The Central Board of Direct Taxes (CBDT) has allowed total income tax exemption on the export of IT-enabled outsourcing services under Sections 10A/10B of the Income Tax Act, 1961. While granting full exemption of taxes on export profits, the Government also excluded demergers and amalgamations from the provisions of sections 10A/10B of the Income Tax Act.

But the Central Board of Direct Taxation (CBDT) has sought to consider for taxation the global profits of a foreign company attributable to the activities performed by a captive BPO unit in India. The CBDT had, through an internal circular dated January 2, 2004, expressed its views on taxation of business outsourcing units in India.
In the CBDT’s view, if a BPO unit, which constitutes a permanent establishment, is performing only ‘incidental’ activities for its foreign counterparts, and prices charged are at arm’s length then the global profit which is earned by its foreign counterpart, will be considered to be embedded in the income of the BPO unit taxable in India. However, if a BPO unit is performing ‘core’ activities, then the profit earned by its foreign counterpart, which is attributable to the activities of BPO unit, shall be taxable in India, under the Income Tax Act.

The CBDT in its circular has not defined the terms ‘core’ and ‘incidental’, but has tried to explain it by giving relevant examples. This step of the CBDT, it is feared, would do nothing, but create only more confusion and chaos that the budding outsourcing services sector can ill afford at this juncture.

The CBDT considers that if for an ‘incidental’ activity, prices charged by a BPO unit are at arm’s length, then global profits are embedded in the income of the BPO unit taxable in India. However, the aspect of arm’s length pricing has been overlooked by the CBDT in the case of ‘core’ activity.

If a captive BPO unit is performing ‘core’ activities for its foreign parent and pricing for its services are at arm’s length, in this scenario, will or will not the BPO unit be taxed in India? The circular is silent about this most crucial aspect.

This circular has been perceived as having the effect of broadening the tax net to include foreign companies having BPO operations in India, particularly some companies that have been establishing a presence in India in the recent past and avoided taxation.

Finance Minister Jaswant Singh in his budget speech reiterated the position laid out in the earlier CBDT circular – that is – if outsourced services are ancillary and auxiliary in nature and adequate remuneration is paid to the Indian call centre, then the overseas company that has outsourced its activity to India will not be taxed in India.

The Finance Minister’s statement has only led to more confusion and dispute, over the issue of what is ‘incidental’ or ‘auxiliary’ and what is ‘core,’ and also over whether an ‘arm’s length relationship’ has, in fact, been maintained between the MNC and its BPO arm.

Given the complexities, there may be a host of tax disputes as companies and tax authorities squabble over the legalities of the transactions in question. In such a scenario, it perhaps makes much more sense to do away with the distinction and exempt all MNC income derived from outsourcing from taxation.