BUDGET 2007-08 : SPECIFIC IMPLICATIONS FOR THE IT /ITES/BPO SECTOR

  1. SERVICE TAX ON LEASE RENTALS WILL IMPACT CASH FLOWS (AND NOT PROFITS)

    Rental /Lease costs to IT Companies will go up significantly, due to the proposed imposition of service tax on rentals related to immovable property for commercial or industrial purposes. The lease rentals will go up by 12.36%, from a date to be announced. Though, the service tax paid by the Company is available as an input credit, to be adjusted against the service tax payable on output services.

    In effect, the service tax paid by the Company on its lease rentals is not an ‘expense’item (but more of a cash flow item) as it is to be adjusted against the service tax to be payable on its output services. In cases where the Company’s services are not covered by service tax or in cases where the service tax payable on its output services are not adequate to cover the service tax paid on input services including lease rentals, recourse may be taken to the provisions of the Act for an appropriate strategy, which would depend on the circumstances of the case.

    Of course, for STP Units which do not have domestic billings and who consequently cannot avail of input credit in terms of the service tax paid by them on any input service including rentals, such service tax paid by them can actually be claimed as a refund from the Government under Section 11B of the Central Excise Act, 1944.

  2. OTHER SERVICE TAX RELATED ISSUES IMPACTING IT UNITS
    • Hardware Engineering Services : Under the existing rules, the definition of ‘Consulting Engineer’ services’ excluded any advice or consultancy or technical assistance in the discipline of hardware or software engineering. The Finance Bill 2007, has sought to remove the hardware engineering from the benefit of this exclusion. This would mean that ‘Hardware Engineering Services’ would now come under the service tax purview, under ‘Consulting Engineer’s Services.
    • Maintenance of Software : The Central Board of Excise and Customs, vide Circular dated March 7, 2006 had clarified that software maintenance would be liable for service tax effective July 9, 2004. Many of the IT Companies were taking a view that software maintenance fell under the head ‘Information Technology Services’, which was not taxable under service tax, till April 30, 2006. Now, the Finance Bill 3007 has sought to introduce an explanation under the category “management, maintenance or repair services” to provide that “goods include computer software”. With this proposal, it is possible for IT
    • Companies to take the view that software maintenance services can be taxes only after the enactment of the Finance Act, 2007.
    • IT companies would be impacted due the imposition of service tax on the following activities which have been added, from input service providers, viz.
      • sale of space or time for advertising (including telephone directories)
      • rent-a-cab operations (to cover hire)
      • mandap keeper, pandal and event management (to cover marriages)
      • banking (to cover cash management and financial leasing)
      • management consultancy (to include business consultancy)

      Here again, the IT Companies can avail of input credit and STPs can go in for refund of all input service tax incurred by them.

  3. EXTENSION OF MINIMUM ALTERNATE TAX (‘MAT’) ON STP UNITS

    Perceived as a major blow (and wrongly so, in our opinion), STP units availing of 100% tax exemption under Sections 10A/10B of the Income tax Act, will now be required to pay Minimum Alternate Tax @ 10% (for 2007-08) of their ‘book profits’, as prescribed. Before this proposed amendment, STP Units were allowed to deduct their profits arising from their export operations, from their book profits, for purposes of MAT under Section 115JB of the Income tax Act. In other words, export profits were exempt from the levy of MAT.

    he Income tax Act clearly provides that the MAT paid by the STP Unit can be adjusted against its tax liability over the next five years. In the light of the situation that the 100% tax exemption for STPs under Sections 10A/10B is very likely to be withdrawn effective March 31, 2009, MAT paid for 2007-08 and 2008-09 can be adjusted against the tax liabilities for the future years (upto five years).

    The effective MAT rate for STPs which are domestic companies would be 11.33%(basic rate of 10% + Surcharge@ 10% + Education Cess of 3%).

  4. STP UNITS ALL SET TO LOSE INCOME TAX BENEFITS CAN’T MOVE TO SEZs.

    With nothing being said about the extension of the tax holiday under Sections 10A/10B of the Income tax Act beyond March 31, 2009, it seems that STPs will come into the tax net from the financial year 2009-10. While the larger Companies are already setting up SEZs on their own, it is the smaller and mid sized STP Units which will have to cough up tax from the financial year 2008-09.

    Many small and medium STP Units were planning to move into Special Economic Zones to avail of the tax holiday after 2008-09. The Budget proposals have dealt a death blow to this plan by amending Section 10AA to provide that tax holiday would be available only for new Units to be set up, under the SEZ scheme. Thus, STPs who have been planning to move into SEZs for tax holiday purposes, would no longer find this option logical.

    Of course, there is another view that the Government might extend the tax holiday under Sections 10A and 10B beyond 2008-09, as these units will anyway pay tax under MAT from 2007-08 onwards and that the Government will any way collect income taxes from STP Units by way of MAT.

    What will the Central Government do, vis-`-vis extension of tax holiday for STP units beyond March 31, 2009 will remain a Chidambara Rahasya, after all.

  5. INCOME TAX RATES – EFFECTIVELY LESSER FOR SMALLER COMPANIES

    Smaller Companies with taxable incomes of less than Rs 1 Crore would not be required to pay surcharge, which is now applicable for corporates with taxable incomes of over Rs 1 Crore. The effective tax rate, after taking into account, the enhanced Education Cess of 3%, would be as follows, for Financial Year 2007-08:


    For Corporates with total income of
    upto Rs 1 Cr (Rs 10 Million)

    30.9% (as against the earlier rate of 33.66%)
    For Corporates with total income of
    over Rs 1 Cr (Rs 10 Million)
    33.99% (as against the earlier rate of 33.66%)
  6. ESOPs AND SWEAT EQUITY TO COME UNDER FRINGE BENEFIT TAX

    A new sub clause (d) in Sub Section (1) of Section 115WB is proposed to be added (d) in sub-section (1) of section 115WB so as to include any specified security or sweat equity shares allotted or transferred, directly or indirectly, by the employer free of cost or at concessional rate to his employees (including former employee or employees), within the ambit of “fringe benefits”. It is also proposed to provide that the fair market value of the specified security or sweat equity shares, on the date of exercise of the option by the employee as reduced by the amount actually paid by, or recovered from the employee in respect of such security or shares, shall be the value of fringe benefits referred to in the proposed clause (d) of sub-section (1) of section 115WB. The Central Board of Direct Taxes will specify the methodology to be adopted for calculating the ‘fair market value’.

    Consequent to the proposed insertion, it is also proposed to omit proviso to sub-clause (iii) of clause (2) of section 17 which provides that the value of any benefit provided by the company free of cost or at a concessional rate to its employees by way of allotment of shares, debentures or warrants directly or indirectly under any Employees’ Stock Option Plan or scheme of the company offered to such employees in accordance with the guidelines issued by the Central Government, is not a “perquisite” for the purposes of section 17. It is also proposed to provide that for these purposes, the cost of acquisition of specified security or sweat equity shares shall be the value under the proposed clause (ba) of sub-section (1) of section 115WC if such value has been taken into account for the purposes of levy of fringe benefit tax. these amendments will take effect from 1st April, 2008 and will, accordingly, apply in relation to the assessment year 2008-09 and the subsequent years.

    The impact would be visible only when the CBDT specifies the ‘fair value methodology’ for closely held companies (which is expected to be the market price for listed companies). These proposals, in our opinion, would cover cases wherein ESOPs/Sweat Equity Shares have already been issued and are yet to be exercised.

    We believe that the valuation of the fringe benefit, in relation to the ESOPs/Sweat Equity would fall under the 100% category (and not on the 20% or the 50% category), which would mean that the Company which has issued ESOPs/Sweat Equity Shares would have to pay a hefty FBT of 33.99% (Basic rate of 30% + Surcharge of 10% + Education Cess of 3%) on the difference between the fair market price and the exercise price.

    THIS IS A VERY MAJOR BLOW TO COMPANIES WHICH HAVE ALREADY ISSUED ESOPs WHICH HAVE NOT YET BEEN EXCERCISED AND WILL ALSO ACT AS A MAJOR DAMPENER FOR COMPANIES WITH ESOP AND SWEAT EQUITY PLANS. OF COURSE, A LOT OF LITIGATION IS TO BE EXPECTED ON THIS CONTROVERSIAL PROPOSAL, VIS-@-VIS SITUATIONS ARISING OUT OF ALLOTMENT OF OPTIONS, ALLOTMENT OF SHARES PURSTUANT TO THE EXERCISE OF THE OPTIONS, FAIR MARKET VALUE ESPECIALLY FOR CLOSELY HELD COMPANIES, ETC.

  7. MORE DIVIDEND DISTRIBUTION TAX

    The tax on the amounts distributed as dividends is proposed to be increased from 12.5% to 15%. The net tax on corporates distributing dividend would go up from 14.025% to 16.995% (inclusive of Surcharge and Education Cess), for dividends declared or distributed after April 1, 2007.

    For employee-wholetime Directors, it would still make sense to have dividends as a preferred way of compensation, in contrast to salaries, which still attract a higher tax rate under the Income tax Act.

    We would advise clients, who have plans for dividends go in for distribution of interim dividends before March 31, 2007 so as to save the additional burden of 2.97%.

  8. 100% DISALLOWANCE IN CASE OF CASH PAYMENTS OVER RS. 25,000/-

    The existing provisions of sub-section (3) of section 40A provide for disallowance of twenty per cent of the expenditure incurred, payment in respect of which is made in a sum exceeding twenty thousand rupees, otherwise than by an account payee cheque drawn on a bank or by an account payee bank draft. The disallowance is now proposed to be increased to 100% of such expenditure. Please note here that the disallowance is in respect of the ‘expenditure’ and not on the ‘payment’. To clarify, if a single expense item of say Rs, 75,000- is sought to be paid out thro’ a cheque payment of Rs 40,000- and a cash payment of Rs 35,000-, then the expense amount of Rs 75,000- (and not the cash payment element of Rs 35,000-) is liable to be disallowed.

    IT Companies would do well to ensure that there is no violation on this count.

  9. PAYMENTS TO NON – RESIDENTS : MAJOR CHANGE WITH REGARD TO PROVISIONS RELAED TO DEDUCTION OF TAX AT SOURCE IN INDIA

    Most of the IT Companies utilize services of Non-Residents for technical and professional services. Section 9 of the Income tax Act which deals with the subject matter is sought to be amended to provide that, services utilized by a resident would be enough, for payments to Non-Residents to be subjected to tax at source, irrespective of whether the Non-Resident has indeed rendered services in India or whether the Non-Resident has had a place of business or business connection or permanent establishment in India.

    This amendment is being made retrospectively from April 1, 1976, so as to annul the impact of several decisions (including a very recent decision of the Supreme Court in Ishikawajima-Harima Heavy Industries Ltd v. Director of Income tax, Mumbai (2007) 288 ITR 408) which had held that the Non-Resident should have performed some activity in India, for payments to him from the Indian resident, to be subjected to deduction of tax at source.

  10. OTHER CHANGES
    • TDS rate in respect of payment of commission or brokerage, under Section 194-H, is proposed to be increased to 10%, from the existing 5% (effective June 1, 2007).
    • The TDS rate, under Section 194-Iin respect of payment of rent for use of any machinery, plant or equipment, is proposed to be decreased from the existing 20% to 10% (effective June 1, 2007)
    • The TDS rate, under Section 194C, in respect of payments for professional services, technical services and royalty, is proposed to be increased to 10% from the existing 5% (effective June 1, 2007). This is a major blow for software and IT professionals, who are not on the regular rolls of Companies, as the net cash inflows to these professionals will come down drastically.
    • Due dates for advance payment of FBT are proposed to be aligned with the dates for payment of advance corporate income tax. The methodology of the FBT computation is also made similar to that of the corporate income tax, in as much as, FBT will now have to be paid on the basis of the annual estimate.
    • Service tax exemption for small service providers raised to Rs 8 lakhs from Rs 4 lakhs and the corresponding requirement to get themselves registered with the Authorities, increased from Rs 3 lakhs to Rs 7 lakhs, per annum.
    • Overall service tax rate will now be 12.36% as against the existing 12.24%, due to the Education Cess going up to 3% from 2%.
    • The Service tax rules are being amended to provide exporters of services (which will cover STP-BPOs as service providers) will be eligible to 100% exemption from service tax, in respect of export services ‘provided from India and used outside India’. Earlier, this rule read that such services had to be ‘delivered outside India and used outside India’. Many STP-BPOs providing services found it difficult to prove that they had rendered services outside India’ for claiming exemption of service tax. The Finance Ministry, in a welcome move, has amended the rules, as stated above, effective March 1, 2007. Some of the existing STP-BPOs may still face some problems in respect of the earlier years, but the amendment effective March 1, 2007 is well intended to clarify doubts.
    • Service providers, effective March 1, 2007, will be allowed to file revised returns within 60 days from the date of filing of the original return.

ALL INCOME TAX AND SERVICE TAX PROPOSALS WILL TAKE EFFECT UPON PASSAGE OF THE FINANCE BILL. HENCE IN EFFECT, SERVICE TAX ON TAXABLE SERVICES WILL CONTINUE TO BE 12.24% TILL SUCH TIME THE FINANCE BILL IS PASSED.

THIS NEWSLETTER HAS BEEN PREPARED BY S3 SOLUTIONS PVT LTD EXCLUSIVELY FOR USE BY ITS CLIENTS, IN THE IT SECTOR. THIS NEWSLETTER MAY NOT BE CIRCULATED TO ANY THIRD PERSON. FOR ANY CLARIFICATIONS, PLEASE FEEL FREE TO CONTACT S SIVAKUMAR AT 98455-07403 OR MAIL TO sivakumar@s3solutions.in.




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