Impact of new IRS tax regulations on outsourcing

I just read a very interesting article in the Business Standard on the impact of certain US tax regulation changes on the overall cost of service operations in India. Here are a few interesting quotes from this article:

Prior to the new regulations, multinationals had an option to club several inter-related services and levy a single charge for the entire gamut of services. The new regulations, particularly SCM, would necessitate maintenance of onerous documentation for low margin services. The captive Indian business process outsourcing and the knowledge processing outsourcing units shall be impacted the most.

India’s numerous R&D centres in pharmaceutical, engineering design and technology sectors catering to US parent would have to review existing contracts for development of intangibles.

Whether or not the newly introduced regulations meet IRS’s objective of reducing compliance burden for corporations is something that time would tell. However, the regulations would certainly bolster revenue collections for IRS, while making US services costlier for Indian subsidiaries.

The article is a bit dense, and I am not qualified to judge the accuracy of the tax implications discussed, so you will have to judge for yourself. The article is written by Mukesh Butani who is a partner with BMR & Associates. Based on BMR’s website, he seems to have held senior positions in firms like Ernst & Young India and Andersen, so I will give him the benefit of the doubt.

If Mukesh is right, how do these new regulations (which will become effective from January 2007) impact Rational Outsourcing? Rational outsourcing aims to ensure that the benefits of outsourcing are greater than the total costs of outsourcing. If the new regulations “necessitate maintenance of onerous documentation for low margin services” then that would increase the total cost of outsourcing, while not significantly affecting the benefits of outsourcing (except as noted below). Thus, outsourcing projects that were marginally beneficial may now fail the rational outsourcing test.

These regulations may also impact the benefits of outsourcing in complex ways. Some of the major benefits of certain outsourcing relationships stem from the complex tax benefits of structuring the relationship in a certain manner. Any regulation that modifies the transfer pricing of services provided by the parent organization may significantly affect these tax benefits. At the very least, both the parent and the captive organizations will have to review their contracts and accounting in light of these changes. These unanticipated expenses may become a source of conflict between the parent and the captive if their contracts do not clearly spell out who will have to pay for these expenses. Finally, the Ernst & Young 2005-2006 Global Transfer Pricing Surveys document notes:

The definition of stewardship expense has been narrowed, presumably resulting in more headquarters or management services costs to be charged to affiliates;

This may affect the “profitability” of certain captives that were not being properly charged for the stewardship services provided by the parent.

I have a feeling that we will end up discussing these regulation changes again over the next few months. In the meantime, here are a few other documents that touch upon this topic. Once I find the time to personally review them, I will post my comments on this blog.

• A press release from the IRS
• An article from Deloitte
• An article by Baker & McKenzie