IT Outsourcing to India

India, as its economy has developed, has emerged over the last decade or so as a major player in the IT outsourcing market. Since 1991 India has undergone a sea change in its outlook toward foreign investment and global collaboration, with software and Internet services helping to create the momentum. Overall, India is currently the leading offshore destination for UK outsourcing.

India is a commonlaw country with a written constitution which guarantees individual and property rights. There is a single hierarchy of courts. Indian courts provide safeguards for the enforcement of property and contractual rights. However, case backlogs often result in procedural delays. Most of the laws are codified, although as in the UK there is a large amount of secondary legislation.

The industrial policy announced in India during 1991 reduced the level of bureaucratic controls on the Indian industrial economy. This new liberalisation made India a more attractive place to be for foreign investors, and the rise of the Internet has provided a fortuitous assist.

In order to encourage investment and growth India offers a number of concessions to foreign investors. But it is worth pointing out that there are usually a number of conditions to be satisfied in order to qualify. It is also important to note that some tax breaks are not as good as they used to be. Some of them have a built-in shelf life and are soon to be withdrawn altogether.

Briefly, there are tax breaks for certain sectors (like infrastructure builders and operators), tax breaks for exports and tax breaks for setting up in a confusing number of designated technology and industrial parks and ‘zones’, all with their own acronyms (more of that later). These are intended to boost exports, reduce the trade deficit and national debt, improve local infrastructure, attract foreign currency and promote tourism and regional development (especially in ‘backward’ areas, as they are called).

To make sense of this, it may help to know something about the way businesses are taxed in India.

Taxation of business in India

Income tax is an annual tax on income levied by the central government. It is charged under the Indian Income Tax Act 1961 at rates fixed in the Finance Act each year.

In India, companies as well as individuals are taxed under the Income Tax Act. There is no separate corporation tax as there is in the UK.

As in the UK, India makes a distinction between income and capital receipts. The Indian Income Tax Department at the Department of Revenue draws a parallel to illustrate the distinction, which will be familiar to anyone who has looked at the same question under UK law:

“Broadly, an analogy is drawn of a tree and the fruits of that tree. The tree symbolises the source from which one gets fruits which symbolise ‘income’. The receipt arising from the sale of the tree itself is, therefore, considered a capital receipt which is not income; but the receipts flowing from this source viz., fruits is income (sic).“

While it does not do away with the distinction between income and capital receipts, the Income Tax Act does not make the same distinctions between the way they are taxed as UK tax law. Instead it widens the scope of ‘income’ by expressly including within its meaning some things which are not so included in the UK.

Mostly, business income is computed according to accepted accounting norms. Broadly speaking, to arrive at the figure that companies pay tax on, the gross earnings of the business are reduced by its operating expenses. These reductions are called allowable expenses or deductions.

Investment incentives typically operate in the same way as other deductions, although often they can be used to reduce income only from certain products or from doing certain things (like exporting).

Business models

IT outsourcing uses one of two basic structures, with the outsourcing company either starting up its own operation in India or simply contracting the work to a local company in India. The section below on the business models available focuses on software development. However many of the incentives to investment have an application to IT generally.

Business models for outsourcing are not written in stone. For example, it can be helpful to combine the most useful bits of different models, or to start with one and move on to another as the needs of the business change or perhaps simply only as the volume of business grows, or whatever.

Because of the rules intended to encourage foreign investment (and despite the liberalisation of the earlier bureaucratic controls), the models available to investors in India fall naturally into categories defined in some ways by their recognition by the Indian authorities. Recognition by the Indian authorities is necessary not only to obtain the required permissions (which depend on the sort of set up you have got in mind) but also to show eligibility for the various incentives (which again depend on the set up and the nature and location in India of the business).

A foreign business can set up in India either through a liaison office, a local branch or by investment in an Indian company. As compared to pure contractual outsourcing, this typically provides better control over management of the organisation. It may also be desirable or even necessary where uniformity of methods and procedures are important to this business. In that respect the benefits can increase where there is a high volume of work or where, for example, it is sensitive in nature.

However there can be a downside. Policies and practices imposed from a foreign parent may be unwieldy in the context of an Indian legal and cultural framework. Also, the management of an offshore branch or subsidiary is more difficult – or at least attended by its own and probably additional problems – if done remotely, more so if the work is intermittent or the volume small.

Liaison office

RBI (Reserve Bank of India – India‘s Federal Reserve Bank) approval is necessary to open what India calls (in English translation) a Liaison Office or Representative Office. Liaison Officers are not allowed to conduct any kind of business or commercial activity or to earn any income in India.

As a variation, and also with the approval of the RBI, foreign companies can set up a local site office in the planning stages of a (usually Indian government approved) project to be undertaken in India. Planning stages can include the implementation of temporary software projects.

Branch office

Again, RBI approval is necessary and again only certain activities are permitted. For example, a branch office is not allowed to carry out manufacturing activities (although it can sub-contract to Indian manufacturers). However, it can trade through imports and exports, it is allowed to conduct certain research work, and it can ‘promote’ technical and financial collaborations between Indian companies and overseas companies.

Branches are not ‘resident’ in India for tax purpose with the consequence that they are taxed at a higher rate but on less of their income (ie only their income from certain activities) – more on this later.

Subsidiary

Unlisted Indian companies can be up to 100% owned by foreign investors, depending upon the business plan of the foreign investor, prevailing investment policies of the Indian government and the obtaining of the necessary approvals. All companies incorporated in India are treated as domestic companies regardless of the nationalities of their shareholders.

A company is ‘resident’ in India for tax purposes if it is incorporated in India or the control and management of its affairs is situated wholly in India throughout the year. Resident companies are liable to tax on worldwide income, including capital gains. All other companies are non-resident companies.

Companies ‘resident’ for tax purposes pay a lower rate of tax than branch offices of foreign companies, but tax is assessed on all of their income.

Foreign investment in an Indian company requires approval. For some investments this is given automatically if certain conditions are met. The amount of foreign equity for which automatic approval is available (inevitably from the RBI) varies depending on the sector. A number of sectors have been designated high priority which means they get approval sooner.

Approval of foreign equity is not automatically limited by these conditions. But for greater equity investments, or for areas of investment without high priority, an application has to be filed with another body, the Secretariat for Industrial Approvals, and a response takes longer. Full foreign ownership (100% equity) is usually allowed as a matter of policy in, among other things, electronics, Export Orientated Units (EOUs) or a unit of the Export Processing Zones (EPZs).

It is virtually impossible to write about IT outsourcing to India without three letter acronyms creeping in. Most of these – the ones ending in Z (for ‘zone’) are designated areas served by certain (sometimes overlapping) benefits, some of them tax benefits. The ones with tax benefits for IT companies, though often not only for IT companies, will be explained in more detail later.

For major investment proposals or for those that do not fit within the existing policy parameters, there is the high-powered Foreign Investment Promotion Board (FIPB). The FIPB is part of central government and can provide single-window clearance to proposals in their totality without being restricted by any predetermined parameters. More stringent restrictions exist on foreign investment in listed companies.

For foreign investors in the software industry the authorities allow 100% ownership in almost all Indian states. However, there are likely to be conditions.

Approval for foreign equity investment is apparently especially likely to be forthcoming (where it is not automatic) for setting up in one of India‘s bewildering number of designated business parks and enterprise zones. Some of these are targeted at IT and some others also offer advantages. The main relevant ones, once again known by their initials, are EPZs (Export Processing Zone), SEZs (Special Economic Zones), STPs (Software Technology Parks), EHTPs (Electronic Hardware Technology Parks), and FTZs (Free Trade Zones).

Joint Ventures

Joint venture companies are a widespread vehicle for investment in India. There are no separate laws for joint ventures in India. The same foreign equity rules apply to investment in joint ventures as to subsidiaries.

Joint ventures offer less direct and managerial control but offer their own advantages. These have been well reported and much discussed in print in this context. But by way of example, these might include the ability to utilise an established distribution or marketing set-up and established local contacts. This often helps with teething problems.

A joint venture also allows the foreign investor and the Indian partner to combine strengths in different areas, and to specialise where they are comfortable and have experience – the foreign partner brings in technology, systems and products and the Indian partner takes care of human resources, marketing and legal and tax issues. This can be useful for a first move to India, and may provide the distribution channels to get sales moving quickly. It can precede a move to a higher share of ownership, should the early advantage become outweighed by the need for greater control. The main risk in a joint venture is that differences of opinion may emerge or develop between the parties.

Simple contractual outsourcing to India

This means simply contracting the work to an Indian company in exchange for a fee, with no investment element. This may make sense where the requirement is occasional and does not justify the overheads and other ongoing costs of having a permanent set-up. Similarly, where the total volume of work does not bring economies of scale, it may be worth looking at, and has the advantage that it bypasses the need for the client company to negotiate local law and taxes.

Those tax breaks

Tax holidays for IT

Some of the main tax concessions for IT outsourcers are listed below, although it is certainly not the intention here to go into comprehensive detail.

The main tax incentives to exporters of electronics and computer software and services come from the Income Tax Act mentioned earlier. This introduced tax holidays for certain exports and for operating out of certain government designated areas. Other provisions have been inserted into this Act by later legislation. The main provisions are mentioned below.

Section 10A of the Act provides for a five-year total tax holiday for industrial undertakings which manufacture or produce any ‘article or thing’ and are set up in notified Free Trade Zones. This provision was introduced by the Finance Act 1981. Similarly, section 10B of the Act allows a five-year tax holiday to approved 100% Export Orientated Units, which manufacture or produce any ‘article or thing’. This provision was introduced by the Finance Act 1988.

The Finance Act 1993 extended the tax holiday under section 10A to industrial units in approved Electronic Hardware Technology Parks or Software Technology Parks (STPs). Under the same Act, an explanation of the word ‘produce’ was inserted to state that ‘produce’ includes production of computer programs.

Since bespoke computer programs are not physical goods but are developed as a result of intellectual analysis of the systems and methods employed by the purchaser of the program, they are often prepared on site (meaning where they are going to be installed and run) with the software personnel going to the client’s premises. Doubts were initially raised whether units undertaking ‘production’ of software at the clients’ premises would be eligible for the tax holiday.

The Indian Government’s policy on tax incentives for software exports is reflected in the provisions of section 80HHE of the Act, which was introduced in 1991. Under this provision, technical services provided outside India for the development or production of computer software are included for the purposes of the tax incentive.

Similarly, for the purposes of section 10A or 10B, so long as the local (Indian) operation produces computer programs and exports them, it should not matter whether the program is actually written on the premises of the unit. Accordingly, where a unit in one of the designated areas develops software at the client’s site abroad, the unit should not be denied the tax holiday under section 10A or 10B so long as the software is the ‘product’ of the unit.

Concessions for newly established industrial undertakings

New undertakings in any Special Economic Zone engaged in the business of exports on or after 1 April 2002 are exempt from tax on their exports for five years, and thereafter on 50% of what they make from exports for a further two years. The relief is by a straight deduction of their earnings from exports from what would otherwise be their taxable earnings.

Concessions for 100% Export Orientated Undertakings

Profits and gains derived from 100% Export Oriented Undertakings are exempt or partly exempt from tax for a period of 10 years from the year in which production (of ‘articles or things’ or computer software) commences, if certain conditions are met. Again this is by deduction from taxable earnings. At present the relief is due to be withdrawn from the tax year 2010/11.

Concessions for income from the export of goods, computer software, film software, and also development of computer software outside India

There is currently still a partial exemption from tax for income derived from the export or transfer of film software, television software, music software, television news software, and also for the export of computer software and the provision of technical services outside India in connection with the production or development of software, subject to certain conditions. However these concessions are being phased out. There will be no exemption from the year 2005/06 onwards.

Concessions for royalties received from foreign enterprises.

Income derived by way of royalty for the use outside India of any patent, invention, design or any registered trademark is partly exempt. Again, concessions are being phased out and no deduction will be available from the assessment year beginning with 1 April 2005.

Depreciation

Depreciation is available on tangible and intangible assets used in business. It is calculated at the written down value of categories of assets at the rates specified in the income tax rules. The income tax rules provide for rates of depreciation which are higher than the rates prescribed under company law for published accounts. The term ‘assets’ includes intangible assets (which include know-how), patents, copyrights, trademarks, licences, franchises and other intellectual property.

Tax Treaties

Licensing arrangements or joint ventures generally involve taxation of income in the country of residence of the taxpayer as well as the country of the source income. To grant relief from payment of tax under the laws of both countries, tax treaties exist with a number of countries including the UK.

Where there is no tax treaty, section 91 of the Act gives relief to foreign investors for income subject to tax in India as well as in their own country. Mauritius is often mentioned in this context. The reason is that according to the Double Taxation Avoidance Act between India and Mauritius, capital gains arising from sales of shares are taxable in the country of residence of the shareholder and not in the country of residence of the company whose shares have been sold. Therefore, a company resident in Mauritius selling shares of an Indian company will not pay tax in India. Since there is no capital gains tax in Mauritius it will escape tax altogether. The Supreme Court has recently confirmed that a certificate of residence issued by the Mauritius Government is acceptable proof of residence in Mauritius.

Transfer pricing

By amending the Income Tax Act, the Finance Act 2001 effectively substituted an arm’s length price on certain international transactions for the purpose of computing income.

For straightforward contractual outsourcing, the parties are likely to be dealing at arm’s length anyway. But for outsourcing to subsidiaries of joint ventures it will be necessary to comply with the regulations where a transaction is between associated enterprises. The definition of enterprise is wide and covers virtually every form of commercial activity. Transactions can be the transfer of goods, intangibles and services as well as any arrangement that has a bearing on the profits, income, losses or assets of the parties. The provisions, however, do not apply where the substitution of an arm’s length price would mean there would be less tax to pay.

Postscript

When the United Progressive Alliance government came to power in May there was concern that the new government could turn its back on the reforms and foreign investment polices that India pursued relentlessly over a decade, under pressure from its allies on the political left. However the signs appear to remain good. One of those signs has been the apparent decision to curb the powers of India‘s foreign investment regulator, the Foreign Investment Promotion Board, perceived as imposing a procedure-driven regulatory regime.

In one of its controversial rules, the FIPB insists that a foreign investor in an Indian venture must seek the Indian partner’s consent if it decides to part ways and launch a venture independently in the country. Foreign investors have often accused Indian partners of using this rule to extract a premium for such exits. The new government (through the budget) has said that it plans to prune the role of Foreign Investment Promotion Board by removing much of its discretion to block transactions, and replacing it with an extension of the existing automatic approvals process (subject to conditions).

Other major incentives include abolition of the long-term capital gains tax (a 30% tax on the profits on sale of investments held for more than year) and replacing it with a new transactions tax.

According to the new Finance Minister, P. Chidambaram, no matter what the new government’s policies are on agriculture and the poor, the fact remains that “foreign investments have the potential to add a competitive edge, and therefore would be actively sought and encouraged”.

Michael Gilbert is an Associate in the Tax Strategies Unit at Hammonds.