Issue dated - 15th September 2003

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Indian BPO firms wary of tax dragnet

The Indian government is all set to examine whether a non-resident company, which has outsourcing deals with a BPO outfit in India, is subject to tax in India. Industry bigwigs say that such a development would mean killing the goose that lays the golden eggs. CHITRA PADMANABHAN reports on whether such a move is likely to have adverse effects on the burgeoning BPO sector

Imposing tax on BPO clients will increase the cost of carrying out a BPO activity in India, says vaibhav parikh

There has been much hoopla about the Indian BPO sector and the opportunity for India in this space. The talk of India being a cost-effective destination with a vast pool of English-speaking manpower is nothing new. India has witnessed various stages of the evolution of the BPO sector and in recent times players are moving towards niche segments to offer specialised services. According to the Nasscom Strategic Review 2003, worldwide spending on BPO services totalled approximately $712 billion in 2001. IDC projects that by 2006, the potential ITeS BPO market may increase to $1.2 trillion with an overall compounded annual growth rate (CAGR) of 11 percent and that India is set to receive a significant share of this pie.

However, the BPO sector has met with a lot of resistance, mostly external, that may or may not have an impact on its growth rate. For instance, proposed legislation in the US which seeks to put restrictions on US companies outsourcing jobs to other cost-effective destinations, is seen as a threat to India by industry bigwigs. As of now the fiasco has subsided and Indian BPO firms have seen considerable maturity since then. But now the industry seems to have attracted yet another controversy and this time it is on the home front. In a recent development, the Indian government has set up a task force, which is all set to examine whether a non-resident company that has outsourced business processes to a BPO service provider in India should be subject to tax in India. So far, no such tax has been levied on the clients of BPO firms. This issue seems to have alarmed Indian BPO service providers who until now were nonchalant about tax issues, since the government had clearly stated that companies engaged in BPO activities were entitled to tax holidays under section 10A and 10B of the Income Tax Act.

How it all began

Admittedly, the fact that the government has refrained from taxing the BPO service providers reflects its co-operation towards the BPO sector. Further, this is also the most important reason why BPO service providers have so far been able to charge a lower service fee from overseas clients. If the government is so keen to promote the Indian BPO sector why all the talk of taxing clients of BPO firms?

This issue has suddenly become relevant due to the recent amendment to the definition of the term ‘Business Connection’ (BC) in the Finance Act 2003. "This amendment has laid down various cases wherein the relationship between an Indian agent and a foreign entity will be termed as a business connection," says Shefali Goradia, who heads the International Tax Practice at Nishith Desai Associates. The task force has been set up to examine whether a client of a BPO service provider comes under the definition of ‘BC’.

Under the Indian Income Tax Act of 1961 the term ‘Business Connection’ is used in relation to the concept of ‘Permanent Establishment’ i.e. permanent establishment of a foreign entity in India. According to Section 9 of the Income Tax Act, a non-resident having a business connection in India is taxed only in respect of income attributable to the Indian operations. The Finance Act, 2003 added an explanation to Section 9 of the Income Tax Act, laying out situations under which an Indian agent would constitute a business connection of such non-resident entity in India. The issues being examined by the Indian government are whether a BPO outfit concluding contracts on behalf of its foreign clients would constitute a business connection and whether the foreign client of the Indian BPO is liable to tax in India.

Sunil mehta says that it is now very important for the government to clarify India’s position at the earliest on such issues

Goradia further adds that this amendment is not very relevant in the case of pure-play BPO service providers since they already fall into the no-tax regime. Thus, as per the amendment, an Indian agent dependent on his non-resident principal will constitute a BC in India. This means that an Indian agent will be deemed to be a dependent agent if he carries out work mainly for the non-resident or its related entities. "The last amendment does not apply to BPO service providers since they carry out work for several different companies and are not dependent on one company. In short, they have numerous clients and are not exclusive to one non-resident company," explains Goradia.

Thus, the amendment is said to be relevant only in the case of companies who have set up wholly-owned BPO subsidiaries or captive BPO service providers. According to a BPO report brought out by Nishith Desai Associates, several foreign companies like General Electric, Dell, Prudential, etc, have set up wholly-owned subsidiaries in India. Some of the companies that have set up subsidiaries in India to render call centre activities also avail the facilities of sales call centre or telemarketing activities. "In certain cases, the scope of work of the Indian call centres is wide enough to include contract negotiation and conclusion. In such cases, the Indian BPO outfit can constitute a BC," says Abhishek Goenka, senior manager for corporate tax with Ernst & Young. Even in the case of wholly-owned subsidiaries, the tax implications have been addressed through transfer pricing agreements between the foreign companies and the Indian BPO outfit.

"India needs to look at this issue in practical terms. Imposing tax on BPO clients will increase the cost of carrying out a BPO activity in India. This might prove to be a case of killing the goose that lays the golden eggs," says Vaibhav Parikh, who heads the technology law team at Nishith Desai Associates. Nasscom vice president Sunil Mehta shared similar sentiments: "It is very important for the government to clarify India’s position at the earliest on such issues. But we are confident that the government will recognise the potential of this industry for the economy in general and especially with respect to creation of jobs and driving investments before taking any significant policy decision."

An industry perspective

Looking at the broader perspective, the BPO industry is credited with creating jobs that otherwise wouldn’t have existed. The Indian government is already benefiting from tax on the individual incomes of employees working in these BPO outfits. Secondly, as a result of BPO activity, the government is levying a significant amount of indirect taxes in the form of customs and excise. "The government needs to have a holistic perspective on the issue. India is just beginning to build the BPO industry and the adverse tax laws may put a blot on competitiveness," says Mehta. India features among the prime outsourcing destinations—among Philippines, China, Mexico, Ireland, Poland, Australia, Hong Kong, Russia and New Zealand—and clients who would look at India as a favoured ITeS-BPO destination would be discouraged if there is any change in the tax structure. India needs to project itself as a country that has stable tax policies and pave the way for smooth entry of even more BPO jobs into the country.

Tax implications for the BPO sector
  • Taxing BPO clients will increase the cost of transacting in India. This will make India less cost-effective.
  • Companies will be discouraged from outsourcing their processes to India, this will slow down the growth rate of the Indian BPO sector.
  • Indian BPO sector will lose out vis--vis its competitors like Philippines, China, Ireland, Hong Kong, etc, if government adopts tough tax regimes.
  • The employment generated by the BPO sector might take a beating and the country will lose out significantly on the income tax charged on individual employees.
  • Overseas clients might perceive India as a country where taxation policies are not stable. India needs to project itself as a stable destination.
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