With inputs from Sonam Agarwalla, Manager, Nangia Advisors (Andersen Global)
Special Economic Zones (SEZs) were introduced to India in the year 2000, following the already efficacious SEZ model used in China. Prior to their introduction, India relied on Export Processing Zones (EPZs) which had a very lean impact on foreign investors. SEZs have been recognized as an important economic enclave for trade and investment promotion, creation of infrastructure and employment, advancement of regional development, growth in foreign exchange earnings, improving export competitiveness and transfer of skills and technologies. At present, there are 232 operational SEZs with close to 5000 approved units (as of December 2018) throughout India. An additional 416 SEZs acquired formal approvals and 32 secured in-principle approvals as of March 2019. As per the statistics provided by the Export Promotion Council, with a direct employment to over 2 million people, the total amount of exports of Indian SEZs was approximately INR 5.7 trillion in 2018-19 fiscal. Presently, SEZs are an integral part of India’s domestic industrial and foreign policy and epitomize the philosophy of the Government’s new age initiatives including such as Make in India, Digital India and Skill India.
The functioning of the SEZs is governed by a three-tier administrative set up. The Board of Approval (BoA) is the apex body and is headed by the Secretary, Department of Commerce. The Approval Committee at the Zone level deals with approval of units in the SEZs and other related issues. Each Zone is headed by a Development Commissioner, who is ex-officio chairperson of the Approval Committee.
The Ministry of Commerce and Industry lays down the regulations that govern the setting up and administering of the SEZs. The Central Government is involved in notifying SEZs and in overseeing their functioning, while the State Governments play a significant lead role in the development of SEZs in their respective states by stipulating the conditions to be adhered to by an SEZ and granting the necessary approvals. The policy framework for SEZs has been enacted in the SEZ Act, 2005 and the supporting procedures are laid down in SEZ Rules, 2006, along with a host of regulations. However, this framework has lately come under the wheels, with upcoming income tax sunset and fiscal impositions, canvassing in an uncertain future for SEZs. SEZs, which had emerged as major export hubs in India, started losing its gleam due to frequent changes in fiscal policy, imposition of Minimum Alternate Tax (MAT) and Dividend Distribution Tax, introduction of sunset clause for income tax holiday, amongst multiple other procedural bottlenecks.
Wide array of benefits has been granted to SEZ enterprises, the major attraction for most occupiers being, fiscal incentives. Section 10AA of Income Tax Act provides for a phased tax-holiday for units operating in SEZs for a period of fifteen years, divided into three blocks of five-year period. For the block of first five years, 100 percent of eligible profits or gains, 50 percent for the subsequent five years and 50 percent of the ploughed back eligible profit for next five years. While the tax holiday benefit is available only for new units, the setting up of such unit is also time bound ie it should commence production or manufacturing or rendering services before March 31, 2020. Additionally, the SEZ unit should not be formed by splitting up or reconstruction of a business already in existence. A fact specific examination and a thorough appraisal of judicial principals is required to pass the eligibility test of clearing a ‘no-splitting up’ or ‘reconstruction’ situation. Additional parameters of the tax -holiday eligibility test are the asset test (new unit should not be formed using second hand plant and machinery, subject to an overall permissible usage of 20 percent of total value of plant and machinery) and employee-count test (transfer or re-deployment of technical manpower from existing units to a new SEZ unit not to be construed as splitting up or reconstruction of an existing business, provided the number of technical manpower so transferred as at the end of the financial year does not exceed 50 per cent of the total technical manpower actually engaged in development of software or IT enabled products in the new unit).
India has witnessed two significant changes with regard to tax incentives in the last few years – the first being a significant announcement in 2015 for reduction of corporate tax rate from 30 per cent to 25 per cent over the next four years, coupled with rationalisation of various incentives and exemptions and the second being the introduction of GST in 2017, which has changed the structure of incentives related to indirect taxes. Keeping in mind the long-term commitment of the Government to rationalize various tax incentives, the likelihood of further extension of the sunset clause for income tax holiday looks feeble. However, it is undisputable that the extension of this sunset clause would result in a revival of stakeholders’ interest in SEZs and also give an uplift to India’s ‘Make in India’ propaganda. Infact, the Baba Kalyani led committee, constituted to evaluate the existing SEZ policy of India, had also recommended several measures including continuation of tax incentives, migration of SEZs to employment and economic enclaves and creation of link infrastructure and maintenance for enclaves.
The existing occupiers could continue operating from SEZs, as the sunset clause would not impact the prevailing direct and indirect tax holiday benefits for the balance unexpired period. New entrants into SEZ space should pre-commit in operational SEZ space or projects that are in advanced stages of construction (or nearing completion) to avoid delays at the eleventh-hour in starting manufacturing operations, which may lead to disqualification from income tax holiday benefit. Irrespective of the above, even if units could not be made functional before the sunset date of March 31, 2020, given the thin gap between the intended headline corporate tax rate (25 per cent) and existing rate of Minimum Alternative Tax (MAT), the additional tax outflow may not be very significant for the Indian enterprise operating outside SEZ, in the overall cost-benefit analysis. GST and several other state-level incentives would continue, even if the eligibility conditions under the Income Tax Act are not met. Additionally, a company discharging taxes under MAT regime would, in any case, have a considerable challenge in setting off MAT credit in such a situation, even though MAT carry forward period has gone up to 15 years from 5 years.
Lack of clarity with respect to utilisation of SEZ reserve created during the tax holiday period of 11-15 years is another challenge from an income tax perspective. Section 10AA (1)(ii) provides that deduction of so much of the amount not exceeding 50 percent of the profit as is debited to the profit and loss account of the previous year in respect of which the deduction is to be allowed and credited to a reserve account to be created and utilised for the purposes of the business of the assessee in the manner laid down in sub-section (2). The incentive is available with respect to the amount transferred to SEZ Reinvestment Reserve and utilised therefrom in the manner stated. No clarity exists on how the reserve should be utilised – can it be utilised by any undertaking (whether SEZ/ STP/ EOU or otherwise) of the taxpayer or only by an SEZ unit of the taxpayer that created that reserve. Further, deduction is available from year 11-15 to the extent of profits debited to profit and loss account and credited to SEZ Reinvestment Reserve account. There is no clarity as to whether the term “profits” include profits derived from exports alone or the profits as such earned by the undertaking, including exports as well as domestic profits. Two-sided interpretation also exists for the issue surrounding quantum of profits to be credited to the Reserve – is it to be arrived at the enterprise level or at the undertaking level. Section 10AA(2)(a)(i) of the Income Tax Act provides that SEZ Reinvestment Reserve could be utilised for the purchase of plant and machinery within 3 years following the previous year in which the reserve is created. Could this be inferred to mean that the reserve be created and utilised within the same year – something that does not seem practical, as reserves could be created only at the end of the fiscal year, post ascertaining of profits. Considering the diverse interpretational issues in connection with Section 10AA of the Income Tax Act, it is imperative to introduce suitable provisions in the law to clarify these open technical positions.
Recent press articles suggested that about 200 US corporations are assessing the possibility of setting up an alternative manufacturing base in India to replace their current assembly lines in China. While the primary reason for this proposed relocation could be China’s trade and tariff war with the United States, it is equally important to weigh what India has in the offering to such manufacturing giants. The Government’s ‘Make in India’ campaign is an ambitious initiative to move India on to a fast-track path of becoming world-class manufacturing hub. Reinstating the fiscal benefits would definitely boost non-resident investments in the manufacturing sector, providing a booster shot to the flagship “Make in India” campaign. Startups, which seem to be the next darling of the Indian middle class, right after Bollywood and Cricket, have witnessed catastrophe in the recent times, all due to delayed Government intervention in plaguing issues such as angel tax and tax on unexplained fund receipts. While SEZs in India, could continue to be labour havens, it would be tough to beat the tax rate that China currently offers. It is important that the Government gauges the pulse on time to prevent the well-thought-out policies, going from glamorous to clamorous. The forthcoming Direct Taxes Code (DTC) also offers a new slate to re-write the fate of SEZs in India.
Contributing Advisors
Myles CulmerDirector, BDO Advisory Services