The outsourcing movement to India is seeing an increase in the number of cross border companies that develop their products or perform services almost exclusively in India, while marketing and developing front facing tools with clients in the USA or other key markets.

Indians in the U.S. are particularly active in this area and today, venture capitalists are pushing many start up companies to do the same thing. Creating such an arrangement requires some amount of structuring and an analysis of several business and legal issues.

The first question would relate to which company would be the holding company and which company would be the subsidiary. Generally, this is most likely depends on the residency of the founders—if they are in the U.S., it is very likely that the U.S. company will be the holding company.

The question then arises as to where the profits of the combined entities should lie—in India or in the U.S. One would assume that a higher profit would flow to the entity that takes on more risk. This is likely to be the company that contracts with the customer, since this company takes on the contractual liability.

It is typical for the U.S. company to contract with the customer and have a back-to-back contract with its Indian subsidiary for the performance of the work. In this arrangement, a larger part of the profit is likely to arise in the U.S.

However, some companies have considered an opposite approach—having the Indian company contract with the customer and retain a larger share of the profits in India. A key reason for this is the prevailing tax holiday in India—if the profits flow into the Indian company, the profits are not subject to any tax.

The Indian company would then contract with the U.S. company to perform marketing services. Though the U.S. company would earn income on this, the income offered to tax in the U.S. under this arrangement is likely to be much less than if the U.S. company contracts directly with the customer.

There are several drawbacks to having the Indian subsidiary contract with the customer. First, a customer may prefer to contract with a company in its home country, rather than with the Indian subsidiary. Especially, if the contract is to be governed by the U.S. laws and disputes need to be resolved in the U.S., the customer would prefer to contract with the U.S. company. This is largely a matter of perception in relation to enforcement issues that can be overcome, as is often the case with the large Indian software companies.

Then there are issues relating to a future IPO. If the U.S. company is to go IPO, would it be preferable to keep the profit in the U.S. company? Or can rules relating to consolidation of accounts of subsidiaries be sufficient from a legal perspective and in terms of perception of would-be investors?

Of course, keeping profits in the Indian company does not rule out repatriation of dividend to the U.S. holding company. However, this will encounter payment of dividend distribution tax in India and this reduces the cost effectiveness of this option. In relation to repatriation of dividend, one would need to consider whether a tax credit would be available in the U.S. This has to be examined carefully since the dividend distribution tax is levied on the Indian company, not the U.S. shareholder. Further, this would be beneficial only if there is sufficient tax payable in the U.S. to make use of the credit.

Perhaps one of the most important aspects of this issue relates to exchange control issues. Indian law regulates the payment of foreign exchange out of India by an Indian company. This means that if the Indian company has to make a payment in foreign currency for some business purpose, it may not have sufficient flexibility to do so under Indian law. On the other hand, if the money were available with the U.S. company, its flexibility would be far greater.

In structuring the above arrangement, one would need to consider “transfer” pricing regulations in both countries. In India, a cost-plus arrangement is generally preferred. However, there have been some challenges faced in countering the attempts by the tax authorities to fix a pricing that is on par with the pricing offered by non associated enterprises.

For example, the tax authorities may insist that the Indian subsidiary charge the same price as a third party Indian service provider. This is not feasible considering the fundamental differences in the arrangements. The third party Indian service provider has to bear the risks of entrepreneurship, marketing costs, interest costs, and so on. The Indian subsidiary is merely given whatever work is assigned by the parent company and is paid on a cost plus basis.

Recent moves by the Indian tax authorities are causing some concerns in the structuring of these arrangements. The Indian tax statute prescribes that a foreign company will have a business connection in India if the Indian company engages in certain activity on behalf of the foreign company and thereby, the profits of the foreign company would be subject to tax in India.

This is different from the transfer pricing issue—it is focused on the income of the foreign company itself, not on ensuring that the Indian company earns an arms length price, regardless of whether the two have a satisfactory transfer pricing arrangement or not.

The Government in India has muddied the waters somewhat in its approach. The issue largely related to situations in which the Indian company could execute contracts on behalf of the foreign company—like a call center operator concluding a sale of goods to a client in the U.S.

The tax authorities have however created a distinction between core and allied activities, taking the view that the sale of goods example above would not create a business connection since it is an allied activity but other activities that do not appear to be contemplated by the statute would create a business connection—such as software development.

This issue is creating some unease among the foreign companies does R&D and BPO work in India and needs to be resolved quickly so that investor confidence is not eroded in the Indian system.

Funding the Indian company also requires some structuring. Often, companies are keen to fund the Indian operations through debt, since this is seen as an easier route for return of the capital/principal. Funding through debt, or what is referred to in India as an External Commercial Borrowing (ECB) has some hurdles, the main one being that there is a minimum period of maturity—the loan cannot be returned before this period.

A company may however be funded through its own earnings – by granting an advance against equity. Though the interest rate is capped and the company needs to export services for which the advance has been made within a prescribed time, this option is reasonably attractive and is increasingly being adopted by companies.

Given the strong outsourcing movement to India, the possibility of more complex structures are very likely in the future. From the Indian perspective, it is important that the government continue to maintain a stable regime that leverages on the countries obvious advantages in terms of costs and talent.

Stephen Mathias co-chairs the Technology Law Practice of Kochhar & Co, a law firm in India. He is a renowned information technology lawyer 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