Income & Wealth Tax Issues in SEZ assessment

1. No time limit for realisation of exports proceeds

The intent of enactment of sections 10A/10B/10BA/10AA in the Income Tax Act, 1961 is to encourage exports which in turn would infuse the economy with foreign currency remittances.

Timely ‘foreign currency remittances’ into India is the underlying intent spelt out in section 10A, section 10B and section 10BA. However, no such provision was made in section 10AA, thereby the objective of timely remittance of ‘foreign currency’ into India gets defeated.

Further, the RBI vide its circular No. 91 dated 01 April 2003 and master circular 09/2009-10 dated 01 July 2009 decided to remove the stipulation of twelve months or extended period thereof for realization of export proceeds from SEZs. Accordingly, there was no provision for any time limit for realization of exports made by Units in SEZ. Further, in the case of Units who are into the business of Gems and Jewellery, they are allowed to receive the export payments in the form of precious metals (Gold/Silver/Platinum) equivalent to value of jewellery exported on the condition that the sale contract provides for the same and the approximate value of the precious metal is indicated in the relevant Forms.

With due regard to the slump in the economy and attendant constraints the entities face, lack of a provision to monitor the economic output of the units at specified periodical intervals (although it may be acting as an incentive) is not in line with the spirit of the Scheme.

We observed in a few illustrative cases viz., M/s Suzlon Wind International Limited, CIT-III, Bangalore, Karnataka and M/s S.E. Blades Limited, CIT-III, Bangalore, Karnataka for AYs 2009-10 that the export proceeds amounting to 1,579.50 crore and 347.71 crore respectively were not received to the end of 31 March 2009. Similarly, in the case of M/s Tata Consultancy Limited, a Co-developer-cum-Unit (IDCO SEZ), Odisha for the year AY 2011-12 revealed that export proceeds of 10.44 crore for the period January 2009 to March 2012 was outstanding for more than 3 years.

DoR in their reply (25 April 2014), while accepting the discrepancy in section 10A/10B etc and section 10 AA, stated that the section 10 AA was inserted in the Income Tax Act through the SEZ Act 2005 by MOC&I and the realisation of forex in twelve month was earlier mandated by RBI but this condition was removed by RBI in 2009; however, the reason for the removal of this condition was not elucidated by DoR.

Further, in their reply stated (June 2014) that RBI has issued instruction in June 2013 to realize the proceeds within twelve months.

Reply is not acceptable to audit because as per RBI circular dated 11/06/2013, the time limit for repatriation of foreign exchange by SEZ Units is twelve months. This circular is issued for regulation of foreign exchange as per Foreign Exchange Management Act 1999 read with Foreign Exchange  Management (Export of Goods and Services) Regulations 2000, and which has no relevance to the Income-Tax Act 1961. Therefore, there is no specific provision in the Income-Tax Act 1961 for timely remittance of export proceeds for claiming deduction u/s 10AA.

2. Absence of clarity in the Income Tax Act, 1961

The following issues in the Income Tax Act, 1961 require clarity.

Section 10A/10AA/10B/10BA of the Income Tax does not define the terms ‘profits of the business’, ‘total turnover of the business’, thereby assessees get an opportunity to tweak their ‘profits of the business’ and ‘total turnover of the business’ according to their suitability which facilitates incorrect claim of deductions.

Assessees compute ‘Profits of the businesses’ either under normal provisions or adjusted book profits u/s 115 JB, whichever is beneficial to them. Similarly, although the expenses like freight, telecommunication charges or insurance, and foreign exchange expenses for rendering services outside India shall be excluded from ‘Export turnover’, the same expenses were also being excluded from the ‘Total turnover of the business’.

DoR in their reply (April 2014) stated that the deduction under 10A/10B of the Income Tax Act is with reference to the profits and gains derived from the export of articles or things. Under section 10AA, the deduction is also available on profits and gains derived from the services. Sub-section (7) of section 10 AA provides that the profits and gains derived from the export of articles or things or services shall be the amounts which bears to the profits of the business of the unit, the same proportion as the turnover in respect of such articles or things or services bears to the total turnover of the business carried on by the unit.

The ‘profit of the business’ for the purposes of deduction under section 10AA has to be computed in accordance with the provisions of part D of Chapter IV of Income Tax Act dealing with the head ‘profits and gains of business or profession’. For the purposes of deduction under section 10AA, the term ‘export turnover’ has been given a specific meaning. The other terms such as ‘total turnover’ in the absence of a definition in the Act will have dictionary meaning. Therefore, the profit of the business for the purposes of deduction under section 10AA has to be computed in accordance of chapter IV D and such profits are not the book profits on which MAT liability is determined.

Audit is of the opinion that though sub-section (7) of section 10AA(7) defines the amount of deduction to be calculated in proportion to the ratio between export turnover and total turnover and profits of the business or profession  of the undertaking to be calculated as per part D of Chapter-IV, however, what should ‘profits of the business or profession’ of the undertaking constitute for the purposes of deduction u/s 10AA is not defined clearly, whether ‘other incomes’ and incomes which are not having nexus with exports shall also qualify for deduction under section 10AA. Similarly, ‘total turnover of the undertaking’ is also not defined.

DoC in their reply (June 2014) stated that already MAT and DDT have been imposed. Other reduction of tax benefits will make the SEZ units unviable.

CBDT in their reply (June 2014) stated that the term ‘profits of the business’ as referred in section 10AA(7) implies profits as computed in accordance with the provisions of the Part D of Chapter-IV of the Income-tax Act. It was also replied that it is not open to Unit to interpret the expression ‘profits of the business’ to mean book profits as mentioned in the observations of the Audit.

Export Turnover shall have the meaning assigned to it in Explanation 1 of section 10AA. However, in the absence of any definition, ‘total turnover’ shall have its dictionary meaning.

Reply is not acceptable to audit because sub-section (7) of section 10AA defines the amount of deduction to be calculated in proportion to the ratio between export turnover and total turnover. Such profits of the business or profession to be calculated as Part D of Chapter-IV.

However, it did not define clearly what should ‘profits of the business or profession’ of the undertaking constitute for the purposes of deduction u/s 10AA, whether ‘other incomes’ or ‘incomes’ which are not having nexus with exports shall also qualify for deduction.

Adoption of dictionary meaning for the term ‘total turnover of the undertaking’ (not defined in the Act) is a clear loophole in the Act, and encourages assessees’ to quantify deduction more beneficially. However, the exact reason for not defining the terms ‘profits of the undertaking’ and ‘total turnover of the undertaking’ was not elucidated in its reply.

3. Need for review of taxing mechanism in view of re-introduction of DDT

Any amount declared, distributed or paid on or after 01 June 2011 by domestic companies within SEZ by way of dividend attracts dividend distribution tax (DDT) vide proviso below sub-section (6) of section 115-O of Income Tax Act 1961. Further, provisions relative to payment of MAT were reintroduced for units operation within SEZs AY 2012-13. When SEZ Act was promulgated, sub-section 6 of 115JB and sub-section 6 of 115O was introduced in the IT Act totally exempting the developers/units within SEZs from payment of MAT and DDT. However, re-introducing these taxes during AY 2012-13 and 01 June 2011 for a scheme aimed at incentivizing exports from these Zones, dampens its relative attractiveness vis-à-vis DTA operations. Further, it signals an unstable fiscal regime to the investors in these Zones, further impacting forex inflow and thus being counterproductive in the long run.

DoR in the Exit meeting stated (29 April 2014) that MAT/DDT are nothing but advance tax to be adjusted in subsequent year, in other words it only affects the cash flow of the developer/unit. This was introduced to avoid cases where the developer/units took the Income Tax benefit and opted out of the scheme after some time.

DGEP further added that new IT/ITES units were operating in SEZs and due to imposition of MAT/DDT, the input price of goods manufactured in SEZs increased in comparison to goods manufactured in non-SEZ units.

DoC in their reply (June 2014) stated that DoC has requested Ministry of Finance to withdraw DDT, but the same has not been agreed so far.

CBDT in their reply (June 2014) stated that MAT is based on the principle that every person participating in the economy must contribute to the exchequer. It also quoted the Supreme Court judgement in Lakshmi Devi’s case wherein the Hon’ble court held that all decisions in the “economic and social spheres are essentially adhoc and experimental. Since the economic matters are extremely complicated, this inevitably entails special treatment for special situations. The State must, therefore, be left with wide latitude in devising ways and means of fiscal or regulatory measures, and the courts should not unless compelled by the statute or by the Constitution, encroach into this field or invalidate such law.”

Audit appreciates the point regarding contribution to the exchequer and also that the state has full powers of dealing with economic matters. However, the audit point is raised vis-à-vis the impact that reintroduction of MAT & DDT has had on the overall economic sentiment vis a vis the SEZ scheme. Audit point is also echoed by the stakeholders of the SEZ viz., the Developers and Units, details of which are outlined in paragraph 6.4.

4.   Failure to invoke provisions of Wealth Tax

As per section 2(ea) of Wealth Tax Act 1957 – asset, inter alia, includes any unused land held by the assessee for industrial purposes for a period of 2 years or as stock-in-trade for a period of 10 years from date of its acquisition is not treated as asset. We noted that SEZ developers were in possession of large tracts of land, and in certain cases the chunk of land is kept idle for a longer duration than the period permissible under the provisions of section 2(ea). It was observed that, selection of assessment for scrutiny basically covers assessees who are actively conducting business operations. However, lands which are not allotted to any Units for various reasons are not monitored for the purposes of invoking the provisions of Wealth Tax Act.

DoC in their reply stated (June 2014) that land in SEZs is to be viewed in a special context as its use is dependent upon the units coming into SEZ, and the entry and exit of the units in SEZ is dependent on factors such as market conditions, the Govt. policies etc. The observation of Audit may not be relevant, if BoA after considering the proposal extends formal approval depending upon merits of each case.

However, CBDT in their reply (June 2014) stated that the matter is under consideration of CBDT. Necessary instructions have been issued to the field authorities to determine the unused land lying in each SEZ vis-a-vis the time period for which the same is lying idle. Field officers have been directed to closely monitor and wherever required invoke provisions of wealth Tax Act of urban land falling in SEZs that escapes the exemptions provided in definition of urban land as contained in para (b) of the explanation 1 contained in Section 2 (ea) of the Wealth Tax Act 1957.

DoC may intimate the final outcome to audit.

5. Changes in the Direct tax incentives

In the investment linked regime, specified businesses will experience accelerated depreciation which in other words means the new regime would favour capital intensive industries. In a scenario where multi-product SEZs constitutes only 4 per cent of the total sectors, this move would trigger establishment of more capital intensive (multi-product) industries. This would facilitate more employment to unskilled people. However, the other side of this change would impact the sectors where ‘employed intensive industries’ including IT sectors which is not capital intensive and lesser requirement of capital. This may be in direct contradiction with the SEZ’s objective of generating employment.

Further, with MAT and DDT being reintroduced, the tax paid by DTA units is less than the tax paid by SEZ units as illustrated below:

The tax payable by the company, if its operations are carried out in a domestic tariff area and in a SEZ would be as under:

AY 2012-13	DTA	SEZ
	32.445 per cent{30% + 5% (SC) + 3.5% (SHEC)}	MAT20.008 per cent (18.5% + 5% SC + 3% S.H.E.C)	DDT16.995 per cent15% + 10% + 3% S.H.E.C
		Effective Tax : 37.003 per cent

 The above scenario may partially answer the question regarding reasons for many units seeking extensions, resizing, and de-notification of the proposed projects. Though it may not fully typify the scenario as there could be other valid reasons, the following chart shows an increase in the number of de-notifications after re-introduction of MAT and DDT:

	2009	2010	2011	2012	2013
Partial de-notification	1	3	5	7	5
Full de-notification	4	7	10	6	4

 This sentiment was also echoed in the responses given by the developers/units in response to a question of survey questionnaire for developers/units on the reason for their exit from the scheme.

Comparison of duty structure and taxes in SEZ and DTA in engineering industry

Comparison of duty structure and taxes in SEZ and DTA
Engineering industry SEZ	Engineering industry DTA
Nil custom duty on capital	Customs duty 7.5 % on capital goods( zero if unit exports 6 times duty forgone)
Nil CVD on capital goods	CVD 12% on capital goods+ 3% cess+ 3% edu cess + 4% addl duty (zero if unit exports 6 times duty forgone)Note- CVD+ cess + edu cess+ SAD are eligible for cenvat credit
CST-NIL	CST-2%
CST – 2%	VAT 14.5% (excavators) – this can be adjusted against VAT on inputs
Excise duty -Nil	Excise duty payable at 12% (now 10% till June 2014)
Service tax – Nil for services rendered or received	Service tax 10.5% payable for services rendered or received
No income tax for first 5 yrs (MAT 18.5% payable)	Income tax payable from first year
50% income tax for 2nd 5 years ie 16.5% but mat applicable at 18.5%	Income tax payable in all years
50 % income tax in 3rd 5 yrs ie 16.5% but mat applicable at 18.5%	Income tax payable in all years
No duty on raw material imports	Duty payable but advance license for imports can be
(duty+CVD+SAD)	taken with 20 % value addition
Sales to DTA with duty+CVD+SAD subject to +NFE	Exports to SEZ get duty drawback
No chapter 3 benefits	Chapter 3 benefits applicable
Duty drawback on exports – Nil	Drawback allowed as per product category
Eg- if a company in SEZ exports for Rs.100 – net realisation is 100. If profit is 10% then tax savings is (33%*-18.5%= 14.5%) of Rs. 10= Rs. 1.45, therefore effective realisation = Rs. 100 + Rs. 1.45 = Rs. 101.45In case of DTA unit, exports for Rs.  100 with 50% import content for which custom duty is 7.5%= Rs. 3.75. The unit also gets drawback 4 %= Rs. 4 and Chapter 3 of FTP benefit of  Rs. 4. Further  the unit pays additional tax compared to SEZ unit =14.5% = Rs. 1.45 (as the unit is not saving any tax as in the case of SEZ unit above) . Therefore, the effective realisation is   (100-3.75+4+4-1.45) = Rs. 102.80. Hence working in DTA is beneficial.* 30% (tax) + 10% (SC)

DoC in their reply (June 2014) while accepting that the introduction of MAT and DDT has affected the SEZ scheme adversely and there has been an increase in the number of de-notifications after introduction of MAT and DDT on SEZs stated that the decision to de-notify a SEZ may depend on a host of factors like global recession, industry specific reasons, local factors etc.

Recommendation: DoR may like to visit the Income Tax Act, 1961 and Wealth Tax 1957 in view of the:

i. Need for timely remittance of foreign currency remittances which was not provided for under section 10AA as in the case of Sections 10A, 10B, and Section 10BA;

ii. Section 10A/10AA/10B/10BA of the Income Tax which does not define the terms ‘profits of the business’, ‘total turnover of the business’, thereby assessees get an opportunity to tweak their ‘profits of the business’ and ‘total turnover of the business’ according to their suitability which is resulting in incorrect claim of exemptions;

iii. Misuse of Section 2(ea) of Wealth Tax Act 1957 where asset, inter alia, includes Land held by the assessee as stock-in-trade for a period of 10 years from date of acquisition; and

iv. Impact of levy of DDT and MAT in SEZs vis-a-vis DTA units based on an empirical study.

Direct Tax: Compliance issues

Income Tax Act provides deductions to the assessees operation in the SEZs subject to certain conditions. Compliance issues related to non-adherence of such conditions involved deficiencies in Tax administration to the tune of 12.08 crore as detailed below:

Information Technology Sector

6.   Excess claim of deduction

In the case law, DCIT Baroda vs. Rameshbhai C. Prajapati ITAT Ahmedabad C Bench it was held that disallowance of expenditure u/s 40(a)(ia) shall not qualify for any deduction. Further, disallowance of employees contribution to provident fund/superannuation fund etc., u/s 36(1)(va) is to be computed under the head income from other sources ¹ which shall not qualify for any deduction.

In the case of M/s Xavient Software Solutions (India) Pvt. Ltd, CIT Noida – Uttar Pradesh AY 2009-10, it was seen that deduction u/s 10AA to the tune of Rs. 27,62,799 was allowed without Auditor’s Report in Form 56F which is mandatory u/s 10AA(8) read with section 10A(5) and hence deduction need to be disallowed. The short demand worked out to Rs. 8,56,072.

7. Incorrect computation of loss

As per section 80A(2) the aggregate amount of deduction shall not, in any case, exceed the gross total income of the assessee.

In the case of M/s Ernst & Young Pvt. Ltd., CIT-III Kolkata, West Bengal for AY 2010-2011 deduction was allowed u/s 10A and 10AA at Rs. 63,76,99,495 against total taxable income of Rs. 55,86,57,869 which resulted in incorrect determination of loss of Rs. 7,90,41,626. The potential tax effect worked out to Rs. 1,68,46,696.

Pharmaceutical Sector

8.   Excess claim of deduction

In the case of M/s Biocon Research Ltd., CIT-I Bangalore, Karnataka for AY 2010-11 we noted that a non-refundable amount of 38,44,00,000 was received from M/s Mylan Gmbh, Switzerland for undertaking research and development activities on which deduction u/s 10AA was claimed to the tune of 15,46,72,345 without Auditor’s Report in Form 56F which is mandatory u/s 10AA(8) read with section 10A(5). However, Assessing Officer estimated income at  Rs. 7,68,80,000 (20 per cent of agreement amount of  Rs. 38,44,00,000) and allowed deduction to that extent u/s 10AA.

We noted that, the amount of 38,44,00,000 received by the assessee was not on account of export of any articles or things or provide any services but for the purpose of ‘initial execution for M/s Mylan and Biocon Collaboration’ and, therefore, would not qualify for deduction. Hence, incorrect allowance of deduction of 7,68,80,000 need to be brought to tax. The tax effect worked out to 2.61 crore. It was replied (January 2104) that the issue would be examined.

Foliage and Handicrafts Sector

9. Failure to examine inter-unit transfer of stocks and Non-restriction of deduction to computed profits

In the case of M/s Vaachi International Pvt. Ltd., CIT-III Kolkata, West Bengal for AYs 2010-2011 and 2011-2012, inter-unit stock transfer from non-SEZ Unit to SEZ Unit of 1,76,29,081 and 2,42,05,506 respectively was not examined [sub-section (9) of section 10AA read with sub-section (8) of section 80IA] while completing regular assessmentu/s 143(3). Further, deduction of 84,73,452 was not restricted to the amount of profit available of 80,67,795 which resulted in incorrect determination of loss of 4,05,657 with a consequential potential tax effect of 1,25,348.

Other

10. Non-submission of Auditor’s Report

As per section 10AA(8) read with section 10A(5) deduction shall not be admissible unless the assessee furnishes the Auditor’s Report in Form 56F.

In the case of M/s Parampara Builders (P) Limited, CIT Moradabad, Uttar Pradesh for AY 2010-11 that, the assessee company claimed deduction u/s 10AA to the tune of 34925 without Auditor’s Report in Form 56F.

1.  section2(24)(x) read with section 56(2)(ic)