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Straight from the Specialists

Is taxing onsite work of IT companies pragmatic?

By Vishal Shah and Smit Sheth
January 30, 2011

An employee counts rupee notes at a cash counter inside a bank in Mumbai June 21, 2010. REUTERS/Rupak de Chowdhuri/Files

(The views expressed in this column are the authors’ own and do not represent those of Reuters)

The Indian IT industry has led India’s “service sector” revolution. This has brought them accolades both in India as also globally. But once again, the taxman seems to have set his lens on them.

This time around it is Infosys which is facing a potential tax liability of a whopping 4.54 bln rupees. There are reports that other IT companies could also be under the lens.

BUSINESS MODEL

Typically, the IT companies follow the classic “offshore-onshore” global services delivery model. The offshore revenues are generated from activities undertaken at the software development centres located in India. The onshore or onsite revenues, on the other hand, are earned from activities undertaken at client’s location or at global development centres, as part of the software development activity.

The onsite work typically includes gathering business requirements, showcasing “project image” of offshore (Indian) development process, conducting real-time testing & implementation processes at the customer’s premises, etc.  The onsite work could constitute around 40 to 50 percent of the revenues of Indian IT companies.

TAX HOLIDAY PROVISIONS

The Income Tax law provides 100 percent tax holiday (under Sections 10A /10B /10AA) for profits arising from export of computer software by the units of IT companies set up in EOUs / STPs/ SEZs.  The tax holiday is available not only in respect of offshore software development activities undertaken in India but also in respect of onsite software development activities (including services thereof) at client locations overseas.

There was a specific amendment in statue in 2001 to recognise the tax holiday availability in respect of onsite development work undertaken overseas at the client location.

TAXMAN’S ARGUMENTS

Now, the Tax Department seems to have argued (in Infosys’ case – based on media reports) that the arrangement of deputation of employees overseas is a “Body Shopping” arrangement and not an activity in relation to software development. Under a body shopping arrangement, the workers are delivered on a project basis, usually as full-time equivalents of employees.

The Tax Department seems to contend that the work undertaken overseas by the technicians of Indian IT companies is not for the Indian company but for the overseas client and thus, not eligible for tax holiday.

DECIDING FACTOR

Clearly, whether the activities of deputing Indian technicians overseas qualify as body shopping or software development activity on behalf of Indian IT company is a question of facts and needs to be determined in each case. The key factors which one has to consider in this context include:

– Supervision and control over the onsite work of the employees
– Regular review of work performed by deputed employees
– Responsibility & ownership of the outcome of onsite work
– Indemnity for work undertaken by deputed employees
– Linkage with the offshore work done in the EOU/ STP/ SEZ of Indian Co
– Interaction with Indian EOU/ STP/ SEZ Units, etc.

In a scenario, where the Indian IT company takes the overall responsibility of work being undertaken by deputed employees and there is a linkage with the offshore work being done in India (which generally is the business model), then the revenues should qualify as software development revenues and not a body shopping arrangement.

On a similar issue, the Mumbai Tribunal in March 2010 in case of Meridian Enterprises Consulting had decided the matter in favour of the taxpayer. The claim of the Tax Department of treating revenues from deputation of employees for undertaking software development activities or services thereof, as not being eligible for tax holiday was not upheld by the tax tribunal. This decision would certainly help IT companies in substantiating the tax holiday claim in respect of the revenues from onsite deputation of employees.

The step of the Tax Department in the case of Infosys has certainly sent shock waves through the IT industry. More so in today’s environment where lower client budgets in the developed world coupled with significant wage inflation back home have put pressure on overall margins.

The larger issue here is though of ‘uncertainty’ of the tax environment. Clearly, as one would imagine that the IT companies (say Infosys here) have not started on a new onsite delivery model but this model has already been in vogue for several years, and for which tax holiday have also been allowed.  While, admittedly, the res judicata principle (position taken earlier to apply) does not extend to tax law, one would expect a more pragmatic approach to provide much needed tax certainty to businesses.

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