CBDT Circular Targeting SEZ Units in IT Sector
CNBC - The firm
Tax Partner, EY
Notwithstanding the International Competitive environment and resistance to outsourcing to India by various lobbies internationally, the Indian software industry has been recognized as the go to vendor, as it is able to provide effective solutions in a cost effective manner to the Global Businesses. This sunrise sector is able to do so on the backdrop of fiscal incentives provided in Sections 10A and 10AA of the Income tax law (ITL) in respect of profits derived from export of computer software. The tax benefit applies to a “unit” or an “undertaking” established under various schemes and deriving profits from export of computer software/IT enabled Services (ITeS) subject to fulfillment of the following conditions amongst others:
It is not formed by the splitting up or the reconstruction of a business already in existence.
It is not formed by the transfer, to a new business, of machinery or plant previously used for any purpose in excess of 20% in value.
A taxpayer will lose the incentive benefit if it violates any of these conditions. Historically, Indian Courts have ruled that split or reconstruction presupposes transfer of plant or machinery from existing unit to new unit. There has been litigation on the issue whether transfer or redeployment of technical manpower from existing unit of a taxpayer to the new SEZ unit amounts to splitting up or reconstruction of the existing business violating the conditions of sections 10A/10AA of the ITL. Dispute between the taxpayers and the Tax Authority led to the denial of benefits and consequent litigation.
In deference to the representations made by the software community, the Government of India constituted a committee under the chairmanship of Mr. N. Rangachary. Pursuant thereto, the CBDT, vide Circular no. 1 of 2013 dated 17 January 2013, had provided clarifications on a number of contentious issues. In the present circular, the CBDT further seeks to clarify on the issue of transfer of technical manpower.
Software industry representations
A software developer has a limited pool of skilled, talented and experienced manpower with domain knowledge. In view of the requirement of highly technical and competitive nature of software development, there is need of technical persons with prior experience having to manage critical functions of software development in a new unit. The movement of technical manpower from an existing unit to a new SEZ unit should, therefore, not be a constraint in availing tax benefit. Instruction No. 70 dated 9 November 2010 issued by the Ministry of Commerce under SEZ Regulations in the context of shifting of existing units to SEZ, has, inter-alia, clarified that provisions of SEZ Act and Rules do not prohibit or place any limit on transfer of manpower to SEZ units. Sections 10A/10AA of the ITL disqualify a taxpayer if there is transfer of plant and machinery from an existing unit to a new unit in excess of 20% value. However, there is no such specific restriction on the transfer of manpower.
The CBDT, vide the present Circular 12, has clarified that mere transfer or redeployment of 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 manpower actually engaged in developing software at any point of time in the given year in the new unit.
New controversy created
How the percentage of 20% came about in total discard to the committee recommendations is what has taken the sector by surprise. In case of the IT industry which is substantially manpower oriented, the taxpayer may find the threshold limit restriction of 20% on transfer of technical manpower from existing unit too low to address the concerns of the industry. The Rangachary committee while recognizing that there is no bar on transfer or deployment of manpower explicitly laid down in the section, it had, amongst others, suggested a liberal transfer of existing employees to new SEZ unit so long as there is billable new employment generation at entity level to the extent of 50% of total billable employees of the new SEZ unit in its first year. The recommendations of Rangachary Committee on this issue do not appear to have been accepted by CBDT.
While, it is appreciated that the object behind issuing the Circular is to mitigate the chances of disputes which have been noticed on the field, any restriction on transfer or re-deployment of manpower appears to be introduction of a fresh condition. The statute has specific provision to provide that transfer of secondhand plant and machinery beyond a certain permissible limit can be considered as a case giving rise to split up or re-construction of an existing undertaking. Any such restriction sought to be applied to manpower is wholly inapt. Firstly, the taxpayer has no control over the employees who are free to join and exit at their will – accordingly maintaining a 80/ 20 ratio at any point of time would be a daunting task. Secondly, how would the concept of new employee work where the company provides services with contract employees/ independent software consultants.. Thirdly, with regularity, technical persons who might be working on one project in a devoted SEZ may be released from that project as the project takes shape or as the project gets completed and personnel are re-deployed in other SEZ projects. It cannot be the requirement that the already existing personnel should be kept idle and new personnel of similar skill should be hired. Fourthly, the factors which are germane to formation of an undertaking are substantially different; employees constitute one of the highly mobile economic resources who are required to be part of a unit which is first duly established and is ready to employ them.
Thus, the introduction of bar on transfer of manpower to SEZ units as introduced by the Circular shall inhibit the growth of the Software Industry, which is already susceptible to high rate of employee attrition. The Circular purports to introduce a condition which is not germane to the formation of new and identifiable undertaking separate and distinct from existing business. Besides, instead of clarifying any ambiguity, the said Circular is likely to add to confusion and uncertainty leading to avoidable protracted litigation especially when such a condition is not prescribed on Statute.
The CBDT clarifications should generally come as a relief to taxpayers in respect of issues addressed by it. However, with respect to the present Circular taxpayers operating in a SEZ may find the Circular imposing an onerous condition on eligibility of unit for incentives. Further, the restriction of 20% is applicable in the first year of commencement of business and is to be maintained at all points of time in the given year. A prima facie reading of the Circular suggests that most of the cases under litigation pertaining to SEZ units on the issue may not find relief having regard to the low threshold restrictions.
Lastly, circular purports to create a condition which is not in sync with SEZ Scheme and rules framed thereunder. This would lead to an unwarranted situation where the policy under which the units operate allow free transfer of manpower to these units, but the Circular would deny benefit of deduction under section 10A/10AA of the Act, if the conditions specified therein are not satisfied. Such rift in policy and taxation is unwarranted and needs to be avoided.
With the IT/ITES sector projecting a USD 200 Billion opportunity for India, it would be prudent to invite all the stakeholders on the table and understand the sector nuances, to ensure that other Jurisdictions like Mexico, Philippines’, China, amongst others which are establishing Special Economic Zones, do not become preferred hubs for outsourcing and while the debate gets activated, it would be prudent to keep the circular in abeyance.
(Views expressed are personal)