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Small businessmen hit by tax levies
March, 09th 2007

Life just got a little tougher for some entrepreneurs. Ram Sundar, who runs a small Rs 5-crore firm that develops mobile content, will now have to pay a service tax of 12% on the content he provides to operators like Bharti and Reliance. While this will be passed on to the operators, his prices will still have to be competitive enough to allow him to compete with large media houses that in are in the same business and in some cases, with the in-house content and software divisions of the operators.

On the other hand, his landlord, from whose property he runs his operation is demanding a higher lease rental. Budget 2007 has brought development of content for telecom and renting of immovable property under the purview of service tax. The difference is, while his landlord can afford to pass the tax on to his tenants, Mr Sundar though may find it difficult to do the same without becoming uncompetitive.

Had he not been so successful and his revenues were still below Rs 1 crore, the budget would have given him a fillip in the form of reduced corporate taxes. Companies with a turnover of below Rs 1 crore have been spared the surcharge. So while the effective tax rate is around 34%, it will be 31% for companies with a turnover below Rs 1 crore, says Sudhir Kapadia, partner, KPMG.

His counterpart, who established an auto component business five years ago, has a different kind of problem. He was in talks with a domestic fund for a capital infusion, but the domestic fund is now not as keen on the investment. The reason being, the budget has removed the pass-through status for all venture capital funds registered in India except in certain sectors such as biotechnology, IT hardware and software, R&D of new chemical entities in the pharmaceutical sector; dairy industry; poultry industry; and production of bio-fuels, and hotel-cum-convention centres of a certain description and size.

The fund now has to take a call on how attractive the investment will be compared to another investment, say, in a biotech firm it was evaluating. A majority of funds, however, have raised money abroad and the measure will have no impact on them. The budget has imposed dual taxation. The returns will be taxed at the fund level and once again, in the hands of the investors, says Pravin Gandhi of Seed Advisors, which manages an angel fund.

Mr Gandhi is also the president of the Mumbai chapter of The Indus Entrepreneurs, an organisation that promotes entrepreneurship through better networking amongst venture funds, professionals, entrepreneurs and other stakeholders. There has never been anything specific for entrepreneurs in budgets. The FM could have encouraged angel investors and/or companies to invest in new ideas by offering them a tax benefit just like investment in R&D as is available today. Additionally, banking channels could have been encouraged to lend to start up companies, he adds.

Post budget, entrepreneurs in software exports will also be paying higher taxes. Rohit Sharma, is the founder-promoter of a Rs 30-crore company that was under a tax holiday till 2009. He and his peers in the software business were lobbying for the tax holiday to continue beyond 2009. But instead, the budget has slapped a minimum alternate tax of 11.3% on them.

Small entrepreneurs have been doubly hit. One, by the service tax on renting of immovable property and two, by the MAT, says Ashank Desai, entrepreneur and co-founder of Mastek. Unlike some of the large companies with offices and development centres in the US, the UK and other countries, his company does not pay taxes in these countries because it has only sales offices there. So while the larger companies can offset the MAT with taxes they are paying in these countries, small firms such as his cannot.
He can get a refund on the MAT after FY09, if the tax benefits under Section 10A/B are not extended beyond that year. But for now, his company will have to take a hit on its cash flows.

Entrepreneurs in the pharma sector can, however, smile. The finance ministers decision to extend the 150% weighted average deduction for research and development expenses by five years will benefit ventures which spend a significant share of their total sales on R&D. Similarly, the service tax exemption for clinical trials on new drugs could benefit research-led companies and Contract Research Organisations (CROs) - organisations which are contracted to run clinical trials and duties with a sponsor.

However, bio-equivalence studies, which represent a large chunk of the clinical trials conducted out of India, will not benefit from the service tax exemption. Finally, the import duty cut for medical equipment from 12.5% to 7.5%, should benefit medical laboratories, as 90% of the medical equipment in India today is imported.

There are positives for other sectors as well. Gems and jewellery firms were asking for a turnover- based taxation to make the assessment simpler, and seem to have finally got their way in the budget.

The wording is not very clear and some clarifications are awaited. But it looks like that is what is intended even if you look at the budget speech, says Mr Kapadia.

In addition, for firms which are just starting up and in the incubation, the budget offers some cheer.

Technology business incubators, which are currently located mostly in the IITs and IIMs but which may also be run by venture capital and angel investors, will have not pay service tax. Firms in these incubators will also not have to pay service tax for the first three years if their turnover is below Rs 50 lakh. Most incubatee companies are likely to fall into this category in the first year of their operations.

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