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At least, extend the tax holiday for SMEs in IT
September, 20th 2008

Even as those in the IT (information technology) industry clamour for tax incentives, others wonder if IT has not matured enough to be able to sustain itself without any further fiscal support of tax incentives from the Government.

Over the period, Indian IT/ ITeS companies have definitely moved up the value chain, and the sector is currently poised at the growth stage of its life cycle, says Mr K. R. Girish, a Bangalore-based chartered accountant with KPMG, and also the Convener for Economic Affairs and Public Policy, CII, Karnataka. There is still some way to move ahead to come under the matured category the point would be clearer if one were to look beyond the top few companies, he adds.

On Friday, the CII released a study on the IT industry, prepared in association with KPMG as the knowledge partner. Titled Indian IT / ITeS Industry Expiry of income-tax holiday: needs a re-examination the report makes a case for the extension of the income-tax holiday under sections 10A and 10B of the Income-Tax Act, 1961 beyond 2010, especially for the small and medium sized companies.

As the sector moves up to the maturity stage it would face more challenges, including tougher competition from other jurisdictions, argues Mr Girish, in the course of an email interaction with Business Line. Even otherwise, the sector is today facing difficulties from various directions exchange fluctuation, rising cost of operation and lack of trained manpower.

Excerpts from the interview.

Isnt the SEZ scheme a substitute for the benefit currently available under sections 10A and 10 B of the Act?

The SEZ scheme is a good fiscal incentive scheme introduced by the Government of India. However, with reference to the IT/ ITeS sector, one would also need to see the contextual need.

The SEZ policy would largely benefit large-scale operations, which makes it difficult for the smaller and medium sized companies to benefit from the scheme.

The IT/ ITeS sector is a manpower intensive sector, where employees rather than assets are the key drivers. SEZs are typically located in the outskirts of the city, and as such, there are issues relating to mobilisation of employees.

Further, there are restrictions on the transfer of existing businesses to SEZs. This means that there needs to be large-scale new business which can be placed under an SEZ unit which can only be the case for the larger companies.

On the other hand, there are no locational or size restrictions under the STPI/ EoU scheme. Any place can be customs-bonded and registered under these schemes. Clearly, this simplicity finds favour from the smaller companies, and has gone a long way in fostering entrepreneurship in this sector.

For the above reasons, I strongly believe that the SEZ scheme is not a perfect substitute for the STPI/ EoU scheme. While our first preference is that the tax holiday should be extended in totality, the next request is that it should at least be extended for the small and medium sized companies.

How would one define small and medium sized companies for this purpose?

I think this can be done by giving a limit of:

*Net capital employed in the business; or

*Assets employed in the business; or

*Revenue generated by the business.

The definition would have to be watertight so that there is no room for ambiguity and different interpretations.

Are there cost inefficiencies in the IT industry that merit immediate attention, in the place of seeking tax concessions?

Though it would not be prudent for me to comment on whether companies are not working in a cost-efficient manner, there is always room for improvement of processes, and doing things in a smarter way.

Indian companies have been typically carrying significant bench strength for future projects. There may be some room for a rethink on policies relating to surplus manpower.

The issue of increase in productivity and re-engineering of processes has also been reflected in the response to the survey as a means for retention of margins.

How has the industry coped with some of the recent big hits, such as currency fluctuations, and the US financial collapses?

The losses on account of currency fluctuation have hit the sector badly. This is seen in the first quarter results of the bigger companies, where the margins have taken a dip because of mark-to-market losses.

The US financial collapse will also have a tremendous impact on the sector. As per a very recent Nasscom report, around 40 per cent of the exports revenue of this sector is from the BFSI sector (Banking, Financial Services and Insurance). In my view, the impact of the financial meltdown would be visible in the coming quarters.

One should also take a note that there has been a visible dip in the announcements relating to bigger projects many large companies are now postponing decisions of tendering their IT contracts, and the timing has increased for conversion of request for proposals to actual contracts.

The sector, to some extent, has hedged itself against the US crisis through geographic expansion to the non-US markets like EMEA (i.e. Europe, Middle East and Africa) and Asia Pacific. There is also tremendous focus now on the domestic market. Having said that, one cannot lose sight of the fact that the US still holds a lions share of the Indian IT/ ITeS exports.

India has not shown its strength in IT product development, in a major way. Is it, therefore, necessary that tax incentives target this space, rather than services?

Traditionally, Indian IT/ ITeS companies have been strong players in the service sector. The performance in the product development segment has however not been that remarkable. This segment is primarily controlled by the bigger players such as the Microsoft and Oracle. Having said that, some of the companies have made their mark in the product segment such as iFlex, Subex, and Onmobile.

There is still a significant untapped market in the global BPO/ IT-engineering segments. As per Nasscom, the combined market potential would be around $380 to $440 billion, out of which only around $76 billion has been tapped. Clearly, there is a huge potential market sitting out there in the service segment.

From the perspective of incentivising, I think there should be no distinction between IT service sector and the IT product development sector, because there is ample scope for expansion in both the segments.

Are there global examples, adoptable here as best practices, of how other nations have been incentivising IT industry?

From a global perspective, the IT industry is generally recognised as a research and development (R&D) intensive industry. A lot of countries such as Australia, Singapore, UK, Mexico, Ireland provide R&D incentives to software companies which typically can be in the form of a super deduction on taxable profits, accelerated depreciation, R&D credits etc., subject of course to fulfilment of requisite conditions.

Hungary, for example, grants an additional deduction to the extent of 50 per cent of licence revenue earned, over and above R&D incentives, if an IPR is created as a result of such R&D activities.

India may look at incentivising the IT industry based on practices adopted globally. The incentives discussed above may however be relevant only for the product development companies.

Some countries (such as Russia) also provide incentives similar to those available in India under the STPI/ EoU scheme. There are also instances where the sector has been incentivised by allowing duty-free imports.

China, even though it has moved away from tax holidays, has extended benefits to R&D, IT, pharmaceutical and other technology-intensive industries.

With Indian companies setting up operations in other cost-effective countries, dont you foresee that any big tax incentives in India can end up attracting companies from other countries into India?

This is exactly the point that we want to drive home. There has already been a significant loss of business for India: at the one end foreign clients are looking at other jurisdictions for availing services, and at the other end, Indian companies are expanding their operations in other countries.

Over the years, there has been a constant increase in the cost of doing business in India, and this has started eating into the savings that India could offer. A further increase in the tax cost would only lower the India-attractiveness index.

What prevents the IT industry from going to tier-2 and tier-3 towns and villages in a big way, to reap cost advantages?

Companies can definitely leverage upon the tier-2 and tier-3 cities to reap cost advantage. Some select companies (such as Infosys and Wipro) have already set-up operations in non-metro cities like Mysore, Mangalore, and Jaipur. However, this trend is restricted only for the bigger companies with the financial strength to set-up their own infrastructure.

For reaping benefits on a larger scale, there has to be a drastic improvement in the infrastructure (connectivity, housing, electricity, and water) in these cities, and a conducive eco-system needs to be created.

If a city like Bangalore is crying for better infrastructure, one can imagine what can be the situation in the smaller cities. Besides that, availability of talent in such locations would also be a concern. The education system around such locations should be strong enough to churn out graduates and qualified people.

Do we have the numbers on how much tax has been paid by the IT industry, as compared to other sectors of the economy, over the recent years?

Such data is not available in the public domain. However, one should note that the effective tax rate (ETR) for corporates currently is around 20 per cent (which has also been spelt out by the Finance Minister himself). As compared to this, the IT/ ITeS companies are currently paying tax at 11.33 per cent under the MAT provisions. Clearly, they are not far behind.

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