following guest post is contributed by Vinod
Kothari of Vinod Kothari & Co.]
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
the question at all?
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:
or trading in Transferable Development Rights (TDRs) but does not include
development of townships, construction of residential/commercial premises,
roads or bridges;
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.”
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.
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.
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.
of office infrastructure: a commercial reality
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.
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.
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.
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.
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.
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.
it occur at arms length price?
defines the term arms length price as follows:
means a price which is applied or proposed to be applied in a transaction
between persons other than associated enterprises, in uncontrolled conditions.
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.
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.
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
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,
also amount to a service, chargeable to service tax.
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?
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.
directly – it may either be a subsidiary of a company having FDI, or the
collective foreign holding in the company may be exceeding 50%.
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.
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.
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?
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”.
space, then there is a question of limitation of the lease rentals, and arms
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
grown, fully Indian companies, which are regarded as “foreign owned or controlled
companies” by virtue of a regulatory definition of “indirect foreign
sharing arrangements of most of such companies to be reexamined. We are of the
view that the Circular creates more issues than it resolves.