Outsourcing and Tax - August 2007

This article covers two subjects. Firstly, it addresses the complex tax issues that can arise on an outsourcing project. And, secondly but no less importantly, it explains the connection between tax, outsourcing and Attila the Hun. Given the amounts at stake, readers involved in outsourcing projects should have a clear grasp of the first subject - as well as a curiosity to discover why specialists in tax and/or outsourcing are such wild and crazy guys.

Tax issues are clearly a significant driver of business behaviour. Companies go to considerable lengths to structure their arrangements in the most tax advantageous way within what the law allows. Tax issues become proportionately more difficult as transactions cross borders and potentially involve more than one possible tax regime.

But whereas companies routinely use tax planning as part of M&A or corporate reorganisation programmes, perhaps surprisingly tax issues are often an afterthought in many outsourcing transactions. This may be because outsourcing originated as a simple concept of an in-country arms' length services transaction with few tax complexities or opportunities for legitimate tax planning. But that has now changed and tax issues loom large in many outsourcing deals - especially those with a heavy financial services component or cross-border element.

This article introduces the most common tax issues that should be considered on any outsourcing or offshoring project. Clearly, the various issues and the application of tax laws vary according to each individual transaction and depend highly upon the parties' exact circumstances and the services, structures and jurisdictions involved. This article is written primarily from a UK and wider European base - although similar principles ought to concern parties to outsourcing transactions in the United States or any other country.

VAT and Sales Tax Issues

The starting point for any tax treatment of an outsourcing arrangement - at least in Europe - will be that value added tax ("VAT") or sales tax will apply, but that in all other respects the service provider will bear all taxes assessed on its in-feed costs or service charges. In most cases, the services being supplied will be such that the service provider will be required to charge VAT to the customer on its fees for the outsourced services, thus adding an additional percentage (17.5% in the UK, but varying across the EU) to the service charges. In most cases, this will not result in additional cost to the customer. The reason for this is that VAT incurred by a company in the course or furtherance of its business (known as "input tax") can be recovered from the relevant country taxing authority. The ability to recover the input tax in full is only available where the company makes "fully taxable" or zero rated supplies. A problem arises, however, where the company's supplies falls within the definition of "exempt supplies", that is they are not required to charge VAT to its own clients. Such companies fall into a no-man's land in that whilst they...