Indian Outsourcing: Winning Strategies through Proper Tax Planning

June 30, 2005

Marshall McLuhan could have been easily denied his place in the sun. Services Offshoring was not meant to be such a reality of the global economic village. And India was definitely not expected to be in the centre of the storm. India‘s arrival on the global financial services radar as a back-end beast came as a bolt from the blue for some and a blessing in disguise for others. Its critical support to fuel the engine of the global economy was viewed with skepticism as well as trepidation.

No argument can gainsay the fact that globalisation of economies has increased competitive pressure, reduced product development cycles, improved service quality and increased efficiency of allocation of available resources.

By outsourcing, organisations are able to adapt to this changing business environment and focus on their specialised activities that provide competitive advantages. India is now acknowledged as the leading offshore outsourcing destination for global corporations, offering compelling advantages like a proven track record in terms of quality of service, reliability and productivity, a large and growing pool of highly-skilled professionals fluent in English, geographical advantage for 24/7 operations and world-class infrastructure facilities. A plethora of multinational corporations have realised India‘s potential and outsourced their core and/or non-core functions, and that has positively impacted their bottom lines. There is no gainsaying that India‘s rise to pinnacle in the BPO arena has been meteoric.

While the credit for the genesis and initial growth of the Indian BPO industry goes to multinationals such as GE and American Express, who set up captive BPO outfits in the country, the last couple of years have witnessed the emergence of Indian third party vendors as a prominent industry segment.

Today, as arguments continue to rage and discussions persist unabated on the world’s biggest back-office, a flurry of initiatives are underway in India to maximize the BPO advantage. And availability of fiscal incentives is one such formidable arena worth a long look.

Taxing Factor for BPO Units

As in the case of all businesses, fiscal provisions continue to be one of the critical factors, influencing the decision-making process, at every stage. The Indian BPO industry, being a relatively nascent industry, throws up issues in respect of which virtually no precedents are available. Hence, the need for careful tax planning and a comprehensive review of every decision in advance cannot be overemphasised.

In India, incentives are available to BPO units set-up under the Export Oriented Unit (EOU)/ Software Technology Park Scheme (STP) and in a Special Economic Zone (SEZ). While units’ set-up in a SEZ are subject to locational restrictions, no such restrictions are applicable in case of units’ set-up in an EOU/STP.

Applying the Chinese experience, SEZs have received significant importance and attention from the Indian Government. Recently, the Indian Government has announced a Special Economic Zone Bill (2005) with a view to provide a long-term and stable policy framework for SEZs with minimum regulatory regime and to provide an expeditious and single window clearance mechanism with a package of fiscal incentives to attract foreign and domestic investments for promoting export-led growth. The SEZ Bill has been passed by both the houses of the Indian Parliament. Upon receiving presidential assent, the SEZ Act will be the self-contained legislation governing the operations of SEZs in India.

Units set up in SEZs after 1 April 2005 would become eligible to claim an extended tax holiday benefit for 15 years (without any sunset clause), subject to satisfaction of certain conditions. Further, a host of indirect tax incentives in the form of exemption from customs duty on goods or services imported into or exported out of India, exemption from excise duty on goods procured from a Domestic Tariff Area (DTA), duty drawback or other admissible benefits on goods brought or services provided from a DTA or services provided from outside India, service tax on taxable services, etc, will also be available to units operating in SEZs.

Alternative Forms of Business Presence

The nature of business presence can at times have significant fiscal implications, and there could be a large potential for tax savings by appropriately structuring the nature of business presence. To illustrate, while the effective corporate tax rate for a branch (being a foreign company) is 41.82%, which is higher than the effective corporate tax rate of 33.66% for a subsidiary (being an Indian company), operation of a BPO unit through a branch structure permits profit repatriation without any tax, unlike a subsidiary, which is a subjected to Dividend Distribution Tax (DDT). Hence for a BPO unit, which is enjoying a tax holiday, the higher corporate tax rate causes no disadvantage to the branch structure, while the savings in DDT brings in welcome tax savings in India.

You also have to consider the fact that, in the case of the branch structure, all profits may be taxable in the home country, even if profits are not repatriated. This may make the branch structure tax inefficient on a global basis, even though there is no DDT in India. However, if the foreign company is located in a jurisdiction where a Double Taxation Avoidance Agreement provides for credit on tax ‘spared’ in India (as in the case of the UK, Mauritius, etc) branch structure may be extremely tax efficient.

In the case of a subsidiary, credit in respect of DDT and tax ‘spared’ in India would normally not be available to the holding company in the home country (eg in the case of the USA). But, if the investments are properly structured through an appropriate jurisdiction like the UK, Mauritius etc, the holding company may not only enjoy credit in respect of DDT, but also a credit for tax ‘spared’ in India.

Routing investments through Mauritius will also be advantageous at the time of divestment of equity stake in the Indian subsidiary since no capital gains tax would be payable (either in India or Mauritius) on account of exemption granted under the
India-Mauritius Double Taxation Avoidance Agreement read with the Mauritian tax laws.

Maximising Indian Tax Benefits

In some of the recently concluded audit proceedings, Indian Revenue authorities have questioned the period of tax holiday for ‘newly established units’ set up under the terms of the initial STP approval on the ground that the tax holiday period will relate back to the date of initial STP approval (and not from the date of set-up of the new unit). Further, the definition of IT-enabled services has been questioned in the case of some BPO units engaged in knowledge management services.

It would therefore be prudent to carefully reorganise and plan to optimise the tax holiday benefits available in India. To illustrate a few:

  • Expansion of existing unit v setting up a new unit Indian tax law provides for tax holiday benefit only for ‘newly established units’. Care should therefore be taken to establish a ‘new’ unit for further operations rather than expanding the same unit in order to claim extended tax holiday benefits.
  • Functional and Risk reorganisationProfit attribution to the Indian BPO unit can be maximised by appropriately reorganising various functions and risks between the holding company and the Indian BPO unit. Where the Indian BPO unit is contractually bearing more risks, higher profits can be captured in the Indian BPO unit, which would be entirely tax-free.
  • Tax efficient business model structuringWhere contracts are made directly with the customers, rather than where the Indian BPO unit merely acts as a cost plus contract service provider to the holding company, tax free profits earned by the Indian BPO unit can be increased.

Taxability of Non Resident in India: What holds for them?

In respect of BPO operations, another relevant question being raised is whether the Indian subsidiary can be said to constitute a Permanent Establishment (PE) of the non-resident (parent/client) on the ground that it is securing orders and/or concluding contracts on behalf of that non-resident. Further, if that question is answered positively, what is the quantum of profits that may be attributed to such PE and taxed in India. The technical view emerging on this question is that securing or concluding non-revenue generating contracts may not create a PE exposure. Also, there has to be an element of continuity in such securing orders/ concluding contracts for a PE to be constituted. Further, an independent service provider (providing services in the ordinary course of business) may not be regarded as constituting a PE of the non-resident (parent/client) in India on account of such securing/concluding of contracts.

Recently, Indian Revenue authorities have issued a Tax Circular that seeks to outline the basis and principles on which non-residents would be liable to taxation in India in respect of any activity outsourced to India. The Tax Circular provides that non-residents cannot be taxed in India in the absence of a PE in India. However, where an Indian BPO unit constitutes a PE in India, profits attributable to the non-residents will be determined on the basis of arms-length price. While the Tax Circular has sought to emphasise the importance of an India specific transfer pricing study, it does not expressly state that even where the Indian BPO constitutes a PE of the non-resident in India, such non-resident would not have any additional tax exposure in India where the Indian BPO has been compensated at arms-length price.


India is widely expected to become the third largest economy in the world by 2035, behind China and the United States. India‘s burgeoning BPO economy rides high on these prospects. In the recent past, India‘s BPO sector has delivered high growth and positive economic spin-offs to the Indian economy. It is unfortunate that the industry is having thrust upon it a Government-created fiscal uncertainty that could decelerate its momentum. Prudent tax planning is imperative in such a scenario to avoid implementation of conditions laid under the Indian tax laws and to avail oneself of the fiscal incentives given to the BPO industry.

Vishal Malhotra is a Partner with the India Tax practice, Ernst and Young