CBDT circular clarifying issues relating to export of computer software and allowance under sections 10A, 10AA, 10B of the Income-tax Act, 1961

 

In the drive towards cutting down on litigation and with the objective of creating a stable and certain tax environment for industry, including specifically for sectors like the IT / ITES sector which has been the torchbearer of India’s growth story, the issuance of the CBDT circular on several aspects related to the tax holidays under section 10A, 10AA and 10B of the Income-tax Act, 1961 (“the IT Act”) is a welcome move, particularly in an environment where the tax holidays have been constantly denied by the Revenue Authorities (“RA”) on some ground or the other leading to litigation.

The Government had constituted a committee on August 3, 2012 under the chairmanship of Mr. N. Rangachary, former Chairman Central Board of Direct Taxes (“CBDT”) and The Insurance Regulatory and Development Authority (“the Committee”) to look into issues impacting the IT sector. The Committee submitted its first report on September 14, 2012 (referred to as ‘Taxation of Development Centre and IT Sector’ providing various recommendations on direct tax issues pertaining to the computer software industry) to the Finance Minister, to resolve the points of controversy in relation to the interpretation of the statute as well as recognizing the business practices followed by the industry.

The CBDT has now issued Circular No. 1/2013 addressing many of the pending issues, which appears to have taken into consideration the representations of the industry, as well as the recommendations of the Committee. A summary of the clarifications and the context in which they have been issued has been captured in the following paragraphs.

1. Onsite software development and manpower deputation

CBDT clarification:

(a) CBDT has clarified that tax holidays shall not be denied merely on the ground that the “software was developed onsite” so long as the same is developed pursuant to a contract between the client and the eligible Unit/Undertaking, depicting the direct and intimate nexus or connection of the development of software abroad with the Unit/Undertaking in India.

(b) CBDT has also recognized that it is a common practice followed in the software industry to depute technical manpower at the client’s place abroad to facilitate software development activities such as up-gradation, testing, trouble-shooting, modification, etc which requires constant interaction with the client.

Considering this, CBDT has clarified that the deputation of technical manpower abroad shall not in itself be considered detrimental to claiming tax exemption, provided that such deputation is for development of software and linked to onsite projects carried out by offshore Units in India claiming the holiday.

BMR Comments:

Most software companies work on a mix of onsite and offshore model and the deputation of employees on long term onsite projects is a common practice. In recent years, the RA had started denying tax holiday on such onsite development on the grounds that no software was developed by the Units India and deputation of employees amounts to only “manpower supply” or “body shopping”. The circular recognizes the business realities and /or contractual obligations that may warrant onsite development of software and deployment of manpower by Indian Units claiming tax holidays. .

2. Statement of Work vs Master Service Agreement

CBDT clarification:

The CBDT has clarified that typically a Statement of Work (“SOW”) outlining project specific obligation between taxpayer and the client would prevail over the Master Service Agreement (“MSA”) which specify the broader and general contracting terms between parties. The exception however, would be in a situation where the Assessing Officer is able to establish that there has been splitting up or reconstruction of existing business or non-fulfilment of any prescribed condition and the MSA is drawn up separately to couch such reality. It also clarified that it is not essential to enter into a separate and specific MSA for each SOW.

BMR Comments:

It has been a growing practice of RA seeking to deny tax holiday on the ground of reconstruction or splitting up of existing business on the basis that a single MSA covers multiple Units, which ignores the fact there could be multiple SOWs for projects carried out by more than one Unit. By reiterating the supremacy of the SOW over an MSA, in a situation where there are no Unit wise MSAs, and instead placing onus on the RA to establish that there is non-compliance of any condition to constitute splitting or reconstruction of business, the clarification would greatly ease the practical difficulties at tax assessment stages and the consequent litigation that follows. This would benefit companies undertaking business through multiple tax holiday units under the ambit of single MSA but different SOW.

3. Migration or change of ownership of eligible unit/undertaking

CBDT clarification:

(a) Change in the ownership of an Unit/Undertaking in case of a slump sale of its business, shall not hinder the entitlement of the purchaser to claim tax holiday for the unexpired period, at the rates as applicable for the residual tax holiday period.

(b) Physical relocation of an eligible Special Economic Zone (“SEZ”) unit from one SEZ to another[1] with the approval of Board of Approvals shall not disentitle such unit from claiming tax holiday for the unexpired period.

(c) Setting up and co-existence of a new Unit/Undertaking alongside an eligible Unit in the same location after obtaining necessary approvals from the competent authorities, would not in itself amount to expansion of existing Unit/Undertaking, unless other specific and determining tests for splitting up and reconstruction fail.

BMR Comments:

These again are important clarifications in the context of companies seeking to realign and reorganize business operations which may also involve Units claiming tax holiday. Clearly, the intention of the CBDT seems to suggest that so long as the substance of the restructuring or realignment of business is not driven by tax holiday needs, but arises more from commercial exigencies, such changes in the location, ownership or transfer of business undertakings cannot be used by the RA to deny tax benefits.

In the past, RA have taken a view of not allowing tax holiday on slump sale of business on the ground that there is a change in ownership and tax holiday sections covers only reconstruction on account of amalgamation or demerger and not slump sale. This view was struck down by the Bombay High Court decision in the case of Sonata Software Ltd[2]. Seen in this backdrop, CBDT’s clarification is again welcome.

4. Separate books of account

CBDT clarification

Maintenance of separate books of accounts is not a requirement prescribed under the IT Act for claiming tax benefits (under sections 10A and 10B of the IT Act), although an Assessing Officer may seek details pertaining to different Units claiming a tax holiday, to enable him to verify the claim and quantum of exemption.

BMR Comments:

While neither the IT Act nor the Software Technology Parks of India Scheme warrants maintenance of “separate books of accounts”, RA continue to insist that tax payers are required to maintain and furnish Unit wise books of accounts, in the traditional manner of book keeping and generation of Unit wise financial statements . By recognizing that there is no requirement in law to maintain separate books of accounts, the clarification enables tax payers to have the flexibility to demonstrate a true and accurate tax holiday claim on the basis of modern accounting and book keeping records which can generate the required information to verify the claim. Seeking “necessary” information would however still leave a window open for the RA to call for voluminous amount of data with the pretext of verifying claims and unless this power is exercised judiciously, the reality faced during scrutiny of tax claims may not change significantly. This clarification is also in line with the Karnataka High Court decision in the case of Fusion Software [3].

SEZ Units would continue to be governed by the SEZ Regulations which do require maintenance of separate books of accounts and hence, to that extent the clarification does not impact the statutory obligation for SEZ Units.

It would have also been useful if the CBDT had clarified as to under what circumstances can information be sought for, considering that the Units/Undertakings claiming a tax holiday are required to not only get their financial statements audited, but also have their tax holiday claims certified in the prescribed forms by a Chartered Accountant.

5. Research and development activities

CBDT clarification

The CBDT has clarified that the research and development activities embedded in the “Engineering and Design” pertaining to software development shall be covered under the definition of “Computer Software” stipulated under Explanation 2 to section 10A and 10B of the Act read with Notification No 890(E) dated September 26, 2000.

Taxbymanish  Comments:

A large number of Indian software companies are engaged in rendering contract research and development activities to their clients. The industry understanding has always been very clear that research and development activity fits into the larger umbrella of software development services that qualify for tax holidays under the IT Act.

Recently however, the RA have been taking a view that research and development services (albeit in the sphere of software development) would not be covered by the notification[1] providing the list of IT services that are eligible for tax holiday under section 10A and 10B, since no specific mention of research and development has been made in the notification recognising eligible services.

By recognising that research and development activity embedded in the ‘Engineering and Design’ would also be eligible for the tax holiday, the CBDT has reassured the industry on what was always the understanding. This is line with the Bangalore Tribunal decision in the case of GE India Technology Centre (P.) Ltd[2]. There could however be challenges the RA at the ground level recognising the fact that such activities are indeed “embedded” in the Engineering and design services, recognised in the notification.