The article discusses the influence of legacies of separate units on tax holiday benefit in the formation of STP units .

It is estimated that approximately 20 per cent of Indias IT/ITES exports can be attributed to Small & Medium Enterprises, with a majority of these players being registered STP (Software Technology Park) units. There are several situations where the formation of such units by a legal entity may be subject to scrutiny by the Revenue authorities, due to the legacy connection of one or more elements of the business of one unit with another unit within the same legal entity.

The tax holiday provisions (sections 10A, 10B and 10AA) do contain anti-abuse conditions. These conditions mainly cover aspects of whether the unit was formed with old machinery and whether the unit was formed by splitting up or reconstruction of a business already in existence.

Courts have in the past held that all elements of an undertaking, namely, machinery, people, contracts and nature of business, are relevant for determining whether there has been a split up or reconstruction of an existing business in the course of formation of a unit.

From a practical perspective , while companies often tend to set up a unit with new machinery, the problem lies in establishing that the other elements of an undertaking are new. Often it is quite difficult to establish a unit with only fresh recruits. Further, from a customer contract perspective , the fact pattern may so be that the new unit may merely undertake additional projects for the existing customers . Also, the differentiation in the nature of services rendered by the old and new units need not necessarily be stark.

Due to all these connections between the two units, the Revenue authorities may be inclined to deny the tax holiday benefit for the new unit. The above discussed practical issues are more relevant for SMEs as the magnitude of expansion in business may not always be significant enough for clearly substantiating the establishment of a new unit.
It is in this light that a recent decision of the Chennai Appellate Tribunal in the case of DSM Soft Limited can be referred to for understanding what in the Revenues mind constitutes a new unit.

The said judgment discusses in detail all the aspects, which are to be considered for determining whether a unit has been formed by splitting up or reconstruction of an existing business.

To state briefly the facts of the case, the appellant had a software unit in Chennai and had been claiming section 80HHE benefit. During the financial year 2000-01 , the appellant had set up a STP unit at Trichy. The Assessing officer disallowed the tax holiday benefit for the Trichy unit for the reason that it was formed by splitting up of existing business.

Such a conclusion was mainly based on the contention that the export clients were the same for both the units and that the employees had been shifted from the Chennai to the Trichy unit.

In respect of employees, the Tribunal observed that though there had been shifting of employees between the units, there was a significant net addition of employees. In respect of clients and services, the Tribunal observed that the new unit did have new clients in addition to clients that were common to both units. Besides, the new unit had also undertaken new services .

Further, a significant percentage of the revenues earned by the new unit were from new services rendered . Based on the aforementioned facts, the Tribunal held that the Trichy unit was not formed by splitting up or reconstruction of an existing business. In drawing its conclusion, the Tribunal referred to many judicial precedents , including the Supreme Court judgement in the case of Textile Machinery Corporation.

The Honourable Tribunal appears to have taken a liberal interpretation of the antiavoidance provisions in as much as it evolves a view that the facts at the end of the first (tax) year of operations should be considered for deciding whether a unit has been established by splitting up of an existing business. It also provides clear direction in holding that the totality of facts is more relevant and that not a single aspect should be interpreted on a standalone basis.

The Tribunal has spelt out in no uncertain terms that genuine and substantial expansion in business when established as a new unit should be eligible for the tax holiday benefit and to this end transfer of certain employees, clients and services from the existing unit should not disentitle the claim as long as there is additional investment in all these aspects.

In rendering its decision, the Tribunal has rightfully taken cue from judicial precedents, which have held that provisions for granting tax exemptions should be construed liberally.

It is however important to note that the decision has reiterated the old principle that the specific facts of the case are critical for deciding whether a unit is new.

A high level of planning and diligence should be exercised by companies at the time of formation of additional units within the same legal entity and on a year-on-year basis in order to safeguard the tax holiday claim. There is no indication of the benefit under sections 10A/10B being extended beyond March 2009.

For those companies that choose to set up SEZ units to avail tax holidays, it is pertinent to note that the antiabuse conditions in section 10A/10B are also contained in section 10AA (applicable to SEZ units). And the principles evolved in the Chennai Tribunal decision would be relevant in interpreting such conditions at the time of formation of an SEZ unit and evaluating tax holiday claims.

Vidya Nagarajan
(Associate Director, Global Tax Advisory Services (GTAS), Ernst & Young Views expressed are personal in nature.)