Trump’s guerrilla trade war is hurting India’s IT industry

US President Donald Trump’s protectionist measures, aimed at discouraging outsourcing of jobs to other countries, have caused concern to India’s information-technology (IT) and information-technology-enabled services (ITes) industries.

In the year ending March 2018, the value of India’s exports of IT, ITes and research and development totaled US$126 billion. Almost 90% of the exports go to the United States and the European Union and more than 3.9 million Indians work in this sector.

Recent protectionist measures taken by the US have been the subject of intense debate, especially those related to tariffs on trade of goods. But the Base Erosion and Anti-Abuse Tax (BEAT) introduced this year is another US protectionist move, one that affects trade in services.

The tax violates the United States’ Double-Taxation Avoidance Agreements (DTAAs) with other countries and makes it costlier for US firms to outsource their tasks. But they and their outsourcing partners have found a way around it, at least for the time being.

Multinational companies use base erosion and profit shifting to avoid taxes by shifting profits from high-tax jurisdictions to low-tax ones (so-called tax havens). Like other countries, the US already has robust transfer-pricing rules and specific anti-abuse provisions.

Some payments made by a US company to its foreign sister concerns are deductible when calculating taxable income. Outsourced expenses are part of deductible payments. BEAT is triggered if deductible payments, after considering a few other factors, is more than the tax payable in the US.

US-based multinational corporations (MNCs) outsource a major portion of their R&D activities, IT and ITes functions, and knowledge processes to such countries as India, the Philippines and Malaysia, by opening subsidiary companies in these countries. BEAT specifically targets this practice.

By outsourcing their business and knowledge processes to destinations where skills are cheaply available, US companies save lots of money and pay corporate tax on the same in the US. Outsourcing is mutually beneficial to both the source country and the destination country.

BEAT, no doubt, makes it costlier for American MNCs to import services. But they have found a way around it. The host countries where outsourcing firms are based also need to make some policy changes to adjust to the US policy.

Earlier, the US company would scout for clients while the Indian affiliate provided contract R&D services (or software services) to the US company. Companies affected by BEAT now find it beneficial to move toward a revenue-share model, wherein the Indian affiliate will not bill the US company but directly bill the client. It requires only a reworking of the contract with the client. Thus BEAT provisions can be avoided.

For instance, a global management-consulting group that earned 78% of its revenue in North America in 2015 employed about 58% of its manpower in India. The majority of services were outsourced to India. To tackle BEAT, the group can restructure so that the client directly pays a part of the revenue to the US company and a part to the Indian subsidiary. The “related-party” payment by the US company will get reduced as a result and BEAT will not apply.

In a revenue-share model, the Indian affiliate will get a chance to become an entrepreneurial concern rather than a captive service provider for the US company. Management personnel at the Indian affiliate will get an opportunity to interact with clients and develop client relationships, which is a big asset.

Another solution for multinational corporations is to restructure into a cost-contribution model. Revenue from American clients will be received in a new affiliate company located outside the US and will be allocated to various group companies globally in the ratio of costs incurred by them. In this model, related-party payments happen from a foreign affiliate to the US company rather than from the US company to foreign affiliates. In this way, the nuances of BEAT don’t get triggered.

BEAT is a violation of DTAAs, which are the pillars of universally accepted principles of international taxation. A company is allowed deduction on the payment it makes for service contracts to a foreign subsidiary because the payment gets appropriately taxed in the hands of the subsidiary in its country of residence.

In the case of outsourcing to India, the Indian subsidiary pays tax at a higher rate in India than the rate applicable in the US. The same income cannot be taxed twice. But BEAT seeks to do exactly that.

If negotiations on the issue fail, one effective way of hurting American business is by targeting the royalty paid from host countries for using American brands. For instance, Indian subsidiaries of US corporations selling fast-moving consumer goods (FMCG), footwear, apparel, aerated drinks etc pay royalty to the parent company for using US brands. According to one study, the royalty payments by 32 listed Indian subsidiaries to their global parents equals 21% of the pre-tax, pre-royalty profits on average. This capital outflow hurts India’s foreign-exchange position and benefits the US.

As a deterrent to the US violating double-tax agreements, host countries can impose an additional tax on such royalty outflow, in the full knowledge that imposing additional tax on royalty payments to the US also violates the DTAA in spirit.

Views expressed by the author are personal and do not reflect the views of his employers.