How severely will the expiration of India’s STPI tax scheme impact the Indian outsourcing industry?

Taj_mahal_4 360DegreeVendorManagement raises some real concerns regarding the Software Technology Parks of India (STPI) tax scheme which expires on March 31 2009.  The scheme currently gives tax-breaks to new Indian organizations in the region of 10-20% for their first 10 years of inception, designed primarily to bolster India’s software industry. Established Indian firms are constantly spinning out new companies to keep enjoying the tax breaks. Today, exports by STPI registered units comprise more than 95% of the total software exports from the country, which include ITO and BPO exports.

Our mystery vendor management expert, recommends to her vendor management peers:

  • Get more knowledgeable on this subject now. Talk with your attorneys, analysts and consultants. Do not wait for your vendor to “educate” you. There are many layers of taxes and your advisors will be able to separate hearsay from fact.
  • Negotiate your pricing terms to reduce your exposure to changes in Indian taxes.
  • Use the risk as another reason to diversify your offshore vendors and locations. Multi-location, multi-vendor strategies mitigate a wide variety of risks.
  • Recognize that this change will not kill the Indian industry – it will just level the comparative costs among countries. India will likely become just as expensive as the Philippines.
  • Adjust your financial plans now as you enter into 2009 budgeting and planning.

To compound issues with the competitiveness of India’s outsourcing exports, Ted Botzum at TPI discusses the issues with foreign currency fluctuations and their impact on outsourcing contracts.  Ted pushes the point that firms looking at outsourcing need to invest in scenario development to balance the financial risk. 

Hence, there are a number of variables that must be built into the Indian outsourcing scenario:

  • Rupee appreciation
  • Weak dollar and potential weakening of the Euro
  • Impact of the STPI tax scheme elimination
  • Impact of Indian wage inflation

By taking away the tax break, the price-playing field will be leveled considerably between the Western outsourcers and the Indian-centric firms.  The Indian firms are now competing for the majority of top-tier enterprise outsourcing contracts, both BPO and ITO – which was not the case five years’ ago.  Firms such as Infosys, Wipro, TCS, Genpact and Satyam (as we discussed here last year) are constantly having to evolve their human capital strategies to retain and develop quality staff over longer periods and keep wage inflation to a minimum.  Moreover, they are moving increasingly towards volume / service-based pricing models and relying less on FTE-based pricing, which leaves them vulnerable to these pricing pressures.  Incumbent global outsourcing firms such as Accenture, ACS, HP and IBM, which have large employee-bases in India, are also facing similar challenges to keep spiraling costs to a minimum, but benefit from having a larger proportion of their employee resources in other global locations, and are not going to be impacted when this tax break is eliminated. 

My view is that the Indian-headquartered suppliers have arrived on the global stage and are now seeking to take their services to a new level by investing in higher-value services and greater onshore presence.  By taking away their tax-break, the Indian government is only serving to harm its star performers at a time they need greater support to maintain their market surge.  With the current economic downturn, outsourcing deals are more competitive than ever, and next couple of years will lay the groundwork for the global sourcing industry for years to come.  I’d be surprised if the Indian government doesn’t relent on extending the STPI tax break, but maybe it’s decided the time has come to cash in on its most successful export? 

Update:  the Indian finance minister is proposal a 1 year extension to the STPI tax holiday until March 31 2010

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10 Comments

  1. Posted April 6, 2008 at 10:58 pm | Permalink

    The impact can be analyzed in two categories – Large & Small players.

    Most of the revenue for the large players comes from on-site consultancy & therefore these companies are paying tax to those Governments. For them tax holiday or no tax holiday has limited influence. The smaller players and those who have a high exposure to off-site works do get affected by the withdrawal of the scheme.

    While STPI scheme is discontinued, there is a new SEZ scheme (Special Economic Zones) which has been announced. This scheme offers better tax and other benefits than what STPI provided. SEZs are Free Trade Zones. The IBMs and Accentures of the world are relocating into the SEZs to stay competitive.

    There is a very strong rumor that the Government is going to provide a sort of extension to the STPI scheme to the small and medium players. How, what & when is unknown still

  2. Posted April 6, 2008 at 11:02 pm | Permalink

    India is facing some interesting social issues, and the tax incentives for the ITO and BPO industries are certainly galvanizing interests on both sides. If this was an election year, I bet the government would err on the sides of more votes. However, the declining dollar/appreciating rupee is impacting the Indian industry. So, I’d bet we’ll see the deadline extended, but the extension will not be beyond the next presidential election (about four years from now?).

    Tony

  3. Posted April 7, 2008 at 7:06 am | Permalink

    Phil, Interesting viewpoint. I have always enjoyed reading your blog. I would have to agree with you (Disclosure: I am also a part of IT outsourcing industry). It appears this step will do more harm and will add to the negative sentiment. It will adversely affect mostly startups and SME. Large enterprises will be affected less because of some of their facilities will move to SEZ and their higher proportion of onsite/consulting work (SEZs are very nicely described in Anil’s response) There has been a somewhat of a glimmer of hope in an article in today’s (Apr 07) Economic Times (it is still early proposal stage). Please see the attached link.

    Picture will hopefully be clearer in 3-4 months as hectic parleys are in progress.

    Links:
    http://economictimes.indiatimes.com/articleshow/2932745.cms

  4. Dr Vikram Venkateswaran
    Posted April 7, 2008 at 9:55 am | Permalink

    Hi Phil

    I beleive that the tax holiday for the STPI’s is an extention of the protectionism policy followed by the Indian Goverment pre 1991.

    The removal of these sops is an intresting inflection point in the history of corporate India as it will test two things.

    It will test the true capability of the Indian IT firms’ and the ability to sustain themselves once the sops are removed.

    Secondly as most of the SWITCH(Satyam, Wipro, Infosys, TCS, Cognizant and HCL)claim to have robust and mature earnings and margins it is time they came out in the open to comptete with the other incumbants (IBM,Accentures, CSC and likes) on a level playing field.

    No other Industry in India has been given so much support as the IT industry and it is time that the goverment looks for other areas to support namely Food Processing, Textiles, Auto to name a few.

    Regards

    Dr Vikram Venkateswaran
    Associate Manager
    CSC

  5. Posted April 7, 2008 at 4:11 pm | Permalink

    Phil,

    Extremely interesting question. Let’s see how smaller vendors react to the new legislation. I agree with everyone above that the this will affect the larger players much less. But, at the rate that companies are taking their offshore operations back in-house, the STPI removal may be the straw that breaks the camel’s back… unless of course the vendors can show that they’re an indispensable part of their business.

    Raza Imam

  6. Posted April 8, 2008 at 1:04 pm | Permalink

    Phil

    The actual impact on of the STPI scheme going away is about 7% of revenue though the worst case scenario calculation tends to put it around 13-15%. Here’s how.

    Give or take a few % points, for every $1 earned by India Heritage players they spend about 30 cents on wages and 25 cents on infrastructure & other fixed costs thus getting an EBIDTA of about 45 cents or there about. Currently there is a Minimum Alternate Tax of 11% applicable on these earnings – so about 5 cents go towards tax and accounting for the other expenses the operating margin is about 23 cents (23%).

    The change in STPI scheme means two things as far as I can understand. There could be some 11% tax applicable on some of the non-wage costs. In the worst case scenario this means that Indian Heritage players would spend an extra 3 cents on the 25 cents towards on Infra & other fixed costs. More importantly the companies need to pay 35% tax on their profit from export revenues. Using the reduced EBIDTA of 42 cents as a basis (for worst case scenario) that is an additional 10 cents paid in taxes. So in the worst case scenario the operating margin is reduced to 10 cents (23-3-10) – a reduction of 13%.

    In reality, this impact is expected to be the much lower 6-7% given that even now, the companies service India market, deliver from non-STPI zones etc.

    There are multiple ways to look at it. The reduced operating margin of 16-17% for Indian Heritage players would still be about twice the margin of the established global players. So while the share-holders may not like it, they still can swallow the hit.

    On the other hand Indian Heritage players, still operate at lower blended average hourly rates than most Global players. Even if they bump up the rates by 6-7%, the blended rates of Indian players would continue to be lower than the blended rates of the global players.

    Furthermore, traditionally Indian players have focused relatively less on reusability and automation than Global players. The margin pressures both in terms of taxes and wage inflation is driving and will continue to drive Indian players to rely less on tapping the vast pool of inexpensive programmers / operators and start automating / reusing components to a greater extent.

    Finally, the Indian Government may relent and extend the tax scheme as others have pointed out. Or maybe they will implement the suggestion made during the Nasscom leader-ship summit by one very vocal proponent of Indian BPO industry – take away the STPI benefits from the Indian IT providers / revenue but continue providing this benefit to the Indian ITES industry / revenue. After-all the Indian IT industry has existed for 30 odd years while the ITES industry is still a baby at 10 odd years.

    Shyam

  7. Mohit Mankotia
    Posted April 9, 2008 at 3:03 am | Permalink

    Phil – My viewpoint – there should not be so much of noise about the STPI tax scheme ending in March 2009. The whole idea of providing tax break is to promote an industry during its nascent stage of inception. Both the IT/ ITES are mature sectors contributing more than 4 % to India’s GDP, infact they are on the brink of riding the next wave. If the Govt does not milk the Cow now when should it ?

    Another question which comes to my mind is that incase the Govt decides to increase the duration of tax sops till when should it do it ? Two yrs, maybe 5 yrs. At the end of those 2 or 5 yrs we will still be debating this same question. Unlike the SEZ regime where you get a tax holiday for 10 yrs from the day the company starts, the STPI regulations have been clear that the tax holiday will end on March 30, 2009 (whenever you may start). None of the Indian players have been caught by a surprise here and have had ample time to plan for this. Infact most of the smart companies have been planning for this.

    Some approx figures : Last year the Indian IT / ITES sector paid taxes of 15 % & 7 % respectively against their top lines. This is not fair when compared to other sectors – if this was the case then why doesn’t the govt give some tax sops to the manufacturing sector so that we can compete with china.

    I think the problem here is larger – US economy slowing down, dollar depreciating, sky rocketing wages, decline in employable resources, attrition, Clients becoming mature, competitive pricing, upcoming players in Philippines, Vietnam & east european countries and the top it all companies have to pay more taxes. It’s all happening at the same time, margins are getting hit from all sides. Every mature industry has their share of problem, tax sop’s is not a solution to fixing these problems.

    Let me end this with one last thought. Most of the fortune 100 companies work at a net margin of 5 – 6 %, however the Indian IT players work anywhere between 20- 22 % and are sitting on huge cash reserves. Do we need to look at this side of the coin?

  8. Posted April 9, 2008 at 6:46 pm | Permalink

    Gentlemen:

    Thanks for the excellent commentary – I couldn’t have asked for a more robust analysis of this issue.

    All-in-all, it sounds like the software side is more prepared to have the tax break lifted than the BPO sector, which is still in a high-growth stage. Moreover, most of the Indian suppliers seeking to take more BPO business from the Western incumbents have quite some catching-up to do over the next couple of years – they need every break they can get,

    PF.

  9. Posted April 11, 2008 at 11:07 am | Permalink

    The STPI scheme may get extended for small and medium IT companies, especially given the decline in US dollar. While this is desirable, there are pressures for incentives in other areas. As such, I would not bet money on any extension for companies like Infosys, Wipro and TCS. Hence it is unlikely to be extended beyond March 2009. Moreover these companies are not highly exposed to the “GLOBAL BIG FIVE” and still compete with local players like Satyam. Apart from this, Indian IT companies leverage from the Tax Holidays they get for every new facility in different cities. Not denying your point totally either but I think Removal of STPI will not have a drastic impact on the top Indian IT Companies. Though they might lay off a considerable manpower to adjust to the change. As estimated by NASSCOM the impact of STPI on job loss to be about 4,00,000 in 3-4 years. Over 1,000 BPO units would suffer a severe blow. At present, tech companies are paying MAT at 11.33 per cent and it was expected to go up to 20 per cent. So threat is for SME’s but they might get an extension or support from Government.

  10. Posted May 19, 2009 at 3:39 pm | Permalink

    Phil,

    Agree STPI is a big risk for clients in the sourcing process. STPI is one of two key risks that should be considered. The second being real and long term currency changes. Right now it appears stable, but the combination of a swing in currency and a the conclusion of tax holidays could have a real impact on the health of an outsourcing decision.

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