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`Get used to the pain'
March, 12th 2007
The fringe benefit tax on employee stock options and service tax on leased or rented premises has players, especially the smaller ones, crying hoarse. A post-Budget round-up.

Say software and the economist in you would immediately associate it with `tax exemptions." As the pitch to tax the industry gets higher, as exemplified by the tax proposals in Budget 2007-08, the industry itself claims that it is concerned not so much by the move to tax its operations as by the taxes that impact two of its very important supply side factors, namely, infrastructure and people.

So, the minimum alternate tax (MAT) - that would tax a company's profits - drew only token protest while the fringe benefit tax (FBT) on employee stock options (ESOPs) and the service tax on leased or rented premises had players, especially the smaller ones, crying hoarse.

Here's what a few players have to say on the various issues that might change the dynamics of the software services industry.


Deepak Ghaisas, CEO Indian operations and CFO, i-flex Solutions, put it most succinctly, when commenting on MAT: "This is almost like saying that you are going to get hurt after 2009 but you will get used to it by then. It's really an advancement of cash outflow."

Ghaisas says, "Whatever a company pays as additional tax due to MAT will be considered as a deferred tax asset thereby having no impact on the bottom-line in coming years. In the future when a company can avail tax credit for excess tax paid in the past under MAT it will be set off against the deferred tax asset, which has been referred to earlier. Hence the payout of taxes will be lesser post 2009 as compared otherwise. However, it will not reduce the impact of tax on the Profit and Loss account."

Nasscom, wishing to voice the concerns of especially small and medium-sized companies, says that MAT can have impact on margins. Says its chairman, who is also chairman of Satyam Computers, B Ramalinga Raju, "The provisions under MAT could erode company profitability and the tax on lease rentals would also add to the margins pressure. Typically, tier II companies operate with a margin of about 20 to 25 per cent and these provisions could slice it down to about 8 to 12 per cent. These call for a thorough review."

There are other voices that do not show too much concern over MAT.

N. Ramachandran, CFO, iGATE Global, explains, "The impact of MAT on IT companies, if at all, will be only for two years, namely 2007-08 and 2008-09 as, due to withdrawal of tax holiday, these companies will be required to pay regular tax from the year 2009-10 any way."

"Even in those two years MAT is not expected to affect the margins of IT companies as most companies will account for it as deferred tax asset consequent to the right of set-off and will claim credit for MAT paid against the regular taxes payable in the years 2009-10 and beyond." Also, those companies that pay income tax in foreign jurisdictions would claim double taxation relief by way of credit of the taxes paid in foreign jurisdictions on the doubly taxed income against the taxes payable in India such credits were hitherto rendered to some measure `unusable' because of the tax holiday in India.

Also, this could well be a push for the Special Economic Zone (SEZ) schemes, since MAT is not applicable under it.

Would companies feel comfortable going into SEZs post 2009? After all, the recent Nasscom-Crisil report says that without tax sops, there would be a huge hit on margins. So SEZs look attractive in this scenario.

Ramachandran feels that the SEZ model is compelling. "At present everything indicates that Government has no intention to extend the tax holiday for STPI registered companies beyond the year 2008-09." Therefore, the case for directing all future infrastructure investments to SEZs has become even stronger because of the tax benefits." However, SEZs allow tax benefits only for new operations and not existing ones. As the SEZ tax holiday will apply only for newly established units, IT companies will have to pay regular tax from the year 2009-10 for income arising from operations outside of the SEZ. The MAT credits, therefore, may not go unused even as IT companies set up new business units in SEZs.

Ghaisas agrees that SEZs look attractive and that i-flex is already in it. "However, most small and medium enterprises, including new undertakings, cannot afford to go in for their own SEZ. Investment made in current STPI units that have recently been established would go waste. The SEZ rules are still ambiguous about the formation of SEZ units, `new industrial undertaking', `new business' and the like."

Four Soft is inclined to take advantage of the SEZ scheme. Its Managing Director, Palem Srikanth, says removal of tax benefits under Section 10A and 10B means that many companies will seek to deploy incrementally more manpower in Special Economic Zones from 2009.

Subex Systems, telecom software player, is enthused by SEZs, especially in the context of the Budget proposals. Says its CFO, Sudha Madhavan, "SEZs do look attractive and we may explore the SEZ options for our new investments." And, to sign off on the topic, she says that if at all MAT is to be imposed, it should be done only after 2009, when the benevolent tax regime is slated to end anyway.


If the SEBI norms apply, then a 33.99 per cent is the rate applicable on benefits accrued through ESOPs. This is calculated as the difference between the fair market value (on exercise) and the grant price. That is, if you get a stock option in 2002 for Rs 300 and you exercise it in 2007 at a market price of Rs 1,200, then the company would pay a 33.99 per cent rate as FBT on Rs 900 per share per employee.

Ramachandran feels that without more clarity from the FinMin, any discussion here is academic. However, he brings to our attention the evolution of the FBT in India. "In his address to parliament on February 28, 2005, the Finance Minister said that where fringe benefits are fully attributable to the employee they are taxed in the hands of the employee and that position will continue. He further said that `where benefits are usually enjoyed collectively by employees and cannot be attributed to individual employees they shall be taxed in the hands of the employer.' He says that any gains on this front were being taxed in the hands of the employee. "So, why then is the sudden necessity to tax the employer in the form of FBT?"

According to him, it is inconceivable that the intention of the Government would be to tax the employer in the form of FBT on potential gains represented by the difference between the exercise price and the fair market value of the security prevailing on the exercise date. Such scheme of taxation defeats any reason, far from being fair and equitable. We will know for sure only when the Government comes with the Rules for computation of FBT.

Interestingly, the way you structure your ESOPs influences how you view this tax. Says Ghaisas, "i-flex has issued ESOPs always at the market price and hence the impact of FBT will be lower as compared with iGate, Wipro or Satyam."

Dr J.K. Nair, COO of California Software, is vehement against FBT on ESOPs. "This is ridiculous and unheard of anywhere in the world. Companies like us will be forced to discontinue ESOP schemes now. This will only increase cost of labour. Government seems keen on `killing the golden goose'."

"Kill" seems to be the buzzword. The Managing Director of Prithvi Information Solutions, V. Satish Kumar, says the company, being a Tier II player, is planning to expedite the issue of ESOPs. Though there is still some lack of clarity on this, from what we understand now, this could potentially kill a company.

Four Soft's Srikanth wonders if the FBT on ESOPs will apply to already issued ESOPs.

Net impact is likely to be approximately 2-4 per cent higher taxes for large companies, is the general understanding. But, would ESOPs, as a tool to reward employees, be on their way out? Not necessarily. Ramachandran says that as the benefits relating to ESOPs can be clearly attributed to individual employees, employers would likely structure their schemes to pass the incidence of FBT to employees. This would also be fair in the light of the consequential proposal to amend Section 49 that has the effect of substituting the fair market value of the security at the time of exercise of the Options as cost of acquisition for determination of capital gains on sale of the underlying securities.

Agrees Sudha Madhavan of Subex, "The FBT impact will be significant and will reduce the attractiveness of the scheme. However, our intent is to pass it on to the employees."

Despite this, wouldn't companies look at rewarding employees differently? She says, "Too early to comment. We are evaluating the impact of FBT on ESOPs."

Says Dr Nair, of California Software, "We will have to rethink our approach. This makes ESOP schemes highly unviable."

Advance FBT, an anomaly

Ramachandran also feels that employers cannot pay advance FBT like advance tax. "It is impossible to estimate FBT on ESOPs in advance because there is no way an employer can either foresee when employees would exercise the Options or predict the fair market value of the securities that may prevail at the time of the exercise.

Service tax on leases

The Finance Bill 2007 proposes to levy Service Tax at 12.36 per cent of the rent in respect of immovable property let out for business or commercial use. Such Service Tax is imposed on the lessor of the immovable property and not the lessee. Whether the lessor can charge and recover the Service Tax from the lessee is something that will normally be governed by the contractual terms between the lessor and the lessee. Often, the lease agreements specify the taxes and/or levies that a lessor may charge the lessee in addition to the lease rent. For iGATE, we do not expect significant impact on margins arising from Service Tax on rent.

For i-flex, it would amount to approximately 0.28 per cent of total expenses, "which is insignificant as we have our own premises as well," says Ghaisas. Smaller companies see an increasingly bigger impact. Subex' Sudha Madhavan says, "Based on the current lease rentals the impact would be approximately Rs 40 lakh."

According to Dr Nair of California Software, "The Government should have provided at least a couple of years' notice for this tax. Then, companies could have made arrangements accordingly."

For a small company such as California Software, this tax is overwhelming. Says Dr Nair, "Close to 80 per cent of our India offices are either leased or rented. The new move will have a negative impact on our cost efficiencies."

Four Soft's Srikanth says, "The service tax on lease rentals would impact the overall cash flows of a company like Four Soft. Companies operating out of leased properties would have to bear with additional cash outflow by paying 12.5 per cent tax.

This is bound to impact the overall profitability of the company and also cut into the earnings per share for shareholders."

Even for bigger companies such as Cognizant Technology Solutions, the impact could be between 0.15 and .20 per cent of operating margin, according to its CFO, Gordon Coburn. "But that is not significant," he says.

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