Authors Sunny Bansal and Akanksha Gupta (Chartered Accountants) in their article unveil the issues and interpretations surrounding Sec. 115BAB recently introduced vide the Taxation Laws (Amendment) Act, 2019 providing a reduced rate of 15% for manufacturing entities. The authors analyse the ‘Elemental Terms’ used in the section. Pondering whether the section allows benefit to Job worker, Contract Manufacturer or the Company engaging such Job worker/Contract Manufacturer, the authors opine that various factors such as license ownership, raw material procurement, supervision, risks, degree of control etc., matter in this regard. Further, the authors examine if R&D activities conducted towards an IP held by the parent company would be challenged as an additional activity other than manufacturing. Thereafter, the authors apprise about the possible scrutiny in cases of SDT wherein the tax authorities might argue that as per sub section (6) of section 115BAB, the taxpayer (a new company) by way of a cost plus arrangement has produced more than ordinary profits which might be expected to arise in the business.

A Probe into 115BAB! 

Introduction

The “Ease of doing business” initiative has been one of the most significant, structured and outcome-oriented policy by Indian Government for attracting foreign investments. With an intent to revive the slack in the economy and to untangle the taxation structure, the Government vide the Taxation Laws (Amendment) Act, 2019, had reduced the corporate tax rates for domestic companies by inserting section 115BAA and section 115BAB in the Income Tax Act, 1961 (“The Act”).

While the reduced rate of tax under section 115BAA is available to all domestic companies, the benefit under section 115BAB is available only to those domestic companies set up and registered on or after Octiber,01, 2019 and not engaged in any business other than the business of manufacture or production of any article or thing and research in relation to, or distribution of, such article or thing manufactured or produced by it.

The section also confines with a wide range of constraints imposed with respect to specified deductions, incentives, exemptions and additional depreciation otherwise available under The Act.

Industry Intent

The tax relief impacts major industries which are looking forward to set-up manufacturing entity in India. However, the feasibility and desirability of continuing in the present regime or migrating to section 115BAB regime needs to be explored based on detailed analysis of facts and circumstances in case of each line of business.

The aim of this article is to unveil the issues and interpretations involved in exercising the option by way of deeper analysis of Elemental Terms used in the section.

A Dive into the Notables

1. Term “Manufacture”

The section intents to give benefit to domestic companies which are not engaged in any business other than the business of manufacture or production of any article or thing.

Now the pertinent question would be as to what activity or transaction qualify as “Manufacture or Production” and “Who is manufacturer to avail this benefit”

Lets discuss !! Section 2(29BA) which defines the terms manufacture as:

“transformation into a new and distinct object or article or thing having a different name, character and use; or a thing with a different chemical composition or integral structure;”

In simple words, conversion of raw material into finished good would qualify as Manufacturing Activity. Concept of Deemed Manufacturing activity such as mere packing/ re-packing of goods as explained in erstwhile Central Excise Act may not qualify for benefit under this section.

Basis above, one can arrive at conclusion as what is manufacture/Manufacturing activity.

Who is Manufacturer?

The Act, however, does not define the term “Manufacturer”. In general parlance, Manufacturer means “a person or a company that makes goods for sale”.

Major industry players carry out the process of manufacturing partly by way of inhouse manufacturing and partly by outsourcing the process on Job Work or by way of Contract Manufacturing.

Under Job work arrangement, the taxpayer supplies raw material to job worker and provides specification to the Job worker for carrying out manufacturing on payment of processing charges.

Contract Manufacturing involves a contract for sale where the manufacturer acts a third party for processing goods, but the entire process is governed by the Taxpayer. In such an arrangement the product concept, specifications, brand name and IP rights in the products are owned by the taxpayer. Taxpayer also supervises and control and has the right to reject the goods in case of unsatisfactory quality. The risk of taking up warranty obligations on the products are all indicators of a taxpayer’s deep involvement as a manufacturer.

The question which arises here is whether the section allows benefit to Job worker, Contract Manufacturer or the Company engaging such Job worker/Contract Manufacturer?

A view can be taken from various judicial precedents [TS-658-HC-2012(MAD)-O], [TS-5133-HC-1982(Bombay)-O], [TS-5096-ITAT-2002(Chandigarh)-O] given by higher courts where it has been held that factors such as such as license ownership, raw material procurement, supervision, risks, degree of control among other factors need to be examined to determine the actual “manufacturer”.

In the case of reported in [TS-5495-HC-1991(Bombay)-O], the Hon’ble High Court of Bombay held that where the specifications as to how the products have to be manufactured along with designs were being given by the taxpayer, but the entire manufacturing activity was being carried out by a job worker, the taxpayer would be considered as a manufacturer.
In such case, industries can debate as who is “Manufacturer” to be eligible for lower tax rate.

2. Whether “Trading” is eligible business?

In General parlance “Trading” refers to an act of buying and selling goods and services. Some time Trading is essential part of Manufacturing companies for various reasons like Nowadays, products are initially marketed for some time and thereafter, the decision to manufacture is taken on the basis of feasibility and other driving factors.

This gives rise to a low volume or miniscule amount of trading income for such products in comparison to overall business income. Therefore, Trading relates to transactions that business prudently takes for commercial sense. The commercial purpose of undertaking a transaction always needs to be tested by the taxpayer.

However, there is conundrum around Commercial vs Tax impact for which the section requires analysis because conditions specified under section 115BAB restricts tax payer from carrying out any other activity apart from manufacturing etc. Therefore, in this regard, it needs to be examined if minor proportion of such activity may not disentitle the taxpayer. View can be taken from SC ruling in [TS-3-SC-1992-O], wherein it was held that an incentive provision should be interpreted liberally and the conditions for availing exemption should be interpreted in a manner that they advance the object of the incentive provision and do not frustrate it.

In the recent rulings, Delhi HC in [TS-5248-HC-2001(Delhi)-O], Delhi HC held that

“Substantial compliance is all that is required. In order to qualify for the relief and satisfy the requirements of the provision, the undertaking must have employed ten or more workers substantially during the period for which relief is claimed. There can be no hard and fast rule by which one can determine whether there has been substantial compliance. It is for the authority or the Court to so decide based upon the facts before it.”

Going by above business/commercial parlance, one can take the view that Trading in certain circumstances can be allowed under section 115BAB.

3. Whether carrying on “Research” is Compulsory?

In today’s business era it is essential for businesses to continuously engage itself in research and development towards innovation, introduction and improvement of products and processes.

Accordingly, one of the requirements to be eligible under section 115BAB is that the Tax payer should be engaged in Research in relation to the products manufactured by it. The drafting of law does not make a clear distinction for research to be compulsory. The reading of section in combination with words “not engaged”, “other than” and “and” leaves the taxpayer in thoughts.

The word “not engaged” restricts the taxpayer from carrying out any other activity which is followed by “other than” thereby specifying the activities which the taxpayer can be engaged in to qualify for lower tax rate.

The word “and” before research and “or” before distribution can be interpreted to mean that the taxpayer should be engaged in both manufacturing and research. Also, in case where the Tax payer undertakes research activities then such research should be for the products manufactured by it.

However, a view may be taken differently.

Let’s delve into other issues around research activities!!!

a) Whether Contract Research is allowed?

In case of a global parent, it has been seen that the global parent is the IP owner of the brands. The Global Parent licenses such IP to its group companies in India to enable them to manufacture such products. The Indian manufacturing entity in lieu of license pays royalty to the Parent IP holder. At the same time, the Indian Entity also carries out R&D activities in India to support Indian Business which is covered as a separate service to Global IP Owner under a Service Agreement.

Considering TP Compliances, the cost of research and development work carried out for IP Owner is recovered from the IP holder for successful research. In such cases, the tax authorities may argue that such an arrangement is violative of the condition specified under section 115BAB as it involves additional activity other than manufacturing.

However, if we focus our lens on the law, then the section does not give any reference to the “usage” of such research, hence a view can be taken that the taxpayer may carry out such research through contract as long as it is not for completely unrelated products.

b) Whether Research can be for Futuristic Products

Research unfolds new and improved products by development of Existing products (EPD’s) or development of New Products (NPD’s). It may not be restricted to existing products only.

While the section lays down research in relation to articles manufactured, as one of the mandatory conditions, it needs to be examined whether research in relation to only EPD’s is eligible or it covers NPD’s also which are currently not manufactured.

View may be taken that as long as the products on which research is conducted belong to the same family/ genus of products manufactured by taxpayer, NPD’s shall also be covered.

4. Whether “Other Incomes” are eligible for benefit?

The wording of the section that the company should not be engaged in any other business other than…, restricts the taxpayer from engaging in any activity other than the one given in the section.

Companiescannot escape presence of certain other Incomes as part of its P&L i.e. interest income from fixed deposits, income from scarp sales, profit on sale of assets or any routine liability written off. The presence of these activities is incidental to manufacturing business.

As the first Proviso to subsection (1) of section 115BAB reads as follows:

Provided that where the total income of the person, includes any income, which has neither been derived from nor is incidental to manufacturing or

production…., such income shall be taxable at the rate of twenty-two percent, and no deduction or allowance in respect of any expenditure or allowance shall be allowed in computing such income.

The question that arises here is whether such income will be eligible for 15% rate or will it be taxed at 22% without any allowance? Though tax authorities can argue that such income shall be subject to higher rate, however, taxpayer in defense can argue that mere earning of income from these activities shall not be construed as a separate business. The intention of legislature is to restrict the taxpayer from being engaged in non-qualifying activity. These types of income are incidental to the overall process of manufacturing.

5. Impact of Specified Domestic Transactions

Section 92BA covers any business transacted between the closely related persons under section 115BAB as specified domestic transaction. By virtue of provision laid out in section 115BAB, an arrangement which has produced more than ordinary profits owing to closely related parties will be subject to arm’s length pricing.

Such arm’s length price will be the price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions.

The question that arises here is with respect to the scenario where existing industries having its own distribution channels and operating on a cost-plus markup model for intercompany transactions set up new subsidiary company which is otherwise eligible for section 115BAB.

In such a case, the arm’s length price will be the price which the existing company/comparable gets from the ultimate customer.

If the newly set up company sells manufactured goods to Existing parent on cost plus markup such that the new company books higher profits against the current markup for intercompany transactions, then such as arrangement can be subject to scrutiny by Tax authorities. The tax authorities might argue that as per sub section (6) of section 115BAB, the taxpayer (the new company) by way of this arrangement has produced more than ordinary profits which might be expected to arise in the business. Industries need to examine if this arrangement can be questioned as a way of shifting profits and evaluate setting up a separate distribution and marketing channel for the new company.

Concluding remarks

The section creates a divergence between the ease of doing business and Indian tax practice. Based on the principles emanating from the above discussion, test must be applied on each activity carried on by the domestic company. The section has a very wide footprint for investors and creates resonance in adopting the benefit. Given the uncertainties shadowed around the legal terms, entirety of the validity of various arrangements are likely to close scrutiny by tax authorities.

Therefore, it is imperative for the taxpayers to conduct a fact driven analysis of the business before opting for a lower rate under section 115BAB.