Bangalore: A new tax rule in the European Union (EU) is making the light at the end of the tunnel for Indian IT service companies look a little dimmer. Starting January 1, the 27-nation bloc plans to impose value-added tax (VAT) on services delivered from non-EU nations such as India, a move, which will put a renewed squeeze on profit margins of companies such as Tata Consultancy Services, Infosys and Wipro, offshore outsourcing experts and tech firms say.

European companies that outsource IT and back office work will be looking to extract better value out of their service providers to offset the financial implications of the tax, which could increase the cost of such projects by up to 25 percent, according to Nick Beecham, Partner at UK-based law firm Field Fisher Waterhouse.

Europe accounts for over a quarter of the $60-billion revenues of the Indian outsourcing industry. "Many businesses will already be doing this in the current economic climate. We particularly expect to see this happening with those outsourcing contracts that were signed two or more years ago at the height of the economic boom," Beecham said, expecting outsourcers to renegotiate billing rates at least 10-15 percent lower. Most contracts have terms included for addressing potential tax implications, but rates have been shrinking in any case for most outsourcing companies, a senior official at an IT company said on condition of anonymity. "Customers want to do more with less, and this tax issue can be an effective excuse for driving rates further down," he added.

Sridhar Vedala, Managing Director of outsourcing advisory firm Quantum Step, is of the view that projects will become more expensive depending upon VAT rates in different EU countries. "This would mean an increase of up to 15 percent in the UK and in continental Europe it's higher, as much as 25 percent," he said.

For India's tech firms, the tax comes with more challenges than just increased pressure on margins. It may force customers to reconsider their overall outsourcing strategy, they may insist on bringing back projects to locations in EU and insist on onsite delivery.

"This may not necessarily involve a move out of India, but a longer term consideration of service providers or zones within the country. There may also be a consideration of returning services back 'onshore' to the UK," said Belinda Doshi, Partner with Field Fisher Waterhouse.

An official at a European company, which outsources work to India, observed that even if the tax burden is not shared with Indian service providers, at 30-40 percent lower costs, offshoring still makes sense.