Budget underscores importance of govt-industry partnership

The Indian IT industry was cautiously optimistic about Budget 2003-04, Union Finance Minister Jaswant Singh’s first-ever Budget. While Singh did not disappoint the industry, there are some grey areas that still need to be addressed, especially on the indirect tax front. Srinivasa Rao of Ernst & Young analyses the Budget and explains how it positively impacts the industry, as well as brings out the issues and areas that have been ignored

The proposed extension of the deadline for obtaining approvals for tax-advantaged R&D operations will provide an impetus to R&D investments in the fields of hardware, software, electronics and telecommunications, says srinivasa rao

In recent years, the government has actively recognised the contribution of the IT industry to the Indian economy and has implemented several measures to accelerate its growth. Favourable fiscal policies form one of the critical elements of the favourable environment that the country offers for the information technology sector. This year, expectations were high and the industry, cautiously optimistic; the Union Budget 2003-04 proposals largely did not disappoint.

The IT industry’s key concerns in the run-up to Budget 2003 centred on the government’s possible implementation of the Kelkar Task Force recommendations on rollback of income tax holidays for software and service exports. The government’s decision to not immediately implement the Task Force recommendations and its commitment to retain the fiscal incentive regime will reinforce investment and growth in the information technology sector. The fact that the commitment was wrapped in soothing language, alluding to past promises and commitments, has gone down particularly well with the industry.

Concerns on the existing income tax holiday restriction to 90 percent of export profits were also addressed, with the Finance Minister electing not to continue with the limiting provision after the current fiscal year. Also, in another significant amendment, the Finance Minister proposed that the provisions currently disentitling a unit from a tax holiday upon change in its legal ownership or beneficial shareholding be withdrawn. The industry has, for long, viewed this as a significant hurdle in implementing business consolidation transactions, and can now work towards achieving not just growth, but also economies of scale through business hive-offs, acquisitions and mergers. However, interpretative issues such as the eligibility of an eligible transferor company to the income tax holiday in the event of a mid-year amalgamation or demerger remain unclear.

The proposed extension of the deadline from March 31, 2003 to March 31, 2004 for obtaining approvals for tax-advantaged R&D operations will provide an impetus to R&D investments in the fields of hardware, software, electronics and telecommunications. The attempt to harmonise the tax treatment of royalties and fees for technical services earned by foreign companies through permanent establishments and fixed bases in India with the treatment under India’s double tax treaties will ensure consistency. The proposal, which provides for a net income basis of taxation in cases where agreements have been executed after March 31, 2003 would benefit branch and project offices of foreign companies earning such incomes. Currently, royalties and fees for technical services are not eligible for expenditure deduction claims, and are taxed at 20 percent on a gross basis.

Indirect Tax front
The overall expectations from the Finance Minister on the indirect tax front included the articulation of a clear distinction between the scope of sales tax and service tax levies on transactions with regard to customised software. The lack of clarity on whether the deliverables in such cases would be services rendered or goods, has been the subject matter of much debate. Excise levy on pre-loaded software has also been a sour point, with manufacturers often having to sell operating systems separately. Other items on the industry’s Budget 2003 wish-list included a speedier implementation of the customs tariff reductions under the Information Technology Agreement with the WTO, and reductions in excise duty rates on hardware items. Some, but not all, of these points have been addressed in the Budget.

Service tax issue
The extension of service-tax levy to new service categories, coupled with the withdrawal of service-tax exemptions to payments received in convertible foreign exchange, could have significant implications for the IT industry. The related provisions will need to be examined closely to assess their likely impact. This will have an adverse implication on the cost structures, pricing strategies, margins, and relatively, the competitiveness of Indian services exports. Also, the liability of individual companies to pay service tax under existing contracts with Indian and foreign customers would need to be examined to determine whether the additional service tax levy can be passed on to customers, or would require to be absorbed. Renegotiation of existing contracts in cases where the levy of service tax has not been considered, or has been pegged at 5 percent, could prove difficult. It is also a moot point as to whether call centre services or other forms of IT enabled services would attract service tax as ‘business auxiliary services’.

In a television interview, the Central Board of Customs and Excise chairman clarified that this would not be the case. However, the text of the new provision is ambiguous and industry associations are in the process of leading representations to the government to both obtain clarity on its thinking and also to articulate a business case for exempting specific services from the proposed tax levy. As a conciliatory measure, it has been proposed that credit will be allowed on service tax and excise duty paid on input services and goods against the service tax liability on output services across all services. The proposed introduction of an advance rulings regime for service tax should also serve the industry well in upfront determination inter alia of the possible levy of service tax, the classification of proposed services and the valuation of taxable services.

The reduced cost of inter-state purchases, with the proposed reduction of central sales tax from 4 percent to 2 percent should also reduce the effective tax burden under the proposed VAT regime. The removal of excise levy on pre-loaded software will address a long-standing request of hardware manufacturers, and further reductions in the basic Customs duty for specified telecom infrastructure related equipment, including routers and modems, should also have a positive impact.

What’s still missing
Several long-standing demands of industry, such as clarifications on taxation of cross-border e-commerce transactions based on principles of tax neutrality, guidance on applicability of withholding tax on import and licensing of computer software consistent with international practices, tax holiday benefits for supporting software developers/manufacturers and reductions in excise duty on IT components have not been fully addressed in the Budget. Some of the unaddressed areas mentioned above can possibly be reviewed and action initiated by the government during the year.

The one area where some administrative guidance is perhaps urgently required relates to withholding tax on import and licensing of computer software. In recent months, the revenue authorities have been taking a view that all computer software, irrespective of the scale of licensing rights contained therein, would be subject to withholding tax in India. This position appears to be in variance with certain internationally accepted principles on the subject, and could be a disincentive or additional cost for software imports into the country.

There is every hope that going forward as well, the government will continue to formulate and implement fiscal and other policy reforms to enable India to achieve a global leadership position in the Information Age. The Union Budget 2003 proposals have not belied the expectations of the IT industry; in fact, they underscore the importance of a strong, continuing government-industry partnership in preserving the growth momentum.

Srinivasa Rao is Tax Partner with Ernst & Young and is based at Bangalore. He can be contacted at Srinivasa.Rao@in.eyi.com