In brief
The article highlights the legal, tax and administrative challenges faced by operational SEZ units transitioning into Domestic Tariff Area units. Key issues include uncertainty during the approval period, inconsistent inventory valuation dates, excessive duties on domestic assets, and full-value taxation of raw materials. Businesses may also face unrecoverable reversals of pre-GST VAT and excise benefits, demands for historical service tax exemptions, and GST registration blocks at the same premises.
Introduction: The reality of moving out
Setting up a unit in a Special Economic Zones (SEZ) used to be straightforward and attractive because the Government wanted to attract businesses with tax breaks. However, now that the popular income tax holiday under Section 10AA has ended 1, the incidence of MAT/AMT on SEZ profits continues, which when coupled with the disparity in tax treatment for domestic clearances by SEZs, is forcing many companies to look for the exit door.
In simple terms, exiting an SEZ is called ‘de-bonding’. The main law governing this is Rule 74 of the SEZ Rules, 20062. It has been repeatedly observed that this rule is meant for a business that is completely shutting down, packing up, and leaving. The law completely ignores the common situation of a running factory that wants to stop being an SEZ unit but wishes to keep manufacturing goods from the exact same building as a normal, local company—known as a Domestic Tariff Area (‘DTA’) unit. The article explicitly highlights various severe practical problems that companies face during exit.
Waiting period and the valuation struggle
A working factory cannot simply turn off its machines while waiting for government paperwork. Yet, the moment a company applies for and gets an ‘In-Principle Approval’ (‘IPA’) to exit, they enter into a regulatory grey area. The authors feel that units routinely face severe administrative deadlocks:
- Business disruptions: We have come across numerous instances where local customs and zone officers challenge how the factory should buy raw materials or bill customers while the exit application is pending. The law gives no clear guidance on how to run day-to-day operations during this middle phase.
- The date issue: It is also difficult to decide the exact date to compute the tax value of the factory’s inventory. Officials often raise concern whether the taxes should be locked in on the day the company applies to exit, the day the exit is approved, or the day the final de-notification paper is signed. Since stock levels change daily, this confusion leads to unpredictable tax bills.
Asset valuation trap: Local vs. Imported Goods
When a company leaves an SEZ, it must pay back the tax exemptions it enjoyed on its remaining stock, factory equipment, and raw materials. In our experience dealing with audits during de-bonding, the calculation methods create heavy financial friction:
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Local sourcing oversight: Exit rules do not differentiate between domestically bought goods and imported goods. This means local Indian materials face the same complicated customs re-assessments as foreign imports, resulting in artificially high tax demands.
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Raw materials vs. Machinery: While the law allows companies to pay depreciated taxes on old machinery based on its usage over time3, raw materials must be taxed at their full, original value. Other export schemes, like Export Oriented Units (EOUs), are allowed to transition their raw materials smoothly into duty-free export programs like the Advance Authorization scheme. However, SEZ rules do not offer such flexibility, forcing companies to pay massive cash amounts upfront just to clear out their inventory.
Legacy tax trap: Old VAT vs. New GST
For factories that have been operational since prior to 2017, the exit process uncovers an intricate conflict between old and new tax regimes:
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The repayment dilemma: Tax officials often demand companies to pay back old pre-2017 benefits like Value Added Tax (VAT) or central excise exemptions. However, the departments are deadlocked on how to take the money.
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Unrecoverable costs: This creates a dangerous financial trap. If a company is forced to pay these reversals under old state laws, it is structurally impossible to claim that money back as an Input Tax Credit (ITC) under current GST rules. The payment simply becomes a permanent, unrecoverable loss for the business.
Services claw-back and digital registration blocks
Physical goods leave a clear paper trail, but the treatment of intangible services—like the fees paid years ago to architects, builders, or IT consultants to set up the factory—is a major legal battleground:
- Demanding money back: Because the law does not state how long a service is supposed to ‘last,’ companies contend against notices demanding pay back historic service tax exemptions, aggressively claiming the factory did not stay open long enough.
- Address lockout: On the administrative side, GST laws require an SEZ unit and a normal DTA unit to be treated as completely separate entities4. When trying to transition, companies regularly hit a wall with the government’s IT portal. The system frequently blocks a company from registering a new DTA tax ID because the portal flags that an active SEZ unit is already registered at that exact same physical address. This digital glitch can freeze incoming supply chains right at the final stage of exit.
Authors’ view & feedback
The Authors feel that a wide spectrum of corporate transitions shows that while the Government made it easy to enter an SEZ, exiting one requires navigating a disorganized web of competing tax departments. Though temporary fiscal policies like Notification No. 11/2026-Cus. have attempted to bridge capacity underutilization caused by sudden global trade disruptions, their restrictive one-year caps clearly highlight that temporary concessions cannot substitute structural reform.
Considering the current global situations, Government should consider removing the ongoing valuation and regulatory disparities built into Rule 74 that artificially hinder or delay a clean transition out of the SEZ. In any case, it is absolutely essential for policy-makers to simplify the complex process of exit to protect operational capital.
Consequently, we strongly recommend that the industry collectively approach the Ministry concerned to demand long-term structural amendments that ensure a smooth, predictable path towards exit from SEZ scheme. Relying on a generic corporate shutdown checklist will almost certainly lead to trapped working capital, frozen tax IDs, and expensive lawsuits. A successful transition requires a customized strategy—one that separates local assets from imports, resolves old tax regime conflicts, and fixes registration blocks long before filing the first document with the Development Commissioner.
Footnotes
1. Section 10AA of the Income Tax Act, 1961 (as amended by the Finance Act, 2016) introduces a strict sunset clause restricting direct tax holidays exclusively to SEZ units commencing commercial operations before 1 April 2020.
2. Rule 74(1) of the Special Economic Zones Rules, 2006 mandates that a unit opting out of an SEZ must pay applicable customs duties and taxes on its remaining inventory, including capital goods, imported/indigenous raw materials, components, components, and finished goods in stock.
3. Rule 49 of the Special Economic Zones Rules, 2006 sets the exact mathematical formula for calculating how much machinery values drop over time for tax purposes.
4. Section 25 of the Central Goods and Services Tax (CGST) Act, 2017 legally splits co-located SEZ and DTA operations into separate tax accounts, creating registration overlaps.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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