India to Tax US Outsourcing Firms

A new tax rule for U.S. businesses that have moved software development, customer service, and research and development work to India was issued by the Finance Ministry of India (GOI) on September 28. The circular, titled “Circular 5/2004,” replaces a circular issued by the Finance Ministry’s Central Board of Direct Taxes (CBDT) in January.

It is important that everyone involved in implementing outsourcing arrangements understand this new tax rule. The consequences of this tax rule could alter the offshore outsourcing landscape more dramatically than any piece of legislation pending in the U.S. right now.

As the Indian and U.S. economies become increasingly interdependent, changes in the business tax system of one country will increasingly impact businesses and consumers in the other country.

Retroactive Application

This new Indian tax rule, which could be applied retroactively, appears to circumvent the GOI’s previous granting of income and sales tax exemptions for 10 years for operations in India that primarily serve non-Indian clients and that are registered with the Software Technology Parks of India (STPI).

Those tax exemptions have attracted substantial foreign investment in India’s tech sector and are the primary driving force behind domestic Indian firms entering the software development, call center and customer support fields. Almost all Indian firms in those fields have experienced excess capacity for the last five years.

By only taxing foreign firms that have captive operations in India, the rule will drive outsourcing business to domestic Indian firms, thereby increasing their capacity utilization and enabling some marginally profitable domestic firms to remain in business. The circular does not set a tax rate.

Tax Rates

According to Sunil Kumar, a Delhi-based banker turned operations manager at Cleave Global e-Services (which also owns accounting offices in New Delhi and Chennai), the corporate income tax rate for firms that are not covered by STPI is 36.59 percent.

Sunil computes the tax rate as follows:

According to Sunil, the total tax rate is 35 + 0.875 + 0.7175 = 36.5925 = 36.59. He said that it is unlikely to be applied retroactively to the period before September 28.

Impact on Domestic Firms

When asked how the new circular would impact Cleave’s call center and back-office accounting business for U.S. clients, Sunil was decidedly upbeat.

“This is a good and smart move on the part of the government,” Sunil said. “We are not affected at all by this,” he said, referring to Indian-owned outsourcing firms. Sunil said that the circular brings clarity with regard to the confusion that had existed previously in the Indian outsourcing business community.

As explained by Sunil, the CBDT assumes that foreign firms are not being taxed by their home governments for income generated by captive operations in India. If these firms are taxed now, Sunil said, any amount taxed by India could be deducted under reciprocal tax agreements from the amounts due in those firms’ countries of origin.

In the period between the January circular and the new circular, the CBDT was reviewing its reciprocal tax agreements with other nations’ governments so as to avoid having India’s tax regulations come into conflict with those agreements.

Problems for U.S. Firms

From a North American perspective, there are five major issues with the new tax circular:

1. Rates and rate base: How to tax revenues for activities that are conducted within a corporation presents a host of problems. The tax circular targets fully or partially captive facilities, referred to as permanent entities in the circular. Those facilities are not operating under competitively priced, externally transparent contract structures with their parent firms.

Even in the case of outsourcing contracts between unrelated business entities, it is not uncommon for an outsourcing arrangement to fail to produce profits for any of the parties to those contracts.

The IT industry in India (and also to some extent in the U.S.) is still so young and in such a state of flux that actual profitability is oftenmore of a goal than an actual outcome. Money might change hands, but often only the U.S. clients far upstream or far downstream will see any economic benefit from an outsourcing arrangement.

Prior to the circular of September 28, the Indian Finance Ministry had discussed the use of presumptive tax rates, which assume that a certain percentage of every outsourcing transaction carries a built in profit rate. For example, it may assume that 10 percent of the value of an outsourcing contract is profit, so income tax would be applied against that 10 percent amount, regardless of whether the transaction actually resulted in profits for any of the parties.

The method for determining profits named in the circular of September 28 is the “arm’s length principle.” Sunil Kumar characterizes this method as taking prevailing market prices into account to determine how much of a profit should have been realized by the permanent establishment in India.

2. Bureaucratic hurdles: My concern with the arm’s length principle is that covered firms may have to set up mini bureaucracies of their own in order to deal with the CBDT’s bureaucracy as that agency attempts to apply the arm’s length principle on a case-by-case basis. We see this already in how domestic Indian firms attempt to gain access to promised tax exemptions from taxes (called octroi) on the internal state-to-state transport of goods for export-oriented IT facilities.

The bureaucratic hurdles associated with domestic Indian firms attempting to obtain octroi exemptions force many Indian IT firms to simply buy their equipment from non-Indian suppliers. If domestic Indian firms (who are often well connected politically) cannot gain access to octroi exemptions, then it will be exponentially harder for foreign firms to remotely navigate the far more complex and subjective terrain of the arm’s length method for assessing corporate income tax liabilities.

The tax base in the September 28 circular is not just restricted to transactions between an Indian permanent entity and its foreign head office. The tax circular states that if an Indian-based permanent entity of a foreign firm concludes contracts independently of the foreign firm, then the profits of those contracts from business activities carried out in India will also be subject to corporate income tax.

Gentlemen, start your bureaucracies.

3. Reciprocity: U.S. firms may be paying little or no corporate income tax in the U.S., so the opportunity to deduct new taxes paid to the GOI will not be fully achieved by corresponding deductions from those firms’ U.S. tax bills. In practice, there may be little actual reciprocity afforded by the new tax circular.

4. Fairness: The new circular creates an unfair playing field between U.S. firms with permanent entities in India and U.S. firms like mine that merely manage outsourcing projects conducted at facilities that are owned by Indian investors. Neither my InternationalStaff.net nor its customers are subject to taxes under this new circular, but that doesn’t make the new tax regime a fair or equitable one.

Firms like Cleave and InternationalStaff.net do not need favorable tax rates to compete aggressively with large vertically integrated outsourcing service providers such as Accenture or GE, which stand to assume substantial tax liabilities under the new circular. Our prices and service levels already allow us to compete successfully with those bigger, slower firms. We have been in India longer than most of thosebig firms and we will remain there long after companies like G.E. have sold off their Indian assets and headed for other shores.

I expect that the provisions of the September 28 circular will be appealed in Indian courts. One of the grounds for appeal is that the provisions appear to contradict commitments made by the GOI for 10-year tax holidays to firms registered with STPI.

The courts in India have not been afraid to stand up to the GOI on other IT tax schemes. At the end of 2003, Lucent’s Indian subsidiary won a case in Bangalore regarding taxes on the importation of customized software for call centers.

If the courts strike down the September 28 circular, I predict that the CBDT will try to cast its net again.

5. Stability: The new circular indicates that there is confusion within the GOI’s Finance Ministry as to how to raise new revenues from taxpayers that do not vote in Indian elections. Confusion breeds instability.

For U.S. firms like InternationalStaff.net, which is preparing to shop around for funds to build two captive IT outsourcing facilities in India to handle existing inbound client volumes, the new tax circular indicates that it would be prudent to hold off until the dust settles and an Indian investment strategy can be finalized according to tax conditions that can be expected to be in place for 10 years.

One point of contention between InternationalStaff.net and its partner firms in India is the fact that we also provide marketing assistance for IT outsourcing firms in Pakistan and Sri Lanka. Managers of the Indian IT firms that we work with have questioned why we would be placing business in those other two countries, arguing that India represents a more stable outsourcing destination.

While my firm has been and continues to be strongly committed to doing business in India, the CBDT’s casting and recasting of its tax net to cover outsourcing and R&D activities makes those other two countries considerably more attractive as outsourcing and investment destinations than they would otherwise appear.

Pakistan’s 15-year tax holiday for outsourcing service providers has not been tarnished by any attempt at circumvention by that government. Nor have we seen any signs of instability or unpredictability from the government of Sri Lanka towards its emerging IT industry.

Both those countries need and deserve U.S. help in finalizing their regulatory systems for technology and telecommunications industries, but as of yet, neither country appears to have done anything dramatic to discourage U.S. vendor or investor confidence.

Investment Strategies

The safest approach to investing in India now appears to be to form independent entities in India. An American firm can still provide an allied Indian IT service provider with marketing services, quality assurance and assistance with strategic positioning. But that Indian entity will have to go out on its own and obtain other clients in order to prove that it is not a permanent entity of its U.S. ally and tothereby stay out from under the CBDT’s tax net.

In light of the new tax circular, GE’s move to sell off its Indian outsourcing service facilities represents a brilliant move and one that will probably be imitated by other U.S. firms.

As someone who has traditionally been bearish about valuations of offshore outsourcing facility assets, GE’s asking price of a billion dollars for its Indian assets is twice as expensive as those assets appear to be worth. IT outsourcing facilities age quickly, technologies need updating, and GE’s commitment to competitively shop its outsourcing work around to other vendors after a brief honeymoon period all serve to reduce the market value of those assets.

If GE cannot sell its assets off in a timely manner, it may need to consider selling them in pieces.

Possible Reorganizing

The CBDT’s new tax circular will spur American firms with permanent entities in India to consider reorganizing those entities to be in line with the strategy that a firm investing on the ground in India for the first time would use.

In other words, the American entity would spin off its assets into firms with mixed Indian-U.S. ownership, and those firms would then accept outsourcing contracts from its original parent firm and third parties.

As new Indian tax schemes for American IT firms are developed, those developments will be covered here.