Outsourcing: Is India Losing Its Competitive Edge?

India has historically been regarded as a favorable country to outsource skilled services such as manufacturing, IT, programming, research and development, distribution and call centers. The declining strength of the dollar, rising wages and bottlenecks in urban infrastructure no doubt will aggravate existing outsourcing arrangements. However, another factor is starting to cause U.S. technology companies to rethink their strategies for outsourcing skilled services to India: taxation.

Over the past several years, India has been enacting and enforcing new, more aggressive tax laws and enforcing them. Among the areas of taxation attracting significant attention from the India Department of Revenue are inter-company transfer pricing, income tax treaties and permanent establishment. In addition, the new 2008 Finance Act, which received approval from the president of India on May 10, also contains new laws that will impact U.S. technology companies with operations in India.

Inter-Company Transfer Pricing

Inter-company transfer pricing relates to how much a company (e.g., a wholly owned Indian subsidiary) should charge for “functions,” such as providing services, selling tangible or intangible goods and funding, performed for a related party (e.g., a U.S. parent or principle) in a controlled transaction. The inter-company price charged for these functions will affect the allocation of total profit among the controlled group of companies.

This is a major concern for fiscal authorities who worry that multinational entities may set transfer prices in cross-border transactions to reduce taxable profits in their jurisdiction. As such, transfer pricing regulations and enforcement has made transfer pricing a major tax compliance issue for U.S. technology companies.

Inter-company markups for services, with research and development being one of the most popular services provided by Indian affiliates, has been the subject of much pain in recent years for multinationals doing business in India. The markup for Indian service providers generally tends to be substantially higher than that for service providers in other countries. In other words, service providers in India are typically subject to more income tax than service providers in other countries. This creates a dilemma for U.S. technology companies wishing to optimize their worldwide effective tax rate.

Income Tax Treaties

India has a number of bilateral income tax treaties (often called Double Taxation Avoidance Agreements or “DTAA”) with other countries. The primary purpose of DTAAs is to prevent double taxation of income earned in one jurisdiction by a citizen or resident of the second jurisdiction. India has been more aggressive in restricting the benefits of bilateral DTAAs by renegotiating them with their treaty partners. An example of the renegotiations is the removal of the capital gains exemption clause, such as that with the United Arab Emirates, which allows capital gains taxation in both jurisdictions. Another area that India is renegotiating with their treaty partners relates to the limitation of benefits, such as that with Singapore.

These renegotiations restrict the ability of U.S. technology companies to insert holding company structures over their Indian partnering businesses by requiring the company to have an increased level of operating activity. Formerly, the U.S. companies would act merely as holding companies and would therefore reduce their withholding tax. As a result, U.S. technology companies will likely pay more tax on remittances from their Indian subsidiaries.

Permanent Establishment

Indian tax authorities have been active in enforcing taxation related to “permanent establishment.” The concept of permanent establishment is the main instrument for a country to establish taxing jurisdiction over a foreigner’s business activities.

Recent trends in Indian courts have been on establishing precedent in cases involving services rendered in India using the Internet and sales and marketing service arrangements. In addition, India has implemented a formulary approach to apportion profits to permanent establishments. These trends have the effect of capturing more business activities of foreign multinationals into the Indian tax net.

The 2008 Finance Bill of India

The 2008 Finance Act’s following provisions will impact U.S. technology companies’ business in India:

• Cross-border transactions. The India Department of Revenue is addressing cross-border transactions with more scrutiny. In particular, India will now tax gains on share transfers of offshore companies. The catch here is that this tax will be retroactive to transactions entered from June 2002, subjecting many cross border transactions from prior years to Indian tax. This comes in the wake of the Indian Department of Revenue realizing the possibility of collecting millions in tax revenue from these transactions.
• Tax holidays for technology companies. The Finance Act has not extended the tax holiday for units registered under the Software Technology Parks and Export Oriented Units regulations. Therefore, companies will have their tax holidays in India expire on March 31, 2009.
• Capital gains. The short-term capital gain rate has been increased from 10 percent to 15 percent. This is mainly an attempt to decrease the volatility of the Indian stock market.
• Increase in excise tax. Packaged software will now be subject to the same 12 percent excise tax that has historically been assessed on customized software. This excise tax, which is a central levy on manufacturing or production of goods in India, is an increase from the eight percent level previously enjoyed by packaged software manufacturers.
• Expansion of the service tax net. The Finance Act added a wider array of services subject to the 12.36 percent service tax. The two main additional services impacting the technology industry are services relating to information technology software for use in business or commerce, and Internet telecommunication services. This includes services provided in relation to Internet backbone services, carrier services, Internet traffic services, telecommunication services and access services.
• Filing deadline shortened. The time corporate taxpayers are required to file their returns was subsequently shortened, pushing the due date up from Oct. 31 to Sept. 30. As a result, more companies may be captured in the penalty net.
• Scientific research deduction. In order to promote the outsourcing of scientific research by small and medium-sized enterprises, the Act provides a weighted deduction of 125 percent of the amount paid to an Indian company engaged in research and development activity.

Despite these negative trends and recent tax policy developments, benefits such as its skilled labor force (that is fluent in English), democratic government, robust domestic economic growth and entrepreneurial energy still currently make India one of the top choices for outsourcing. However, competition from other low-cost destinations such as South Africa, Philippines, Vietnam, China and Eastern Europe have entered the stage and begun to challenge India as the preferred choice for outsourcing skilled services of U.S. technology companies.