In a move to rationalize and simplify corporate tax rates, the Indian government is considering a phase-out of the tax benefits offered to business units located in Special Economic Zones (SEZ) for the purpose of delivering export services. The proposal would reduce the overall corporate tax rate from 30 percent to 25 percent on these business units, typically known as captive centers, while at the same time phasing out various tax exemptions, including the SEZ tax exemption. The government claims it lost nearly $285 million in potential tax revenue between 2014 and 2015 from the SEZ exemption. With other tax exemptions added in, the effective tax rate on SEZ-eligible businesses was 23 percent.
The SEZ tax code benefits IT service providers over a period of 15 years, beginning with a full corporate tax exemption for the first five years, a 50 percent exemption over the next five years, and a 50 percent exemption on the profits invested back into the business for the last five years. This is a significant benefit.
Experts in India expect the phase-out of the SEZ to include a grandfather clause that allows those who already avail themselves of these benefits to continue doing so until the end of their 15-year periods. The current proposal will stipulate a sunset date after which the new, lower tax rate will apply to new units in lieu of the current SEZ tax exemptions.
So, what is the implication to the sourcing industry?
A roll back of the current SEZ tax exemption will likely result in higher tax liability and higher operating costs for in-house centers in India. Meanwhile, service providers may not feel a significant impact because they have a portfolio of delivery centers, including ones that do not have tax exemptions anymore. Therefore, while service providers’ tax liability may go up due to the fact that they have no new SEZ units, they will benefit from the new, reduced tax rate on their overall aggregate profits. At an individual corporate level, of course, the impact will vary depending on the mix of specific revenue levels and the effective tax rates today.
It is unclear whether the Minimum Alternate Tax (MAT) applicable to SEZ units will be abolished as a result of the phase out of the SEZ exemption, and what will happen to those currently entitled to receive tax-free services as long as they are consumed within the SEZ unit.
While all tax-paying corporations will benefit from the potential easing of procedural formalities that comes with these kinds of tax rationalizations, it appears that only some will be able to offset the loss of tax exemptions vis-à-vis the reduced rate.
The additional tax burden on the Global In-house Centers (GICs) will complicate the business case that makes them attractive today.
Will the phase-out of the SEZ exemption lead to the transfer of work from captive centers to service providers? Will it make other countries more attractive places in which to locate captive centers? These are complex decisions that include many factors, but an additional tax burden (if any) will certainly add to the complexity. Contact me to discuss further.
About the authorDinesh is a highly experienced and well-respected advisor in the outsourcing industry with more than 23 years of experience in management consulting and outsourcing. He works with enterprises to craft sourcing strategies, structure and negotiate complex sourcing transactions and design and implement sourcing governance organizations. Prior to joining ISG, Dinesh worked with Infosys and Accenture, where he led large transition programs and consulted on IT strategy and implementations, business process-reengineering and operational improvement programs. He is a published thought leader and a regular speaker at industry conferences. Dinesh manages the ISG India Business.
