Indian Taxation of “Body Shops” and Onshore-Offshore Model: 100% Tax-Exempt No Longer?

January 20, 2011 by Bierce & Kenerson, P.C.

In mid January 2011, Indian tax authorities reportedly directed Infosys to explain, in a tax audit, why the existing tax exemption on revenue from software exports should apply to revenue generated by employees providing services outside India, at customer locations in “onshore” countries like the U.S. and Europe. Indian Income Tax Law Sections 10A and 10AA exempt from Indian tax the export income of Indian companies in special economic zones. The question is whether the work performed outside of India qualifies for the Indian income tax exemption. It is a new perspective on the legal interpretation of the common practice loosely referred to as “body shopping,” which has many different meanings. For Infosys, the amount of income that could be taxable is reportedly 400 crore (400 times 10 million Rupees, or about $87.7 million).

The Classic Global Services Model. The Indian tax audit approach is new and could augur a possible rethinking of the classic “offshore-onshore” global services delivery model. In this classic model, software is developed by sending experienced technicians to the customer’s locations to gather business requirements, “project manage” the offshore (Indian) development process and implement exported software on customer computers. Relying on a 1994 advice from the Indian tax authorities, Indian IT companies take the position that all such integrated services are part of the software as a unit, and that separating components of the software development process by location is contrary to prior tax regulatory interpretation. NASSCOM President Som Mittal reportedly expressed support for the exemption of all services income from the export of software developed in India and onsite in the customer countries.

Rethinking the Classic Model: Impact of BPM on ADM and “Body Shops.” Software development services are typically referred to as applications development and maintenance, or “ADM.” Whether software development uses a “waterfall” method or an “agile” method such as SCRUM, every software development requires “business analysis” to map processes and define process requirements and for software engineers to conduct validation testing with feedback from end-users to technical personnel for confirmation of usability and conformity to requirements. Before the advent of business process management (“BPM”) software, sending foreign IT workers to the U.S. was normal. Since the late 2000’s, such software has become prevalent to assist enterprises in integrating and transforming the dispersed operations and enabling transparency as required under the Sarbanes-Oxley Act of 2002.

Indian Regulatory Image of the Classic Global Services Model: “Body Shops.” From the Indian tax standpoint, the audit inquiry suggests a new scrutiny of whether sending Indian technicians to America should be taxable as a “body shop” arrangement. “Body shop” arrangements have historically not been seen as the temporary exportation of people to perform services in the customer countries. Rather, such arrangements have been seen as an integral element of software development. In short, this Indian tax audit of Infosys suggests that the advent of BPM software tools for process mapping and management could justify a change in the interpretation of Indian tax laws 10A and 10AA.

American Image of the Classic Global Services Model: “Body Shops.” This Indian tax exemption issue casts a mirror image in India of the American “problem” of “body shops” (or, as Sen. Chuck Schumer said in 2010, “chop shops”). A body shop delivers workers on a project basis, usually as full-time equivalents of employees. American labor and legislators have bemoaned “body shopping” under H1-B visas, which were typically the visa chosen to enable foreign workers to work in the U.S.

“Body shop” arrangements involve some complex tax issues in the U.S. If the employee of the foreign IT firm is a U.S. citizen or lawful permanent resident (“LPR”), no visa is required. Further, such U.S. citizens or LPR’s normally are employed by a U.S. affiliate of the foreign IT company. This generates U.S. taxable income for the U.S. affiliate that is taxable by the U.S. and is subject to taxation in India (or other home country) on distribution as a dividend. Local U.S. employees pay U.S. income taxes too. When foreign IT service providers send foreign employees to the U.S. for short periods on temporary visitor visas where they do not become taxable residents, U.S. tax revenue is lost. Where they stay for longer periods, they are seen as displacing American citizens and LPR’s.

Tax Policy Tensions in India. It is not clear whether the Indian tax authorities’ audit inquiry will result in any imposition of tax in India or, if so, how much would be exempt from Indian tax under the relevant Double Tax Agreements with customer countries. The Indian tax authorities have not concluded their investigation or assessed Infosys. But the topic is a hot one, underscoring the tension between

promoting an IT industry with tax exemptions for export, and

collecting revenue from a narrow re-interpretation of a 1994 tax view that onshore services are integral to the export from India’s “offshore” locations (export-oriented units, software technology parks and special economic zones).

Indian Taxation of “Body Shops” and Onshore-Offshore Model: 100% Tax-Exempt No Longer?

Publisher’s Blog