INTERNATIONAL COMPANIES ARE INCREASINGLY turning towards outsourcing as a means of cutting costs. India is the leading destination for outsourced software development; call center and BPO related work. Companies are either outsourcing to third party Indian vendors or setting up their own facilities in India. The sheer volume of outsourced work in India is leading to different types of hybrid outsourcing structures.

One can increasingly see projects involving a joint effort from the Indian subsidiary of the customer and the third party vendor. The customer may look to the subsidiary to manage the outsourcing effort in India, including sending out RFP’s, evaluation of vendors, co-ordination of projects and acceptance testing. There have also been projects where two or more vendors work jointly on projects out of the subsidiary’s facilities. It is also possible that the subsidiary may often need additional resources from third party vendors to implement projects.

A whole host of legal and tax issues arise in these situations. These issues stem from the tax holiday that is available to Indian vendors. Indian software companies get an income tax holiday on profits arising from the services they render if (a) the services are exported out of India; and (b) the payment is received in convertible foreign exchange.

In joint outsourcing projects, if the work product is delivered by the vendor to the subsidiary in India rather than to the ultimate customer overseas or is paid for in Indian rupees, this would not amount to an export and consequently, the vendor would be taxed on the profits arising from such work. Ultimately, the customer will have to bear the tax burden through higher rates. Consequently, the outsourcing arrangement needs to be carefully structured to take advantage of tax benefits.

This may involve ensuring that the vendor exports the work product directly and receives payment in foreign exchange from the overseas customer. This may not work out where the subsidiary is leading the project and requires additional resources. The local management of the subsidiary may also have its own objectives in terms of profitability and maximization of tax benefits.

Certain changes made in India’s Import Export Policy are relevant. The policy makes it clear that an STP unit can sub-contract work to another STP or to companies within the domestic tariff area. However, only one company can claim the tax benefit and this would be the company that makes the actual export.

Another change that is significant is the relaxation of the minimum export commitment. Under the previous regime, the total foreign exchange inflow earned by the vendor needed to be at least 10% more than the outflow. Further, there was a minimum export requirement in revenue terms. Now, the foreign exchange inflow only needs to be more than the outflow, that is, the vendor must be a positive net foreign exchange earner.

These changes create flexibility in outsourcing projects, particularly joint outsourcing projects. The subsidiary can now outsource to a third party vendor and need not be concerned about meeting minimum export earnings as long as it is a positive net foreign exchange earner. This is particularly beneficial for a customer who sets up a subsidiary to co-ordinate outsourcing projects with no clear intention as to the extent to which the subsidiary will be involved in development work.

Joint outsourcing projects may involve a joint corporate structure as well. For example, the customer may require the customer to set up a separate subsidiary for its work. The customer may make an investment in the separate subsidiary and later on, may consider taking over its ownership. Previously, there were restrictions on transfer of corporate ownership for tax exempt entities but thankfully, these have been removed in 2003.

There is also the possibility that the customer may take over the operations of the vendor other than through a stock transfer—this may involve a transfer of employees, equipment, etc to a subsidiary of the customer. In this situation, the customer’s subsidiary in India may be affected by restrictions that prevent these types of tax exempt units from being set up through re-organization of existing units. Though tax rules are clear on how much of used equipment can be employed by a newly formed tax exempt entity, the law is not clear on whether transfer of employees, customer contracts and receivables would affect the new subsidiary’s enjoyment of the tax holiday.

Customers often need to set up supervisory units in India —a handful of employees or perhaps only one employee. In this scenario, the customer needs to consider from a foreign investment perspective whether it would be setting up a business presence in India and therefore, require permission to open a branch office. The customer also needs to think of PE (permanent establishment) issues that could arise under tax law.

As outsourcing projects continue to flow into India, more complex structures are likely to be implemented. India could become the services hub for the world where almost every type of service that can be performed remotely would be performed in India. The government needs to constantly evaluate whether restrictive provisions can be further liberalized while continuing with measures against abuse of tax benefits. Customers and vendors need to carefully navigate through these rules so that tax advantages can be maximized while meeting business objectives.

Stephen Mathias co-chairs the Technology Law Practice of Kochhar & Co, a leading law firm in India. He is one of the most renowned information technology lawyers in India and cited by Global Counsel as the Leading Lawyer in India for Information Technology and E-Commerce legal work. He can be reached at stephen.mathias@bgl.kochhar.com