The government has withdrawn tax benefits enjoyed by consortia of foreign and Indian engineering firms undertaking infrastructure projects, in a move that may hit the sector plagued by severe capacity deficit.

The Central Board of Direct Taxes (CBDT) has withdrawn a 20-year-old instruction that provided tax exemption and lower tax rates to foreign firms setting up consortia with domestic companies for engineering, procurement and construction (EPC) contracts in power, oil & gas, roads and other infrastructure sectors.

Under this instruction, an EPC contract is broken up and taxed separately for different portions despite the presence of a consortium. For example, equipment supply by a foreign partner in such contracts is usually tax-free while erection and commissioning face a lower tax rate of 10%.

But now, authorities will tax the income of a consortium as a single unit, at the rate of 42%, the applicable rate for such entities called association of persons in tax parlance. A domestic company as a single entity has to pay tax at the rate of 30%.

The move will increase the cost of implementation of several projects besides discouraging foreign participation in the crucial infrastructure space, say experts.

We are still in a nation-building mode and there is lack of capacity in the infrastructure sector, so we need to incentivise infrastructure companies. This move puts foreign infrastructure players at a disadvantage as they will have to bear additional tax burden, said Mr Vinayak Chatterjee, chairman, Feedback Ventures.

While all future contracts will now have to bear the new policy in mind, projects already bid may not be spared either, say tax experts. Since CBDT has clarified that the withdrawal of the beneficial instruction will not prejudice the tax departments plea in any appeal, reference or petition, it is likely that past cases may be looked into, said Sandeep Ladda, associate director (tax and regulatory services) of consultancy firm PwC.

The instruction was intended for the power sector. But now all other sectors are also taking advantage, leading to a loss of revenue for the exchequer, said a finance ministry official, requesting anonymity. There have been instances when a consortium has been created only to take advantage of the instruction.