The SEZ relay: Tax hurdles

[ FRIDAY, MARCH 30, 2007 12:00:00 AM]

Vikram Bapat & Shilpa Shanbha

The Special Economic Zone (SEZ) is no less than a phenomenon that hit
India with battering impact in these last few months. As the baton
passes back and forth there is yet one runner waiting patiently for the
baton to pass to him—the taxman.

The insertion of Section 10AA in the Income Tax Act, 1961 ('Act'), has
effectively forced a clearly reluctant finance ministry to run the race.
Whereas the February 28 annual fair ushers in most of the tax offering
to the public at large through the Finance Acts, section 10AA originates
from the SEZ Act, 2005, thus forcing the finance ministry in the relay
and out of its monopoly.

Once the current controversial dust settles, we hope that India is truly
poised to set up world class infrastructure to usher an era of sustained
exponential growth. That's when the entrepreneurs or units will set up
and then will start the inevitable battle with the taxman.

Quantum of deduction

In 2000, Finance Minister Yashwant Sinha had proposed to delete sections
10A and 10B from the Act. Pandemonium broke loose. Eventually public
opinion prevailed and the sections were reinstated in the statute book
in a new avatar. This version raised the first controversy that—lo and
behold!—is back to haunt us in section 10AA.

To elucidate, the deduction is to be computed in the manner provided in
the section. The formula stipulated is that the profit derived from the
export of articles, things or services (including computer software)
shall be the amount which bears to the profits of the business of the
undertaking, being the unit, the same proportion as the export turnover
in respect of such articles or things or services bears to the total
turnover of the assessee.

This raises the first major controversy. How will an entrepreneur or a
company having multiple units or units with diverse activities, one of
which is a unit in an SEZ, calculate the available deduction? The
application of the formula will result in a reduction of the available
deduction because of the ratio between export turnover and total turnover.

Whereas, export turnover is only of the SEZ unit as the numerator, the
denominator is the total turnover of all units of the assessee in the
aggregate. This is also inconsistent to the extent that whereas the
profit is of a specific unit, basis of allocation (particularly the
denominator) is for the business as a whole.

You may recall that this anomaly also existed in the re-introduced
section 10A/10B but was promptly amended by specifying that the total
turnover will also be only of the singular unit. This amendment has not
happened thus far in section 10AA—until then it will be anybody's guess.
Let's move on.

Migration of units

Existing IT/ITeS units are looking to SEZ to bridge the fiscal gap that
is staring in their face effective March 2009 (rumours of an extension
notwithstanding). Migration is the buzzword for the business but is
taboo for the authorities. It won't be long before our abominable taxman
picks it up either. But do they have a case?

The first interesting departure from the section 10A/10B norm that was
that certain restrictive conditions don't find a place in section 10AA.
There were no conditions stipulated that units should not be formed by
the splitting up or reconstruction of a business already in existence.

Neither was there a condition that the unit should not be formed by the
transfer to a new business of machinery or plant previously used subject
to a cap of 20% of the value. Let us put the second condition at rest.
If it is not in the tax law it is very clear from the SEZ rules itself
that no unit can be registered as an SEZ unit if it proposes any
machinery or plant previously used in any area outside of an SEZ.

No limits either. The tax law therefore is immaterial. The critical
difference now is the question—can the unit transfer its employees from
an existing unit to a new unit in an SEZ. There is no apparent
restriction to this whatsoever at least in the SEZ law.
Conclusion—migration with substantial expansion in an SEZ would have
been a distinct possibility—until Budget 2007.

It is now proposed that the restrictive conditions of section 10A/10B be
inserted in section 10AA as well. Should this become law (and in all
likelihood it will be) the question of migration perhaps is finally
nipped in the bud and is likely to be a non starter. Perhaps, just as
well. This is one step towards achieving the primary goal—incremental
economic growth and not merely shifting of existing economic resources.

Export from an SEZ

The dichotomy between business realities and revenue collection may just
come to the fore in the provisions of section 10AA that deal with what
can be construed as "export turnover" for the purpose of the section.
There are some differences of opinion even in the current section 10A
regime but section 10AA holds greater potential for the taxman to turn
yet another step away from business reality. Here's why.

"Export Turnover" is defined in the Act to mean the consideration in
respect of export by the undertaking, being the unit of articles or
things or services received in, or brought into, India by the assessee
but does not include certain charges or expenses. Seems quite straight
forward.
However, there is yet another definition; "Export in relation to the
SEZ" has been defined to mean taking goods or providing services out of
India from an SEZ by land, sea, air or by any other mode, whether
physical or otherwise. Interestingly, this definition is not referred to
or does not find place anywhere in the rest of the section.

What, therefore, is its significance? The significance may be understood
in the context of sub-contracting by an SEZ unit that is extensively
permitted by the SEZ Act and Rules. Take this example.

What if an SEZ unit manufactures a product and sends it out for
specialised packing to a third party contractor for onward export on
behalf and on account of the SEZ. Would the letter of the law require
that the goods be necessarily sent back to the SEZ because of the "from
the SEZ" condition? From a business perspective, it would be illogical
and uneconomical for the packed products to be sent back to the SEZ unit
for onward export just because the tax law says so.

This example is by no means the end of all. As units start taking shape,
many more issues will be raked up by the taxman particularly after
Budget 2007 amendments see the light of day. We may have just one point
to put forward our case.

Section 10AA takes birth from the SEZ Act and hence it stands to reason
that as long as the units undertake "authorised operations" as laid down
in the SEZ Act, there should be no reason why the taxman should deny a
legitimate tax benefit. It fact, there is every reason for the tax
authorities to assume good faith as soon as the authenticity of the SEZ
registration is proved. Otherwise, this may result in a miscarriage of
justice.

(Mr Bapat is associate director & Ms Shanbha is associate,
PricewaterhouseCoopers)
http://economictimes.indiatimes.com/News/Economy/Policy/The_SEZ_relay_Tax_hurdles/articleshow/msid-1830254,curpg-3.cms