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Finance minister P Chidambaram has finally resolved the controversy over the taxation of business process outsourcing (BPO) units in India. The distinction between core and incidental (non-core) activities performed by a BPO unit of a foreign company will be done away with.

This should legally align the Indian tax practice with international norms. And, from now on, tax will be attributed to the foreign company only if its dependant BPO outfit in India is paid less than the market price . A formal announcement will be made shortly.

Simply put, the difference between the market price - that is, arm's length price - and the actual price paid to the Indian company will be taxed in the hands of the foreign company. Most importantly, the taxman will have no discretion in determining what is core and non-core activity.

Early this year, the government had threatened to tax the India-based captive BPO units of overseas MNCs. The issue was whether the work done by the captive unit in India enhanced the MNC headquarters' profitability by deliberately keeping pricing low - or, in other words, whether the MNC paid a sub-market price to the captive Indian BPO to improve its global profitability.

The CBDT circular issued in January this year had differentiated between core and non-core activities for tax purposes. Any activity was considered core when it contributed significantly to the overseas parent's turnover or profits. This could include, for example, research and development work or even direct selling through call-ins from India

Non-core activity typically referred to low-end work, such as payroll processing, which did not typically add to the bottomline. This created confusion as it was reckoned that tax authorities could use their discretion while defining core activities for tax purposes.

The ministry's decision will help resolve the controversy over attribution of income to BPO activities here and will remove the uncertainty of foreign companies setting up IT and ITES units here.

"This is a correct application of the transfer pricing principle where due weightage is given not only to services rendered at India by the BPO unit but also to the assets - brand name, customer relationship etc - deployed and business and economic risk taken by the foreign company," according to Samir Gandhi, tax partner with Deloitte, Haskins and Sells.

The profits of a non-resident or foreign company attributable to the business activities carried out in India become taxable under the Income Tax Act if the non-resident or foreign company is treated as having a business connection in India (under ITA section 9) or a permanent establishment (PE) under article 5 of a tax treaty.

The CBDT circular held that the manner and extent of the attribution of profits resulting from BPO units will ultimately depend on the facts of each case and the nature of services provided by the BPO unit, as determined in accordance with the provisions of the relevant treaty and applicable domestic law.

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