Units of REITs and InVITs: From Hybrid towards Equity?

[Owais is a student at Government Law College.]

On 17 April 2025, the Securities and Exchange Board of India (SEBI) has released a Consultation Paper which inter alia proposes increase in the investment limit by mutual funds in real estate investment trust (REIT) and infrastructure investment trust (InVIT). The paper also recommends for classifying REITs and InVITs, which are herein collectively referred to as investment trusts (ITs), as equity.

The present article deliberates the later recommendation of change in the classification, outlining the present regulatory regime, the nature of hybrid instruments in the context of other imperative commercial aspects, the global regulations and finally the impact and possible outcomes of this proposed classification on these ITs.

Units of ITs: Features of Equity but not the Crown

Investment in ITs takes place by investing in their units. The units of ITs are explicitly recognized as securities under Section 2(h)(ib) of the Securities Contracts Regulations Act 1956 (SCRA).

Equity and debt are the major instruments used by a company for capital raising. While the former denotes ownership of the company, the latter acknowledges a debt on the company. The units of ITs are thus placed at a juxtaposition, wherein though the unit holding does not evidence ownership of the ITs but their assets are owned by unit holders. Similarly, the requirement to distribute 90% of cash flows by ITs to unit holders does not entail a fixed coupon or guaranteed return of principal obligations to investors. The requirement is akin to having a dividend distribution policy in equity securities but are a mandatory requirement unlike equity securities.

Similarly, the taxation structure in these ITs is a combination of equity and debt such that the rate of capital gain taxation is similar to that of equity securities while the holding period for classification of capital gains as short term or long term is in line with that of debt securities. Also, the unit holders like equity holders have voting rights, but the same is restricted only for material transactions.

Considering these implications, the units of ITs hold sufficient but not complete features to acknowledge the same explicitly with the crown of equity. Hence, SEBI in a board meeting in January 2017, had classified these units as hybrid instruments. The paper similarly outlines other features of these units that resemble with equity. Further, the lack of liquidity offered by these units on the stock exchanges owing to the limited and developing market of the ITs is another impediment in classifying these units as equity and their inclusion in equity indices as recommended by the paper. Similarly, the ITs being a trust, the unitholders are beneficiaries and not shareholders. Most importantly, they are presently outside the ambit of SEBI (Issue of Capital and Disclosure Requirement) Regulation 2018 which at present exclusively covers companies. This may possess significant risk due to absence of strict due diligence mechanism, which can have detrimental impact on the retail investors.

Hybrid Instruments: Cocktail of Equity and Debt

The preposition of whether hybrid instruments are securities within SCRA was discussed in depth by the Supreme Court in Sahara India Real Estate Corporation Limited v. SEBI wherein it was held that any instrument which satisfies the tripartite criteria of being marketable, transferable and saleable shall be classified as securities. Thus, the substance of the instrument was given superiority over form. Similarly, in Narendra Kumar Maheshwari v. Union of India, it was held that hybrid securities like compulsorily convertible debentures (CCD) which does not postulate repayment of the principal, does not constitute debenture in its classic sense. Any instrument which is compulsorily convertible into shares, shall be regarded as an equity and not a debt or a loan.

This also holds significant relevance in Insolvency and Bankruptcy Code 2016 (IBC) and income tax laws. In the context of IBC, a hybrid instrument like CCD, which is a debenture before the conversion, constituting debt on the entity, makes the instrument holder a financial creditor under Section 5(7) of the IBC, who can then institute an insolvency proceeding against the corporate debtor. This subject is still in the nascent stage of adjudication with the tribunals providing varying orders on the same on a case-to-case basis. In SGM Webtech Private Limited v. Boulevard Projects Private Limited, the CCD was treated as a financial debt whereas in IFCI Limited v. Sutanu Sinha, only the interest accrued on CCD was treated as a financial debt. 

In the context of income tax, whether a hybrid instrument is an equity or debt, before conversion can have significant impact under Section 36(1)(iii) of the Income-tax Act 1961 (IT Act) as the interest paid on any borrowed capital can be treated as a deduction. The tribunals on many instances has treated this instrument as a debt enabling the borrowers to claim exemption as witnessed in ACIT v. CAE Flight Training (India) Private Limited and Embassy One Developers Private Limited v. DCIT. Similarly, under the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations 2017, convertible debentures are treated as equity as per Regulation 2(v).  

The above judgements and orders postulate that hybrid instruments are often ambiguous as to their recognition as a debt or equity. However, the units of ITs, though being a hybrid security are presently exempted from this rigmarole, since these are issued by a trust and not a company and explicitly covered as a security under SCRA.

Global Perspective

In the United States of America, REITs are treated as a company, and hence the units are treated as an equity. This company is exempt from corporate tax if it satisfies certain specific criteria and thus follows a pass through or a flow system, wherein only the dividends received from this equity is taxed in the hands of the unit holders. This is mainly envisaged to avoid double taxation. Same system is followed in the United Kingdom, wherein only the dividend in the hands of the unitholder is taxed.

Thus, no trust mechanism is followed in both these jurisdictions, but the companies are exempt from taxation. This is what majorly differentiates and at the same aligns partially with the functioning of ITs in India.

Analysis

ITs in India are trusts which are governed under the provisions of the Indian Trusts Act 1882. Under the provisions of SEBI (REIT) Regulations 2014 and SEBI (InVIT) Regulations 2014, the ITs hold the assets directly or through a special purpose vehicle (SPV) or through a holding company wherein 50% or more shares are held by the ITs. By virtue of Section 10(23FC) of the IT Act, income earned by trusts by way of interest or dividends is exempt from taxation. Also, if the REITs directly own the assets, then the rentals received by them, which is their major source of income is exempt from tax by virtue of Section 10 (23FCA) of the IT Act. This exemption is not available for InVITs. Thus, it is always desired to use the SPV mechanism, if the ITs have other sources of income other than rentals, as the same would then be subject to taxation.

The author believes that any attempt to characterize these units as equity rather than hybrid would affect the very artificial juridical character of these ITs as trusts. The rationale of treating these units as equity in the above jurisdictions lies in the fact that the ITs are treated as a company and not a trust. Similarly, the term equity in Section 43 of the Companies Act 2013 refers to equity in the share capital of a company. Hence, this would further lead to the question of whether trusts can issue equity. The coherent fact that most of the ITs follow the SPV model owing to the tax benefits, leads the author to an argument that the entities may instead invest in the equity of these SPVs which are companies that earn income on behalf of these ITs, rather than conversion of the units from hybrid to equity.

The paper outlines the suggestions made by the Association of Mutual Funds in India and Mutual Funds Advisory Committee, wherein they recommended for maintaining the present mechanism for treating the units of ITs as hybrid and not equity.

Way Forward

The trust structure of these ITs will surely suffer a setback if at all the units are treated as equity. This would then require remodeling of the entire taxation regime, which would eventually result in India following the pass through or flow through system from the present quasi pass-through model. This would involve exemption of corporate tax for companies operating as ITs.

Considering the nascent stage of these ITs in India, the time is not yet ripe for treating these units as equity and thus the author is of the view that the status quo must prevail.