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Sun set of tax holiday for IT
November, 16th 2009

Despite the economic slowdown, the Indian information technology (IT) and the information technology enabled services (ITeS) industry have displayed considerable resilience in helping the country to maintain its leadership in the global outsourcing industry.

As per Nasscom reports, the contribution of the IT/ITeS sector to the national GDP has grown from 1.2% in 1998 to around 5.8% in 2009 and the sector's share of total Indian exports has increased from less than 4% in 1998 to almost 16% in 2008.

Most of the players in the Indian IT and the ITeS industry are enjoying a corporate tax holiday on their export profits, set to expire on March 31, 2011. While a minimum alternate tax (MAT) of around 17% on its book profits is currently payable by the units enjoying a tax holiday (other than SEZ units), this MAT can be set off (subject to certain conditions) against future corporate taxes.

These units largely operate out of software technology parks (STP), electronic hardware technology parks (EHTP) or 100% export-oriented unit (EOU). While special economic zone (SEZ) units are also entitled to the tax holiday, the March 31, 2011 sunset period does not apply to them under the current tax legislation. Tax holiday was introduced in the year 1981 for free trade zones (FTZ), extended in the year 1994 to the IT sector set up as STPs/EHTPs and later on to the business process outsourcing (BPO) and knowledge process outsourcing (KPO) segments.

With the easing up of foreign direct investment (FDI) norms for the IT/ITeS sector and the availability of relatively cheap skilled manpower, the tax holiday doled out to the sector was a boon for multinational companies to select India as a preferred destination to set up their IT/ITeS operations.

Currently, the IT/ITeS industry is poised at a phase, where it is bracing itself to pay taxes. The draft Direct Taxes Code Bill, 2009 (DTC) (with a proposed implementation date of April 2011) does not grant tax holiday to the STP/EHTP/100% EOUs. Significantly, the DTC does not even grant tax holiday to SEZ units.

While on the one hand, as per the principle of promissory estoppel, the question is whether the government can discontinue tax holiday to SEZs when it is seen as having been promised it in SEZ legislation, on the other hand India's obligations to the World Trade Organisation (WTO) to phase out tax holidays may be one of the main reasons in not continuing the tax shelter.

The industry would argue that coupled with the appreciating rupee, withdrawal of tax holiday would severely dent its margins in this competitive global market.

With an expectation that the government would roll back its proposal (in the DTC) of discontinuing tax holiday to SEZ Units and also to take benefit of other fiscal benefits that SEZs have to offer, some of the STP/EHTP/EOU are contemplating migrating to a SEZ to renew their tax holiday, to maintain their margins.

A word of caution here is that tax holiday to SEZ units (even assuming that the same is continued in the DTC) is not automatic. While the SEZ rules have been recently relaxed to allow shifting of existing plant and machinery to SEZs, availability of tax holiday for SEZ operations would still be determined by certain tests laid out in the tax legislation. Tax holiday will not be available if the used plant and machinery shifted to the SEZ exceeds the prescribed threshold of 20% (to be computed in the prescribed manner).

Even if this threshold is satisfied, the business shifted to a SEZ will still have to prove that the SEZ unit was not formed by reconstruction or splitting up of an existing unit.

SEZs may be ideal for units that want to shift for non-tax reasons like consolidation of multiple units. Of course, this will have to be weighed against the incremental rental costs, if any. For large business houses, consolidation of operations in a SEZ may be an option that could be looked at.

Should the DTC continue the tax holiday for SEZ units, with adequate planning, tax holiday may be availed for new business as well.

While the industry bats for tax holiday to be continued, there is an ongoing debate whether the IT/ITeS industry has been tax sheltered by the government for a long time now. From a quality and efficiency perspective, if the Indian IT/ITeS industry sees itself as a leader.

One may wonder why the same Indian IT/ITeS behemoth would not be in a position to compete with the non-Indian players (most of who may not have the tax shelter) without the tax holidays.

The government argues that large business houses should be today in a position to pay taxes on their profits. If support is still desired for the SME sector, a selective tax holiday policy may be ideal.

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