Case Study on Splitting up/ reconstruction of business of old unit

Case Studies

Case Study on Splitting up/ reconstruction of business of old unit Case Study 1: XYZ India Ltd, is engaged in the business of developing softwares. The company already has an established software unit at SEEPZ set up in 2010 not eligible for deduction under 10AA. Later, during the financial year 2016-17, in order to claim benefit under section 10AA, the company set up a new unit which was approved as an SEZ unit on 29th June 2016 on the following terms: Purchased Plant and machinery of Rs.5 lakhs and furniture and fixtures amounting to Rs.10 lakhs. However, there was no addition of asset in relation to software development. Leased a premises for the purpose of setting up of SEZ unit. However, most of the software development were done from the customer s site. The employees headcount at the end of the year are as follows: q 150 employees specialized in software development transferred from the existing SEEPZ by issuing a fresh employment. q 50 employees specialized in software development newly recruited. q 25 employees recruited for administrative works. The nature of business will be the same as SEEPZ unit. However, the target clients of the SEZ unit will be completely different from the SEEPZ unit. Does the new SEZ unit amount to splitting/ reconstruction of existing business of SEEPZ unit merely to avail the benefit under 10AA or a mere addition of basic assets and focus on a new market classify a newly established unit as independent unit eligible for deduction under section 10A?

Case Study on Splitting up/ reconstruction of business of old unit Case Study 1: Conclusion It is a case of the same people doing the same business, the only difference being that the people have been shifted to the new office. The business of software development carried out in both old and new location with same employees, there was no requirement of different specialization. Merely because the customers in the new unit were different, it cannot be a basis to hold that the new unit was separate and independent. The new unit can be considered as independent only if it is capable of functioning as such and is not an integral part of the old business. Hence, the commencement of new business in SEZ is considered as formed by splitting and reconstruction of old business and becomes in eligible for claim us 10A of the Act. The Mumbai Tribunal in the case of Chenab information technologies (P) Ltd vs. Income tax office, (2008-TIOL-562-ITAT-MUM) on the similar facts as above has concluded that the formation of new unit to splitting up or reconstruction is not eligible for deduction under section 10A of the Act.

General guidelines to prevent triggering splitting up/reconstruction of existing business Sl.No Particulars Comments 1 Articles/ goods/ services It is not necessary that a new article or thing is produced or a new line of service is to be provided for proving that the SEZ unit is not formed by splitting up or reconstruction. (Madras High court in the case of Premier Cotton Mills Ltd Vs CIT (240 ITR 434) 2 Plant & Machinery 80:20 rule to be followed. (Instruction No.70 issued by Department of Commerce (SEZ Division) Valuation of assets may be done on the basis of book WDV/Tax WDV/Fair Market Value. (Instruction No. B- 11/3/2008-SEZ, issued by the Government) 3 Employees Though there is no specific requirement to maintain ratio of 80:20 for employees transferred, it needs to be ensured that there is a minimal movement of employees only on a need basis. However, CBDT vide Circular no. 14 of 2014 dated October 8, 2014 allowed transfer / redeployment of technical manpower from existing unit to eligible unit up to 50% of the total technical manpower strength as at the end of the first year 4 Other requirements Fresh contracts to be entered into with the customers and service providers (like transporters, caterers, etc.) SEZ unit has to generate revenue from new contracts / agreements. However, if new contracts are not entered into, ensure that there is a new SOW for new line of business. To maintain the same level of revenue at the STPI unit even after the commencement of SEZ operations.

Case Study on Splitting up/ reconstruction of business of old unit Situation 2: Same facts as Illustration 1 with the following variations: The employee headcount at the end of year is 350, having: q q q 180 employees specialized in software development newly recruited. 150 employees specialized in software development transferred from the existing SEEPZ unit by issuing a fresh employment. 20 employees recruited for administrative works.

Case Study on Splitting up/ reconstruction of business of old unit In the above illustration, it shall be noted that as applied in Illustration 1, there has no been no transfer of physical assets required for software development to the new SEZ unit. As discussed before, production of new articles or offering a new line of service is not an mandatory criteria in order to become eligible as an independent unit. Further, in the instant case, since the total number of technical manpower transferred from existing SEEPZ unit is 150. i.e. less than 50% of the total actual technical manpower [i.e. 50% of 350 (excluding non-technical manpower) =175( as at the end of the FY 2016-17, it can be concluded that transfer / redeployment of manpower would not vitiate the tax holiday benefit of XYZ India Ltd. Infact, it may even be possible to adopt a view that the movement of employees in a subsequent year need not be tested, as the aforementioned circular of the CBDT confirms that technical manpower transfer criteria need to be tested only in the first year of formation (being FY 2016-17). In any event (i.e. even if the employee movement is undertaken in a subsequent year), XYZ India would still be compliant with this condition in view of the fact pattern. However, it maybe argued that employees to be transferred to new unit shall only on a need basis and minimal and hence transferring of 150 employees shall also amount be an attempt to shift the existing business in order to avail benefit. Hence, litigation in connection with claim of deduction under section 10AA is inevitable.

Case Study on Splitting up/ reconstruction of business of old unit Situation 3: Same facts as illustration 2 with the following variations: The computer and computer peripherals necessary for software development amounting to Rs. 50 lakhs was transferred from SEEPZ unit to SEZ unit in the financial year 2017-18. Will the benefit still continue to prevail in subsequent years considering the violation of 80:20 rule in respect of capital assets?

Case Study on Splitting up/ reconstruction of business of old unit The clarifications provided under various policy and operational issues relating to IT SEZs have been summarized vide Instruction No.706. issued by Department of Commerce (SEZ Division): While dealing with the issues relating to shifting of units to SEZ, the Committee has clarified that transfer of used capital goods and business from Domestic Tariff Area (DTA) and STPI units is allowed. However, if such transfer is in excess of 20% of total capital goods and in respect of business, the unit would lose the exemption. Further, it was clarified that, the final decision of allowing the exemption lies with the Income Tax authorities, the ratio of 80:20 of new: used capital goods shall be reckoned on the date the unit starts to produce goods and services. The above circular also reiterates that the new unit should be commenced with new capital goods and new business. However, a relief of upto 20% is granted in transfer of used capital goods and business. Though the judicial precedents and the Instruction issued clarifies that the conditions relating to plant and machinery needs to be satisfied only in the year in which the unit begins its operations, maintaining the ratio throughout the tax holiday period is to be analyzed. The claim may not be allowed if the condition of 80:20 is invoked in subsequent years as well.

Case Study on stage of claiming deduction under section 10AA Case Study 2: X Ltd, incorporated on 1st April 2014 is engaged in the manufacture of gold jewellery. The profits from its business units for the financial year 2016-17 are as follows: Unit D (in Particulars Unit A (in crores) Unit B (in crores) Unit C(in crores) crores) Income from operations 145 450 270 340 Total Expenses 160 420 220 305 Profit for the year (15) 30 50 35 The following additional information is available: Unit B and Unit C are units located in the Special Economic Zones as notified under Special Economic Zones Act, 2005. The brought forward business loss of earlier years eligible for set off is Rs.50 crores Assuming that the profit for the year as mentioned above is same as business profit as computed in the Income Tax Act, 1961 i. Compute the total income for the purpose of computing tax, considering that X Ltd has no other sources of income or deductions available. ii. Will your answer differ if financial year 2017-18 is substituted in place of financial year 2016-17?

Case Study on stage of claiming deduction under section 10AA Summarized profits of X Ltd are as follows: Particulars Profits from SEZ units Profits from non-sez unit Total profit of X Ltd Income from operations 80 20 100 A litigating issue in respect of deduction to be claimed under section 10A/10B was regarding the stage of deduction: Whether will the deduction be available while computing income under the head profits and gains of business or profession under Chapter IV-D (Or) at the stage of computation of computation of total income under Chapter VI of the Act? Supreme court in the case of CIT vs Yokogawa India Ltd. [2017] 77 taxmann.com 411 held as follows: For the aforesaid reasons we answer the appeals and the questions arising therein, as formulated at the outset of this order, by holding that though Section 10A, as amended, is a provision for deduction, the stage of deduction would be while computing the gross total income of the eligible undertaking under Chapter IV of the Act and not at the stage of computation of the total income under Chapter VI. Hence, following the decision of the Hon ble Supreme court, a view can be taken that deduction u/s section 10AA can be taken at the stage of computing the profits and gains from business or profession upto AY 2017-18

Case Study on stage of claiming deduction under section 10AA To be in line with the Circular No.7/DV/2013 dated 16th July 2013 issued by CBDT, Finance Act 2017, has inserted with effect from 1.4.2018, an Explanation after sub-section (1) which read as follows: For the removal of doubts, it is hereby declared that the amount of deduction under this section shall be allowed from the total income of the assessee computed in accordance with the provisions of this Act, before giving effect to the provisions of this section and the deduction under this section shall not exceed such total income of the assessee. Hence, from AY 2018-19 and subsequent years, the deduction under section 10AA can be claimed only from the total income of the assessee computed in accordance with the provision of the Act.

Case Study on stage of claiming deduction under section 10AA The analysis of the stage of deduction and its impact on brought forward loss pre and post amendment are as follows: Particulars AY 2017-18 (Pre amendment) AY 2018-19 (Post amendment) Business profit 100 100 Less: Deduction under section 10AA 80 - Balance 20 100 Less: Set-off of brought forward loss 20 50 Carry forward of business loss 30 - Business Income - 50 Gross Total Income - 50 Less: Deduction under Chapter VI- A Total income (before deduction u/s 10AA) - - - 50 Less: Deduction u/s 10AA - 50 Total Income - -

Case Study on creation & utilization of Special Economic Re-investment Reserve Case Study 3: ABC Ltd engaged in the business of manufacture and export of hand knitting accessories, commenced its operations on 30th June 2006. It has its factory located in a notified Special Economic Zone (SEZ) in Noida. The company has been claiming deduction under section 10AA of the Income Tax Act from the AY 2007-08. The profits for the financial year 2016-17 are as follows: Particulars Export (in millions) Others (in millions) Total (in millions) Turnover 100 80 180 Expenses 50 60 110 Profit for the year 50 20 70 Issue 1: What is the amount to be credited in SEZ Re-investment Reserve, for the purpose of claiming deduction under section 10AA(1)(ii) for the AY 2017-18 (11th Year)? Can deduction be claimed for the whole profit of the unit or only for the profit earned from export of Hand knitting accessories?

Case Study on creation & utilization of Special Economic Re-investment Reserve A plain reading of the section would indicate that the absence of said words derived from the exports of articles or things or from services in (ii) implies the allow-ability of deduction in respect of all profits derived from SEZ units, in contrast to the deduction of only export profits, as contemplated in the first clause. However, section 10AA, being a beneficial provision is to be construed liberally for computing the deduction available. Further courts cannot supply the words missing in the statue, as enshrined by the principle of Casus Omissus. View 1: For the reasons mentioned above, it is fallible to take a view that the second clause applies only to export profits, by supplying the missing words therein from the first clause. Thus, a view can be taken that in the eleventh to fifteenth year, deduction can be claimed for all the profits and gains if SEZ units. View 2: However, considering that the intention of the legislature is to promote exports and develop SEZ s and that the profits under clause (i) of Section 10AA(2) makes specific reference to profits derived from exports, it could be concluded the terms profits as used under clause (ii) of section 10AA(2) would refer to the profits derived from export turnover and only such profits should be considered for the purpose of computing the eligible profits to be transferred to the SEZ Reinvestment Reserve. Considering the intention of legislature, View 2 can be a better view.

Case Study on creation & utilization of Special Economic Re-investment Reserve Particulars Export sales SEZ Unit-A Others Total SEZ unit-b Non-SEZ unit Turnover 100 80 180 200 700 Expenses 50 60 110 180 610 Profit for the year 50 20 70 20 90 Issue 2: Can the amount invested in SEZ Re-investment reserve be utilized for any other undertaking being an ineligible unit or eligible unit other than the unit of which deduction has been claimed?

Case Study on creation & utilization of Special Economic Re-investment Reserve View 1: SEZ Reinvestment Reserve can be used by any undertaking of the assessee The Apex Court has held in several instances that beneficial provisions, such as exemption provisions (as in the case of section 10AA) are to be interpreted liberally, in favor of the assessee. Accordingly, section 10AA may be interpreted in favor of the assessee in case of an anomaly created under the said section. On plain reading of subsection (1) and (2) of section 10AA, it could be reasonably concluded that the funds in SEZ Reinvestment Reserve can be used for any undertaking of the assessee and need not be restricted to the usage of an SEZ unit. View 2: SEZ Reinvestment Reserve can be used for any SEZ undertaking of the assessee The legislative intention for creation of reinvestment reserve under section 10A can be understood from Circular No. 7/2003 which provides as follows: 18.2 With a view to promoting the development of Special Economic Zones, the existing sub-section (1A) of section 10A has been substituted so as to provide for a further deduction for three consecutive years beyond the existing period eligible for deduction, which shall be equal to 50% of the profits as are credited to a reserve account to be utilized for the purposes of business. Hence, a position can be taken that the reinvestment reserve can be used only for the purpose business of an undertaking being a unit in SEZ and not for any other undertaking.

Case Study on creation & utilization of Special Economic Re-investment Reserve View 3: SEZ Reinvestment Reserve can be used only by SEZ undertaking which created the reserve. The above position is be supported by a reference being made to prescribed Form 56FF which the Company is required to file with the Assessing Officer ( AO ) providing the particulars of the amounts transferred and withdrawn from the SEZ Reinvestment Reserve during the year. The form requires the authorized signatory to declare that a specific undertaking situated in a SEZ has acquired the new plant and machinery, for which purchase price has been paid by making withdrawal from the SEZ Reinvestment Reserve. Considering Form 56FF as an external aid of interpretation, a conclusion could also be taken that the funds in SEZ Reinvestment Reserve account should be utilized for specific SEZ units and cannot be utilized by all SEZ undertakings Hence, in light of the above discussion, litigation in connection with claim of deduction under section 10AA is inevitable.

Case Study on creation & utilization of Special Economic Re-investment Reserve Particulars Export (in millions) Others (in millions) Total (in millions) Turnover 100 80 180 Expenses 50 60 110 Profit for the year 50 20 70 Issue 3: Can the Reserve be utilized in the same year it has been created?

Case Study on creation & utilization of Special Economic Re-investment Reserve A restriction is placed by Section 10AA only on the last date by which the reserve is required to be utilized which is three years from the end of previous year in which the reserve was created. However, no restriction is placed on time of usage of reserve for acquisition of plant and machinery. Section 10AA(2)(b) specifies that the assessee is required to furnish particulars in Form 56FF in connection with utilization of reinvestment reserve for purchase of Plant and Machinery. View 1: Form 56FF make provision for disclosing the quantum of creation of reserve during the previous and utilization of such reserve during the previous year. Thus, the timing of creation and utilization of reserve can be in the same previous year. View 2: However, it may be argued that the term during the current previous year ending on as used in clause II is in connection with the reserve already created during any of the previous years and utilized during the immediate previous year.

Case Study on Deductions claimed under section 80-IA Case Study 4: ABC Ltd incorporated on 1st April 2013, is engaged in the business of generation of power through windmills. The business income of the power generation unit from the financial year 2013-14 to financial year 2016-17 are as follows: Particulars AY 2014-15 (in crores) Ay 2015-16 (in crores) AY 2016-17 (in crores) AY 2017-18 (in crores) Profit as per P&L (205) 220 480 1080 Add: Depreciation as per Companies Act 58 175 172 170 (147) 395 652 1250 Less: Depreciation as per Income Tax Act 1300 1088 277 122 Net Income from the unit (1153) (693) 375 1128 The company is eligible to claim a deduction under section 80IA for the above unit. However, ABC Ltd, prefers to start its year for claim of deduction of 10 years only from AY 2015-16. Issue 1: Will the initial assessment year for the purpose of section 80IA be considered as the year from which deduction is said to be claimed (AY 2015-16) or the year the unit commences its operations (AY 2014-15) Issue 2: Will the losses incurred in the AY 2014-15 (years prior to the start of claiming deduction) be set off against the profits before calculating the deduction under section 80IA?

Case Study on Deductions claimed under section 80-IA The illustration is similar to the case of Velayudaswamy Spinning Mills. The Madras High Court in the case of Velayudhaswamy Spinning Mills (P) Ltd. and Sudan Spinning Mills (P) Ltd. vs ACIT (340 ITR 477) had ruled in similar to the below grounds: The initial assessment year for ABC Ltd. shall be considered as the year the assesseee opts to claim the said deduction (i.e. AY 2015-16) or the end of 5th year whichever is earlier, irrespective of the year the unit said to commence its operations. Losses and depreciation of earlier years cannot be notionally carried forward and set off against the income from the year in which the assessee started claiming deduction under s.80-ia. CBDT vide Circular No.1/2016 dated 15.02.2016 has clarified the initial AY selection. Particulars AY 2014-15 (in crores) Ay 2015-16 (in crores) AY 2016-17 (in crores) AY 2017-18 (in crores) Profit as per P&L (205) 220 480 1080 Add: Depreciation as per Companies Act 58 175 172 170 (147) 395 652 1250 Less: Depreciation as per Income Tax Act 1300 1088 277 122 Net Income from the unit (1153) (693) 375 1128 Less: Set- off of losses of AY 2015-16 Profit eligible to be claimed as deduction under section 80-IA (375) (318) - 810

Case Study on Deductions claimed under section 80-IA Ruling of Madras High Court The Madras High court in the case of Velayudhaswamy Spinning Mills (P) Ltd. and Sudan Spinning Mills (P) Ltd. vs ACIT (340 ITR 477) where the Hon ble judge agreed to the decision of the lower authority which reads as follows: Adverting to the facts of the case, the initial assessment year in this case starts from 2004-05 since the assessee has opted to claim this deduction only in this assessment year, the initial assessment year cannot be the year in which the undertaking commenced its operations and in this case, the initial assessment year is the assessment year in which assessee has chosen to claim deduction under s. 80- IA. Hence, the provisions of s. 80-IA(5) treating undertaking as a separate sole source of income cannot be applied to a year prior to the year in which assessee opted to claim relief under s. 80-IA for the first time. Depreciation and carry forward loss relief to the unit which claims deduction under s. 80-IA, cannot be notionally carried forward and set off against the income from the year in which the assessee started claiming deduction under s. 80-IA. In view of this, we are of the opinion that there is no question of setting off notionally carried forward unabsorbed depreciation or loss against the profits of the units and assessee is entitled to claim deduction under s. 80-IA on current assessment year on the current year profit. Accordingly, we allow the claim of the assessee. CBDT Circular No.1/2016 dated 15.02.2016 The CBDT has clarified that once a initial assessment year is opted by the assessee, he shall be entitled to claim deduction u/s 80-IA for ten consecutive years beginning from the year in respect of which he has exercised subject to fulfillment of other conditions prescribed under the section.

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