The coming profits squeeze

Taxes in India and US and the rupee rise will cut into margins of IT companies

S Gopalakrishnan, COO,
Infosys Technologies

In 2002-2003, India's big information technology (IT) companies reported net profit margins ranging from 20.78 per cent (Wipro Technologies) to 26.44 per cent (Infosys Technologies). Relatively smaller companies like MphasiS BFL reported a 32.59 per cent net profit margin.

The bad news is that IT companies are unlikely to maintain this scorching pace of profit growth for very long. Two factors "� taxation and the appreciating rupee "� could affect the profits of large software companies like Infosys Technologies, Tata Consultancy Services, Satyam Computer Services and Wipro Technologies.

Indeed, Nandan Nilekani, managing director and president of Infosys, in a recent media interview, cautioned that the rupee's appreciation, a possible change in Indian tax rates in 2009, low pricing or falling billing rates and employee costs remain key risks to Infosys' profit margins in the future.

Exports of IT services are currently tax free but leading software majors may have to start paying taxes by April 1, 2009, if the government sticks to its original plan. Some believe that the government may not extend further tax breaks for IT companies because of its own deficits and to negate complaints from the US and Europe that a tax waiver acts as a non-tariff barrier under World Trade Organisation rules.

Senior officials at Infosys, Wipro and MphasiS argue that the impact of both taxes and currency fluctuations are minimal and manageable. But these come at a time when there is pressure on billing rates, increasing competition from foreign multinationals and a political backlash against offshoring work in the US.

At a broader level, Indian software companies plan to mitigate the impact of taxes and currency fluctuations by expanding their markets and offering higher value to customers even as they strive to increase their billing rates.

Even so, yet another tax threat looms overseas. In a case that could set a precedent for other US states, California is interpreting its tax code to levy taxes on foreign companies doing business in the state "� on a worldwide basis. For example, if a software company makes 30 per cent profits worldwide-after depreciation and before taxes - California is demanding that companies pay 30 per cent tax on its revenues in California, which in some cases could mean that companies pay much higher taxes. For Indian companies, this means that they have to pay tax on their offshore profits also.

A partner at a leading American tax consultant firm in India notes that California follows a much more aggressive taxation policy than other US states. The Californian tax law states that foreign companies, which render services in the state for an aggregate 90 days in a year have to pay local taxes. Moreover, companies should derive 20 per cent of their global turnover from operations in California to pay state taxes.

The US is the biggest IT services market for Indian software companies. Both Infosys and Satyam derive almost 73 per cent of their revenues from North America, according to their US GAAP statements. The figure for Wipro is around 53 per cent, largely because it has a presence in other businesses also. Most of the expansion plans of Infosys, Wipro, Satyam and TCS focus on the US.

The tax issue has affected Infosys but it has the potential to hurt others this year such as Wipro, TCS and Satyam. "We have not looked at it as yet. The impact does not seem to be high," says Ashank Desai, chairman of Mastek (most of Mastek's business comes from the UK, however, though it does have business in the US). A Wipro official says that the company might come under Californian tax this year.

The California tax code also has a provision which permits corporations to pay taxes only on the profits earned from operations within the state. Infosys had requested that the latter method should be applied in its case, which the state's Franchisee Tax Board rejected.

Infosys, which has its US headquarters in Fremont, California, argued that the standard tax formula computed by the state failed to take into account that two-thirds of Infosys' project work was done offshore in India, and that there was a wage differential between its staff in India and in California. Because the differential inflated its California taxes, Infosys argued that it owed only around $180,000 instead of the $1.3 million it was taxed over a two-year period using the standard method.

"We are in discussions with tax consultants in this regard. Based on these consultations, we will decide the next step. We have paid all taxes and have asked for a way in which computation of taxes would take into account the fact that 70 per cent of the work is done remotely by us," Kris Gopalakrishnan, chief operation officer, Infosys, said on the sidelines of a CII summit. "Either way, we will bear minimum impact as the tax amounts to $1 million against a revenue of $1 billion and it is not a federal tax, but a state tax," he said.

A Wipro official argues that the Indo-US tax treaty currently treats operations in the US either through a office or a branch as a separate entity for federal taxation. This implies that the US can only collect taxes on US operations. However, state taxes do not come under the purview of the federal tax treaty.

Indian infotech companies don't have many options to avoid paying taxes in America. Some reports suggest that they could move to neighbouring Canada. But US federal and state taxes are imposed on the activities of Indian companies in the US, irrespective of where they have their offices.

The only other option for Indian companies is to press their case at a government level. India needs to pursue the case with Washington and argue that such taxation policies are akin to a non-tariff barrier.

The second big challenge Indian IT companies face is that their net foreign exchange gains, once a key component of overall profitability, have dipped considerably "� by more than two thirds in the last quarter of 2002-2003 for Infosys, Wipro, MphasiS and Mastek. They've responded by aggressively hedging and striving to increase exposure to other currencies.

Wipro's chief financial officer Suresh Senapaty told analysts that aggressive hedging strategies helped reduce the impact on the company's operating profit margin in the March 2004 quarter. "The OPM was affected only to the extent of 40 basis points. Without hedging, this impact could have been 200 basis points in the last quarter."

MphasiS has a foreign exchange band, indicating the floor and ceiling levels in its long-term contracts, are applicable more to BPO projects. Contracts are renegotiated when the bands are broken.

Ravi Ramu, CFO at MphasiS, points out that the company was one of the first to hedge since October 2002 and has aggressively hedged ever since. Nilekani said that Infosys had bought forward contracts worth $203 million last year to hedge against the appreciating rupee. "We have already said that every one per cent rise in the value of the rupee shaves 0.5 per cent off our operating margins," he said.

Still, Indian IT companies have had a great run, financially speaking. They will, no doubt, continue to fare well "� but in this case, their past track record performance clearly is no guide to future performance.