Impact of direct tax code on special economic zones

The Special Economic Zones Act (SEZA) 2005 was enacted with the underlying objective to boost economic activity, promote exports and investment from domestic and foreign sources, create employment opportunities and develop infrastructural activities. Keeping such objectives in mind, various fiscal incentives were provided to the special economic zones (SEZs) under the Income Tax Act (ITA) 1961.

As of 1 December 2010, out of 579 formally approved SEZs and 367 notified SEZs, only 122 SEZs are operational due to functional anomalies and rigid timelines. The development of SEZ was already stunted thanks to the recent recessionary conditions, ambiguity in various provisions of SEZA 2005 and the 2006 SEZ Rules. The two draft direct tax codes (DTC), released in August 2009 and September 2010, have further hindered the development of SEZs. This article, in the first part, explains the changes proposed by the second draft DTC (the September DTC) to the framework of SEZs and, in the second part, analyses the effect of the changes proposed by the September DTC on the SEZs.1


Under the current provisions of ITA 1961, profit-based incentives are available to an undertaking developing, operating and maintaining a SEZ notified on or after 1 April 2005 under provisions of SEZA 2005. Such undertaking is eligible for a 100% deduction of the profits and gains derived from such a business for ten consecutive years out of 15, commencing from the year in which the SEZ is notified by the central government. Further, in case a developer developing such SEZ on or after 1 April 2005 transfers the operation and maintenance of such SEZ to another developer, the transferee developer shall be eligible to deduction for the remaining ten consecutive years.

The September DTC has proposed to substitute the profit-based deductions under the existing provisions of ITA 1961, with investment-based deductions for SEZs notified after 31 March 2012. Thus, deductions to SEZ developers notified after 31 March 2012 are proposed to be investment-linked and profit-linked. The September DTC has also proposed that SEZ units commencing operations after 31 March 2014 shall be entitled to investment-linked deductions and not profit-linked incentives. Further, all SEZ developers notified prior to 31 March 2012 will continue to be eligible for the profit-based deductions for the unexpired deduction period (the ‘grandfathering clause’).


Presently, as per s115JB of ITA 1961, SEZ developers and SEZ units are exempt from the payment of minimum alternate tax (MAT). The September DTC has proposed to levy MAT on all SEZ developers and SEZ units. Thus, all SEZ developers and SEZ units would be liable to pay MAT at the rate of 20%, irrespective of the date of notification of such SEZ or commencement of operations by the SEZ unit.


Presently, as per s115O of ITA 1961, SEZ developers are exempted from the payment of dividend distribution tax (DDT). Further, DDT is presently applicable on SEZ units. The September DTC proposes to extend DDT to SEZ developers also at the rate of 15%, whether notified prior to or after 31 March 2012. Further, as per the September DTC, DDT continues to be applicable on the SEZ units.


The September DTC and its impact on SEZs will have to be analysed in context. The policy on SEZs has been a bone of contention between the two arms of the Indian government: the Ministry of Commerce (MoC) and the Ministry of Finance (MoF). While MoC vehemently promotes the SEZ exemptions on account of export growth, the MoF opposes the SEZ exemptions on account of large revenue losses.

The rationale for the shift from profit-linked incentives to investment-based deductions appears to be that profit-linked incentives are considered distortionary in nature, as they create an incentive to inflate profits and transfer profits from taxable entities to non-taxable entities to maximize deductions.

This change from profit-linked incentives to investment-based deductions proposed in the September DTC will regress the growth of SEZs. This is because the shift to investment-based deductions will demoralise the low capital intensive projects, particularly in the IT/IT enabled services (ITES) sector. Thus, given that 353 SEZs out of 579 formally approved SEZs belong to the IT/ITES sector, the magnitude of impact of investment-based deductions on SEZs is anyone’s guess. More importantly, the provisions of the September DTC, would lead to tax discrimination between the existing SEZ developers and SEZ units on one hand, and the new SEZ developers and SEZ units on the other.

Even if it is argued that, given the long stop dates suggested in the September DTC (31 March 2012 for SEZ developers and 31 March 2014 for SEZ units), companies would be prompted to pace up their projects and benefit from the profit-linked incentives, it seems rather difficult to justify the levy of MAT on SEZ developers and SEZ units. Even though MAT paid by the companies may be carried forward and set off in the subsequent 15 years, the levy of MAT will result in additional cash outflow issue to such companies, particularly small and medium enterprises (SMEs). Thus, instead of assisting the companies in overcoming the jolts of liquidity crunch, levy of MAT will add to the cash crunch of companies.

It is also interesting to note that, under the present provisions of SEZA 2005, applicability of the September DTC to SEZs may be challenged. This is because SEZA 2005 has an overriding effect over anything inconsistent with its provisions. In other words, to uphold the applicability of the September DTC to SEZs, the provisions of SEZA 2005 will need to be amended and a niche created for the September DTC.

Undoubtedly, the withdrawal of exemptions proposed in the September DTC for SEZs is anti-thesis to the Finance Minister’s statements, on 26 February 2010, in the budget speech:

‘The SEZs have attracted significant flows of domestic and foreign investment… [the] government is committed to ensuring continued growth of SEZs to draw investments and boost exports and employment.’

‘Promissory estopple’, an equitable principle, is intended to counter the evading tendencies of parties (including the government) and insist that parties fulfil the promises or commitments made to the other party, when such other party has acted in accordance with the promise or commitment. This doctrine has also been incorporated under s115 of the Indian Evidence Act 1872.

However, it may be too far-fetched to say that the legislature can be ‘estopped’ from enacting a new legislation, even if such new legislation takes away certain exemptions. The courts in India have held in various cases that the doctrine of promissory estopple cannot be invoked against statutory provisions.

SEZs today are not only a tool for export promotion, but also contain the potential to generate an economic spin off of enormous proportions leading to regional development. The international experiences of SEZs lend credibility to the fact that countries such as China, Ireland, and the Philippines have achieved high economic growth supported by strong performance of their SEZs. This is primarily because of sustained fiscal incentives over a long term and an attractive policy framework covering preferential policy and procedures, zonal administration and labour laws.


It is high time that the MoC and MoF stop their supremacy war. The government must recognise that SEZs are a long-term project and must not curb the fiscal incentives proposed under the September DTC. Largely, the September DTC has been a dampener on the investment sentiment of the global and domestic investors in SEZs, and exposed the unstable policy framework in India. Thus, instead of nurturing the policy on SEZs, settling the turbulence created by recession and removing the operational anomalies, the SEZs in India have been nipped in the bud. Alas, Indian SEZs competing with Chinese SEZs continues to be a dream.

The views expressed are those of the authors and do not reflect the official policy or position of Amarchand Mangaldas.


  1. The September DTC has been given the nod by the Cabinet of Ministers and has been tabled before the Lok Sabha. Once approved by both houses of the Parliament (Lok Sabha and Rajya Sabha) it will come into force from 1 April 2012.