Tax troubles for SEZs

Updated: Aug 22 2014, 14:47pm hrs
Tax on SEZThere are also indirect tax incentives such as exemption from customs duty on imports for authorised operations. (Reuters
The concept of special zones for promoting exports first emerged in India with the establishment of the Kandla Export Processing Zone (EPZ) under the EPZ Scheme, 1965. By the late 1990s, seven more EPZs came into existence. In April 2005, to remove shortcomings of EPZs and similar formats, the government introduced the SEZ Act. Since then, about 570 special economic zones (SEZs) have been formally approved, of which 388 SEZs stand notified. Investments to the tune of R2,88,476.98 croreas on December 31, 2013have been infused in the SEZs and employment to 12,39,845 persons is being provided. Thus, SEZs are one of the important infrastructure levers in the country.

Like all infrastructure projects, SEZs are also showered with tax incentives to make them viable over the long term. For instance, the SEZ developer (an entity developing an SEZ) gets income-tax incentives100% deduction of profits derived from the business of developing, operating and maintaining an SEZ for a period of 10 consecutive years from the date of notification. The SEZ developer has a choice of selecting a block of 10 years out of 15 years. The deduction from operation and maintenance profits is also available to the transferee developer. There are also indirect tax incentives such as exemption from customs duty on imports for authorised operations; exemption from excise duty on domestically procured goods for authorised operations and manufacturing activity carried on inside the SEZ; exemption/refund of service tax on input services procured for authorised operations; exemption from central sales tax on domestically procured goods for authorised operations; and exemption from sales tax/VAT on domestically procured goods for authorised operations, subject to provisions of state sales tax/VAT laws.

Similarly, the SEZ unit (entity setting up its business in SEZs) gets income-tax incentives such as deduction of export profits of an SEZ unit for 15 years: 100% for the first 5 years, plus 50% unconditional for the next 5 years, and a maximum of 50% for another 5 years, subject to conditions. As far as indirect tax incentives are concerned, these are similar to those available to the SEZ developer.

However, SEZs are yet to achieve their full potential. While there exist reasons for reduction in the interest levels in SEZssuch as difficulty in satisfaction of minimum contiguous land requirement, problems in land acquisition, slowing of global economies, high inflation in India, emergence of other alternate destinations, etcthe non-addressing of the tax issues, withdrawal of the tax incentives originally provided and policy cartwheel have had significant adverse implications.

Recently, the Central Board of Direct Taxes (CBDT) issued a circular (number 12/2014, dated July 18, 2014) in the context of eligibility of IT/ITeS units for claiming deduction under the Income-tax Act. CBDT has clarified that mere transfer or redeployment of existing technical manpower from an existing unit to a new SEZ unit in the first year of commencement of business will not be construed as splitting up or reconstruction of an existing business, provided the number of technical manpower so transferred does not exceed 20% of the total technical manpower actually engaged in developing software at any point of time in the given year in the new unit. The background to this circular is representations made by various IT/ITeS industry bodies and companies that, from a business perspective, movement of some technical persons with prior experience from existing units to new SEZ units is essential, and in absence of any specific bar in the Income-tax Act the same should not be regarded as a case of formation of unit by way of reconstruction or splitting up of existing business, dis-entitling the SEZ unit to claim the income-tax holiday. It is also relevant to note that there is instruction number 70 issued by the ministry of commerce, which states that movement of employees is permissible.

The term reconstruction or split-up in various contexts has seen its fair share of tax litigation at all judicial and administrative levels. This is because there is nothing that sets out a specific rule except that old plant and machinery should not exceed 20% of the total value of plant and machinery used in the new business. Employees of IT/ITeS units are arguably its most important asset but would they fall within the term of plant and machinery as used in the Income-tax Act has been a debatable question. Since 2005, many companies have taken various positions based on the set principles in law which evolved through these judicial precedents.

To the surprise of the IT/ITeS industry, which was expecting a relaxation, the circular not only unsettles the likely plans but could also impact the past tax holiday claims of various companies. That is the reason not many see this circular as a relaxation. The circular does not specify what happens to other cases, especially past ones. Therefore, can this be retrospectively applied by the authoritiesbeing clarificatory in nature Also, what happens in cases where some judicial precedents have actually upheld a higher percentage of transfer of employees For instance, the Chennai tribunal in the case of DSM Soft (P) Ltd held that transferring existing employees (one-third of total employees at year-end) by themselves would not make the new unit ineligible for tax relief under Section 10A of the Act. The unit was not formed by splitting up or reconstruction of a business already in existence and was eligible for tax relief under Section 10A of the Act. Therefore, while there are good intentions behind the circular, this can cause more policy cartwheel impact in a sector which has already seen enough.

Also, at the time of the introduction of the SEZ Act, in addition to the above mentioned income-tax holiday, SEZ developers and units were exempt from the levy of minimum alternate tax (MAT) on their book profits. However, this exemption was withdrawn from FY12 onwards. An alternate minimum tax was also introduced on limited liability partnerships setting up SEZs or SEZ units. The sudden withdrawal of incentives resulted into a policy cartwheel impression and scepticism on SEZs. There were expectations that this would be corrected in the latest Budget of the new government. It did not happen, but there is hope that this anomaly will see a correction in the ensuing Budget.

Similar to MAT exemption, at the time of introduction of the SEZ Act, SEZ developers were exempt from levy of dividend distribution tax (DDT) on the dividends declared out of profits earned from development, operation and maintenance of SEZ. This exemption was also withdrawn from FY12 onwards. Hopefully, this will too see a change.

The proposed Direct Taxes Code 2013 (DTC) intends to withdraw the existing profit-linked incentives available to SEZs. Instead, investment-linked incentives will be available. This will further marginalise incentive for SEZs. While the future of DTC is unknown, it has created uncertainty around the tax incentives available to future SEZ developers and units. The SEZ developers and units would expect the existing incentives to continue even under the DTC.

If job creation and investment flows are to be pushed, then the SEZs should be actively promoted.

By Vikram Doshi

(With inputs from Nirmal Nagda, Chartered Accountant)

The author is partner, KPMG in India.

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