Outsourcing To India: Legal And Tax Consideration

Over the last few years, India has emerged as a leading destination for companies wishing to outsource their software development, and business process requirements. International companies have either entered into contracts with Indian service companies or set up their own facilities through Joint Ventures and Indian subsidiaries.

Indian Government has been a catalyst in the growth of the Indian software and BPO industry through the tax incentives provided to exporters. These incentives are aimed largely at maximizing exports, thereby resulting in an inflow of foreign exchange into India. Industrial policy reforms have eliminated the licensing requirements except for certain select sectors, removed restrictions on investment and expansion and facilitated easy access to foreign technology and direct investment. This has contributed to increased inflow of foreign exchange into India.

Foreign Investment Policy
Foreign investment is permitted in virtually every sector, except those of strategic concern such as defence (opened up recently to a limited extent) and rail transport. Foreign companies are permitted to set up Wholly Owned Subsidiaries in India. No prior approval from the exchange control authorities (RBI) is required, except for certain specified activities. The investment should be in accordance with the prescribed guidelines and the details of the investment should be filed with the authorities within the prescribed time limit. This investment procedure is commonly known as the "automatic approval route".

Foreign Investment Promotion Board (FIPB) of the Government of India is constituted mainly to promote inflow of FDI into the country, as also to provide appropriate institutional arrangements, transparent procedures and guidelines for investment promotion and to consider and approve proposals for foreign investment.

Automatic approval route and FIPB route
Foreign investment into India is governed by the Foreign Direct Investment (FDI) policy of the Government and the Foreign Exchange Management Act, 1999 (FEMA). With increasing liberalisation of the Indian economy, generally, there is no need to obtain prior approval of the Government of India for a fresh investment to be made into an Indian company (only procedural filings have to be made with the Reserve Bank of India (RBI), the Indian central bank). In certain cases, however, and also for investment in certain specified sectors, prior approval is required. Further, investment in certain specified sectors is subject to foreign equity caps.

Outsourcing vs. Software Development Centre

The determination of whether to outsource to an Indian software services company or set up one’s own facility is largely a business decision. A long term requirement could make investment in a subsidiary worthwhile. Recent transfer pricing regulations may however have an impact on the pricing of the services provided by the subsidiary. A requirement for highly specialized work may also point to setting up one’s own facility. The need to exercise control over valuable intellectual property and maintenance of confidentiality is also a key factor. The slowdown since 2001 has also seen some hybrid structures, for e.g., where the Indian company sets up a separate entity, is assured a steady stream of business and grants the customer an option to purchase the business later. This would have the effect of leveraging on the benefits of outsourcing while sheltering the associated risks.

Software Outsourcing Arrangements

Contractual Protection

Where at least one party is a foreign entity, the parties can choose the law governing the contract. The negotiating power of international customers would typically weigh in favor of choosing a governing law of the customer. The parties may also choose a foreign venue for arbitration. A Foreign arbitral award would be recognized in India if the country of venue has signed either the New York or Geneva conventions and has been notified as having reciprocal relations with India in the matter of enforcement of foreign awards. A foreign arbitral award would generally be more easily enforced in India than a foreign court judgment.
If dispute resolution is to be held in India, it is generally recommended that the parties opt for arbitration because litigation in India can be long drawn and subject to delays. However, it is possible to obtain quick injunctive relief in case of intellectual property violations.

Contract Liability Concerns

Indian law does not contain statutory provisions or case law dealing specifically with liability issues arising from development of software. However, customers should keep in mind that under Indian law, compensation can be awarded for breach of contract only in relation to damages that naturally arise in the usual course of things and which the parties knew would result from such breach. It cannot extend to any remote or indirect losses. Further, Indian courts rarely award large damages for breach of contract. Delays in the justice system also make speedy recovery of money difficult. This may impact the ability of customers to recover fees paid or obtain damages in Indian courts.

Copyright and Protection of Intellectual Property

It is generally difficult to patent software programmes in India. Under copyright law, the software developer, being an independent contractor, would be the author of the works and therefore, the owner. However, Indian law permits the parties to agree that the customer would be the owner of the copyright. Under Indian law, in the absence of anything to the contrary, it is presumed that an assignment or license of a copyright work would be limited to 5 years and to the territory of India. Further, the assignment may lapse if the work product is not made use of within one year. Accordingly, the contract would need to mention specific language to overcome these presumptions. An assignment agreement must also specifically describe the work to be assigned. It is important to note that the knowing violation of copyright in India is a criminal offence. It is possible to obtain reasonably quick injunctive relief from Indian courts for intellectual property violation. However, it is important that the customer chooses an IP friendly jurisdiction. The Business Software Alliance has had some success in obtaining Anton Pillar orders from Indian courts and conducting raids on distributors of pirated software. Another remedy that could be used is criminal breach of trust, if the developer has misused proprietary software or know-how provided by the customer.

India does not have a statute governing the protection of confidential information and trade secrets. Further, there is no statute dealing with data protection or privacy matters. One would typically obtain protection through a civil action under common law. Recently, the central government and some state governments have expressed an interest in bringing forth a separate legislation for data protection in an effort to attract more investment in BPO activities. Another option would be to file an action for criminal breach of trust. This is based on the principle that confidential information is provided “in trust" and any misuse would amount to a breach of trust. Criminal action has its advantages in that the individuals involved will be put to inconvenience in terms of personal appearance before the court, the perceived stigma and the restrictions on traveling out of India.

Tax Issues
Under Indian law, software and BPO companies would typically be exempt from tax in relation to income earned from export of software out of India if the fees are received in convertible foreign currency. This may affect certain types of outsourcing arrangements, for example, where the customer wishes to outsource the work from its existing Indian subsidiary. Payment of fees in Indian Rupees could significantly increase the cost, because the developer would seek to recover the tax payable on its margins. Another important issue is the possibility that the customer may be held to have a permanent establishment in India if it transfers testing equipment to the developer for use while developing the software.

Another relevant issue is the taxation on Information Technology related services. In an attempt to boost the growth of software exporting, Government of India has exempted export of services and also secondary services consumed in exported services from service tax.

As mentioned earlier, India’s software companies are largely exempt from tax. However, it is possible that the exemption may be removed or substantially reduced in the future. In such event, the Vendor would seek to increase its fees. The customer must recognize this as a reasonable possibility and perhaps, obtain fixed, tax inclusive costs, at least in the short term.

Outsourcing Through Ownership Model

Foreign Investment Regulations
Software development and BPO services is now under the automatic route and no foreign investment approvals are required to set up a wholly owned subsidiary; only certain filings need to be made after receipt and issue of share capital. However, acquisition of shares in an existing Indian company may still require a prior foreign investment approval.

Choice of Vehicle - Private Company

Most foreign corporations set up their subsidiaries as private limited companies with liability limited by share capital. This entity is similar but not identical to an unlisted C Corporation in the USA and has no flow-through taxation. A private company can have a maximum of 50 shareholders (excluding employees), must restrict the transferability of its shares and is prohibited from making invitations to the public for subscription to shares, debentures or deposits. A private company is generally less regulated than a public company. It must have at least 2 shareholders. Regulations relating to personal presence of shareholders at shareholder meetings, and limitations on transfer of shares under exchange control laws would require a careful structuring of share capital investment into the subsidiary.

Funding the Venture

Restrictions imposed by Indian exchange control laws on the ability of an Indian company to obtain short term debt from abroad make it difficult to fund the subsidiary through loan funds. Inflexible buy back regulations make a buyback of share capital difficult. Hence, the parent would typically seek to fund only the capital costs through share capital. One could possibly consider funding the operating expenses by the holding company making trade advances to the subsidiary for services to be performed.

Software Technology Park Units

Most foreign corporations interested in engaging in development of software and BPO services in India set up their Indian subsidiaries as Software Technology Park (STP) Units. This is not a separate legal entity but merely a status obtained from the government. The STP status entitles the company to substantial tax benefits, subject to it meeting certain export commitments.

An STP unit would need to be a customs bonded area. This means that it can be at a location of the Company’s choosing but must be in an area demarcated specifically for STP operations. Some formalities on entry and removal of goods would apply. In practice, most companies handle these requirements with ease.

Activities of an STP

The permitted activities of an STP do not cover just software development activities. An STP’s activities could include (a) software development (b) hardware design, digital signal processing; and (c) business process outsourcing, including medical transcription services, customer relations, document processing and call centres. On site services through deputed personnel would also be covered.
Because an STP is supposed to be engaged primarily in export activities, its ability to make sales within the Indian market is limited to the equivalent of 50% of its total exports. Further, restrictions under both STP regulations and tax laws would limit the ability of the Indian subsidiary to outsource work to another Indian STP.

Export Requirements for STP Units

The export related commitments that need to be satisfied by an STP Unit are driven largely by the Government’s objective of maximizing the country’s foreign exchange reserves. These commitments are as follows:

# Exports of US$ 0.25 million or 5 times the CIF value of imported capital goods, whichever is higher (if no capital goods are imported, the US$ 0.25 million requirement would apply).

# An annual Net Foreign Exchange Earnings as a Percentage of Exports (NFEP) of 10%. This means that the inflow of foreign exchange earned by the company should be at least 10% more than the outflow of foreign exchange out of India.

Both the requirements need to be satisfied over a period of 5 years. The value of capital goods would cover the entire CIF value - cost, insurance and freight. However, the value of exports would cover only the landed cost. Further, it may be noted that in considering the outflow of foreign exchange, the dividend distributed to the holding company would also need to be considered.

Income Tax Benefits

An STP Unit in India would be entitled to enjoy the remainder of a 10 year tax holiday commencing from April 1, 2000 to March 31, 2009. (The Indian tax year runs from April 1 to March 31). The tax benefit would apply only if the software/service is exported out of India and payment is received in convertible foreign exchange. It would also not cover profits earned from domestic business or income other than from STPI services. The tax holiday will not cover dividend distribution.

The STP Unit cannot be set up as a result of the re-organization or break up of an existing business and not more than 20% of its hardware should constitute hardware previously used by another business. Hence, in an acquisition, a careful structuring may be required in order to preserve the tax holiday.

Transfer Pricing Regulations

Indian tax laws have recently included provisions relating to transfer pricing, requiring pricing of transactions between associated enterprises to be at arms length. Even in the case of a tax exempt software company, this assumes significance because if the tax authorities conclude that the consideration payable to the Indian subsidiary is not at arms length, the enhanced income determined by the authorities would be subject to tax and would be the basis of possible penalties. Typically, companies opt for a cost plus method (between 7-15%) or standard per diem rates. Since these developments are relatively recent, there is no consensus yet on what would be an acceptable pricing formula.

Indirect Tax

An STP company can import capital goods and consumables without payment of any customs duty. However, the higher the value of imported goods, the higher will be the export commitment, as above. The company would also be exempt from payment of excise duty on manufacture of goods, when purchased from the manufacturer and can claim a refund on sales tax paid by the supplier on sale of the product to the STP.

Tax Benefits for Non-STP Companies

Even if a software exporting company does not have an STP unit, it can avail of the general exemption for profits derived from export of computer software under Indian tax laws. At present, 30% of such export income is tax exempt.

Procedure for Setting up the STP

Setting up the STP Unit involves compliance with numerous regulatory procedures that would typically take about 3 months. After company incorporation, a detailed STP application has to be prepared, that would include the prescribed application form, a project report, projected 5 year accounts and details of expenses and foreign exchange remittances. This would involve substantial work from the company officials. After obtaining the STP registration, certain other formalities need to be completed relating to customs bonding and obtaining tax registrations.

Operating a Business in India - Key Regulatory Issues

Company Law

Indian company law is based on the English Companies Act of 1948. Key requirements include mandatory board and shareholder meetings, shareholder approval in respect of certain matters, appointment of officers, restrictions on loans and investments, etc.

Exchange Control

The Indian Rupee is fully convertible on the current account though control remains on the capital account. Doing business in India involves wading through India’s complex exchange control regulations that restrict the remittance of foreign exchange out of India.

Employment Laws

Indian employee laws are considered to be somewhat restrictive in terms of requirements relating to lay offs, closure of business, etc. BPO companies need to be particularly concerned about rules relating to flexible working hours, holidays and employment of women at night as well as regulation of leave policies.

Stock Options

Exchange control restrictions that limited the amount that an employee could remit out of India for purchase of foreign stock have been lifted in the case of listed stock of holding companies. Subject to the employer fulfilling certain requirements, employees receiving foreign stock can also claim a tax status similar to the ISO status in the USA.

To conclude
India many believe has just the right "climate" for entrepreneurial development and in 2007 India is the place to be in. It provides a great combination of skill and competency. Combine that with the right investment climate and the ever improving technological efficiency, you find that the great Indian time has arrived. The India boom is here to stay. The heat is on and it's only getting hotter.

More Articles on Outsourcing:
Outsourcing-An Overview
Data Protection: A Study
Strategic outsourcing the key affair in all sectors
The Bpo Strategy - New Mantra For Corporate Efficiency
Data Privacy And Cyber Security Policies Shaping The Legal Outsourcing Landscapes In India

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