BPO tax system needs clarity

For every benefit you receive, a tax is levied," said Ralph Waldo Emerson. Business process outsourcing (BPO) units should be in sync with the quote even after Finance Minister P Chidambaram has appeared to have solved the BPO tax muddle.

A fresh circular has been issued replacing the circular no. 1/2004, dated January 2, 2004. There are no two thoughts that the previous circular concealed more than it revealed.

It put an emphasis on distinguishing between "core" and "non-core" activities. Core activities outsourced were to be taxed while the non-core ones were to be ignored.

Considering the vast repertoire of BPO services rendered by India Inc, establishing the difference between core and non-core activities was akin to solving Rubiks cube.

The backlash against this levy made the previous finance minister and the current one make statements about reconsidering the levy.

The latest circular removes the concept of "core" and "non-core" activity. Tax will be attributed to the foreign company only if its dependent BPO outfit in India is paid less than the market price. Simply put, the difference between the market price ""that is, arm's length price ""and the actual price paid to the Indian company will be taxed in the hands of the foreign firm.

Most importantly, the taxman will have no discretion in determining what is "core" and "non-core" activity. Tax on profits of foreign companies from the operation of their permanent establishment will be based only on fair pricing rules.

The circular says in determining profits attributable to an IT-enabled BPO unit constituting a permanent establishment, it will be necessary to determine the price of services rendered on the basis of arm's length principle.

It also says the definition of arm's length price or transfer pricing will be the same as stated in Section 92F(iii) of the Income Tax Act, 1961.

The circular has stated two types of relations between a BPO and an overseas firm. First, if a non-resident entity outsources certain services to an Indian firm but has no business connection with it, there will be no tax liability on the former.

Second, if there is a business connection between the two, the Indian entity will be considered a permanent establishment of the non-resident and will be taxed accordingly.

While these entities perform numerous functions, the non-resident entity will be taxable in India only if the IT-enabled BPO unit in the country happens to be a permanent establishment of the former.

What the latest circular has done is to bring BPO units at par with other entities that are covered by a double taxation treaty. The "arms-length" principle will be used to tax such entities. In doing so, the finance minister has probably not taken into account the unique sales proposition (USP) of BPO in India""low costs.

To survive in the rat race of BPO in India, units will have to charge the market price in any case. In case they charge less than the market price, sustenance becomes a nightmare and charging more is a guaranteed way to get out of the business. The vast repertoire of BPO services being rendered in India will render keeping a database of market prices a Herculean task.

The Organisation for Economic Cooperation and Development (OECD) has done a lot of work in international taxation. Its clarification on the application of the permanent establishment definition in the context of e-commerce, draws up a fairly exhaustive list of situations when one can decide whether a permanent establishment is in existence or not.

There was a general feeling that where electronic commerce operations carried on through computer equipment located in a country are restricted to preparatory or auxiliary activities, no permanent establishment can be said to be in place. Instances of preparatory or auxiliary activities were interpreted to include:-

• Providing a communications link between suppliers and customers
• Advertising of goods or services
• Relaying information thr-ough a mirror server for security and efficiency
• Gathering market data
• Supplying information.

The definition of permanent establishment as per the Indo-US double-taxation avoidance treaty encompasses- a place of management, a branch, an office, a factory, a workshop, a mine, a warehouse, a farm, a store and an installation or structure used for the exploration or exploitation of natural resources.

It is clear from the definition of PE and the examples cited that what is crucial is not the existence of the establishment but the nature of activities carried on.

If BPOs could prove that they fall into the list given by the OECD, they could still get away from the taxman by doing a convincing act with the assessing officer. But more clarity from the tax department would make the lives of the BPO tax consultants much easier.