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SEZ: The Dealmakers' Dealbreaker

SEZ: The Dealmakers' Dealbreaker

The government's highly motivated optimism on SEZs is not reflected among the practitioners, and it should come as small surprise that after a lengthy wild goose chase by our office, the Commerce Ministry officials kept bouncing us around from bureaucrat to another, confusing matters, and in effect dodging hard questions. Although India's exports, targeted to grow at 25 per cent to reach $500 billion by 2014, may not take a major beating, fewer SEZ developers and investors are seeing the special zones as lucrative, writes Shashidhar Nanjundaiah.

The 22 July meeting of the Special Economic Zones (SEZs) Board of Approvals had to deal with as many as 14 requests to withdraw. While there were six withdrawals of in-principle approvals, there were three withdrawals of formal approvals and as many as five requests of de-notification. There were only two proposals to set up new SEZs.

Finance Minister Pranab Mukherjee may have calculated the revenues from withdrawing tax benefits for SEZs, but he may not have anticipated the industry's drastic reactions to the Budget plan: In Gujarat, which accounts for about half of all SEZ exports from India, it is said that 24 business units have postponed their plans to move into the state's SEZs, while doubt has been cast on the future of 50 SEZ developments which are at various stages of implementation. There are 133 ope­rational SEZs (among 580 approved ones) in India, out of which 26 were approved before the SEZ Act came into existence in 2005. With so many players backing out or braking, nearly Rs 30,000 crore worth of bank debts to SEZs (under various stages of implementation) face the risk of being Non-Performing Assets (NPAs).

The slowdown is no longer impending. Last month, Parsvnath dropped six of its SEZ projects (Group sub­sidiary Parsvnath SEZ Ltd has offered to surrender six SEZs – in Uttar Pradesh, Haryana, Tamil Nadu and Maharashtra—that were earlier granted in-principle approval by the government.) while as many as 45 SEZ developers, including Raheja SEZ, Navi Mumbai
and GP Realtors, have sought more time to execute their projects. Parsvnath's pullout comes after obtaining in-principle approvals for a multi-product SEZ in Kanchipuram, Tamil Nadu, leather (Agra) and han­dicrafts (Moradabad) SEZs in Uttar Pradesh, a gems and jewellery tax-free zone in Jaipur, a food processing SEZ in Sonepat, Haryana, and an auto component zone in Pune. Oval Developers, which was one of the first to excitedly enter West Bengal's ambitious IT SEZ plans four years ago, has now asked for denotification.

MAT may end matters

Although the Minimum Alternative Tax (MAT) of 18.5 per cent, reimposed on SEZs this Budget, may be only one of the factors involving such a drastic action, the crux seems to be in the now-familiar voice of dis­appointment about these high-promise-low-delivery zones: “The initial euphoria around SEZs has diminished substantially,” as an SEZ developer said on condition on anonymity. A slowdown in the realty market is also cited as a reason, as is the “flip-flop policies of the government”, as the developer called it.

The issue of MAT imposition is indicative of a larger problem, the uncertainty in policy. Initial guidelines brought in much interest from developers and investors, but to their chagrin, they have discovered that revisions in those guidelines and flip-flops have occurred too frequently for comfort since then.

Parsvnath says it surrendered in principle approval for its six SEZs because of multiple reasons. “For one thing, we were unable to acquire the land needed for the SEZs at prices, which would maintain the viability of the SEZs,” said SP Aggarwal, Joint Managing Director, Parsvnath Infra. “Second, under the present scenario, acquisition of land by the state government[s] was not an option. And thirdly, with the large scale changes in the taxation regime concerning SEZs both for the developers as also the units and still more expected in the Direct Taxes Code (DTC), we did not find those SEZs very viable.”

SEZs are also a real estate game, especially so for IT SEZs, where the developer provides ready-to-move-in buildings apart from the land and infrastructure. The problem is compounded for IT SEZs, which enjoy tax benefits while units under the Software Technical Parks of India (STPI) scheme do not, but the STPIs are looking more lucrative for investors as developers gain more flexibility of location there—therefore offering a strategic advantage of situating themselves in the proximity of major clients, for example.

“With MAT,” declares Parsvnath's Aggarwal, “there is no reason for investors to set up their units in SEZs, as their viability would be drastically affected and it would not be lucrative at all.”

Grey matter eludes grey areas

There are many grey areas in India's SEZ policy, but the bigger and darker cloud over SEZs is whether, as we head towards a policy regime where the clear advantages of SEZs may no longer lure investors—and even dev­elopers—as they have so far. Burdened by problems in Service Tax, benefit of DEPB/Duty Drawback on supplies to SEZ developers, interpretation of Section 10AA of the Income Tax Act, etc, developers are not sure of the future of SEZs. An example, classic in its nature, is the Sunset Clause in the Export Oriented Unit (EOU) policy, which has faced the Damocles' Sword of can­cellation after its duration expired last year. The Sunset Clause provided an attraction to developers under Section 10B of the Income Tax Act, whereby EOUs could continue to avail the exemption from income tax, especially in a year when all the exporters have been hit badly on account of rupee appreciation. The government, after making the right noises, went back to slumber on its renewal.

All this uncertainty, translates into cost pressure. With an 18.5 per cent MAT and an effective tax rate of around 22 per cent, SEZs do not offer any major advantage to investors. Units in SEZs have far less tax incentives than developers do, but were initially com­fortable with the five-year initial tax holiday. But if that period reduces, the units—especially smaller ones—will be hard-hit and less confident of investing in an SEZ.

SEZs are somewhat like dry ports, in that they have a customs office and a customs clearance process. “Process zones”, typically comprising 50 per cent of an SEZ, are notified only for export units, and are heavily regulated, while the rest of the land, the “Non-process zones”, are unregulated and are intended to be support the process units. But several developers had assumed the interpretation of non-process zones as units that can produce goods for domestic consumption, only to receive clarifications from the SEZ authorities that non-process units can only provide support services and goods to the process units (such as power, water, employee residences, schools, hospitals, etc).

Unshared optimism

Exports from SEZs have jumped over the years and stood at Rs 3.18 lakh crore in 2010-11, a 43 per cent leap over last year. But the recent 40 per cent growth in exports is clearly not sustainable, and as the government predicts, may come down to about 20 per cent. Experts also believe that a larger economic environment may be the real, deeper reason for pullout. Land, uncertain and barely-limping-back-to-normal global markets and infrastructure issues are also at the heart of the issues. The government has finally acknowledged that finding 5,000 hectare for an SEZ will not be easy, and is con­sidering doing something about that threshold land limit that has been set. Commerce Secretary Rahul Khullar has expressed concern that developers do not want to look beyond six states—Andhra Pradesh, Gujarat, Karnataka, Kerala, Maharashtra and Tamil Nadu—that account for 92 per cent of the exports from SEZs. He has urged developers to look at locations where land and labour is cheaper.
Land acquisition blues have deterred the mightiest, including Mukesh Ambani's Navi Mumbai SEZ. Khullar has said: “You are not going to find 5,000 (hectares) of land area, it is a pipe dream.” The economy is likely to go through a difficult patch over the next three years
due to lack of adequate land for the industry, mounting wage bills and poor infrastructure which could blunt the competitive edge. Mathematics also predict that the infrastructure sector is going to face 20 to 25 per cent shortage of power, and the water problem will only
get worse.

Then there is the dreaded Exit Clause. The stated policy says that no approvals are required for exits under 49 per cent of stakeholding in an SEZ, while a Board of Approvals (BOA) approval is required for exit of holding over 49 per cent. Yet, not a single application for app­roval has met with success so far, scaring investors who would like to roll their investments in a healthy way. “On one hand,” says Sanjay Ubale, CEO, Tata Realty and Infrastructure, “you have a policy which you say you can exit and on the other hand in terms of imp­lementation you have no exit. So this is creating a policy distortion which the developers are finding it difficult to cope up with.”

“The exit clause needs to be made much more liberal,” agrees Aggarwal. “In its present form, it leaves much to be desired.”

That said, SEZ policies and processes have been smoothened along the way. For example, the developer no longer needs to approach the Board of Approvals for any issues. Most issues are solved at the Development Commissioner's office; rules have been set needing no specific sanctions.

For example, goods that enter an SEZ will not be allowed to be taken out, and there was no exception to the rule. Later, for construction scrap and other material, a clarification was then issued. The government seems keen to be solution-oriented.

Perhaps the learning from this is how badly , and to what extent, withdrawal of promised incentives can affect development activity.

How SEZs work

A company that develops the SEZ attracts investors in the development of the zone. These investors need to get money through dividend distribution and subsequently have an option to exit the business. Experts say that the exit norms for SEZs need to be flexible, and that is exactly the opposite of what the reality in India offers.

In the second phase of activity, post-development of the SEZ, exporters invest and export their wares. These investors have certain sets of benefits as unit holders in the SEZ. The business model for the developers is that they invest money in buying land and constructing and maintaining the property, and the returns go back into repaying those dues. For units, the property almost works like rented space.

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