The Income Tax department has allowed profit-linked tax deductions to new special economic zone (SEZ) units upon transfer of technical manpower up to 20 per cent from an existing unit. This will provide some tax relief to software and IT-enabled services (ITeS) companies operating from such units.

Under section 10A/AA of the Income Tax Act, tax benefit is disallowed if the unit is formed by splitting up or reconstruction of a business already in existence, or transfer of machinery previously used for any purpose in excess of 20 per cent in value. Restrictions on manpower transfer are not specifically mentioned.

The Central Board of Direct Taxes (CBDT) in a circular clarified that mere transfer or redeployment of technical manpower in the first year of commencement of business would not be construed as splitting up or reconstruction of an existing business, provided the number people transferred does not exceed 20 per cent of the total manpower actually engaged in developing software in the new unit.

"The circular would apply only to the taxpayers engaged in the development of software or providing ITeS in SEZ units," it added.

Though the I-T Act doesn't explicitly bar transfer or deployment of manpower, earlier, tax authorities were disputing claims of tax deductions by taxpayers on such transfers and this gave rise to litigation.

The industry's argument was that there was a need of technical persons with prior experience to manage critical functions of software development in a new unit and the movement of technical manpower should not be a constraint in availing tax benefit.

"In case of the IT industry, which is substantially manpower oriented, taxpayers may find the threshold limit restriction of 20 per cent on transfer of technical manpower from the existing unit too low to address the concerns of the industry," said Rajiv Chugh, Tax Partner, EY.

The Rangachary Committee which had submitted its report on tax issues of software sector last year, had suggested a threshold of 50 per cent of total billable employees of the new SEZ unit of first year for transfer of manpower.

"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 per cent limit and wish to rely on the clarification, may claim the Circular as clarificatory for past years as well," Chugh said.

The restriction of 20 per cent is applicable in the first year of commencement of business and has to be maintained at any point of time in a year and not necessarily on the date of formation of the unit. (Business Standard)