CBDT clarifies allowability of profit-linked deduction to new SEZ Unit upon transfer of technical manpower up to 20%

This Tax Alert summarizes the Central Board of Direct Taxes (CBDT) Circular No. 12/2014 (the Circular) on allowability of deduction to a taxpayer in case where there is transfer of technical manpower from an existing unit of the taxpayer to its new unit under Sections 10A/10AA of Indian Income Tax Laws (ITL).

As part of eligibility conditions, the Sections provide that the unit should not have been formed by splitting up or reconstruction of a business already in existence; and it should not have been formed by the transfer, to a new business, of machinery or plant previously used for any purpose in excess of 20% in value.

The CBDT has clarified that mere transfer or redeployment of technical manpower from an existing unit of a taxpayer to its new Special Economic Zone (SEZ) unit in the first year of commencement of business will not be construed as splitting up or reconstruction of an existing business, provided the number of technical manpower so transferred does not exceed 20% of the total manpower actually engaged in developing software at any point of time in the given year in the new unit.

The CBDT clarifications should generally come as a relief to taxpayers in respect of issues addressed by it. However, with respect to the present Circular taxpayers operating in an SEZ may find the Circular imposing an onerous condition on eligibility of unit for incentive benefits.

In case of the IT industry, which is substantially manpower oriented, taxpayers may find the threshold limit restriction of 20% on transfer of technical manpower from the existing unit too low to address the concerns of the industry. The Rangachary committee, while recognizing no such bar on transfer or deployment of manpower has been explicitly laid down in the Sections, had suggested a threshold of 50% of total billable employees of the new SEZ unit of first year for transfer of manpower. This view appears to have not been accepted by the CBDT. Further, the restriction of 20% is applicable in the first year of commencement of business and is to be maintained at any point of time in the given year and not necessarily on the date of formation of the unit; being the date with respect to which the condition of split or reconstruction is generally tested by the Indian Courts.

A prima facie reading of the Circular suggests that most of the cases under litigation pertaining to SEZ units on the issue may not find relief having regard to the low threshold restrictions. However, taxpayers in litigation who meet the 20% limit and wish to rely on the clarification, may claim the Circular as clarificatory for past years as well.

If the CBDT clarification is viewed as imposing a condition on transfer of manpower from existing unit to new SEZ unit which is not prescribed in the Sections, there could be doubt on the validity of the Circular, being contrary to the legal provisions.

Under Indian jurisprudence, a circular issued by the CBDT, for proper administration, is binding on the Tax Authority but not on taxpayers.