Today's Editorial 15 August 2014

                     How to kill an SEZ

Source: By Sunil Jain: The Financial Express
As 

prime

 minister Narendra Modi readies to lay the foundation stone for the R4,000 crore multi-product special economic zone (SEZ) at the Jawaharlal Nehru Port Trust at Nhava Sheva on August 16, and commerce minister Nirmala Sitharaman prepares to review the SEZ policy, they would do well to examine closely the role of the taxman and others in killing off the concept. Hardly surprising then, that, of the 564 SEZs that have been approved, only 387 have been notified and, of these, only 192 are operational. Given that, between February 2006 and now, investments in SEZs have risen from R4,000 crore to R3 lakh crore and employment from 1.4 lakh persons to 12.8 lakh, the potential of SEZs is obviously large.

Much of the problem, of course, stems from the taxman’s view that SEZs are causing a lot of revenue loss—the fact that commerce minister Sitharaman also holds a dual charge in the finance ministry will, hopefully, help resolve this issue soon. The latest budget gives a sum of R14,992 crore as the likely tax loss from units in the SEZs, R1,394 crore from the developers of SEZs and another R6,198 crore on account of export promotion concessions. What Sitharaman and her boss Arun Jaitley, and prime minister Modi need to assess is whether these ‘losses’ are worth the gains in terms of employment and exports. More so in the context of the R3.76 lakh crore of tax giveaways in FY14.

While this columnist has gone along with the view, made forcefully in this year’s Economic Survey as well, that tax concessions are not a good idea since they distort investment incentives, the larger point is that once an incentive has been given, it cannot be either withdrawn or whittled away—hence the alternative title for this column, ‘why should investors trust us?’. So while the original SEZ Act promised a tax free enclave—100% for the first 5 years, 50% for the next 5, and an amount equal to the reinvested profits for the next 5—the finance ministry decided to levy both minimum alternate tax (MAT) and dividend distribution tax (DDT) on SEZ developers and units operating in them since April 2011. What does this do to the profit calculations and the internal rates of return for SEZs which have already invested R3 lakh crore in the business?

While this damage to the SEZ policy was done during the UPA regime—it is also the one that came up with the policy, in 2005—what Sitharaman needs to focus on first is the damage being done under her watch. SEZs get their tax-exempt status under Section 10AA of the Income Tax Act—while the tax holiday for units in the SEZ have been mentioned earlier, developers are allowed a 10-year tax holiday anywhere within a 15-year window after the SEZ commences operations. Section 10AA says the units in the SEZs must not be formed by merely transferring plant and machinery used in an old business —the idea is to ensure people are setting up new businesses, not merely reclassifying existing ones to get a tax advantage. Section 80IA, in turn, has clarifications on what a new business is. It says, “the total value of the machinery or plant or part so transferred does not exceed twenty per cent of the total value of the machinery of plant used in the business...” Pretty straight forward, you’d think, with no scope for misunderstanding.

Think again! On July 18, 2014, the central board of direct taxes came up with a clarification saying this 20% rule applied to ‘technical manpower’ also. While the commerce ministry had opined on several occasions that firms were free to transfer manpower from existing units, the new circular says the “number of technical manpower so transferred does not exceed 20 per cent of the total manpower actually engaged in developing software at any point in time ...”

Imagine the havoc this will create as the taxman can now go back and re-open assessments of units on this basis ... and there is the ambiguity of what ‘technical manpower’ actually is. And how does the taxman come up with this “clarification” when the parent ministry (commerce) has clearly said there is no bar on transfer or redeployment of manpower? There were simpler solutions, like ensuring the older (non-SEZ) units didn’t show a decline in sales or manpower employed, but these have been given up in place of an arbitrary demarcation. Given the tax advantage is often what determines where to set up the unit—in India or in the Philippines, for instance—this is an issue that needs to be looked at carefully, and quickly.

What is an even bigger killer is the proposal emanating from the commerce ministry itself. The Export Promotion Council for EOUs and SEZs, a wing of the commerce ministry, has asked for comments on a proposal to mandate 51% physical exports in SEZs—that is, half of the production of units in SEZs should be physically exported. This, in turn, is based on the recommendations of the Public Accounts Committee. The original SEZ Act had specified that SEZs needed to be net foreign exchange positive, and so they have with, according to commerce ministry data, SEZs delivering R4.9 lakh crore of exports in FY14. Given the sales in the domestic tariff area (DTA) were just R38,000 crore in FY14, you’d think this is irrelevant as SEZs are already exporting 92% of their turnover.

Not quite, it depends on whether you see the SEZ as one composite unit or as a series of units. Let’s say Unit A in the SEZ imports $100 of goods, does $10 of value addition and sells $110 worth of goods to Unit B in the SEZ which, in turn, does value addition and sells it to Unit C for $120 and that, in turn, exports it for $130. The SEZ as a composite whole is clearly forex positive, but Unit A and B are not, in the sense they are not making any physical exports, their exports are what are called ‘deemed export’. Under the new proposal, Unit A will have to physically export $55 worth of goods and Unit B $60. Unit B and C, in turn, will have to import goods since their suppliers—A and B, respectively—will no longer be able to meet their needs fully.

 Once again, this is something Sitharaman and her bosses need to take a call on. Since the basic purpose behind looking at SEZs as a holistic unit and not a series of units was to develop value chains and industry clusters—with each unit feeding into the other—this one change, if accepted, will pretty much spell the end of industrial clusters. All because of some mindless tinkering with the SEZ Act over the years.