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With the Budget for 2009-2010 just around the corner, all eyes in the Indian IT industry are now on the Finance Minister. The industry, which is already battling the current economic downturn, protectionist policies of the Obama administration and a volatile dollar to name a few, is also faced with the challenge of competing with new emerging outsourcing destinations such as Philippines, China, Japan and Sri Lanka.

With these broad issues in mind, we have highlighted some of the key issues that plague the industry today on the tax front, and the possible alternatives the Finance Minister could consider to address them:

Extension of income-tax holiday: The income-tax holiday which is currently availed by most companies operating out of Software Technology Parks or by companies registered as export oriented undertakings is due to phase out by March 31, 2010. This tax holiday was earlier expected to terminate by March 31, 2009 but was given a one year extension by the UPA government in the 2008 Budget.

Thus, based on the law as it stands today, a company which is not operating out of a SEZ would end up having to pay income-tax at the rate of approximately 34% on its net profits post March 31, 2010.

This situation has created a disparity between the SMEs and the big industry players. While most big industry players have set-up operations in SEZs to avail of tax incentives, the SMEs are not able to afford the full cost of setting-up operations in SEZs. In addition to this, the SMEs are also at a distinct disadvantage over their foreign competitors in countries such as Philippines, China and Sri Lanka where the IT industry continues to enjoy tax incentives.

Thus, to provide Indian companies with a level playing field vis--vis their foreign counterparts, the need of the hour is to extend this tax holiday by a period of five years (instead of a year-on-year extension).

Anomaly in the SEZ formula: The law currently provides a lower tax holiday on profits of the SEZ unit where the company operates businesses outside the SEZ units. This is due to an anomaly in the formula for calculating the tax holiday. To tide over this issue, some companies have set up separate legal entities for housing their SEZ units.

This issue should be put to rest.

Consolidation of operations in SEZs: The boom in the IT industry over the last few years and the euphoria associated with the introduction of SEZs resulted in major IT companies locking space in multiple SEZs. However, the current slowdown which took most companies by surprise has created substantial unutilized capacity in these SEZ units.

Ideally, in this scenario, the company would have preferred to shift its business from the another unit.

However, the tax statute contains a restriction on shifting of existing businesses into an SEZ unit which is claiming the tax holiday benefit. Thus, in such a situation there is some risk that the revenue authorities could deny the tax holiday status to the SEZ unit into which the business is transferred.

With a view to help these IT companies ride through this crisis, the Finance Minister could clarify that such shifting of businesses between SEZ units should not impair their tax holiday status. This should help companies streamline their operations and costs and improve efficiency.

Safe harbor provisions and advance pricing arrangements for captive service providers: In the last couple of years, the captive service providers have been faced with increased litigation on the transfer pricing front. The revenue authorities have been contending that these companies should earn margins in the range of 25-30% on operating costs. This has resulted in significant transfer pricing adjustments for these companies.

Interestingly, while the profits reported in the tax return by most of these companies is not subject to tax on account of the tax holiday, the artificial increase in profits as a result of the transfer pricing adjustment does not get the shelter of the tax holiday.

To avoid the above situation, the captive service providers have been suggesting the introduction of safe harbor provisions.

Another mechanism to reduce the litigation on the transfer pricing front is to introduce APAs. An APA is an agreed arrangement between the taxpayer and the revenue authorities made in advance of actual related party transactions, with a view to solve potential tax disputes in a co-operative manner. The agreement is on the transfer pricing method and their application for a certain period of time in future.

Abolition of Minimum Alternative Tax: In 2007, when the IT industry was eagerly awaiting the extension of the sunset tax holiday, introduction of MAT on the profits of the STP units eligible for the tax holiday was the last amendment anticipated. Simply put, MAT is an alternative tax payable by companies which report substantial book profits but whose tax profits are minuscule (even NIL) due to various benefits available under the tax laws. Levy of MAT on STP units will further increase the disparity with SEZ units as SEZ units continue to enjoy exemption from MAT.

In todays scenario, the compelling need is to provide a complete tax holiday to the IT industry which includes the abolition of MAT.

Abolition of Fringe Benefit Tax: FBT, which is a tax based on the expenditure incurred by the company, has always been a subject matter of criticism by the industry. The IT industry, in particular has been up in arms against the levy of this tax, especially on ESOP and travel costs. Admittedly, this tax has not even contributed significantly to the government kitty.

This is the opportune time for the Finance Minister to take the bold step of abolishing this tax.

Duality of taxes (VAT and service tax) on software licensing transactions: The introduction of Information Technology Software Services under the service tax net by Budget 2008 has resulted in an unintended anomaly that transactions of software licensing could be considered to be subject to dual levies of service tax and VAT.

The IT industry is looking at the new Finance Minister to remedy this anomaly by distinguishing software as service and software as goods, to ward off needless litigation and reduce increased tax costs due to these multiple levies.

Simplify the service tax benefit to SEZs: The stream of recent changes on the service tax benefit to services rendered to SEZs developers and units is becoming a matter of debate within the industry. The latest amendment classifying services into services consumed wholly within the SEZ and other services is already leading to disputes. While the SEZs are giving a wide interpretation of what should be treated as consumed wholly within the SEZ for classifying most services for the exemption, the service providers are ascribing a more conservative meaning to the term for charging service tax and urging the SEZs to claim a refund of the same.

This dichotomy in the benefit given will not only open another avenue for litigation but also prolong the delivery of the benefit as far as the granting of actual refunds is concerned.

Rationalize the service tax refund process for exporters: In many jurisdictions, the service tax refunds filed by most of the IT/ITeS exporters are yet to see the light of day. With the IT industry striving hard to overcome the economic downturn, there is a pressing need that the government takes an immediate look at streamlining the administration of these refunds to the exporters.

Conclusion
It is clearly a momentous occasion for the Finance Minister to inject simplicity in administration of the myriad tax levies, certainty in quantum of taxes applicable to the IT industry and speed in refunding the just tax dues to the industry in their hour of need.

Sudhir Kapadia
The author is tax leader: telecom, communications and entertainment, Ernst & Young, India
maildqindia@cybermedia.co.in

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