Obama's tax proposals won't stop outsourcing to India

>> Thursday, May 28, 2009

Few would argue that in recent years, globalisation has increasingly come to be synonymous with the trend of outsourcing; a trend that has changed the global equation. The phenomena of outsourcing has allowed emerging markets in developing countries to reach into developed economies, offering a talented workforce at a fraction of the price.

However, with the recent tax proposals of the US, multinational US Companies which make more than 50% of their revenue from markets outside the US and the Indian industry, which earns $60 billion from outsourcing, are panic-stricken. The new US tax proposals intend to (i) curb overseas tax advantages enjoyed by multinationals in the US; (ii) change the legal treatment of international subsidiaries that companies have used to shift earnings into low-tax offshore havens; (iii) reduce the role of small tax-haven countries that have eroded the tax bases of US; and (iv) eliminate an ambiguity that allows US multinationals to avoid paying taxes on profits earned overseas. Further, it is believed that with rise in the taxes paid on the profits earned overseas, the US companies will shift their location of business back to US.

Existing US Tax Code

The present US Deferral System allows US companies earning profits in a foreign country to deduct expenses for overseas operations and defer payment of US taxes until those profits are repatriated back to the US. While several developed countries have shifted to territorial tax system where only company profits generated within a country's borders are subjected to tax, the US is the only country in which both a worldwide system and a corporate tax is applied. Hence, US tax regime provides for Deferral System to enable US multinational companies operating in foreign countries to be on a more equal footing with their competitors. However, this Deferral System is under attack from the US administration as US multinational companies are increasingly found to be evading taxes by shifting their earnings into low-tax offshore havens and enjoying overseas tax advantages.

Hence, the US administration intends to reform the Deferral System by limiting the ability of US companies to defer tax on profits earned abroad. The new US administration proposes to curtail US multinationals from (i) receiving deductions for expenses supporting their overseas investments until they pay taxes on their offshore profits; (ii) inflating or accelerating the foreign tax paid to claim credit against the US taxes; and to make the Research and Experimentation Tax Credit permanent for investment in the US.

Implications of the New Tax Code

Though the proposal of the new US Tax Code is still at an early stage, the immediate impact on the Indian outsourcing industry cannot be accurately assessed, as the transition of this proposal into legislation will involve extended debates, expert opinions and oppositions from US multinationals, republicans, and even democrats. Even assuming that the proposal of the new US Tax Code comes into force, it is an attempt by the US administration to reduce the role of small tax-haven countries that have eroded the tax bases of US rather than targeting the outsourcing industry of India in general. However, the proposed new US Tax Code may impact foreign operations of US companies operating abroad and makes it more difficult for them to compete with foreign companies.

RandD Outsourcing

RandD is considered as one of the important factors for economic growth of a country. Recently, RandD outsourcing industry of India has grown immensely and deals with all major sectors like IT, telecom, auto, research and pharmaceuticals. Presently, US tax code allows US multinationals to claim immediate deductions for expenses supporting their overseas investments and defer payment of US tax until those profits are repatriated to the US. In order to curb avoidance of tax, US proposes to provide deductions to US multinationals on overseas expenses only if they pay taxes on their offshore profits.

However, in its new tax proposal, the US has exempted the overseas Research and Experimentation expenses enabling US multinationals to receive immediate deductions on their US tax returns. Hence, even if the new tax proposal transforms into legislation, it should not have a significant impact on the RandD outsourcing industry of India.

Structuring the Outsourcing

In a global economy where capital flows freely across borders, it will be difficult for the US administration to restrict multinationals from investing in India. Most US multinational companies do not invest in India only to take advantage of the deferral system existing in the US tax code. In case, the US administration legislates the proposed tax code, it may lead to US multinationals conducting a detailed analysis of economic benefits of outsourcing a particular service and outsourcing only those jobs to India which produces higher profits when outsourced to an Indian subsidiary in comparison to the taxes associated with outsourcing such jobs.

In such a scenario independent BPO units will have to be more competitive and captive BPOs will have to look at maximising their profits by cutting costs. However, it is unlikely that outsourcing would yield less profit considering India's potential to provide highly skilled manpower, cost-effectiveness, and proximity to fast-growing Asian markets.

The Indian government may also have to consider revising and upgrading the existing sops to BPOs including tax incentives. BPOs may consider shifting operations to suburban and rural India to avail benefits of cheaper labour and the likely tax and infrastructural incentives provided by the government.

Outsourcing is an economic reality and cannot be curtailed by changing the tax code applicable to the outsourcer and most economic and business experts would agree that India will remain a lucrative investment destination for the US as it continues to offer skilled manpower, large and inexpensive labour force and immense growth potential. Even in case the US administration succeeds in bringing the new tax code into force, decisions on outsourcing will still not rest in their hands. Businesses, large and small, will continue to be driven by and to do what they believe is best for survival and growth.


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