Recently, Department of Industrial Policy and Promotion (DIPP), via a Circular clarified that facility sharing arrangements between group companies through leasing/ sub-leasing arrangements shall not be treated as ‘Real Estate Business’ under the Foreign Direct Investment (FDI) Policy for the larger interest of business (subject to two conditions, elaborated below). This update up goes on to enunciate how this clarification will cause more problems than it solves.

FDI Policy: Under the FDI Policy, Indian companies which are recipient of any FDI are prohibited from engaging in `Real Estate Business`. Recently via press note 10 of 2014, DIPP defined the term `Real Estate Business` to mean `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.`

Notably, the phrase ‘dealing in land and immoveable property’ includes within its ambit not only buying and selling of, but all transactions in relation to, land and immoveable property. Consequently, the phrase includes any lease or sub-lease entered into in relation to an immoveable property.

In India, it is a common practice for one company in a group to own/ lease office space and own facilities, which are then shared by other group companies. The use of office space by the other group companies is generally not done by leasing/ sub-leasing transaction but rather by entering into facility sharing arrangement. The reason is that leasing and sub-leasing entail creation of interest in the property while the facility sharing arrangement entitles the other group companies to merely use the premises like a license. Transactions of the latter nature address the commercial intent, i.e. one of the group companies bears the cost of the office space while the other group companies also use it. However, the DIPP Circular relates to arrangements of former nature which are not only rare but are also far from commercial reality, therefore the utility value of the DIPP Circular is a question mark.

Further, similar arrangements are also done for sharing servers, cafeteria/ water purifier services, elevators, key managerial officers etc. But as these are movable properties, they are not a subject matter of the DIPP Circular. It is also not clear if such transactions makes the lessor company a ‘service provider’ and therefore makes it liable to pay service tax.

Condition in DIPP Circular: DIPP Circular prescribes two conditions, and if the facility sharing arrangements between group companies through leasing/ sub-leasing arrangements conform with such conditions, they will not be categorised as ‘Real Estate Business’ transactions under the FDI Policy. This means that a FDI recipient Indian company will be permitted to act as a lessor in transactions of such nature. These conditions are the (a) arrangements should be at an arm’s length price calculated as per the Income Tax Act, 1961 (IT Act) and (b) annual lease rent earned by the lessor company should be less than 5% of such lessor company’s total revenue.

On analysing the two conditions closely, it will not be wrong to say that the lose drafting of the DIPP Circular gives rise to a number of problems.

Arm’s length pricing: How should the arm’s length price be calculated? As per the IT Act, 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. Now, if a company permits the use of its office space by its group companies on arm’s length price, the company will have to charge the group companies for such usage and a mere reimbursement will not do. If so, such arrangements shall yield profits for the company. This would mean that office space leasing/ sub-leasing would become a business of the company.

Issues under the company law due to arm’s length pricing: Given that due to the above calculation, the office space leasing/ sub-leasing would become a business of the company, it will have to be inserted as one of the objects of the company in its Memorandum of Association, in spite of the fact that the company in reality has no intention of engaging in any ‘Real Estate Business’. Further, as the group company will be a related party, such an arrangement (not being in the ordinary course of business) will require a board or shareholder’s approval (as the case may be) in terms of section 188 of the Companies Act, 2013.

Limit on the annual rent lease: Furthermore, for a facility sharing arrangement to not qualify as a ‘Real Estate Business’ transaction, the Indian company with FDI will have to ensure that the annual rent earned by it due to the facility sharing arrangements does not exceed 5% of its revenue. (a) Now, in the event the office space of a company is shared by multiple group companies then there is a possibility that the sum total of the rent earned from all such group companies together exceeds 5% of the company’s revenue, to meet the arm’s length pricing condition. (b) Secondly, in multiple cases the office space is owned or leased by a less revenue generating company and therefore it will be difficult for the company to ensure that the annual lease rental earned by it does not exceed a meagre 5% of its revenue. (c) Thirdly, as the revenues of a company fluctuate on yearly basis, the annual rent will have to be determined at the end of the year (so that the lessor company’s revenue figures are frozen) rather than at the beginning of the contractual cycle of the facility sharing arrangement.

Apart from all the above complications, looking objectively at the DIPP Circular, one does not understand its need. Office space sharing arrangements between group companies are not entered into to make profits and therefore cannot be construed as a ‘Real Estate Business’. These transactions are done for commercial ease.

MHCO COMMENTS

DIPP Circular has complicated an uncomplicated situation as it categorises transactions which are not in the nature of `Real Estate Business` as transactions for `Real Estate Business`. The situation has become further obscure by introduction of impractical and conflicting conditions (with no thought given to the consequences of complying with such conditions), to be met to qualify such anyway `Not Real Estate Business` transactions into `Not Real Estate Business` transactions.

This update was released on 17 Oct 2015.

The views expressed in this update are personal and should not be construed as any legal advice. Please contact us directly on +91 22 40565252 or legalupdates@mhcolaw.com for any assistance.

Legal Update Team
MANSUKHLAL HIRALAL & COMPANY
Advocates, Solicitors and Notaries
T: +91 22 40565252
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