While Real Estate sector all over country is facing stagnancy and even downward trend due to multiple factors such as high rates of GST, compliance under RERA, absence of financial credit, etc., two amendments made to Income Tax Act through Finance Act, 2017 and Finance Act, 2018 will act as further blow to industry. Most surprising part of these amendments is that they seek to tax builder/developers on notional income, that is income which a builder/developer has not yet earned.
1. A section 28(via) has been introduced through Finance Act, 2018 to provide that fair market value of inventory “converted” or “treated” as capital asset will be charged to tax as “business income”. This section is applicable from F.Y. 2018-19.
1.1 Generally, builder/developers construct flats, offices, etc. with intention to sell them, however, they may proceed to rent unsold units, not only to cover costs but also to attract high networth individuals (HNIs) interested to invest in the income yielding assets.
1.2 The serious concern here is, whether renting out of flats/offices/units would tantamount to “treatment” of inventory of completed flats/offices/units as capital asset, thereby attracting notional tax under section 28(via).
1.3 What value will be taxed?
For this purpose, the fair market value (FMV) of the such inventory on the date of “conversion” or “treatment” will be considered as business income. Another, question arises here is what is FMV? Answer to this question is not given by income tax laws and therefore, one may take ready recknor value as FMV.
1.4 What happens when this property is actually sold?
When the property taxed under S. 28(via) is actually sold, the profit/gain will be charged as Capital Gain under Income Tax Act. For the purpose of calculating capital gains, the FMV treated as “business income” under S. 28(via) will be allowed to be deducted as “cost of acquisition”. Thus, sales amount over and above such FMV will be taxed either as short term capital gain or long term capital gain as per provision of income tax act.
2. Another section 23(5) was introduced in the budget of 2017 to provide that, where a builder/developer has received certificate of completion/occupation certificate (CC/OC) for the property, and if it is not able to sell flats/offices/units within 1 year from end of financial year in which such CC/OC is received, it will be required to pay tax on annual lettable value of such property as Income from House Property (IFHP). This section is applicable from F.Y. 2017-18.
3. Let us understand above two provisions through an illustration. Say, a developer A Ltd. develops 50 office spaces of equal sizes. Say, Completion Certificate (CC) for this project has been received in F.Y. 2017-18.
(a) 12 offices were sold before in F.Y. 2016-17
(b) 11 offices sold in F.Y. 2017-18
(c) 10 unsold offices rented out in F.Y. 2017-18 for say, Rs. 10 Lac per annum; these offices are sold in F.Y. 2018-19 for total value of 800 lacs.
(d) 9 unsold offices rented out in F.Y. 2018-19 for say, Rs. 12 Lac per annum (FMV Rs. 60 Lacs for each office); these offices are sold in F.Y. 2019-20 at total value of 700 lacs.
(e) 8 unsold offices lying idle, not rented and sold in F.Y. 2021-22
Now, let us discuss treatment for all of the above offices:
3.1 Offices mentioned in point (a) and (b) won’t have any special effect under above stated amendments.
3.2 Offices mentioned in point (c) will be treated as under:
U/s 23(5) – Since this section seeks to charge income tax on notional rent value, income from offices actually rented out would be chargeable to tax but not u/s 23(5).
U/s 28(via) – The offices rented out remain out of scope of S. 28(via) since, this section was not applicable for F.Y. 2017-18.
Sale value of these office units will be taken as business income in year of sale, that is, F.Y. 2018-19.
3.3 Offices mentioned in point (d) will be treated as under:
U/s 23(5) – Since this section seeks to charge income tax on notional rent value, income from offices actually rented out would be chargeable to tax but not u/s 23(5).
U/s 28(via) – The date of renting out said office units will be treated as “date of treatment as capital asset” and fair market value (FMV) as on such date will be added to business income of A Ltd. Thus, the company will be burdened with tax on Rs. 540 lacs (9 units * Rs. 60 lacs) without actually earning that amount.
Now, when in F.Y. 2019-20, these office units are actually sold, A Ltd. will said to have earned capital gain of Rs. 160 Lacs, being difference between actual sale value and FMV taxed earlier (700 Lacs – 540 Lacs).
3.4 Offices mentioned in point (e) will be treated as under:
U/s 23(5) – For upto 1 year from end of 31.03.2018 (year in which CC is received), that is till 31.03.2019, notional rent will not be taxed for 8 unsold office units under this section. However, from 01.04.2019, A Ltd. will have to pay income tax on notional rent upto date of sale in F.Y. 2021-22.
U/s 28(via) – A Ltd. won’t be impacted by this section, since the office units continue to be treated as “inventory” and sale value will be taxed only in the year of actual sales.
4. Conclusion
4.1 Therefore, it can be clearly concluded from above illustrations that if builders/developers are not able to sell their finished units and rent them out, they will be burdened with tax on “notional sales” and if they hold them vacant, they will face tax on “notional rent”.
4.2. Further, these sections also open scope of further litigations with tax department on the issues such as “treatment as capital asset”, quantification of “fair market value” to name few.
4.3 Absence of representation from real estate industry suggest that either they have not fully understood implications of these amendments or they are failing recognize its adverse effects on their cash-flows and liquidity. Therefore, there is need for industry bodies to make strong representation before Finance Ministry.
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Disclaimer: This article is for the purpose of general awareness and does not represent professional opinion of the author.