The issue of exemption from service taxes on supplies of services from the Domestic Tariff Area (DTA) to developers of Special Economic Zones/units located in Special Economic Zones (SEZs) has been the subject of much controversy and debate. As is, by now, well known, SEZs have been set up with the fundamental objectives of promoting exports from India. Accordingly, they have been granted benefits in the form of exemptions from all taxes and duties. In the area of service tax however, problems have arisen regarding the manner in which the exemption from service tax would be granted to SEZs.

Before alluding to the recent developments with regard to the above exemption, it is important to appreciate the overriding provisions of the Special Economic Zones Act 2005 (Act). Section 51 of the Act states that the provisions thereof shall have effect notwithstanding anything inconsistent therewith contained in any other law. Accordingly, Section 26 of the Act, which holds that the SEZs are entitled to exemptions from customs duties, excise duties, service taxes and sales taxes will have effect regardless of any provisions to the contrary in any other enactment.

Of course, Section 26 also authorizes the Central Government to prescribe the manner in which the exemption would accrue. Further, Rule 31 of the Special Economic Zones Rules 2006 (Rules) states that the exemption from payment of service tax on taxable services rendered to SEZs by any service provider shall be available for authorized operations. The Act and Rules were effectively brought into force from 10/2/2006.

With regard to the services provided to SEZs by a service provider, there exists Notification No. 4/2004 dated 31/3/04, which states that the exemption from service tax would apply for consumption of services within the SEZs. The only other condition is that both the developer and the unit ought to have obtained the necessary approvals to carry on activities as such.

It may be noticed that this Notification predates the coming into force of the Act/Rules by almost two years. Upon the coming into force of the Act/ Rules therefore, the issue of harmonizing the provisions of Notification No. 4/2004, which limits the benefit of exemption only to services consumed within the zone, with the provisions of the Act/Rules, which exempt the payment of service tax on taxable services rendered to a SEZ developer/unit for the authorised operations, arose.

Given the overriding nature of the Act/Rules, it was clearly the position that the DTA supplies of services to the developer/unit would be exempt from service tax, as long as they were for the authorized operations, regardless of whether the services were consumed within the zone or outside of it.

Indeed, it could have been argued that the Notification would apply even if services were rendered outside the zone, as they were necessarily to be construed as having been consumed within the Zone, since the developer/unit was physically located within the Zone. Notwithstanding this, the service tax authorities continued to hold that the Notification was in force, even though contrary to the relevant provisions of the Act/Rules.

This led to an ongoing tussle between the SEZ developers/units and the DTA suppliers of services on the one side and the service tax authorities on the other, as to whether the services rendered by the DTA service providers were eligible for the exemption from the tax. The Ministries of Commerce and Finance were in constant discussion as to how to resolve the problem.

As a result, the Government of India has recently, superseding the earlier Notification No. 4/2004 , issued Notification No. 9/2009 on the exemption from service tax on taxable services provided in relation to authorized operations in a SEZ and received by a developer or a unit, whether inside the Zone or outside. The Notification however provides that the exemption will apply by way of refund of the service taxes paid on the above services.

Accordingly, the erstwhile complete exemption from the tax that was available to supplies of services to SEZs has been replaced with a modified scheme of exemption by way of a refund. The refund would operate in a manner, as laid down in the above Notification, whereby the taxes would be paid by the DTA service providers and the refunds would be granted to the SEZ developers or units who would file claims accordingly, having reimbursed the taxes to the service providers.

It is thus the position today that the exemption from the service tax that is available to developers or units under the Act/Rules has apparently been operationalised through the above Notification, by way of a refund. It seems that the Government has not been able to implement a complete exemption from the tax to services supplied to a Zone, unlike the situation regarding supplies of goods to a Zone wherein the exemption operates simpliciter and not by way of a refund.

However, the Notification has laid down this refund procedure even with regard to services provided and received within the Zone, including on services provided from abroad, in regard to which the reverse charge mechanism of payment of the service tax operates. In other words, not only has the Government not granted the benefit of exemption from the service tax to DTA services provided to developers or units for their authorized operations but has also imposed the refund mechanism on imports of services from abroad into the Zone.

Thus, developers or units will now need to first discharge the service taxes, either by way of reimbursing these taxes to DTA service providers or by way of the reverse charge on imports of services etc and then file claims to recover these taxes from the authorities, by way of refunds. The Notification thus makes no distinction in procedure between services received in the Zone or outside of it.

This bring us to the issue of whether Notification No. 9/2009 is in consonance with the SEZ Act and Rules, especially when the operative provisions therein extend the benefit of exemption to the payment of the service taxes. The moot question is whether an exemption by way of a refund is an exemption simpliciter or an exemption from payment of the tax. It can be argued that it is not.

The refund mechanism is not favoured by anyone who has any experience of dealing with the Government in regard to obtaining refunds of any taxes. The process is cumbersome, the intention is to delay, if not deny altogether, the refund and the amounts of cash flows locked up a result put a real strain in business. It is a wholly unhappy experience. The point is brought to sharp focus as the above Notification does not specify any timeframe for grant of the refund.

It is strongly urged that the Government reconsider the matter afresh. The Notification, as is presently worded, is sure to significantly and negatively impact the SEZ developers and units, in terms of cash flows and costs of compliance. To be fair, one clear benefit of the new procedure is that the DTA suppliers will no longer need to reverse input tax credits on their supplies to the SEZs. This benefit is however outweighed by the above disadvantages in relation to the refund procedure. The Government should intervene immediately to remedy matters.