Foreign IT firms use transfer-pricing provisions, double taxation
treaties to minimise taxes in India
These are differences that are increasingly drawing the inquisitive
and corrective eye of the income-tax department. In 2009-10, TCS, the
largest home-grown IT company, recorded a net profit per employee of
Rs 4.3 lakh. By comparison, Capgemini, a foreign IT firm with
operations in India, recorded a net profit per employee of Rs 1.5 lakh
-- about onethird of TCS.
The operations of Indian and foreign IT firms are now structured
similarly, they fight for the same business, there is parity in their
contract pricing and employee salaries, they follow the same tax
rules. So, then, why are foreign IT firms reporting profitability
numbers that are a fraction of their Indian peers?
It's a question the IT department is beginning to evidently ask
foreign IT firms with greater frequency -- and extract more tax
revenues from them.
It's not just profits per employee. The differences are equally wide
on every comparative financial metric: revenue per employee, operating
profit margin, net profit margin...This, say tax experts, is the
effect of 'transfer pricing' --or how a foreign parent with operations
in many countries, including tax havens, prices its transactions with
its Indian subsidiary, ostensibly to reduce its overall tax liability.
The basic premise of rules governing such related-party transactions
is that the price at which the Indian subsidiary (say, IBM India)
provides a service to its parent (say, IBM US) should be similar to
what it would have charged a client.
Claiming that foreign IT firms don't always invoke this principle of
pricing, the IT department is showing the transfer-pricing rules --
introduced in 2001 --to them. Cases of the department asking foreign
IT companies to recalculate revenues are increasing.
As is the quantum of adjustments on account of transfer pricing. The
overall adjustment figure for all foreign companies operating in
India, in both the IT sector and in non-ITsectors, hit a new high of
Rs 22,800 crore in 2010-11.
Individual numbers for the IT sector are unavailable, but Rohan
Phatarphekar, head of transfer pricing at KPMG, estimates that IT and
ITES (IT-enabled services) companies accounted for "onethird to half "
of these adjustments.
THE CASE FOR ADJUSTMENTS...
Most Indian subsidiaries of foreign IT companies operate as 'captives'
-- that is, they mostly service their parent companies, located in the
US and Europe. So, the parent or another subsidiary located in those
continents receives orders from clients. They sub-contract this work
to their Indian subsidiaries. At least 90% of the revenues of the
Indian subsidiaries of Accenture, Capgemini and IBM were with group
companies.
The Indian subsidiary of a foreign IT company takes limited risks. All
the risk related to the order, like pricing and delivery, is borne by
the overseas unit. So, the profit margin is lower for the Indian
arm.The operations of, say, TCS and IBM India are not strictly
comparable, as these companies abroad bring the customers and it's
their name that stands before the customers.
HITENDER MEHTA
Partner, Vaish Associates Advocates
The pricing is usually on a 'cost-plus' basis. This means the Indian
subsidiary is reimbursed for all costs incurred and a margin. In
effect, this model delinks the price paid by clients in the UK or US
and the amount paid to the Indian subsidiary for the work done by it.
As a result, while the top three foreign IT firms in India have 30% of
their global workforce in the country, they report only 5% of their
global revenues from India.
In its 2010 annual report, Capgemini, for instance, says: "...the
margin for Asia-Pacific is not representative of its activities, which
mostly consist of internal subcontracting carried out in India."
Capgemini, initially, agreed to participate in the story, but did not,
despite repeated reminders over email and phone. According to Nasscom,
the association for the industry in India, there were about 750
captives in the country in 2009, employing 400,000 professionals and
accounting for $10.6 billion in revenues.
These did work for their parents, either wholly or mostly. In
addition, according to Som Mittal, president of Nasscom, there are 100
units of foreign IT companies, which are not captives. Together, they
would be accounting for 30-35% of India's software export revenues and
40% of employees.
The growing presence of captives and Indian subsidiaries of foreign IT
firms has drawn the attention of tax authorities, who are looking at
transfer-pricing transactions closely than ever before. Says a senior
income tax official not wanting to be identified: "The issue is how
the company apportions its cost and profit. The department initiates
action when it sees unfair apportionment to reduce tax liability in
India."
According to Rohan Phatarphekar, a reason cited by tax authorities to
justify adjustments is higher profit margins of homegrown IT firms.
For example, in 2009-10, TCS recorded an operating margin of 45%,
whereas IBM India reported a margin of 30%.
Mittal says there is no reason why foreign IT and ITES firms should be
targeted. "Till March 2011, these companies were covered under Section
10A and 10B of the Income Tax Act (which exempt income from taxes),"
he says. "There is no motive for them to undervalue transactions."
...AND THE CASE AGAINST
Even otherwise, tax experts say, given the nature of the work done by
the respective parties, foreign It companies can justify lower
revenues. Hitender Mehta, partner with Vaish Associates Advocates, a
law firm specialising in tax matters, says the Indian subsidiary of a
foreign IT company takes limited risks. "All the risk related to the
order, like pricing and delivery, is borne by the overseas unit," he
says. " ."
According to Vaish, the operations of, say, TCS and IBM India are not
strictly comparable, as "these companies abroad bring the customers
and it's their name that stands before the customers." IBM India, the
whollyowned subsidiary of IBM World Trade Corporation of USA, declined
to respond to a questionnaire.
We comply with all international standards of transfer pricing. The
revenue and profits of Accenture India cannot be compared with those
of Indian IT companies, as their business models are different. We are
organised into 40 industry groups and these in turn are grouped into
five operating groups, where our profit and loss resides.
JIM MCAVOY
Spokesman, Accenture
This argument is corroborated by E Balaji, CEO of Mafoi, an HR firm.
"In the IT industry, client-facing jobs carry a premium compared to
other functions like coding," he says. "Also consultants earn at least
15-25% more than normal IT professionals."
By these arguments, foreign IT companies should get some leeway in
transfer pricing. But the question remains: how much? Mittal says
numbers of foreign information technology firms should not be
benchmarked to those of top homegrown technology services firms. "Tax
authorities can't take the best performers and ask for a higher mark
up," says Mittal.
"They should look at the industry average." In 2009, Nasscom estimated
an average operating margin of 15-16% for the industry. "We comply
with all international standards of transfer pricing," says Jim
McAvoy, spokesman of Accenture, which is registered in Ireland, a
low-tax regime.
Its Indian arm posted revenues of Rs 5,270 crore in 2009, about 92% of
which was related-party transactions. The company declined to give
details of transfer-pricing methods adopted by it, or the mark up in
contracts undertaken by Accenture India.
McAvoy says the revenue and profits of Accenture India cannot be
compared with those of Indian IT companies, as their business models
are different.
"We are organised into 40 industry groups and these in turn are
grouped into five operating groups, where our profit and loss
resides," he says.
"Also the global numbers are prepared under US GAAP (generally
accepted accounting principles), whereas the Indian numbers are not US
GAAP-compliant." The three companies declined to reveal the quantum of
adjustments under transfer pricing, if any, made by the tax
department. Their latest annual reports show that IBM India had tax
disputes of -- though not necessarily on account of transfer pricing
-- Rs 94 crore and Capgemini Rs 9.4 crore; Accenture India did not
disclose its figure. No further details were given.
The companies may also have paid some tax on these disputes.
Typically, the department raises a tax demand once its transfer
pricing officer determines undervaluation. "Companies can appeal, but
they have to pay 50% of the demand raised," says Mittal. "This
(appeal) process takes time," adds Gandhi of Deloitte. "In some
instances, the cases are pending for 7-10 years, adding to the
uncertainty." Phatarphekar of KPMG says if the tax authorities sought
a higher mark up, India would lose business. "Clients expect cost
savings to be passed on when work is outsourced to India," he says.
MANAGING TAX LIABILITY
Compared to homegrown firms, foreign IT firms with operations in India
have greater scope to avoid taxes (See box: Methods of Tax Avoidance).
And they are using it to good effect. Take Cognizant Technology
Solutions, which is registered in the US.
It uses a provision in US tax laws to reduce its tax liabilities. The
provision allows USbased firms not to pay tax on their non-US income
if they declare they will not repatriate the money to the US. "We have
indicated that since 2002," says Gordon Coburn, chief fi-nancial and
operating officer of Cognizant. "The reinvestment policy will drive
our future capital and acquisition expansion plans outside the US,
including in India." In 2010, Cognizant incurred capital expenses of
$180 million, globally. In calendar 2010, Cognizant's tax incidence --
tax paid as a percentage of profit before tax -- was 10 percentage
points lower than that of Infosys.
Another active method of tax avoidance is share buyback, which the
Indian subsidiaries of Accenture and Capgemini have used in recent
years to potent effect. It enables companies to take profits out of
India; if they route it through a tax haven, as both these companies
did, they pay zero tax on this transaction.
For example, Accenture holds nearly 100% in Accenture India through a
Mauritius-registered entity, Beaumont Development Centre Holdings. In
the last five years, Accenture India has twice bought back shares,
paying Rs 474 crore to Beaumont. When asked why Accenture opted for a
buyback when there was only one shareholder, and not dividend, McAvoy
says: "It was more (tax) efficient."
Long-term capital gains tax (holding period of above one year) in
India is zero. And since India has a double taxation avoidance
agreement with Mauritius, the company does not have to pay capital
gains tax in the island nation too.
Had Accenture routed the profits as dividend, it would have had to pay
dividend distribution tax of 16.9%, or Rs 80 crore. Even Capgemini
India had a share buyback scheme in March 2011, where it extinguished
7% of its capital for Rs 366 crore; interestingly only one
shareholder, Kanbay Asia (Mauritius), participated.
Foreign IT firms can make clever use of tax laws, and the tax
arbitrage between nations, to minimise their tax liability in India.
That said, the tax department seems to be checking at least one of
those strategies: transfer pricing.
treaties to minimise taxes in India
These are differences that are increasingly drawing the inquisitive
and corrective eye of the income-tax department. In 2009-10, TCS, the
largest home-grown IT company, recorded a net profit per employee of
Rs 4.3 lakh. By comparison, Capgemini, a foreign IT firm with
operations in India, recorded a net profit per employee of Rs 1.5 lakh
-- about onethird of TCS.
The operations of Indian and foreign IT firms are now structured
similarly, they fight for the same business, there is parity in their
contract pricing and employee salaries, they follow the same tax
rules. So, then, why are foreign IT firms reporting profitability
numbers that are a fraction of their Indian peers?
It's a question the IT department is beginning to evidently ask
foreign IT firms with greater frequency -- and extract more tax
revenues from them.
It's not just profits per employee. The differences are equally wide
on every comparative financial metric: revenue per employee, operating
profit margin, net profit margin...This, say tax experts, is the
effect of 'transfer pricing' --or how a foreign parent with operations
in many countries, including tax havens, prices its transactions with
its Indian subsidiary, ostensibly to reduce its overall tax liability.
The basic premise of rules governing such related-party transactions
is that the price at which the Indian subsidiary (say, IBM India)
provides a service to its parent (say, IBM US) should be similar to
what it would have charged a client.
Claiming that foreign IT firms don't always invoke this principle of
pricing, the IT department is showing the transfer-pricing rules --
introduced in 2001 --to them. Cases of the department asking foreign
IT companies to recalculate revenues are increasing.
As is the quantum of adjustments on account of transfer pricing. The
overall adjustment figure for all foreign companies operating in
India, in both the IT sector and in non-ITsectors, hit a new high of
Rs 22,800 crore in 2010-11.
Individual numbers for the IT sector are unavailable, but Rohan
Phatarphekar, head of transfer pricing at KPMG, estimates that IT and
ITES (IT-enabled services) companies accounted for "onethird to half "
of these adjustments.
THE CASE FOR ADJUSTMENTS...
Most Indian subsidiaries of foreign IT companies operate as 'captives'
-- that is, they mostly service their parent companies, located in the
US and Europe. So, the parent or another subsidiary located in those
continents receives orders from clients. They sub-contract this work
to their Indian subsidiaries. At least 90% of the revenues of the
Indian subsidiaries of Accenture, Capgemini and IBM were with group
companies.
The Indian subsidiary of a foreign IT company takes limited risks. All
the risk related to the order, like pricing and delivery, is borne by
the overseas unit. So, the profit margin is lower for the Indian
arm.The operations of, say, TCS and IBM India are not strictly
comparable, as these companies abroad bring the customers and it's
their name that stands before the customers.
HITENDER MEHTA
Partner, Vaish Associates Advocates
The pricing is usually on a 'cost-plus' basis. This means the Indian
subsidiary is reimbursed for all costs incurred and a margin. In
effect, this model delinks the price paid by clients in the UK or US
and the amount paid to the Indian subsidiary for the work done by it.
As a result, while the top three foreign IT firms in India have 30% of
their global workforce in the country, they report only 5% of their
global revenues from India.
In its 2010 annual report, Capgemini, for instance, says: "...the
margin for Asia-Pacific is not representative of its activities, which
mostly consist of internal subcontracting carried out in India."
Capgemini, initially, agreed to participate in the story, but did not,
despite repeated reminders over email and phone. According to Nasscom,
the association for the industry in India, there were about 750
captives in the country in 2009, employing 400,000 professionals and
accounting for $10.6 billion in revenues.
These did work for their parents, either wholly or mostly. In
addition, according to Som Mittal, president of Nasscom, there are 100
units of foreign IT companies, which are not captives. Together, they
would be accounting for 30-35% of India's software export revenues and
40% of employees.
The growing presence of captives and Indian subsidiaries of foreign IT
firms has drawn the attention of tax authorities, who are looking at
transfer-pricing transactions closely than ever before. Says a senior
income tax official not wanting to be identified: "The issue is how
the company apportions its cost and profit. The department initiates
action when it sees unfair apportionment to reduce tax liability in
India."
According to Rohan Phatarphekar, a reason cited by tax authorities to
justify adjustments is higher profit margins of homegrown IT firms.
For example, in 2009-10, TCS recorded an operating margin of 45%,
whereas IBM India reported a margin of 30%.
Mittal says there is no reason why foreign IT and ITES firms should be
targeted. "Till March 2011, these companies were covered under Section
10A and 10B of the Income Tax Act (which exempt income from taxes),"
he says. "There is no motive for them to undervalue transactions."
...AND THE CASE AGAINST
Even otherwise, tax experts say, given the nature of the work done by
the respective parties, foreign It companies can justify lower
revenues. Hitender Mehta, partner with Vaish Associates Advocates, a
law firm specialising in tax matters, says the Indian subsidiary of a
foreign IT company takes limited risks. "All the risk related to the
order, like pricing and delivery, is borne by the overseas unit," he
says. " ."
According to Vaish, the operations of, say, TCS and IBM India are not
strictly comparable, as "these companies abroad bring the customers
and it's their name that stands before the customers." IBM India, the
whollyowned subsidiary of IBM World Trade Corporation of USA, declined
to respond to a questionnaire.
We comply with all international standards of transfer pricing. The
revenue and profits of Accenture India cannot be compared with those
of Indian IT companies, as their business models are different. We are
organised into 40 industry groups and these in turn are grouped into
five operating groups, where our profit and loss resides.
JIM MCAVOY
Spokesman, Accenture
This argument is corroborated by E Balaji, CEO of Mafoi, an HR firm.
"In the IT industry, client-facing jobs carry a premium compared to
other functions like coding," he says. "Also consultants earn at least
15-25% more than normal IT professionals."
By these arguments, foreign IT companies should get some leeway in
transfer pricing. But the question remains: how much? Mittal says
numbers of foreign information technology firms should not be
benchmarked to those of top homegrown technology services firms. "Tax
authorities can't take the best performers and ask for a higher mark
up," says Mittal.
"They should look at the industry average." In 2009, Nasscom estimated
an average operating margin of 15-16% for the industry. "We comply
with all international standards of transfer pricing," says Jim
McAvoy, spokesman of Accenture, which is registered in Ireland, a
low-tax regime.
Its Indian arm posted revenues of Rs 5,270 crore in 2009, about 92% of
which was related-party transactions. The company declined to give
details of transfer-pricing methods adopted by it, or the mark up in
contracts undertaken by Accenture India.
McAvoy says the revenue and profits of Accenture India cannot be
compared with those of Indian IT companies, as their business models
are different.
"We are organised into 40 industry groups and these in turn are
grouped into five operating groups, where our profit and loss
resides," he says.
"Also the global numbers are prepared under US GAAP (generally
accepted accounting principles), whereas the Indian numbers are not US
GAAP-compliant." The three companies declined to reveal the quantum of
adjustments under transfer pricing, if any, made by the tax
department. Their latest annual reports show that IBM India had tax
disputes of -- though not necessarily on account of transfer pricing
-- Rs 94 crore and Capgemini Rs 9.4 crore; Accenture India did not
disclose its figure. No further details were given.
The companies may also have paid some tax on these disputes.
Typically, the department raises a tax demand once its transfer
pricing officer determines undervaluation. "Companies can appeal, but
they have to pay 50% of the demand raised," says Mittal. "This
(appeal) process takes time," adds Gandhi of Deloitte. "In some
instances, the cases are pending for 7-10 years, adding to the
uncertainty." Phatarphekar of KPMG says if the tax authorities sought
a higher mark up, India would lose business. "Clients expect cost
savings to be passed on when work is outsourced to India," he says.
MANAGING TAX LIABILITY
Compared to homegrown firms, foreign IT firms with operations in India
have greater scope to avoid taxes (See box: Methods of Tax Avoidance).
And they are using it to good effect. Take Cognizant Technology
Solutions, which is registered in the US.
It uses a provision in US tax laws to reduce its tax liabilities. The
provision allows USbased firms not to pay tax on their non-US income
if they declare they will not repatriate the money to the US. "We have
indicated that since 2002," says Gordon Coburn, chief fi-nancial and
operating officer of Cognizant. "The reinvestment policy will drive
our future capital and acquisition expansion plans outside the US,
including in India." In 2010, Cognizant incurred capital expenses of
$180 million, globally. In calendar 2010, Cognizant's tax incidence --
tax paid as a percentage of profit before tax -- was 10 percentage
points lower than that of Infosys.
Another active method of tax avoidance is share buyback, which the
Indian subsidiaries of Accenture and Capgemini have used in recent
years to potent effect. It enables companies to take profits out of
India; if they route it through a tax haven, as both these companies
did, they pay zero tax on this transaction.
For example, Accenture holds nearly 100% in Accenture India through a
Mauritius-registered entity, Beaumont Development Centre Holdings. In
the last five years, Accenture India has twice bought back shares,
paying Rs 474 crore to Beaumont. When asked why Accenture opted for a
buyback when there was only one shareholder, and not dividend, McAvoy
says: "It was more (tax) efficient."
Long-term capital gains tax (holding period of above one year) in
India is zero. And since India has a double taxation avoidance
agreement with Mauritius, the company does not have to pay capital
gains tax in the island nation too.
Had Accenture routed the profits as dividend, it would have had to pay
dividend distribution tax of 16.9%, or Rs 80 crore. Even Capgemini
India had a share buyback scheme in March 2011, where it extinguished
7% of its capital for Rs 366 crore; interestingly only one
shareholder, Kanbay Asia (Mauritius), participated.
Foreign IT firms can make clever use of tax laws, and the tax
arbitrage between nations, to minimise their tax liability in India.
That said, the tax department seems to be checking at least one of
those strategies: transfer pricing.
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