Understanding the Tax Aspects of Outsourcing

Small, mid-sized, and large enterprises constantly seek ways to boost their business operations without spending extensively on non-core processes. They aim to access a dynamic talent pool and robust technology at competitive pricing. 

However, how do they achieve these goals without compromising product and service quality?

Companies have found solace in business process outsourcing (BPO). Third-party companies provide scalable resources and cost-effective services. While preparing and signing contracts seem simple, BPO transactions involve complex financial processes.

Among them is tackling tax-related principles and regulations. In this article, we discuss the tax implications of outsourcing. Keep reading to learn more.

Tax Implications Based on Outsourcing Types

Tapping into flexible resources while cutting costs is what BPO’s primary role in many businesses is. Service providers optimize their workforce and modern tech to help increase efficiency and maintain quality at affordable fees. 

Before reaping such benefits, you must find a BPO partner that suits your requirements, work strategies, and business targets. However, you must also note the practice’s economic aspect to make a well-structured budget plan and ensure returns on investment (ROI). 

Because BPO is a transaction between two or more companies, often from different locations, varying tax policies and procedures are involved. Understanding these concepts can help avoid costly legal issues, especially when working with foreign providers. 

Here are some tax implications that apply to location-based outsourcing. 

Tax Implications of Onshore Outsourcing

You adopt onshore BPO when collaborating with a third-party company in your home country. For example, you outsource onshore when you and your provider operate in the United States. Federal and state tax rules cover this arrangement’s service-level agreements (SLAs). 

The U.S. Internal Revenue Code (IRC) outlines guidelines for calculating taxable income. Under this law, BPO companies are taxed as regular corporations, depending on their structure and eligibility. The tax treatment before incentives involves several components:

• Corporate income tax (CIT). The Tax Cuts and Jobs Act decreased the federal corporate tax rate from 35% to 21%. CIT rates vary per state and typically range from 1% to 12%. Meanwhile, some states, such as Alaska and South Dakota, do not have income taxes.
• Pass-through taxation (for S corporations). Providers in this category do not pay federal income taxes at the entity level. Instead, the deductions and credits flow through shareholders’ tax returns. They report their share of the company’s income and pay taxes individually.
• Corporate tax deductions. BPO companies can cut taxable income by necessary and ordinary expenses. They can deduct payrolls, health benefits, and bonuses. Moreover, they can use tax preparation fees, legal services, and marketing costs to reduce business income.

In addition, the IRC influences how onshore BPO providers report their overall financial performance. Compliance with this legislation helps minimize the vendor’s tax liability. The tax code also offers the following benefits:

• BPO companies that hire individuals from target groups, such as veterans and government beneficiaries, can receive a maximum Work Opportunity Tax Credit (WOTC) of $2,400. The credit reduces the provider’s tax liability.
• Service vendors focused on innovations are eligible for the IRC’s research and development (R&D) tax incentives. These credits encourage technological advancements.
• The IRC Section 199A provides a deduction for specific pass-through companies, including BPO firms built as partnerships or sole proprietorships. This provision lets owners deduct up to 20% of their qualified business income from their taxable ordinary income.
• Third-party providers adopting energy-efficient technologies and practices may receive tax credits under specific IRC sections. This advantage aims to promote eco-friendly efforts and enable cost savings.

Tax Implications of Nearshore Outsourcing

Nearshore outsourcing refers to collaborating with third-party providers headquartered in nearby regions, such as Canada and Latin America. BPO companies and clients share geographical borders and time zones. Compared to offshore outsourcing, this practice emphasizes closer physical and cultural alignment. 

Despite their similarities, the difference in tax laws between the two involved countries still affects SLA terms and conditions. Let us say your U.S.-based manufacturing company partners with a provider from Mexico. The country’s value-added tax (VAT) and income tax laws impact the contract through the following:

• VAT exemption for exported products and services
• Competitive pricing for international services
• A 30% tax credit for R&D-focused projects
• A 30% corporate tax
• Withholding tax on payments for specific services performed by non-residents

Tax Implications of Offshore Outsourcing

You exercise offshore outsourcing when hiring support vendors from a foreign country miles and miles away. Typically, these providers come from nations that offer more competitive labor fees due to the lower cost of living, such as the Philippines and India. 

Some BPO companies from these countries do not pay taxes because of the local government’s exemptions and incentives. For instance, India’s Goods and Services Tax (GST) Council does not consider providers as “intermediaries,” freeing them from paying an 18% tax on services delivered to foreign clients. 

Meanwhile, the Philippine administration implements a corporate tax rate of 25% and a minimum CIT of 2% on gross income. It has laws such as the Special Economic Zone Act to provide tax-related guidelines and benefits for its BPO sector. So far, these measures have led to $467 million in total tax incentives from 2016 to 2019. The other advantages include:

• Income tax holiday (ITH)
• A 10-year 5% Special CIT (only for export enterprises)
• Enhanced deductions for labor, R&D, training, domestic input, and power expenses
• Importation incentives

These tax benefits allow BPO companies from both countries to cut costs and refocus their monetary resources on enhancing their infrastructure. The incentives also allow them to create more jobs and offer competitive salaries. This addresses unemployment issues and urges workers to deliver quality output, boosting a provider’s bottom line and national economic growth.

Key Practices to Ensure Tax-efficient BPO Strategies

Rules and regulations related to BPO taxes offer perks depending on geographical locations and local governments. However, you need to understand the tax implications of outsourcing to maximize the benefits. Ensure tax-efficient BPO strategies by executing these strategies:

• Perform due diligence on the tax laws in the home country and the outsourcing destination. Study BPO-related tax policies, incentives, and compliance requirements.
• Select outsourcing locations with tax advantages and favorable business environments. Note factors such as corporate tax rates and industry-specific incentives.
• Structure SLAs in a tax-efficient manner. Consider the legal aspects, payment structures, and other contractual terms to optimize tax outcomes.
• Create and execute transfer pricing strategies that match business objectives and regulatory requirements. These methods help allocate profits that optimize the overall tax position.
• Conduct a comprehensive risk assessment tackling tax-related measures. Develop approaches to mitigate potential issues and foster improvements.
• Be informed about changes in tax regulations in the home country and the BPO hub. Monitor updates regularly to ensure ongoing compliance and adjust accordingly.

The Bottom Line

As businesses continue to adopt BPO to enhance cost efficiency, understanding the tax implications of outsourcing is crucial. Whether you outsource onshore, nearshore, or offshore, each model has unique tax benefits, opportunities, and risks. You must align these factors with your BPO plan to ensure positive output and ROI. 

Maximizing such advantages requires a proactive approach, starting with thorough diligence of tax principles in your home country and your potential BPO partner’s location. Choosing the best outsourcing destination while familiarizing yourself with relevant laws helps you develop tax-efficient BPO approaches. 

Let’s connect if you seek further clarification on the tax aspect of outsourcing and how it affects your business. Unity Communications has a vast knowledge base online to give you insights into the complexities of BOI-related tax rules. The certified provider also houses skilled professionals and scalable solutions to meet your front- and back-office needs.