The Taxman Cometh

India sees "big dollar signs" in the legions of foreign customers of its IT services industry.
Kate O'SullivanSeptember 1, 2008

After years of doling out tax breaks and incentives to support the domestic information technology industry that made offshoring a household word (and lured plenty of U.S. businesses to Bangalore and other high-tech hot spots), India’s government is looking for a little payback. The 2008 Finance Act, signed in May, includes an array of changes designed to extract more tax revenue from businesses in India.

Indian tax authorities are “realizing that the services that Indian citizens provide for foreign-owned companies are worth more than [the amount] they’re being paid, and they’re seeing big dollar signs,” says Don Jones, an international tax partner at BDO Seidman. In raising taxes on IT companies, India is targeting the very businesses that have driven much of its recent economic boom. But the legislation has been politically popular in India because it also provides tax breaks to small farmers and the lower middle class.

For U.S. companies that manufacture in India or tap offshoring services there, the changes “definitely hurt more than help,” says Jones. Vikas Sehgal, a consultant at Booz Allen, says some clients are already rethinking their operations in India; those who are strictly pursuing labor arbitrage are considering other locations, such as Eastern Europe or Mexico. Don’t blame the tax man alone, however. The strengthening rupee, the dollar’s recent decline, and rapidly rising labor rates all make India more expensive for foreign clients. “To survive, Indian firms will need a very clear value proposition, backed up by experience and manpower,” says Sehgal.

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Some Key Changes Mandated by the New Finance Bill:

• New tax on gains from the transfer of Indian shares
• Expiration of tax holiday for software companies (in 2009)
• Increase in short-term capital gains tax from 10 percent to 15 percent
• Increase in excise tax for packaged software from 8 percent to 12 percent
• Expansion of service tax to include business software and Internet services
• Filing deadline for corporate tax returns moved to September 30 from October 31
• Increase in scientific research deduction for small and midsize companies