Pranab Babu, are you Listening?

Its that time of the year when industry representatives get together to
present their wish lists to the Honorable Finance Minister (FM)! While stability
in the government has encouraged business organizations in the IT and BPO
industry, the industry as a whole is looking up to the FM to help ride over
various hurdles such asthe global economic slowdown; skyrocketing costs;
appreciating rupee; emergence of the Philippines, Vietnam and Eastern European
nations as competing low-cost jurisdictions; and the protectionist policies
being adopted by the western economies.

Clarity on Tax Holiday

The tax holiday for units located in software technology parks (STPs),
export oriented units (EoUs) and so on, is expected to terminate on March 31,
2011. Undertaking operations in the IT sector requires significant investments
and long term capital commitment on the part of the industry players. Absence of
clarity on tax treatments of the operations serves as a deterrent for the
expansion plans of existing players as well as for fresh capital investments in
the sector. Accordingly, there is a need for the FM to clarify the tax treatment
of such STP, EoU units beyond March 2011.

Further, extension of the tax holiday would significantly help in improving
the competitiveness of Indian IT companies. Such an extension would be
especially useful for small and medium enterprises (SMEs), which operate on
wafer thin margins and cannot afford to set up units in special economic zones (SEZs)
where they would be entitled to enjoy tax holiday beyond March 31, 2011.

Pranab Mukherjee, Finance Minister, Government of India

MAT on STPs

The levy of Minimum Alternate Tax (MAT) on units located in STPs results in
disparity of tax treatment of units operating in STPs/EoUs vis--vis units
operating in SEZs. It has also severely affected the cash flows and
profitability of units operating in STPs/EoUs. The abolition of MAT on book
profits of units operating in an STP/EoU would be a welcome step, as these units
were originally entitled to enjoy a complete tax holiday in respect of their
export profits.

Payments to Non-residents

The recent Karnataka High Court ruling in the case of
Samsung Electronics and other taxpayers suggests that taxpayers need to withhold
taxes on all payments made to non-residents, unless an order is obtained from
the Tax Authority for withholding tax at a lower rate or not withholding the
tax. As a consequence, Indian IT/BPO companies may be faced with additional cost
and the burden of ensuring compliance or obtaining withholding tax orders. Such
a requirement could also disrupt smooth running of business given the huge
quantum of their transactions with non-resident vendors on various accounts.

In view of the above, all taxpayers in general, and the IT/BPO industry in
particular, are hoping that the FM would clarify in the forthcoming budget the
applicability of withholding tax provisions on payments to non-residents which
are not taxable in India.

Transfer Pricing

In the budget speech for 2009, the FM had himself acknowledged that transfer
pricing is one of the areas of tax litigation which has significantly impacted
the Indian IT industry.

As a next step to his acknowledgment of the hardships faced by the industry
players on this front, the FM had implemented certain positive measures such as
introduction of alternative dispute resolution panel. However, the gravity of
the problem requires further attention and implementation of certain additional
steps to curtail litigation on the transfer pricing front.

The safe harbor provisions announced in the Budget 2009 provided that safe
harbors would be defined by revenue authorities, and taxpayers meeting the safe
harbor thresholds laid down in these provisions would not be subject to transfer
pricing scrutiny. However, the industry still awaits detailed rules for
implementation of safe harbor provisions. An early release of safe harbor rules,
coupled with expeditious and fair implementation would be cheered by the
affected parties.

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 to minimize the litigation on implementation of the
transaction. The FM should consider advancing the implementation of APAs by
introducing an appropriate APA framework in the forthcoming budget.

Taxation of ESPOs

Use of employee stock option plans (ESOPs) and similar share award plans to
attract and retain the best talent in the industry is one of the key
compensation policies followed by most IT/BPO players. With the introduction of
new rules for taxation of perquisites following the abolition of fringe benefit
tax (FBT), the benefit received by employees under ESOPs is now considered as a
taxable perquisite in the hands of the employee. Under the current regime, the
employer is required to withhold taxes on the benefit arising to the employee
from such ESOP/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 FM should consider implementing rules which are
similar to those which existed in the pre-FBT era. As per these rules, the
benefits arising out of ESOPs/share award plans which complied with certain
guidelines of the central government 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 shares, which is when the gains
were realized by the employee.

Indirect Tax Related Measures

In the previous budget, implicit ambiguity on levy of customs/excise duty
and service tax on software licensing transactions were eliminated by granting a
customs duty and excise duty exemption on such transactions. However, by
exempting only a part of the transaction value for software transactions,
additional questions have emerged as to the manner in which the transaction
value may be equitably apportioned to avail such an exemption. In the absence of
any clarification on this matter, the IT sector expects the FM to guide the
industry on valuation of such transactions for customs and excise duty exemption
purposes.

Critically, amendments are required to eliminate the dual levy of indirect
tax under service tax and state VAT legislation on software transactions. The
center and state governments need to identify their respective jurisdictions on
this matter. Given the fact that the intention of the central government
appeared to levy service tax only on customized software transactions, it may be
prudent for the FM to consider amending the definition of IT software service
as per the Service Tax Law by limiting its ambit only to customized software.
This amendment, by itself, should suffice in significantly reducing the
ambiguities and potential litigation surrounding software transactions.

Another concern, especially for IT exporters, is the administrative delays in
grant of refunds to service exporters. Even with most of the IT and BPO services
being covered within the purview of the Service Tax since 2008, service
exporters have not seen refunds forthcoming. In the current economic scenario,
the need of the day is to streamline the disposal of such refunds to ensure cash
efficiency for the IT/BPO companies.

The industry has placed India on the map of the global IT sector and led to
the recognition of India as a pool house of skilled talent. However, some of the
above mentioned hurdles are creating serious operational difficulties for the
players in the IT/BPO industry and the industry is currently facing challenges
which could wipe away the competitive edge which it has gained against its
global competitors. Accordingly, the industry has set its expectations from the
forthcoming budget to bring in measures which would help in reviving the Indian
IT/BPO industry, which in turn is capable of initiating a chain reaction of
consumption, savings and growth in India.

Ravi Mahajan, with inputs from Kartik Rao

The authors are tax partner, technology practice, Ernst & Young; and senior tax
expert respectively

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