Factories, Business Processing Units and software development firms inside Special Economic Zones (SEZ) will lose all income tax benefits—the most crucial incentive for the tax free industrial enclaves— if the direct taxes code replaces the Income Tax Act of 1961 without any change. The proposed norms also talk of tightening tax incentives to developers of SEZs, which are notified after the new income tax law is operationalised.
The underlying principle behind not allowing income tax incentives to the SEZs is that new code discourages profit-based exemptions of any kind. Instead, it calls for linking tax benefits to investment related expenditure in nine activities, including development of SEZs.
The SEZ Act of 2005 doles out a slew of direct and indirect tax exemptions for units and developers of SEZs. These exemptions are implemented through various provisions in the existing Income Tax Act.
The code does not mention anything about units inside SEZs, but has a separate chapter on proposed guidelines that specify how developers of the tax-free industrial enclaves will be treated in the new tax regime. If the provisions of the code get translated in to the new Income Tax Act, it is clear that SEZ units set up after the new law is implemented, will not enjoy any direct tax exemptions.
At the moment, there are 2,279 functional units inside the zones, out of which only 478 have been set up after February 2006, when the SEZ Act became operational. There are 98 operational SEZs while the board of approval under the commerce ministry has formally approved over 570. As many as 325 SEZs are notified. It seems, SEZ units have been completely ignored by the code, while there are some provisions for developers of the zones.
The new code could become the new point of friction between the finance and commerce ministries. “The Direct Taxes Code will replace the Income Tax Act 1961 and its provisions including those for exemptions. Those exemptions given in the I-T Act will be grandfathered but no new ones will be given out when the Code comes into force from April 1, 2011,” said a finance ministry official in the condition of anonymity.
Officials in the commerce ministry insist that benefits prescribed by the SEZ Act of 2005 cannot be diluted. “We are studying the provisions. SEZ related benefits cannot be taken back under any circumstances,” said a commerce ministry official, who wished not to be identified.
Experts also warn that the new code does not say anything specifically on how existing functional units of SEZs will be treated when the new Income Tax Act is enforced. This is because discussion paper mentions that that the provisions of the Income Tax Act of 1961 will be grandfathered. A grandfather clause is like an exception, which allows old rules to continue in cases for which it is applicable in a situation where the new rule is applicable to future conditions.
“It is not clear if the existing SEZ units will enjoy tax exemptions through the grandfather clause as it is not specifically mentioned in the discussion paper. It only mentions provisions related to SEZ developers.,” said Hyderabad-based SEZ expert Vikram Doshi. “Why will a unit come to an SEZ if there are no income tax benefits,” he added. Moreover, the new code could lead to imposition of Minimum Alternative Tax or Dividend Distribution Tax on SEZ developers, experts said.
This is because the new code proposes to rejig the nature of tax holiday for developers. It says that a SEZ developer will not have to pay any tax, until he recovers his capital and revenue expenditure (which excludes cost of land).
“The developers can enjoy the incentive till it recovers all its investments and expenditure made in the developing the SEZ. This would promote greater investments in the SEZ as the developers would be allowed to set off the entire capital expenditure, without any cap on the period,” said Hitender Mehta, of Vaish Associates.
According to the discussion paper, if profit is made the basis for exemption, there is no incentive for investment and up gradation during the period of the tax holiday. Terming such incentives as regressive, the paper states it leads to laundering and are a cause of significant loss of revenue and encourage rent-seeking behavior.
Significantly, the SEZ Act links the tax benefits to prevalent tax laws of the country. “The provisions of the I-T Act of 1961, as in force for the time being, to apply to, or relation to, the developer or entrepreneur for carrying on the authorised operations in a SEZ or a unit subject to the modifications specified in the second schedule,” says section 27 of the SEZ Act of 2005. The SEZ Act allows SEZ units to enjoy direct tax exemption for 15 year period. For the first five years, 100% export linked profit is exempted, while for the next five years, it is 50%. In the remaining five years, SEZ units can claim exemption on 50% of the reinvested export profits. For developers, exemption of income tax on income from SEZ development is allowed for 10 continuous years, in a block of 15 years. Thus, a developer can start claiming exemption, the moment he starts getting profits, which is usually about three to five years after the zone becomes operational.