Outsourcing continues to be a high growth activity for many
In considering this approach there is a choice in effect between what is termed onshore, near-shore, and offshore. This shorthand language is used to distinguish between outsourcing facilities in the country where a business is based, outsourcing facilities in a geographically proximate country (for example, in the case of the UK, countries such as Eire, Poland, Hungary or elsewhere in Europe would be regarded as “near shore”), and countries that are physically distant, such as India, Russia, or South Africa.
As businesses become increasingly sophisticated in managing their needs, and particularly for those which are global in nature, there is recognition of the need to adopt a portfolio approach in which some combination of at least two if not all of these activities is pursued. In the early stages of adopting an offshore strategy, the willingness tends to be to outsource mature and less technically complex processes such as applications support to offshore locations, while more complex areas of activity might be dealt with on an onshore or near-shore basis. This approach might apply for example where there is a high degree of iteration and client/supplier involvement in which case geographical proximity would facilitate the use of meetings between those involved relatively easily when needed. Portfolio approaches also offer other benefits; for example, it is possible to approach 24-hour working by utilising different time zones effectively. In this way response times can be shortened.
In considering offshore outsourcing Gartner advocate choosing the country first, then the provider, and finally choosing or negotiating the deal. In choosing the country, there will be many factors to take into account including the geopolitical risks. Again it is an advantage of a portfolio approach that the risk will be spread amongst different jurisdictions.
This article examines the benefits offered by offshore outsourcing with specific reference to
There may well be a drift over the next five years to lower cost locations such as China for processes that are less quality sensitive and do not require high levels of language skills and education in the general workforce,
but the reasonable expectation must be that outsourcing to
We will concentrate primarily on
Defining objectives
As with any outsourcing, it is absolutely critical to identify the objectives behind the project at the outset. This may sound obvious project management practice but it is surprising how many businesses fail to do this.
There are three main reasons to outsource a business function. These are:
· achieving cost savings
· improving service quality
· transforming the performance of business functions.
In the offshore context, and in particular in the current phase of the economic cycle, businesses will tend to focus on the cost element with quality improvement and business transformation being less of a priority (at least in the short term). Senior executives will often only be willing to take the decision to offshore if they can see a short-term cost saving.
Our experience is that objectives can and do change during the contracting process. Once contract discussions with suppliers are commenced, the focus inevitably moves at some stage to an examination of the detailed operational issues. It is possible that the strategic objectives will change completely if the pricing discussions reveal that the cost savings are not as great as at first thought (this can be the case if set-up costs are high) but that the operational advantages are considerable (significant short-term service level improvements are often achievable through greater staff education and flexibility). If the strategic objectives change, it is important to recognise this fact and change the emphasis of the process accordingly and ensure that senior management is backing that change.
Choosing a Model
A clear definition of the strategic objectives is absolutely key to deciding what model to adopt for an offshore venture. There are many different approaches that can be used but the main options are:
- direct and indirect outsourcing
- the joint venture and “build operate transfer
- the captive facility.
1. Direct and Indirect Outsourcing
In the past, many
The outsourcing approach has the following main advantages:
· The set-up costs will be relatively low, as the customer will not need to establish its own presence or entity in
· The customer should be able to take advantage of the tax advantages enjoyed by the supplier through its Indian subsidiary through lower pricing (see Tax Issues below).
· The structure is relatively simple and easy to unwind and exit costs should be relatively low as there will be no transfer of assets or staff out of
· The political and legal fall out from any exit may be more manageable as the facility staff will not be employed by the customer organisation.
The main disadvantages are:
· It is more difficult to achieve management control though a purely contractual structure as there is no jointly owned and managed vehicle. In attempting to achieve as much control as possible, the contract will move towards a “virtual joint venture” model and will become more complex and costly to manage. If close management control is required (for example, for regulatory reasons), operation through a JVCo or captive may be more suitable.
· The experience of operating offshore is harder for the customer to capture and the supplier is more likely to insist on retaining ownership of intellectual property it develops as a trade off for agreeing to a short-term contract. One of the main long-term concerns about offshoring is the possibility that Indian suppliers may start to encroach on their customer’s marketplaces using the intellectual property they develop (for example, a supplier providing back-office processes to an investment bank may eventually have the wherewithal to start offering investment banking services itself). If the knowledge and long-term value of the intellectual property is to be retained by the customer, a JVCo or captive may be the best route.
· It is often difficult to make the typical contractual mechanisms for incentivising performance by the supplier (usually in the shape of “carrot and stick” service credits and bonuses) really effective as a means of achieving first class performance coupled with continuous improvement, and such arrangements can be difficult to manage. It is in practice difficult to agree a contract, which truly encapsulates a “partnership approach”, or which ensures the supplier really has “skin in the game”. Ultimately, if the customer is reliant on legal action to incentivise the supplier, this is a fairly blunt instrument. A joint venture approach may be more appropriate if partnership is the real strategic objective.
· The facility used by the supplier may not be transferable to the customer if the customer wishes to take it over at the end of the contract term as the supplier will view this as its core business and will be unwilling to agree to such a transfer without a significant premium being paid.
On balance an outsourced contractual approach may be the best route where the processes are well defined, where cost is the principal driver and where the customer wishes to limit its risk and test the Indian market on a short-term basis. If management control, partnership and long-term business transformation are the drivers, it may not be the best option.
2. Joint ventures and “Build Operate Transfer”
There are a multitude of JV options and the scope of this article does not permit examination of all the different structures that can be used. The two main categories are clearly JV structures involving the setting up of a jointly owned corporate entity (the JVCo) and those which rely purely on contractual structures between the parties. The latter approximates to the traditional contract model examined under 1 above but where the relationship architecture is highly developed to reflect the partnership aspirations of the parties. We will focus here on issues surrounding the setting up of a JVCo.
Setting up a JVCo will have the following advantages:
· It is possible for the customer to have a large degree of management control from day one. An equity, voting rights, and general governance structure will need to be agreed but if desired this can be designed to give the customer ultimate control over major operational issues.
· Operational control will also be more effectively in the hands of the customer which can assist in easing regulators’ concerns in regulated sectors such as financial services.
· The supplier will have more “skin in the game” through its shareholding and as a result it will be encouraged to perform more effectively than through a contractual mechanism where legal action is the end-game. This will assist if business transformation is the principal strategic aim and will mean that partnership is built on more than a set of contractual obligations.
· The value of the local knowledge and intellectual property will be captured in the JvCo and will be reflected in the customer’s shareholding. The JVCo may be able to offer services to other organisations and become a profit making organisation in its own right.
· It will be tax efficient if the JVCo is to be a profit making entity (see Tax Issues below).
A JvCo has the following disadvantages:
· It can be complicated and expensive to set up and maintain a JVCo. An entity will need to be established in
· The exit costs and risks will probably be higher than a contractual outsource as the customer may have to buy out the supplier’s stake and then dispose of the assets and re-deploy the staff or make them redundant.
· The responsibilities of the customer and the supplier can be difficult to disentangle in a JVCo. If anything does go wrong, allocation of responsibility can be almost impossible (it is very often very difficult on outsourcing contracts too).
· There are a number of legal and tax issues involved in a JVCo structure which increase the set-up costs (see Other Factors affecting the Choice of Structure below.
On balance, a JVCo is most suitable when the customer has made a long-term commitment to the offshore location, where knowledge building, intellectual property and business transformation are drivers and where management and operational control is a key concern. It is less appropriate where the commitment is short term, or where costs are the main driver.
One variation on the JVCo approach is to go for “build operate transfer” or “BOT”. This approach is becoming an increasingly popular way of creating a new facility in
This can be viewed as a number of different contractual elements. The build stage will be similar to a consultancy arrangement with the supplier being employed to procure and build a facility to the customer’s specification, to integrate technology and to source staff. The staff will be employed by the JVCo and the local assets owned by the JVCo. The run stage is basically an outsourcing contract between the customer and JVCo with a service contract with the local supplier to manage the facility until the transfer. The transfer stage consists of a share transfer in a JVCo to the customer. This is the most tax effective way of setting up a BOT in
3. A Captive Facility
The third option is to outsource processes to a wholly owned subsidiary of the customer from day one and draw upon the experience of a local supplier on a consultancy basis to assist in setting up that subsidiary (“assisted build out”). This is often known as a “captive” facility. All staff and assets will be owned by the subsidiary from the outset. Any supply of services from the entity to the customer will therefore be intra-group. An outside supplier may well be employed to assist in the set-up of a captive subsidiary.
This has the following advantages:
· The customer will have full management and operational control from day one. It may be easier to re-create the customer’s corporate culture as a result.
· It is relatively simple in terms of contractual issues – there is no ongoing contractual relationship with the supplier.
· The customer will have the full value of any knowledge, intellectual property and business transformation conducted in the subsidiary.
· The legal structure is relatively cheap to set up as it simply involves incorporation of an Indian legal entity and application for tax status (see Tax Issues below).
· It can be tax efficient if the subsidiary will be a profit-making centre (see Tax Issues below).
· Of all the options it may be the one with greatest appeal to regulators.
The disadvantages are:
· The customer will bear all the risk of ownership of staff and assets from day one. If the customer needs to exit it will bear the redundancy costs and any other wind-down costs in liquidating the subsidiary.
· The customer will need to be confident that it can operate without ongoing operational support from a local supplier. To achieve this, the customer will need to recruit a management team familiar with local conditions early in the process and bear the cost that brings. There is a risk otherwise that the customer’s inexperience will lead to diminution of cost savings or failure to achieve its operational improvements. In a rapidly changing environment, it can be difficult at a distance to stay on top of the management issues and needs of the offshore facility. For example, a very successful facility which grows quickly will have rapidly changing management needs.
· This may be seen as an all or nothing option by senior management. They may not be willing to make this sort of commitment, at least initially.
This approach may be appropriate where a long-term commitment is being made, where management and operational control is key, where the customer is confident of its ability to operate offshore without ongoing support from an early stage and where the customer is looking to make the subsidiary a profit-making centre. It is less appropriate where the move offshore may be short term, where exit risks need to be minimised and where there is less than full management buy-in.
Tax Issues
Where
There are significant tax incentives available when outsourcing functions to
In addition to local incentives, it is always important to consider other tax considerations such as transfer pricing, repatriation of profit, management charges, VAT and the use of intermediate holding companies.
Before considering the tax position for each of the three alternative structures outlined in this article, it is worth setting out in more detail what local tax incentives are available in
The Incentives
There are two relevant tax-relieving provisions in Indian tax legislation (ss10A and 10B of the Indian Income Tax Act 1961). The first is for new undertakings established in one of several special economic zones, including those known as Software Technology Parks of India (STPI), and the second is for newly established export oriented undertakings (EOU). The benefits of and conditions for both sets of provisions are very similar.
Benefits:
· Relief from the substantial (but recently reduced) import duties on bringing computer equipment and other kit into the country (it is necessary to import virtually everything to be used by the undertaking in order to obtain and retain either STPI or EOU status – see conditions below).
· Relief from Indian sales tax on all transactions with foreign entities.
· Relief from Indian income tax on all profits income and gains derived from “export” activities (ie any income derived in a foreign currency from foreign customers). The amount of this relief is slightly different for the two systems. STPI status gives 100% relief for five assessment years (1st April-31st March), followed by 50% relief for two, subject to a long-stop date of
There is nothing to stop a new undertaking applying for relief under both sets of provisions. It is possible to elect in each year for the most beneficial relief of the two.
Conditions:
· The undertaking manufactures or produces articles or things or computer software (this includes data processing and similar activities). In the case of STPI status, this activity must take place in free trade zones, software technology parks or special economic zones.
· It is not formed by the splitting up, or the reconstruction of, a business already in existence (except transfers pursuant to a scheme of amalgamation or a de-merger). This is to prevent the abuse of artificially extending the tax relief period by transferring an existing business to a new entity, but it also has a significant impact on the choice of structure for outsourcing – see below.
· It is not formed by the transfer to a new business of machinery or plant (including computer equipment) previously used for any purpose. “Used” for these purposes means used in
· If the undertaking is a company, the beneficial ownership of at least 51% of the voting power must remain in the same hands throughout the periods mentioned above in order to retain STPI or EOU status (again except transfers pursuant to a scheme of amalgamation or a de-merger).
If it is anticipated that the undertaking will make profits, then the availability and maintenance of these reliefs becomes potentially very important. It is worth noting that if STPI or EOU status is obtained but then lost due to the failure of one of these conditions, there is no claw back of income tax relief already obtained. There is however a claw back of relieved import duties, plus interest.
So what is the impact of these reliefs and other tax issues identified above on the alternative outsourcing structures?
Tax and Contractual Outsourcing
With this form of outsourcing, the customer is not concerned about Indian tax reliefs, although on the assumption that it itself uses an entity that qualifies for either STPI or EOU status (or both), the customer should see the savings reflected in the prices it pays. The customer should however resist any contractual provision allowing the supplier to increase its prices in the event of favourable tax status being lost as this could have a significant cost impact.
The other tax issues referred to above will not come into play, with the exception of VAT. Whether or not VAT is an issue will depend entirely on the nature of the supplies being made by the supplier. Many of the services that are outsourced to foreign jurisdictions, for example data processing, the provision of information, telecommunications, banking, financial and insurance services are all treated as supplied where received. That means that unless the supplies are VAT exempt, the
Tax and “BOT”s and JVs
BOTs must to be structured in a way that retains the benefit of the local Indian tax incentives.
If a new customer entity is set up and receives assets at the transfer stage, the conditions prohibiting the splitting up or reconstruction of a business already in existence and the transfer of significant quantities of machinery and plant are likely to be breached.
In the case of the transfer of ownership of a corporate entity, the 51% beneficial ownership test is likely to be breached, resulting again in the incentives ceasing to be available (and a claw back of relieved custom duties).
If the benefit of the tax relief on profits is significant, and a BOT model is to be used, then it is necessary to explore methods of coming within these conditions.
For example, in the case of an assets transfer from the supplier to the customer at the transfer stage, if a significant ramp-up of activities is expected, the 20% test for the value of transferred machinery and plant may not be an issue. It will still be important to assess whether the new entity is carrying on a business previously carried on by the supplier. If the same assets are operated, by the same employees, for the same customer, this is almost certain to be the case.
It may still be possible to work around the rules by providing for employees to be hired by the customer’s entity at the outset and seconded to the supplier and for that entity to buy the equipment and lease it to the supplier for the operate stage. However, these steps substantially defeat the commercial objective of using a BOT structure in the first place; in most cases, if tax is the overriding factor, it would be better to adopt either a JVCo or wholly-owned structure from the outset.
In the case of a share transfer, it may be possible to structure things from the outset so that the customer has the majority of the voting rights in the Indian entity, with the supplier taking the majority of the economic rights until the point of transfer.
In the Indian Finance Bill 2003, potentially important changes were made allowing tax reliefs to follow a business where it is transferred pursuant to a scheme of amalgamation or a de-merger. At present it is not clear whether these provisions are wide enough to cover BOT structures and detailed advice would need to be taken in each case.
Apart from VAT, which is as set out above for the contractual outsourcing structure, the other tax considerations come into play only at the post-transfer stage. The issues may be summarised as follows:
· Transfer pricing – in common with the
· Management charges – (subject to the above) these will probably be kept to a minimum anyway if income tax relief is available. There is an Indian withholding tax of 20% on such payments. This is reduced by several treaties. Under the UK-India treaty it is reduced to 15% (or in the case of payments for certain services, 10%).
· Repatriation of Profit – Under the UK-Indian treaty, the rate of withholding on both dividend and interest payments is 15%. In the case of interest payments, transfer pricing concerns must also be addressed. The most important issue on repatriation is whether the repatriated profits would suffer tax in the
· Intermediate holding company – In pure tax terms, interposing an intermediate holding company in, say,
· VAT – In addition to the general points raised above, the presence of an Indian company owned by the customer opens up the possibility of including that company in a UK VAT group as a method of mitigating any unrecoverable VAT charges. In order to do this, the Indian company needs to have a branch in the
Tax and Captives
From a pure tax perspective, where the customer is expected to end up with a degree of ownership of the Indian outsourced operation, setting that operation up in a wholly owned Indian subsidiary from day one has many advantages. STPI and/or EOU status is likely to be available from the start and, subject to transfer pricing considerations, the customer will have control over the level of recharge of fees and profit remittance. The possibility of VAT grouping will also exist from the outset.
As ever, tax is only one of the considerations to be taken into account when deciding on an appropriate structure for outsourcing to
Conclusion
Offshore outsourcing has become a much more frequently used basis for outsourcing.
There are other material issues that are highly relevant to an outsourcing of this kind which have not been considered in this article. These include employment, regulation, data protection, intellectual property and law and jurisdiction.
