In budget FY11-12 companies operating in special economic zones (SEZ) and SEZ developers were brought under the purview of minimum alternate tax (MAT). This means that the developers and units operating out of SEZs will now have to pay tax at the rate of 18.5 per cent on their book profits. Further, the dividends declared by SEZ developers will attract a tax of 16.23 per cent.
Many experts have pointed out post-budget that this is a retrogressive step that will discourage companies from setting up units in SEZ zones. In any case, SEZs are fast losing their charm among Indian companies. Slowdown in global trade together with problems in land acquisition has already made SEZs unattractive. As many as 40 SEZ developers, including the likes of Reliance and Ranbaxy, have asked for more time to complete their projects, citing difficulties in acquiring land. Twenty-three developers have already surrendered their projects due to global economic uncertainties.
DTC adds to confusion
Earlier, the direct tax code (DTC) had created confusion regarding the tax treatment of income from SEZs. Later, it was decided that new SEZs will have to pay MAT at 20 per cent (under DTC the rate is 20 per cent, not 18.5) and dividend distribution tax, but existing units will continue to enjoy exemptions. This led to a last-minute dash by mid and small IT companies to relocate their existing units to an SEZ (to qualify as existing players), since for most the tax holiday will end by March 2011.
In October 2010, the government cancelled the operating licences (for operating in SEZs) of Geometric, Stratify Software and a subsidiary of Mphasis because it felt that these companies were relocating units to SEZs instead of setting up new ones. Perhaps it is this kind of abuse that has led to the government closing the tax arbitrage that these small- and mid-cap companies were trying to exploit. The sound bytes emanating from the Finance Ministry also indicate that it is not happy with the performance of SEZs. Officials in the Finance Ministry are said to be of the view that the reason exports from SEZs have grown at a compounded annual growth rate of 58.62 per cent between FY04 and FY10 is that export units have relocated from other parts of the country to SEZs to take the benefit of tax exemptions.
Back in 2005-2007 the government had lured India Inc. into investing in SEZs because it wanted to rival China in manufacturing. Within just five-six years, it is now ready to pull the plug on its SEZ initiative. By contrast, China has sustained its commitment to SEZs for 30 years. Now the companies that have already established their units in SEZs are left in the lurch.
Better to be outside SEZs
Export units operating outside SEZs enjoy incentives amounting to 3 per cent of their total exports, which brings down their effective tax rate. This incentive does not extend to units operating inside SEZs, who will now have to bear the full impact of tax outgo. They will still be able to carry forward their MAT credits for 10 years on their books. But since they are exempt from paying taxes in the first five years, they will not be able to enjoy MAT credits for at least five years.
In the long run, this measure is tax neutral, but in the short run it will put pressure on the cash flows of companies within SEZs. Diversified companies like Infosys and Reliance Industries will add their revenues from SEZs with revenues from other businesses and then pay tax at the normal rate or at the MAT rate, thereby neutralising the effects of MAT. But small- and medium-sized companies, which are most cash-strapped, will now have to part with 18.5 per cent of their profits.