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Softening the Tax Bites of Outsourcing

In presidential election years, candidates often seek to appeal to voters with threats of levying taxes or penalties on corporations that move jobs offshore.  While these concepts may fire up populist sentiment, these proposals seldom result in generating new domestic job opportunities, and some studies demonstrate that restrictions on offshoring negatively impact the economy.

For businesses and politicians, anti-offshoring sentiment is ultimately overshadowed by Wall Street share price expectations and demands for companies to innovate, control costs and increase revenue and profitability. And the fact remains that outsourcing can facilitate those objectives; as such, in an environment of unrelenting business pressure, IT and BP outsourcing will continue to thrive.

That said, clients must recognize that outsourcing arrangements involve significant taxation issues unrelated to political agendas.  Ignoring those implications can compromise the business case for offshoring and lead to value leakage.

So what are the “Tax Bites” that customers should be aware of, and what can be done to mitigate their impact?

State sales taxes on sourcing services – A number of jurisdictions – including Connecticut, Ohio and to some extent Texas – assess sales taxes on computer-type services.  To minimize sales tax impact, make sure the sourcing agreement and provider pricing are structured so that the charges subject to tax are transparent and can be identified to where benefit is received.  Although not always necessary, an upfront demonstration to the state tax agency to obtain concurrence on the approach may sometimes be prudent.  Always remember that the provider has the fiduciary responsibility to collect the sales tax, and that the sales tax is an assessment upon the consumer of the services received.

VAT, GST, PST – Countries outside of the United States assess Value Added Taxes (VAT), Government Sales Taxes (GST) and Provincial Sales Taxes (PST) on services.  Within some areas in Canada, the GST and PST are combined to create the Harmonized Sales Tax (HST).  Although these taxes are greater than in most US-based jurisdictions, these countries have a mechanism for tax offsets (e.g., recoverable VAT) to prevent multiple taxation of the cost elements included in the final delivery of services.

Sales tax on asset sales to providers – Less prevalent in today’s environment, some companies that outsource still wish to divest their assets to a provider.  This may create a transaction subject to sales tax, either on the front end of the transaction or in the charges back to the client from the provider.

Property taxes on assets – Property taxes may be separately charged or embedded in the monthly lease charge, even when the assets are not legally owned by the customer.  Additionally, the customer may still be responsible for reporting leased assets in property tax filings if the outsourcing or lease agreement is not structured properly.

TUPE (Transfer of Undertakings, Protection of Employment). While not a tax, TUPE can have a major impact on outsourcing arrangements in Europe, and in some countries can involve incurrence of staggering severance payouts covering multiple years of employees’ annual salaries.

Planning and action are imperative to effectively manage potential tax impacts on the business case.  Regardless of the specifics of the tax under consideration, be sure to thoroughly assess and define financial responsibilities of both customer and provider. If your company is global, for example, assess recoverable VAT, GST, PST and HST and determine services or charges subject to services-type taxes in different locations.

Engage the tax department early in the transaction, so that they can plan for the impact and address any reporting requirements.  Leverage your provider’s internal tax expertise and have their experienced advisors work with your team.  In the Financial Responsibility Matrix, clearly define ownership of the respective cost elements.

As does most any business endeavor, outsourcing initiatives involve taxes.  But through preparation and insight into specific requirements and implications, customers can avoid unpleasant surprises and mitigate financial impact. While perhaps inevitable, taxes needn’t undermine a business case for outsourcing.