|
Introduction:
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.
|
Outsourcing To India: Legal And Tax Considerations
More
Articles:
The
author can be reached at: soumya@legalserviceindia.com /
