MEASURING IMPACT AND OUTCOME OF TAX SOPS OFFERED TO CORPORATE TAX PAYERS

Kiran Mazumdar-Shaw

CMD, Biocon Limited

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PREAMBLE

Every ruling government has offered Tax incentives to Corporate Tax Payers in order to boost investment and economic growth as well as augment private sector contribution to social welfare needs.

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The following is a comprehensive table that provides a break-up of various Tax incentives under various sections of the Income Tax Act:

TABLE 1

Sl.No. Nature Of Incentive

Revenue Impact

(2013-14)₹ : Cr

Revenue Impact

(2014-15)₹ : Cr

% Of Total Incentive

1. Deduction of SEZ Export Profits (Section 10A & 10AA)

17,000 18,400 18.7

2. Accelerated Depreciation(Section 32)

34,300 37,000 37.6

3. Weighted Tax deduction for R&D (Section 35(1),(2AA),(2AB)

7,500 8,100 8.2

4. Deduction of Profits Under Section 80-1A forDevelopment, Infrastructure IT & Power

15,000 16,200 16.5

5. Deduction of Profits from Production of mineral oil & Natural Gas (Section 80-1B)

6,200 6,700 6.8

6. Deduction of Profits under Section 80-1C in Uttaranchal & Himachal Pradesh, Sikkim etc.

7,000 7,500 7.6

7. Deduction under Section 80-1AB In development of SEZs

1,400 1,500 1.5

8. Deduction under Section 80G & 80GGA & 80GGB, 35AC, 35AD Covering Donations & Social Programs

1,750 1,900 1.9

9. Deductions under Section 80-1B J&K, Cold Chain, Storage of fruit, Vegetables, grain etc.

800 850 0.9

10. Miscellaneous deduction sunder Section 80JJA, 80JJAA, 80LA, 801D

200 250 0.2

TOTAL 91,150 98,400

Deducting Nett MAT 33,350 36,000

FINAL TOTAL 57,800 62,400

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OBJECTIVES:

Each of the incentives categorized above, have been offered to Corporate Tax Payers with desired objectives:

INCENTIVES FOR SEZS: SECTION 10A, 10AA, 80-1AB

Special Economic Zones have been created to create new engines of growth and to make India’s exports globally competitive through quality infrastructure backed with attractive fiscal incentives and minimum regulations.

The main objectives of the SEZ Act are:

(a) Generation of additional economic activity(b) Promotion of exports of goods and services(c) Creation of employment opportunities(d) Development of infrastructure facilities

The total outlay in 2014-15 of fiscal incentives being extended to investors in SEZs is approximately ₹20,000 crores or US$3 Billion. These incentives have been categorized as follows:

Duty free imports 100% Income Tax exemption on export income for first 5 years and 50%

for the next 5 years and 50% of the ploughed back export profit for an additional 5 years.

Exemption of MAT under section 115 JB Exemption of CST Exemption of Service Tax Exemption of State Sales Tax Exemption of Dividend Distribution Tax under section 115 O

In addition to the above, Developers of SEZs have been extended Tax exemptions under section 80-1AB

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IMPACT & OUTCOME OF SEZ TAX INCENTIVES

As on date, the SEZ Policy has witnessed the establishment of 363 Special Economic Zones across the country. These SEZs cover businesses in IT/ITES, Biotechnology, Pharmaceuticals, Engineering, Automobiles, Gems & jewelry, Aluminum products, leather products, Chemicals, Textiles, Agro-processing, Power/Energy and Handicrafts.

The following Table 2 provides an overview on the outcome and impact of the SEZ Policy:

TABLE 2: FACT SHEET ON SPECIAL ECONOMIC ZONES

Number of Formal Approvals 413Number of notified SEZs 327Operational SEZs 202Units approved in SEZs 4,102

₹ : CrINVESTMENT Investment

(As on February, 2006)Incremental Investment

Total Investment

Central Government SEZs 2,279.20 10,674.65 12,953.85State/Pvt. SEZs set up before 2006 1,756.31 9,009.01 10,765.32SEZs Notified under the Act - 3,25,264.05 3,25,264.05Total 4,035.51 3,44,947.71 3,48,983.22

PersonsEMPLOYMENT Employment

(As on February, 2006)Incremental Employment

Total Employment

Central Government SEZs 1,22,236 1,13,488 2,35,724State/Pvt. SEZs set up before 2006 12,468 67,343 79,811SEZs Notified under the Act 0 11,89,062 11,89,062Total 1,34,704 13,69,893 15,04,597

₹ : CrExports in 2013-14 4,94,077Exports in 2014-15 4,63,770

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The total investments in SEZs as on date is approximately ₹ 350,000 crores (US$55 Billion), with exports amounting to ₹ 500,000 crores (US$75 Billion), collectively employing approximately 1.5 Million people.

The US$3 Billion being extended as Tax incentives has realized the stated objectives of the SEZ Policy.

INCENTIVES FOR R&D: WEIGHTED DEDUCTIONS UNDER SECTION 35(1), (2A), (2AB):

Developed economies such as Europe and USA have identified key enabling technologies for which funding has been significantly increased in the areas of research, innovation and education:

Information and Communication technologies Biotechnology Nanotechnologies Advanced Materials Advanced Manufacturing and processing Space

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India has also identified these sectors as thrust areas for research and innovation. Investments have been optimal in some areas and sub-optimal in others but nevertheless, success signals are now beginning to be perceptible especially in Space, ICT and Biotechnology:

India’s Mangalyaan, Mission to Mars program has been celebrated the world over as a success of frugal innovation led by advanced Science and Technology.

ICT which supports India’s globally successful Software Services sector, is now ready to enter the realm of next generation products.

India’s Pharmaceutical sector is catering to 30% of global generics and is aptly refered to as ‘The pharmacy of the world’.

India’s Biotechnology sector has reached critical mass in recombinant technology based agricultural and pharmaceutical products which has seen India become the world’s largest Vaccine producer, a global Insulin producer and the world’s largest supplier of Bt Cotton. Biomedical devices, Genomics and 3D printing offer the next spate of opportunities.

The following is a comparative table of Tax SOPs of BRIC countries who are all vying for FDI and Venture Capital across its businesses:

TABLE 3: COMPARING R&D SOPs of BRIC ECONOMIES

BRAZIL RUSSIA INDIA CHINACorporate Tax Rate 34% 20% 30% 25%

Super Deduction160% of All

R&D150% of Eligible

R&D200% of In-house R&D

150% of Qualifying

R&DSpecial Economic Zones

--- 10 Year Tax Holiday

5 Year Tax Holiday

5 Year Tax Holiday

Miscellaneous

20% super Deduction for

patents

15% Corp tax for High/New Technology

First RMB 5 M at 50% VAT

Eligible Sectors S&T S&T S&T S&T

As can be seen from above, India’s R&D SOPs are comparable to those of China, Brazil & Russia and enables us to compete on a level playing field.

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However, when viewed in context of Corporate Tax Rates, China and Russia score better.PATENT BOX REGIME

The term ‘Patent Box’ refers to a lower tax rate applicable to a separate box of income derived from Intellectual Property or patents. Several European countries as well as UK have adopted this Tax regime to foster research led business activity necessary to build global leadership in innovation. Under such a scheme, Corporate Tax rate is lowered significantly to between 5-15% applicable to various forms of Intellectual Property.

The following table compares the Patent Box Regimes in several EU countries:

TABLE 4: COMPARISON OF EU PATENT BOX REGIMES

TAX FACTOR Netherlands Spain U.K. France

Income Qualified*

Net income from qualified IP

Gross patent income

Net income from qualifying IP

Royalties, net of cost of managing qualified IP

Acquired IP? Yes, if IP is further self-developed

No Yes, if further developed and managed

Yes, subject to conditions

Cap on benefit?

No Yes, 6 times cost incurred to develop IP

No No

Includes gain on sale of qualified IP?

Yes No Yes Yes

Can R&D be performed abroad?

Yes Yes but must be part of licensor’s IP

Yes Yes

Year enacted 2007, 2010 2008 2013 2001, 2005, 2010

Applicable to existing IP?

Only applicable to IP granted after 2006

Yes Yes Yes

Credit for tax withheld on royalty?

Yes Yes Yes Yes

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Nominal Tax Rate

5% 15% 10% 15%

* Qualified IP includes patents, patentable inventions and improvements made to them. It also includes industrial manufacturing processes that are the continuation of patents or patentable inventions. IP rights must also qualify as assets. If IP rights are acquired (that is, do not result from R&D activities performed by the company), they must be held for at least two years to qualify for the patent box regime.

INDIA INC’s R&D SUCCESS:Thanks to R&D incentives, India is today:

The Pharmacy of the world where Indian generics account for 30% of global generics which has made a huge impact on Global Healthcare.

India is the largest Vaccine producer where one in three children globally are vaccinated by a ‘Made in India’ vaccine. WHO is one of the largest procurers of Indian vaccines.

India is one of the large producers of Recombinant Human Insulin which has lowered the cost of Insulin dependent diabetes across the globe.

India’s innovation potential has been recognized by MNCs who have established their R&D centers in India. Eg. GE, Mercedez Benz, Bristol Myers Squibb, Abbott, Sanofi etc.

India’s growing stature as an innovation led economy is seeing reversal of the scientific brain drain that was apparent in the 1960s – 1980s. Today India Inc. invests on an average 10% of their sales in R&D.

As can be seen from TABLE 1, the total R&D Incentives under Section 35(1), (2AA), (2AB) amounting to Rs:8100 crore in 2014-15, represents only 8.2% of total tax incentives offered to Corporate Tax Payers.

The outcome of this speaks volumes for the impact R&D incentives have made on India’s Pharma Sector: ₹ : Cr

INVESTMENT Investment (As on Apr 1, 2015)

Pharma Sector 174,000 SEZ Pharma/Biopharma 35,000Biopharma 6,000

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Total 215,000

EMPLOYMENT Employment(As on Apr 1, 2015)

Pharma 1,500,000Pharma/Biopharma SEZs 150,500Ancillary Industry (Pharmacies, C&F) 8,,500,000Total 10,150,500

Exports in 2013-14:

US$ 14.6 Billion

Exports in 2014-15:

US$ 15 Billion

The total investments in India’s Pharma and Biotech industry (including sector-specific SEZs) as on date is approximately ₹ 215,000 crores (US$36 Billion), with exports amounting to ₹ 94,000 crores (US$15 Billion), collectively employing approximately 10 Million people.

India’s Pharma Exports to Top 5 DestinationsRank Country 2014-15 Exports

(US$ million)Contribution

(%)

1. US 4,500 28%2. UK 540 4%3. South Africa 500 3%4. Russia 450 3%5. Nigeria 400 3%

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India in the Global Arena

Authority Numbers

USA

DMFs filed with USFDA (companies) (As on 31st March 2015)

238

No: of Sites(Bulk drugs + Formulations) Registered with US FDA (as on 15th April 2015 )

605

Total No Of DMF’s (Type II Active) Filed from India (as on 31st March 2015)

2911

ANDAs(As on 15th April 2015 ) 3070Formulation companies with USFDA approvals.

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Europe

Number of CEPs received (as of 18th April 2015)

1187

No. of companies with CEPs 160Number of Molecules for which CEPs have been filed with EDQM

371

No of Sites registered with EDQM In India (As on 15th April 2015)

553

UK MHRA (Medicines Healthcare Regulatory Agency), Market authorizations as on May 2014

1275

No. of CEPs with Irish Medicines Board

300

No. of companies registered in Irish Medicines Board

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No. of Authorisations with Sweden MPA (Läkemedelsverket)

209

No. of companies having MA`s with Sweden MPA 14 (Läkemedelsverket)

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WHO GMP WHO GMP Certified Plant (as per Drug Controller General of India)

1400 (as per Drug Controller General of India) (approx.)

Source: Pharmexil Annual Report 2014-15

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Combined Market Cap of Companies on S&P BSE Healthcare Index: ₹: 795,500 cr or ~ US$135 billion.

Pharma Industry is the Sixth Largest Recipient of FDI between 2000 and 2015

STATEMENT ON SECTOR-WISE FDI EQUITY INFLOWS (From April 2000 to June 15)S.No. Sector Amount of

FDI Inflows% of Total Inflows

(₹ : Cr) (US$bn)1. SERVICES SECTOR 209,600 43,350 16.82. CONSTRUCTION DEVELOPMENT:

Townships, housing, built-up infrastructure and construction-development projects

113,355 24,100 9.5

3. COMPUTER SOFTWARE & HARDWARE

89,500 17,500 6.8

4. TELECOMMUNICATIONS 86,600 17,450 6.85. AUTOMOBILE INDUSTRY 70,900 13,500 5.26. DRUGS & PHARMACEUTICALS 66,650 13,350 5.1

Source: DIPP

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THE CASE FOR PHASING OUT ACCELERATED DEPRECIATION UNDER SECTION 32:

Accelerated Depreciation is a policy announced by the government in the 1990s to promote large ticket investments in specific industry sectors. Accelerated Depreciation was seen as an incentive to reduce taxable income specifically with the objective of reinvestment. However, there has been a misuse of the benefits of the Accelerated Depreciation policy which is evidenced by over-capitalization and an idle capacity of 60% in India.

Renewable Energy: Misused accelerated depreciation, missed opportunities

Renewable Energy is one such sector that was extended Accelerated Depreciation benefits since 2002. Under the policy, companies generating renewable energy such as solar and wind could avail of accelerated depreciation @ 80% of their capital assets in the first year.

However, data reveals that there was a high level of fraud where investments in wind energy remained on paper and companies and individuals got extensive depreciation benefits. Consequently, Accelerated Depreciation was withdrawn for wind energy in 2012, but retained for solar power projects.

In July 2014, the Indian government announced plans to restore the Accelerated Depreciation program for wind energy.

Total

Estimated Renewable Energy Capacity (as of March 31, 2013) = 26,000 MW

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Source

Renewable Energy

Capacity Installed

(MW)

Total Investment

Equity (30%)

Debt (70%)

Tax (₹ : Cr) foregone through

Accelerated Depreciation

Biomass 4,500 27,000 8100 18,900 21,600Wind 20,160 131,040 39,300 91,700 104,800

Solar PV (ground)

1,300 13,000 3,900 9,100 10,400

Solar PV (rooftop)

40 640 192 450 500

Total 26,000 171,680 51,500 120,150 137,300

In hindsight, if the forgone tax collections (₹ : Cr 137,300) had been instead utilized as equity financing for establishing new Renewable Energy plants, the government could not only have retained the land and property in its name, but it would have generated greater employment as well.

CASE STUDY: Accelerated Depreciation Fails To Raise Capacity Utilization In Wind Power Sector in India

In the 10th and 11th Five Year Plan, Wind Power investors were allowed to avail 80% Accelerated Depreciation. This effectively allowed investors to recover their equity in the first year itself by writing off taxes. Though this policy boosted investments in the wind power sector, it also led to poor capacity utilization for wind turbines (See Table: THE INDIAN WIND POWER SECTOR'S CAPACITY UTILIZATION FACTOR). This was because the incentives were for intended for installing wind power and not generating wind energy. Investors were more interested in tax benefits through Accelerated Depreciation and not in earning money by selling power.

The Accelerated Depreciation benefits were availed only by those companies that were making profits - either on their own or through their sister concerns. Independent power producers (IPPs) were not able to avail AD benefits; it was also of little use in drawing FDI.

Table: THE INDIAN WIND POWER SECTOR'S CAPACITY UTILIZATION FACTOR

Year Up to 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12Installed Capacity (MW) Cumulative

5350.77 7092.82 8756.14 10241.04 11805.64 14154.84

Installed Capacity (MW) Year wise

1742.05 1663.32 1484.9 1564.6 2349.2 3196.7

Power Generated (BU) 9.547 11.413 13.334 18.188 18.735 23.353Methodology 1 CUF (%) 20.4% 18.4% 17.4% 20.3% 18.1% 18.8%

Avg CUF 18.9%Methodology 2 CUF (%) 18.6% 17.2% 16.5% 19.4% 17.1% 17.6%

Avg CUF 17.7%Methodology 3 CUF (%) 17.7% 16.6% 16.1% 18.9% 16.6% 17.15

Avg CUF 17.2%Source: Data from MNRE. Analysis by CSE

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Using three different methodologies, it was observed that the average capacity utilization factor (CUF) of the Indian Wind Power sector in the years 2006-07 to 2011-12 varied between 17% and 19%, which is low as compared to other countries. (Source: ‘State of Renewable Energy in India – A Citizen’s Report’ by Centre for Science & Environment)

Conclusion: If the Government wants to phase out tax exemptions, I do believe that Accelerated Depreciation under Section 32 is a low hanging fruit as it accounts for 37.6% of the total tax incentives. Moreover, Accelerated Depreciation, which is linked to the amount invested, favours capital-intensive industries over labour-intensive ones. Such a policy is therefore highly unsuitable in a country like India, which needs to create 10 million jobs per year for the next 10 years to sustain an acceptable Gross Domestic Product (GDP) growth. Phasing out Accelerated Depreciation would, in effect, lead to better capital efficiency and will also deter over capitalisation of large projects which is often the case as data reveals.

THE ISSUE WITH TAX HOLIDAYS UNDER SECTIONS 80IA, 80IB, 80IC

Tax holidays have been in vogue in the Indian income tax regime for a long while. Section 15C of the Indian Income-tax Act, 1922 introduced in 1949-50 (on the eve of the First Five Year Plan) provided exemption of tax on profits to new industrial undertakings in priority sectors, hotels and all Small Scale Industries (SSI) in specified backward areas subject to certain limits. These exemption-rated holidays were incorporated in the Income-tax Act 1961 through sections 80I and 80J until they were replaced by new sections. Provisions that have come in their place (for example, sections 80IA, 80IB and 80IC) allow deduction or exemption of tax on income from new industrial undertakings (or their extensions) set up in specified sectors and/or areas subject to certain limits and conditions.

Section 80IA allows deduction of profits and gains from industrial undertakings or enterprises engaged in the development of infrastructure. This section was first introduced in the IT Act in 1991 and was amended almost every year thereafter until it was substituted by sections 80IA and 80IB in 1999. Section 80IA, as it stands now, holds out promises of tax holidays to enterprises engaged in the development or maintenance/operation of infrastructure facilities specified in the Act, providing telecommunication service, developing and/or operating an industrial park or SEZ; in the generation and/or distribution of power or renovating or modernising distribution lines.

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Section 80IB allows an income tax holiday to industrial undertakings other than those covered under section 80IA, like mineral oil & natural gas.

Section 80IC provides an income tax holiday specifically for certain undertakings or enterprises set up in special category states like N-E states, Sikkim, Himachal Pradesh and Uttaranchal.

The rationale for tax holiday to new industrial undertakings in developing countries is simple viz., that new ventures in areas such as infrastructure development, new sectors/activities are risky, and therefore to be incentivized through Tax Holidays that are seen as the government sharing the risks. However, the efficacy of tax holidays to achieve this is highly questionable.

Problems with such tax holidays:

Tax holidays are extremely difficult to administer because of the opportunities they open up for ‘transfer pricing’ by shifting income to related ‘holiday’ firms (where it will not be taxed) and shifting deductions to non-exempt firms.

It attracts fly-by-night operators that shut shop and relocate to the next area with such benefits.

Region-specific tax holidays are detrimental to economic efficiency, as they create an artificial competitive advantage to businesses leading to idle capacity and sick industries when such tax incentives are withdrawn. Eg. Pharma units in Baddi, Himachal Pradesh

An impact evaluation study of the North-East Industrial Policy, 1997 which envisaged tax holidays to industries set up in the N-E states, concluded:

o No large-scale investment has taken place as a result of the policy: Small and medium enterprises dominate the scenario, with low investment, low value add, and low employment.

o Several excise intensive units reflect only the final stage of manufacturing activity, entailing relatively low investment and employment, and figure among the major excise beneficiaries.

o Developed states within the region continue to attract most of the investment: Assam and Meghalaya account for 91 percent of the investment.

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o Better connectivity with the mainland, quality of infrastructure and logistics, security concerns are identified as the driving force for the observed pattern of location of investment.

o With the tax holidays extended to Uttaranchal and Himachal Pradesh, most of the investments will flow to them, as they are strategically better placed to attract investors, with closer connectivity to the major markets and therefore having a competitive edge in attracting investment.

The study recommended that creation of better infrastructure, better transport facilities and interest subsidy would spur investment in the N-E states.

CONCLUSION:

If the Government is keen to phase out a plethora of tax exemptions extended to Corporate Tax payers in India, for the reasons discussed above, it would be prudent to examine the relevance of Accelerated Depreciation under Section 32 especially for Renewable Power Projects. This should either be phased out or the rate of depreciation lowered. Another set of Tax exemptions under sections 80IA, 80IB, 80IC may also be examined for their impact on achieving investment and employment generation in backward areas. Perhaps, a tax subsidy on the final product may be a preferred option. On the other hand, tax exemptions pertaining to SEZs and R&D have delivered on their stated objectives and must be further augmented to drive investment, growth and employment. It is further recommended that India adopt a Patent Box Regime as described in Table 4 to foster innovation and create high value whilst harnessing scientific and engineering jobs.

A recent report from consulting firm Zinnov has stated that India is the No. 1 choice for global Technology led R&D. 69% of all new offshore R&D Centers established in 2015 were in India. Furthermore, India accounted for $12.3 billion or 40% of globalized Engineering and R&D investments in 2015 compared to China’s $9.7 billion. This is a formidable position which must be augmented and not weakened by any policy change. Any measures to remove R&D incentives will see a resurgence of the proverbial ‘brain drain’ which will be highly detrimental to India’s future.

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