Kannan Ramanujam, president of a well-known multinational IT company headquartered in the US is in the process of preparing a SWOT analysis for his company's new operations. The choice is between offshoring its activities and utilising a third-party vendor. The company has offshored most of its service delivery processes, both directly by setting up its own subsidiary in India, as well as through third-party vendors. While he is aware of the company's strengths and weaknesses, and their numerical impact on the company's bottom line, his research to identify industry and country-level threats and opportunities, led him to President Barack Obama's State of the Union address recently. Kannan had the following questions — What is insourcing? What are the exact incentives that Obama proposes to deny transnational companies that offshore jobs? How does it impact services offshoring in terms of cost savings?
INSOURCING
Our analysis today tries to answer these very queries as concretely as possible. We start with insourcing. So what is insourcing? Simply put — bringing jobs into the US rather than shipping them offshore to countries such as Philippines or India. So how does the US government propose to accomplish this? Quite easily, by denying offshoring transnational companies any tax benefits in the US. As an example, the moving expense deduction, which is a deduction allowed for expenses incurred due to a shift in the place of work, might be denied to offshoring MNCs.
Another example is the growing bid to force repatriation of cash held abroad by foreign subsidies of US companies, by proposing an 85 per cent dividends-received deduction to US Corporations for repatriation of funds from foreign subsidies. This tax reduction was given once before, for one year in 2004. At that time, of the estimated $1 trillion held abroad, approximately $350 billion was repatriated. It is presumed that approximately $500 billion could be generated currently in capital inflows. What is the investment benefit from the repatriation? Research suggests that in 2004, actual benefits from such repatriation accrued only to a very small percentage of corporations. Point to be noted here is that many of these corporations are not cash-strapped. They do have cash reserves in terms of both domestic and repatriated money. However, these corporations haven't found any avenue of profitable investment, and this fact, rather than tax benefits / deferrals have been the cause of a disinclination to invest domestically in the US. Studies have proved that the dearth of job-boosting investment has been the direct effect of a dearth of opportunity, rather than the absence or presence of tax incentives.
TAX INCENTIVES
Kannan needs to consider the fact that a change in tax incentives is likely to impact manufacturing assignments offshored, while it won't impact the services sector much. For instance, a typical job, such as design engineering, might earn approximately $6,000 per month in the US, and could be done offshore at as low a rate as $2,000 per month. There will, of course, be some incremental offshoring cost in addition to the $2,000 payable to the employee, but even with that built in, the offshoring company stands to save a clear 40 per cent on costs. However, in the manufacturing sector, significant material cost is involved, and the leveraging varies, based on product and country.
The current corporate tax rate in the US is 35 per cent, and assuming that companies shipping their jobs abroad end up losing a tax benefit that results in an additional cost of 20 per cent, operations will still be better off by 20 per cent, cost-wise. Commercial prudence and economic logic, therefore, would still favour offshoring, or even moving and setting up shops abroad. Kannan needs to study typical situations wherein a US corporation sets up a fully-owned subsidiary, enters into a joint venture with a vendor offshore, or merely ships the jobs to a third-party vendor. A comparative analysis of the three will help Kannan analyse the exact quantum of threat. The analysis may vary based on the applicable transfer pricing-related taxes, as well as credits on double taxation in each situation.
(The author is a Coimbatore-based chartered accountant.)