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Unintended Consequences: Tax Changes May Force U.S. Outsourcers, Work Offshore

May 11, 2009

The Obama Administration could be applying the ‘law of unintended consequences’ in its plans to do away with tax credits and loopholes for U.S. companies with foreign operations that it says are enabling work, and jobs, to go offshore. Its actions may end up, ironically, driving even more volume, business, and jobs out of the country and reduce resulting tax revenues.

Peter Ryan, contact center and outsourcing analyst at Datamonitor who has been examining the issue, says the measures will have negligible effect on offshoring because the benefits, derived from less expensive quality labor, outweigh in most instances the added tax burdens. The estimated savings can run as high as 65 percent in countries like India and The Philippines over having the same functions handled by domestic workers.
India has become the prime locale for contact center, business process outsourcing (BPO), and for increasingly sophisticated IT functions for that reason. Consequently that country has been spotlighted because it has drawn American jobs and because of well-publicized complaints over customer service from its contact centers, an issue that some observers remark may be overblown.
Instead the Administration measures could increase offshoring to India and The Philippines, which also has very low labor costs. That is because the changes will not apply to outsourcing, and to foreign-based firms.
Therefore U.S. companies that have been using the loopholes and credits for internal offshored operations may well go to outsourcers if the added savings are sufficiently significant. There is razor sharp competition between outsourcers that has kept prices and margins low.
The loophole crackdown may have an unintended victim: U.S.-based outsourcers. The new measures will place them at a major disadvantage to offshore-headquartered competitors that do not have such tax costs.
The problem is that contact center programs have some of the lowest margins in BPO work, Ryan points out. If the tax bill goes up slightly it could force American firms to hike prices, which could make a big difference in winning contracts, and in revenues and profits.
“If American outsourcers are forced to raise their prices because their taxes are going up, it would be very logical for clients to switch to offshore-based providers with equal capabilities and qualities who offer better rates,” explains Ryan. “There is no shortage of such firms. American outsourcers may have no other choice but to join them in tax-friendlier nations, taking their administrative, IT, marketing and other jobs with them.”
And in another application of the unintended consequences law the tax code changes may drive more offshoring to India and The Philippines from other countries such as Canada, Central and Eastern European nations, and South Africa. These locations have not been cast in the same glare on offshoring as India. Yet the added taxes would be much larger percentagewise in those other countries, whose costs fall between the U.S. and their notable rivals.
The White House plans to require companies from deferring any foreign-investment-related deductions – such as for interest expenses associated with untaxed overseas investment – until the company repatriates its earnings back home. Companies would only be able to take a deduction on their U.S. taxes for foreign expenses when they also pay taxes on their foreign profits in the United States. This proposal makes an exception for deductions for research and experimentation because of the positive spillover impacts of those investments on the U.S. economy.
Currently, a firm that invests in America has to pay immediate U.S. taxes on its profits from that investment. But if they instead invest and create jobs overseas through a foreign subsidiary, it does not have to pay U.S. taxes on its overseas profits until those profits are brought back to the United States, if they ever are.  Yet even though companies do not have to pay U.S. taxes on their overseas profits today, they still get to take deductions today on their U.S. tax returns for all of the expenses that support their overseas investment.
The Administration’s proposal would take two steps to rein in foreign tax credits.  First, a taxpayer’s foreign tax credit would be determined based on the amount of total foreign tax the taxpayer actually pays on its total foreign earnings.   Second, such tax credit would no longer be allowed for foreign taxes paid on income not subject to U.S. tax.
Current rules and tax planning strategies make it possible to claim foreign tax credits for taxes paid on foreign income that is not subject to current U.S. tax.  Companies are able to use such credits to pay less tax on their U.S. taxable income than they would if it was all from U.S. sources: providing them with a competitive advantage over companies that invest at home.
“Barack Obama targeted companies during the election campaign that did business offshore from the standpoint of IT providers and contact centers,” says Ryan. “What’s he’s done, effectively, is really tried to make good on the ability to capture the public sentiment that does not want to see jobs going to other countries. Yet this may yet be another policy example of having to take steps visible to resolve a major issue like high unemployment because the need is there, that at the end of the day may have little very impact and which could do more harm than good.”

Brendan B. Read is ContactCenterSolutions’s Senior Contributing Editor. To read more of Brendan’s articles, please visit his columnist page.

Edited by Stefania Viscusi