Business

INDUSTRY ANALYSIS

Outsourcing Could Be Affected by Indian Tax

The Indian government has made various proposals recently to tax foreign firms sending outsourcing work to India and firms that import and resell shrinkwrap software in India. Proposals range from setting a simple 4 percent tax on the value of outsourcing contracts to a more complex system of taxing the global income of corporations with standalone operations in India.

These proposals could have a greater impact on offshoring activities than any of the legislative proposals being made in North America to moderate the amount of information technology and back-office work being outsourced.

The Indian proposals have been issued as circulars by that government’s Central Board of Direct Taxes (CBDT). Although they have the force of law, these circulars are largely not being enforced yet because the CBDT is conducting research on how implementation of the circulars may impact international tax treaties.

The circulars are expected to be superceded by newer ones that provide definitive guidance on where and how India’s taxing authority will be applied to the IT industry and its clients. However, the events of the last three months have made it clear that Indian authorities intend to tax IT outsourcing and R&D work conducted in their country for foreign consumption, and they intend to tax software imported into their country.

Strategy Being Reassessed

What remains are formal determinations of how the government will go about collecting revenue and at what points it will be collected. Also to be determined is the extent to which retroactive ratemaking will be utilized. Remember that botched outsourcing project that everyone lost money on three years ago? Hold onto those records; you may owe taxes on it.

Regardless of which tax schemes are ultimately implemented, these moves by what Indians refer to as “the Centre” are leading to reassessments of global strategies by both clients and competitors of India’s growing IT sector. Even if top officials in India’s ruling coalition government act decisively to delay the implementation of new taxes, the confidence that India enjoys as a preferred offshore destination will be impacted by recent events for years to come.

I’ll review current proposals and the contexts in which they appear and identify sources for additional information along with options for macroeconomic reforms that would eliminate the need for new taxes.

Existing Tax System

There is a 10-year corporate income tax and sales tax holiday granted for IT operations in India, regardless of ownership type. These IT operations (at least the domestically owned ones) have to receive 75 percent or more of their revenues from overseas sources to maintain their tax exemptions. Without this holiday, the corporate income tax for foreign firms is 40 percent.

The sales tax rate is 12 percent in the states, but only 3 to 4 percent in Union Territories. Without the sales tax exemption, more IT firms would have located in Union Territories, most of which were outside of the British Raj, either because they were colonies of other nations, such as France and Portugal, or because they were small independent states at the time of India’s formation in 1947.

Many Westerners outsourced work to India on the assumption that they would be covered by that 10-year corporate income tax and sales tax holiday. Many Western firms embarked upon offshoring efforts to India without the foresight to put together offshore tax strategies first, before they incurred substantial offshore tax liabilities.

The Centre is moving quickly — by Indian standards — to circumvent the exemptions granted to IT facilities serving international clients. Circumvention is being achieved by going upstream and pursuing the clients of those facilities.

The tax regime in India is by far the largest single factor accounting for the number of domestic Indian firms involved in software development and call center services that work for Western clients. It is not uncommon to encounter fully staffed software development facilities in India that have been in existence for three years without attracting a single contract, foreign or domestic.

There are a few fully staffed call centers seeking to hit that mark, such as United Telecom’s UI-CL call center division, although these commercial entities’ lifespans tend to be shorter before other economic realities set in.

Tax Exemptions

Tax exemptions have been the sole reason propelling many Indian firms to enter the IT field. By having non-IT divisions of a corporation pay the bills for an IT operation, Indian corporations can claim whatever income comes from an IT division as tax exempt. This has led the call center industry in India to be occupied by numerous firms with no real interest in conducting customer service work at Western standards, only in taking advantage of tax exemptions.

At the beginning of 2003, we conducted an overview of the Indian call center industry to follow up on a survey we did in 2001, when there were only 35 call centers in India with international private leased connections (IPLCs, primarily T1s) to the United States. Among the top 10 firms that were examined in 2001, 60 percent have failed and closed. Ten percent have survived but are not profitable. They are supported by subsidies from elsewhere within their firms. Thirty percent of the firms from 2001 have been sold and appear to have made money overall, largely due to inflated sales prices.

In 2003, according to interviews with executives at Indian call centers, we found that out of more than 500 call-center firms with connections to the United States, fewer than 100 were profitable. Having 20 percent of an industry in the black has led to consolidations, but has not dissuaded new entrants from joining the field.

Many of the entrants to the call-center field in India since it began in 1999 have been funded by money that was never declared for tax purposes. This money is known as black money. It is often found among firms involved in construction, gems, jewels and brewing. There is one notable exception to this rule, a world-class call center in Mumbai funded by a construction company.

Collection of Octroi

Now in India, just as it was during colonial and Mughal times, the easiest types of taxes to collect were those that can be collected on goods in transit. The use of internal customs duties avoids the issue of black money. The British employed 12,000 men to maintain a 2,500-mile-long hedge of cactus called the cactus line. The cactus line was initially set up to tax internal salt shipments, but was also used to collect revenue from the shipment of bulky goods.

The cactus line was maintained until the end of the Second Afghan War in 1879. It was ultimately replaced by roadblocks, which in many areas of the country are maintained by municipal workers, many of whom are former soldiers. On Remount Road leaving the Port of Calcutta, several roadblocks in a row can sometimes be seen as trucks attempt to exit the port area.

State and municipal governments collect and use funds from inland goods-transit duties, called octroi. Many municipal governments are highly dependent on octroi to pay the salaries of city workers. Octroi collection points can slow goods transport while tax amounts are determined and paid. Private agents may be retained by shippers to help negotiate and expedite the assessment of collection of octroi. This provides opportunities for corruption.

The central government does not collect octroi. Instead, it collects customs duties on goods imported into the country. Indications of the unevenness of the collection of customs duties may be found in markets in Chennai and Calcutta, where smuggled goods are sold openly.

Drag on Economy

High customs and octroi duties have slowed the Indian economy for hundreds of years and made it an expensive place to conduct certain types of businesses. Clothing items such as blue jeans and dress shirts are more expensive in India than in the United States, for example. No cell phones are manufactured in India.

To upgrade the personal income tax system in India and to institute property tax systems would cause political difficulties for any government that attempted it. Efforts to pursue black money have been going for decades, with limited success.

The quickest way for a Byzantine government to raise additional revenues is to levy new taxes on the movement of goods and services from new, high-profile industries. If taxes target foreigners, that makes the government’s job easier. This brings us to current proposals for taxing foreign businesses.

Taxes on Software

In December 2003, India’s Central Board of Direct Taxes (CBDT) declared its intention to levy taxes on noncustomized software (shrinkwrap software) imported into India. The Centre held that payments to non-Indian firms represent royalty payments. The nominal tax rate on royalties is 20 percent, although the CBDT might adjust this rate according to the provisions of tax treaties with other countries.

In justifying the tax on imported software, the CBDT cited Singapore’s explicit tax emption for imported software. Since India had never set out such an exemption, the CBDT held that it had the authority to collect taxes from importers and dealers of imported software. The CBDT appears to be adopting a go-slow approach to levying this tax.

The CBDT had originally intended to levy taxes on both customized and shrinkwrap software. However, late in 2003 Lucent’s Indian subsidiary won a case in a Bangalore court regarding taxes on the importation of customized software for call centers. The Lucent decision is seen as applying to other types of customized software, but not to shrinkwrap software.

Shrinkwrap OEMs and resellers are under severe price pressures in India due to piracy. Taxing shrinkwrap products would encourage piracy and discourage the transfer of modern technologies to India.


Anthony Mitchell, an E-Commerce Times columnist, has beeninvolved with the Indian IT industry since 1987, specializing through InternationalStaff.net inoffshore process migration, call center program management, turnkeysoftware development and help desk management.


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