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.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

2 comments

  • “…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)

  • 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” .

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