Budget 2010: Hope for revival

Pranav Sayta argues that the IT industry hopes for a revival from Budget 2010

Pranav Sayta

In the run up to Budget 2010, expectations from the Information Technology (IT) and IT enabled Services (ITeS) sector are running high. As compared to the double digit growth witnessed by the IT industry in prior years, industry reports are estimating only a 4-7% growth in export revenues in FY 2009-10. This adverse situation has been compounded by the appreciation of the Rupee by almost 10% from the beginning of FY 2009-10 and the emergence of Philippines, Vietnam and Eastern European nations as competing low cost jurisdictions.

In the backdrop of this challenging economic scenario, the industry is looking at support from the Government to help it ride out this crisis. Some critical areas where the industry is expecting the Finance Minister to step in when he announces his Budget proposals are as follows:

Extension of tax holiday to units in STPs, EOUs and so on

Given the current adverse economic environment, the industry is looking to the Finance Minister to extend the tax holiday for units located in Software Technology Parks (STPs), Export Oriented Undertakings (EOUs), and so on, which is expected to terminate on 31 March 2011, by another five years. Extension of the tax holiday would go a long way towards improving the competitiveness of Indian IT companies. Such an extension would be especially useful for small and medium enterprises, which operate on wafer thin margins and cannot afford to set up units in Special Economic Zones (SEZs) where they could be entitled to enjoy the tax holiday beyond 31 March 2011.

MAT related amendments

Units located in STPs are subject to minimum alternate tax (MAT) of 16.995% on their book profits. The levy of MAT results in an immediate cash outflow for these companies, which are otherwise entitled to enjoy a complete tax holiday with respect to their export profits. This has had an adverse impact on the cash flow position of Indian IT companies and has consequently resulted in increased borrowing and related interest costs, ultimately affecting the profitability of these companies.

Therefore a rollback of the MAT levy for companies operating in STPs, EOUs, and so on would certainly bring cheer to the industry at this critical juncture. This would also ensure parity between units located in STPs and units located in SEZs which enjoy an exemption from the payment of MAT.

Transfer pricing related amendments

Recent media reports suggest that the Indian Revenue authorities have made adjustments of close to Rs 10,000 crores on transfer pricing matters, which were scrutinized in the current year. Companies in the IT/ITeS sector have borne a significant portion of these adjustments making transfer pricing one of the severely litigated issues for the industry.

While the Government had, with a view to stem the increased litigation arising out of transfer pricing adjustments, implemented certain positive measures in the recent past such as the introduction of the alternative dispute resolution panel, the industry is looking at certain additional steps to curtail litigation on this front:

• The proposed draft of the Direct Tax Code contains provisions for an advance pricing arrangement (APA), wherein a taxpayer could enter into an APA with the Revenue authorities. If the taxpayer meets the income thresholds laid down in the APA, the taxpayer would not be subject to a transfer pricing adjustment. The Finance Minister should consider advancing the implementation of APAs by introducing an appropriate APA framework in the forthcoming Budget.
• The safe harbor provisions announced in Budget 2009 provided that safe harbors would be defined by the Revenue authorities, and taxpayers meeting the safe harbor thresholds laid down in these provisions would not be subject to transfer pricing scrutiny. However, the detailed rules to operationalize the safe harbor provisions are still awaited. The industry is looking at an early release of the safe harbor rules so as to ensure its expeditious implementation

Withholding tax issues

Certain recent judgments seem to suggest that in the absence of a tax withholding order from the Revenue authorities, it is incumbent on the taxpayer to withhold taxes on any payment made to non-residents, even if such payments are not taxable in India. This could lead to significant administrative hassles for Indian IT/ITeS companies which have a significant quantum of transactions with non-resident vendors for procurement of hardware, software, bandwidth, connectivity and so on. Moreover, the requirement of obtaining withholding tax orders from the Revenue authorities in all cases could also delay the settlement of transactions with such non-resident vendors, thereby affecting business adversely. At the same time, processing such a large quantum of tax withholding applications would also put a strain on the Government’s resources.

In view of the above, the industry is looking at the Finance Minister to provide explicit clarifications in his Budget proposals that payments to non-residents, which are not taxable in India may be remitted without the requirement of a specific tax withholding order from the Income-tax department. As per the current practice, companies could continue to obtain a certificate from a chartered accountant to validate that the payment to the non-resident is not taxable in India.

Taxation of Employee Stock Option Plans (ESOPs)

The Indian IT/ITeS sector regularly uses ESOPs and other similar share award plans to attract and retain the best talent in the industry. With the abolition of the fringe benefit tax (FBT) regime, the benefit granted to employees under ESOPs or share award plans is now considered as a perquisite and taxable as salary in the hands of the employee. Under the current regime, the employer is required to withhold tax on the benefit arising to the employee from such ESOP or share award plan at the time of allotment of shares to the employee, despite the fact that the employee may not have sold the shares so allotted and actually realized the gains. This creates an adverse impact on the cash flows of individual employees.

In view of the above, the Finance Minister should consider implementing rules which are similar to those which existed in the pre-FBT era. As per these Rules, which existed in the pre-FBT era, the benefits arising out of ESOPs or share award plans which complied with certain Central Government guidelines were considered to be exempt from tax as salary perquisite, and the employee was required to discharge the tax liability on such benefits only at the time of sale of the shares, which is when the gains were realized by the employee.

Dual levy on software transactions

Currently, both the Central and the State Governments seek to levy tax on software transactions under service tax and VAT legislation. This dual levy of tax on software transactions is inconsistent with the principles of taxing such transactions as propounded by the Supreme Court. The Finance Minister should initiate talks with the State Governments to notify rules and regulations to define boundaries around which software transactions would be liable to either Service Tax or VAT and avoid dual levy of tax on the same transactions.

Streamlining of Service Tax refunds

Even with most IT and ITES services coming under the purview of Service Tax since 2008, service exporters have not seen much respite on the refund of Service Tax promised by the Ministry of Finance. The Finance Minister should consider the need to streamline the administrative process around efficient delivery of refunds to exporters of services.

Valuation for software licensing transactions

While the Finance Minister in the previous budget made an attempt to rectify double taxation in software licensing transactions by granting an excise duty exemption on the same, there is a need to bring in additional clarity on the manner in which the valuation of such transactions would be undertaken for excise duty exemption purposes.

The sector, which contributes nearly 6% to the national GDP and employs 2.2 million people directly and 8 million people indirectly is currently facing challenges from multiple fronts—the global economic slowdown, spiraling costs, an appreciating rupee and protectionist policies being adopted by Western economies. The industry has set its hope that the fiscal budget would bring in some relief and help revive the industry.

The author is Tax Partner, Ernst & Young