SEZ Amendment: Floor-Wise Demarcation for IT Businesses

On December 6, 2023, the Ministry of Commerce and Industry notified the Special Economic Zones (Fifth Amendment) Rules, 2023, providing for floor-wise demarcation of non-processing areas for businesses engaged in Information Technology (IT) or Information technology-enabled services (ITeS) Special Economic Zone (SEZ).

Accordingly, Rule 11B has been introduced to amend the Special Economic Zones Rules, 2006. Sub-rule (1) of this Rule specifies that the demarcation of a portion of the built-up area of the IT or ITeS SEZ as a non-processing area may be allowed by the Board of Approval at the developer’s request. Further, the Board can provide its approval only on repayment of the tax benefits enumerated under Rule 11B(5)(i) and (ii). It has also been clarified that part of a floor cannot be demarcated as a non-processing area.

In an SEZ, the processing area is where SEZ units are set up for the manufacturing of goods or rendering of services. SEZ developers can avail of several exemptions (from customs duty, service tax, etc.). Whereas the non-processing area is where the infrastructure to support these activities is set up. Activities conducted in non-processing areas could be residential, commercial, recreational, and so on.

As per Rule 11B(2) of the amendment rules, a non-processing area may be used for setting up and operation of businesses engaged in IT or ITeS.

However, certain safeguards need to be in place in such non-processing areas. For instance, the movement of persons and goods in and out of the premises has to be screened with the help of appropriate access control mechanisms.

Moreover, if the demarcation reduces the processing area to less than 50% of the total area or less than the minimum built-up processing area prescribed based on the categories of cities (i.e., 50,000 square metres in category ‘A’ cities, 25,000 square metres in category ‘B’ cities and 15,000 square metres in category ‘C’ cities), the demarcation cannot be carried out.

The rights, facilities and privileges available to SEZ units are not applicable to businesses engaged in IT or ITeS services in non-processing areas of a SEZ. The operation and maintenance of infrastructure and facilities used for SEZ entities are eligible for tax benefits, but such benefits will not apply in cases of dual use. Further, the businesses engaged in IT or ITeS SEZs in non-processing areas are to be bound by the same legislations, rules, etc. that apply to entities operating in domestic tariff areas.

Overall, the amendment rules will lead to an increase in government revenue with higher GST collection and also owing to the repayment of tax incentives that developers had availed earlier for processing area that gets converted into non-processing area now.

Considering that the direct tax holiday expired in the year 2020 with the introduction of sunset clauses by the Central Board of Direct Taxes (CBDT) and the rules (before the amendment) provided only for a full building denotification, the vacancy in IT SEZ office spaces reportedly rose to 20%. The new amendment seeks to address this issue by enabling developers to lease out the non-processing areas to IT companies.

Previously, denotification was permitted only building-wise as a result of which large portions of SEZs were lying vacant. It is anticipated that easing the restrictions for denotification of processing areas and adopting a hybrid model for setting up supporting infrastructure for IT or ITeS in SEZs, will cause a ripple effect by boosting domestic demand and facilitating continued growth of the sector.

However, there seems to be a lack of clarity on certain points, and thus, detailed procedural guidelines addressing the following ambiguities are much needed: - 

• The precise rights and facilities available to SEZ units that will not be accessible to the category of businesses setting up and operating IT or ITeS services in non-processing areas.

• The standards for implementing security measures such as access control mechanisms and adequate screening for businesses engaged in IT or ITeS services in non-processing areas. 

• Whether the application procedure for setting up and operating IT or ITeS services in the non-processing area shall be harmonious with the procedures applicable to the units in processing areas as per the Special Economic Zones Rules, 2006.  

• Whether the co-developer may also be permitted to repurpose unused built-up areas in SEZs for non-processing use. 

• Whether the minimum processing area threshold is to be maintained by the developer, based on the SEZ’s total area or within each building respectively. 

• Whether the considerations for calculating repayment of tax benefits for the creation of social and commercial infrastructure such as roads, transport and waste management facilities, electricity grids, hospitals, residential housing, and educational institutions, are to be impacted by their proximity to non-processing areas.  

Addressing the ambiguities in the policy would enhance the effectiveness of the amendment. Nevertheless, by and large, the amendment underlines a strategic shift towards providing solution-based accommodations to counteract the loss of tenants as a result of the revocation of direct tax benefits in 2020. Notably, SEZ entities will be able to foster a symbiotic relationship with domestic tariff area businesses leasing floor space within the same buildings. This adjustment should cultivate a mutually beneficial financial ecosystem. Any concerns over foregoing the tax benefits available to SEZ units should be assuaged as insights published by market leaders indicate that improved occupancy rates and subsequently augmented rental income will far outweigh the initial costs. This development will draw the attention of global investors, leading to strategic economic growth of our country.

On the whole, the amendment will help in reducing SEZ vacancy rates by enhancing leasing prospects for IT or ITeS companies in non-processing areas and in increasing integration amongst IT or ITeS companies engaged in both international and domestic segments being housed within the same premises. We can be certain that the new policy forecasts positive ramifications for both SEZ entities and their domestic counterparts. 

About the authors: Sushant Shetty is a Partner, Arati Sawant is a Group Head and Disha Malkani is an Associate at Fox Mandal Solicitors & Advocates.

Disclaimer: This article is for informative purposes only and no part of it shall be construed as legal advice.