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Taxation issues around outsourcing contracts and cross-border outsourcing

Tax implications are important in outsourcing contracts. Let’s refer to the issues in a cross-border outsourcing contract. Assume the company to which work is outsourced is an Indian company - we’ll refer to the outsourcing service provider as the Supplier and the consumer of the service as the Client.

Income tax implications in cross-border outsourcing

Assume that the Supplier is an Indian company and the Client is offshore. In this situation, the Supplier will have to pay income tax on the remuneration it receives from the Client. Usually, if the Supplier and the Client are independent third parties and are not considered to be ‘associated enterprises’ under tax laws, there is no other ramification.

However, certain business arrangements may result in two parties being treated as associated enterprises, which will have additional tax ramifications for the offshore Client. For example, a captive outsourcing subsidiary is an example of an associated enterprise. Situations where two parties can be treated as related enterprises are typically when there is common ownership or control between two enterprises, or one of them either holds a substantial level of ownership or control over the other, or is disproportionately dependent on the other.

Typical indicators of are the commonality of owners, shareholding of one enterprise in another, rights of appointment of board of directors, lending-borrowing or customer-supplier relationships, etc. (see the annexure below for detailed criteria of such indicators).

In such cases, there is a possibility that the offshore Client may be taxed on a certain portion of its income, even if it is earned internationally and no portion of it has been earned in India, by Indian tax authorities. Tax authorities in India will carry out two kinds of assessments to determine this:
  1. Whether the Client has a business presence in India – if the Supplier can be treated as a ‘permanent establishment’ of the Supplier, tax authorities will have a right to tax its income, subject to the condition below. The ‘permanent establishment’ determination is carried out with reference to the Double Taxation Avoidance Agreement (DTAA) that India has with the country in which the Client is based. 
  2. Whether the Supplier was paid on an independent or ‘arms-length’ basis as though they were unrelated third parties. If the Supplier was not paid on an arms-length basis, tax leakages would have occurred, that is, Indian government would have lost some tax revenue due to itself due to the pricing of the transaction. In such a situation, a portion of the income of the Supplier (even if it is generated internationally and without any reference to India), which can be attributed to the operations of the client, will be taxed in India.
Certain acceptable pricing methods are used to determine the price that would have been charged by independent third parties.
International taxation and captive outsourcing

Many large companies have established wholly-owned subsidiaries in India to meet all of their outsourcing requirements – these companies exclusively serve their parent companies and are called captive subsidiaries.

What will be the tax implications for the offshore Client in case it has a captive outsourcing subsidiary in India? As discussed above, a captive outsourcing subsidiary will qualify as an associated enterprise under Indian tax law – however, can it automatically be treated as a permanent establishment as well?

If the captive subsidiaries have independent management, are not controlled in their operations by the Client’s management and do not have the ability to represent or enter into contracts with third parties on behalf of the Client, they will not be treated as permanent establishment of the client. Back-office operations do not create a permanent establishment of the offshore Client.

If, however, the offshore Client uses the premises of the subsidiary through which it carries on its own business, or if it habitually enters into contracts on behalf of the principal, it is said to have established a permanent establishment.

Offshore Clients also send their employees to the Indian subsidiary for various purposes. For example, employees may be sent to ensure that the Indian Supplier is performing services as per the standards set out in the outsourcing contract – this is primarily to protect the interest of the Client. These activities are known as ‘stewardship’ activities and do not create a permanent establishment. However, in case employees are sent on deputation and stay in India for a period longer than that which is specified under Indian tax law or the applicable Double Taxation Avoidance Agreement (DTAA), the employees will be treated as providing services to the Indian Supplier, and on this basis, the Offshore Client will be considered to have a permanent establishment in India.

For reference, read:
  • Supreme Court judgment in Department of Income Tax v Morgan Stanley
  • Delhi High Court judgment in eFunds Corporation v. Assistant DIT
Service tax issues

Let’s understand possible service tax issues in outsourcing contracts:

Situation 1: Where both parties are located in India, that is, in a domestic outsourcing transaction

Where both the Supplier and Client are both located in India, service tax will be levied (at the rate of 12 percent) and the liability of payment of such tax lies on the supplier.

Reasoning: As per Section 66B of the Finance Act (as amended upto 2013) any service which is not on the “negative list” will be levied a service tax at the rate of 12%.  As outsourcing of services is not mentioned in the negative list, service tax will be payable.

Situation 2: Where the Client is located offshore
Provision of services to an offshore client will be treated as export of services, which is exempt from service tax under Indian law

Reasoning: As per rule 3 of the Place of Provision of Service Rules, 2012, the place of provision of the service is where the service recipient is located. As the service is deemed to have been provided outside the taxable territory (India) and as per 66B of the Finance Act, service tax is applicable only when the service has been provided within the taxable territory. Hence, service tax will not be applicable on such transactions.

Situation 3: Where the Client is in India but the Supplier is offshore, that is, where an Indian company outsources work to another destination

When an outsourcing service has been provided by a foreign supplier to a domestic customer, service tax must be paid by the Indian customer.

Refer: Section 66B of Finance Act read with Rule 3 of the Place of Provision of Service Rules, 2012 and Service Tax Notification No 30/2012 (See serial number 10 of the table in Rule II). Though ordinarily the liability of payment of service tax lies on the person who is providing the service, in case the person providing the service is located in a non-taxable territory (outside India), the person receiving the service in the taxable territory (India) is liable to pay the service tax.

Allocation of tax liability in outsourcing contracts

Tax implications of the outsourcing contract need to be clearly understood negotiated by the parties. Financial burden of taxes can be allocated by the parties amongst themselves by negotiation to a certain extent, as explained below.

Ordinarily, the party making the payments, that is, the client or the consumer of outsourcing services will be required to deduct or withhold tax under Indian tax law. Parties must be clear on whether this amount will be deducted from the price mentioned in the contract, or whether it is exclusive of the withholding tax. If the contract price is independent of the withholding tax, then the total payment made by the client will have to be ‘grossed up’, which increases the client’s financial outgo.

Similarly, in a domestic outsourcing contract parties should clearly specify whether service tax will be added on the contract price – in international outsourcing contracts, service tax is not payable.
How to identify an associated enterprise?

(For reference, see also Section 92A of the Income Tax Act, 1961)
To identify whether an enterprise has direct or indirect management or control of the other enterprise, or on the capital of the other enterprise, one can check the following indicators:

i) direct or indirect holding of shares which enables one enterprise to cast twenty six percent or more of the total votes in the other enterprise

ii) loan advanced by the enterprise which is equal to 51 percent or more of the book value of the total assets of the other enterprise

iii) guarantee of 10 percent or more of the total borrowings of the other enterprise

iv) more than half of the board of directors, members of the governing board, or even if one executive director or executive member of the governing board is appointed by the other enterprise

v) the manufacture or processing of products or services carried out by one enterprise is wholly dependent on the intellectual property owned by the other enterprise

vi) 90 percent or more of the raw materials and consumables required for the manufacture or processing of goods or articles carried out by one enterprise, are supplied by the other enterprise, or by persons specified by the other enterprise, and the prices and other conditions relating to the supply are influenced by such other enterprise

vii) if products manufactured or processed by one enterprise are sold to another enterprise (or to persons specified by the other enterprise), but prices and conditions relating to them are influenced by such other enterprise

viii) where both the enterprises are controlled by the same individual or his relative or jointly by such individual and relative of such individual

ix)  where the enterprise owns 10 percent or more interest in a firm, association of persons or body of individuals

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