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
The industrial policy announced in
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 Some of them have a built-in shelf life and are soon to be withdrawn altogether.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
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
As in the
“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
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
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
A foreign business can set up in
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
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
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
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
A company is ‘resident’ in
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
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
Joint Ventures
Joint venture companies are a widespread vehicle for investment in
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
Simple contractual outsourcing to
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
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
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
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
Concessions for royalties received from foreign enterprises.
Income derived by way of royalty for the use outside
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
Where there is no tax treaty, section 91 of the Act gives relief to foreign investors for income subject to tax in
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
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.
