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Captives: Does India Still Captivate?

Continued from page: 1

Rajneesh De

Friday, August 17, 2007

With other big captive players like Dell (probably the largest) and Aviva following a hybrid model of outsourcing to third-parties, there are possibilities of the club further dwindling in FY 08. And, imagine if one of the largest players, HSBC Electronic Data Processing, too changes colors, the Indian offshore BPO story would no doubt cease to be captivating. Though there would still be enough captive operations left, the fact is that unlike third-parties, these take much longer to scale and, hence, could easily lose out if one or two established players switch allegiance.

Forrester predicts that by 2009, more and more companies will move out their captive BPO operations to rely more on third-parties for services like customer support

With scaling up obviously being a harder option, the only way this apparently irreversible momentum of dwindling captive numbers could be arrested and even overturned is by more players entering the space. And, just looking statistically, that would be possible even if a few of the technology and telecom MNCs who have started captive R&D and IT operations here in the last 18-24 months also take up BPO. Most of them do have small voice kind of operations, and even some sort of scale up could again tilt the scale in favor of captives.

Blame it on Cost
Forrester predicts that by 2009, more and more companies will move out their captive BPO operations to rely more on third-parties for services like customer support and maybe even receivables management.

A Forrester report titled "Shattering the Offshore Captive Center Myth" tries to substantiate the cost factor with some interesting numbers. Instead of saving money, the cost of operating a captive center is typically higher than using third-party providers, it says. The cost per person, per month of a captive center is $4,944, compared to $4,231 for a third-party supplier. And, over three years, the costs of a 150-person captive center are $29,453,799, compared to $21,723,299 for using a third-party supplier. The report concludes that more than 60% of the current captive BPOs are not in a healthy shape.

According to analysts, Citigroup too would become one of the high-profile victims of spiraling costs in managing captive BPOs in India. Apparently, Citi is putting its BPO on the block after finding it difficult to keep its costs down, especially after recruiting thousands of employees on the companys rolls. Citigroup Global Services (in its eServe avatar) had spent a huge amount of money in advertising that included hoardings, which third-party competitors reckon goes against the industrys practice of keeping costs low.

Supreme Court Rescues Captives

The death knell for captives could have been sounded this year only in case the Supreme Court had not come with a favorable ruling for taxation of captive BPOs. The captive Indian entity exclusively services the parent MNC for which it gets paid appropriate fees. The question that was the bone of contention was whether the Indian revenue authorities can only tax the captive Indian entity for the fees that it receives from the MNC parent or whether the MNC parent (that is outside India) can itself be taxed by the Indian authorities to the extent of the income it has derived internationally from operations attributable to the captive Indian entity.

This was the subject matter of litigation before the Authority for Advance Ruling (AAR) in the Morgan Stanley Case. In February 2006, the AAR ruled that even if the captive Indian BPO operation was treated as a "permanent establishment" of the MNC, only the income received by the Indian entity from the MNC parent would be taxed in India. It also held that the MNC parent itself would not be liable to be taxed in India to the extent of profits attributable to the Indian operations so long as the Indian entity was remunerated by the MNC parent on an arms length basis.

With the AAR ruling being in favor of the assessed, it was naturally the subject-matter of an appeal preferred by the revenue before the Supreme Court. The Supreme Court subsequently upheld the decision of the AAR and ruled in favor of the assessed. The ruling established that it was first necessary to determine whether the Indian captive BPO is a "permanent establishment" of the MNC parent. If not, then the MNCs profits are not taxable in India; and, if the Indian captive BPO is determined to be a "permanent establishment", then the MNC parents income (attributable to the Indian operations) will be taxable in India only if its remuneration of the captive Indian BPO is not on an arms length basis.

The logic of the Supreme Court decision seems to be to ensure that there is no tax leakage through outsourcing. In other words, if the transaction between the MNC parent and the Indian captive BPO is on an arms length basis, then the Indian entity receives sufficient revenue on which it pays taxes in India. However, if services of the Indian entity are undervalued (and not on an arms length basis) resulting in less revenue to the Indian entity, that would in turn result in less taxes being paid in India and hence revenue leakage. It is, therefore, important for all captive BPO entities to have proper transfer pricing arrangements with their MNC parents such that the transactions are conducted on an arms length basis.

Too Many Hurdles
It would be unfair to blame only spiraling costs for the current predicament of captive BPOs in India. It is more often than not a combination of factors including skyrocketing attrition, lack of management support, and a lack of integration that has started spelling the doom for captives. And, therefore, while costs are still most important, there are other factors that force a rethink amongst the MNCs. Most of the captives serve the parent companys global operations and, over a period of time, these captive units do not get the cost arbitrage factor because they do not match the growth of third-parties.

Analysts say that Indias high rate of attrition, coupled with low productivity levels could also spell the end of the captive honeymoon. A recent Nasscom study found that the annual attrition rate is as high as 30% and industry experts point out that attrition rates in MNC-owned captive centers are higher at 30-40%. This makes it more expensive for MNCs as they have to either keep a huge bench (a waiting pool) or consistently hire HR consultants to hire new sets of employees.

Productivity too is low in Indian units, when compared to nations where the MNCs are headquartered. According to Zinnov, a research firm, staff productivity at offshore centers like in India is 50-60% lower than that at the onsite units located in parent countries. For many firms, this creates a severe mismatch in the productivity between their Indian and US teams. Experts add that captive units are further burdened with a poor delivery record, operational problems, a lack of scale, and poor morale.

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