depth consideration, besides by the writer, by the equally expected -to-be- concerned enterprises and their tax (including service tax) advisers infield practice, the copious material in public domain should immensely help /provide guidance . Such sources of knowledge input, as quickly selected / identified links of relevance are, -

< Business Centres and Indian Income-Tax Law - SKP Group
< Service Tax Implications for Business Centres - SKP Group
Key Note:

1. Wrt the observations on the concept of ‘dealing’ and scope for construing it in such a manner as to suit the context, in one’s perspective , that is bound to drive even an eminent lawyer crazy, by perforce being driven to resort to a convoluted process of reasoning, in an attempt to arriving at any convincing view. For, as per its dictionary, so also commonly understood meaning, dealing in something (e.g. land and /or building) simply connotes ‘buying and selling; nothing else.
2. The other moot but inconvenient point of doubt one may wish to share , simply with a view to provoking others to think of and probe deep is this: - Whether the ROC - with whom the specified documents are mandated to be filed and registered for effectuating any change in ‘objects clause’ - will be within his powers to refuse registration in case he is ‘satisfied’ that there are valid grounds or reasons for doing so. A plain reading of Sec 13 (1) alone provides no clue. Nonetheless, what calls for incisive deliberation, on first principles, by eminent law experts both within and without the government (i.e. the law ministry) is as to the scope to regard him to have such inherent, though not specified, powers on any of the grounds (such as, ‘ public interest’ in its most comprehensive sense) found a mention elsewhere in the company law- say, in sec 213, or the set of provisions covering the aspects of / aiming at prevention of “oppression and mismanagement” .