The Truth About Obama’s “Tax on Outsourcing”

U.S. President Barack Obama had barely finished his seven-minute speech decrying a tax code “that says you should pay lower taxes if you create a job in Bangalore, India, than if you create one in Buffalo, New York,” when the press reports started pouring out. Headlines referred to the President’s plan to close overseas business tax loopholes as a ‘tax on outsourcing’ and proclaimed that he was taking direct aim at Indian offshore outsourcing firms—and the American companies who hire them. Misconceptions about offshoring and outsourcing littered their initial analysis of Obama’s plan.

To clear up those misperceptions, CIO.com separates fact from fiction, pointing out what is known and—just as important—what isn’t clear about the White House’s proposal and what it means for IT vendors, their customers, and for IT jobs.

Perception: Outsourcing and offshoring are synonymous.

Reality: More than a decade into the age of offshore outsourcing, people still get these two concepts confused.

Outsourcing is the practice of contracting out of goods or services to a third party. You can outsource IT services anywhere in the world—from Bangalore to Buffalo.

Offshoring refers to the practice of completing work at a non-domestic location, whether by workers at a company’s own offshore subsidiary (often called a “captive” center) or by a third-party. When you combine the two—offshore outsourcing—you’re getting more specific, referring to contracting with an overseas vendor for goods or services.

Understanding the difference between the terms is more than just good semantics; it can create clarity around what Obama might actually be proposing and whom it will affect.

Perception: Obama wants to tax offshore outsourcing.

Reality: In his remarks last week, Obama said his budget will end tax breaks for companies that “ship jobs overseas.” But no one is quite sure whether Obama is talking about companies with captive offshore operations or companies that outsource to third-parties based overseas, or both.

“I still don’t know what the President is referring to when he talks about eliminating the tax benefit associated with offshoring jobs,” admits Daniel Masur, an outsourcing attorney and partner in the Washington, D.C. office of Mayer Brown.

Masur, like most, assumes Obama wants to eliminate U.S. multinationals’ ability to deduct business expenses associated with overseas operations while deferring tax payments on profits earned abroad.

The confusion stems from the fact that there’s more than one way to ship a job overseas (see the difference between offshoring and offshore outsourcing above).

In fact, Obama’s plan addresses only those U.S. companies who operate subsidiaries overseas (the captive centers.) In the IT vendor community, that would include, for example, IBM Global Services and Accenture. It would also affect a good number of non-vendor Fortune 500 companies who maintain a presence abroad, such as GE and Proctor & Gamble, some of which provide their parent companies with IT services.

Obama’s proposal would not impact U.S. companies who “ship jobs overseas” by hiring an offshore company, such as Tata Consultancy Services or Wipro. The only offshore outsourcing customers this plan could have any bearing on are those who work with U.S.-based IT services companies like IBM, which then deliver those services offshore. It’s unlikely the customers would see much of a trickle-down effect.

Perception: India’s IT services industry will take the biggest hit.

Reality: Initial reports that India Inc. was crying in its chai over Obama’s tax plan have been corrected. Based on the President’s remarks, U.S.-based outsourcing providers have the most at risk. “Although the announcement was unclear, it will presumably make it more expensive for all American multinationals to operate on foreign soil,” says Lee Ann Moore, chief marketing officer for outsourcing consultancy EquaTerra.

If there were any remaining confusion, Som Mittal, president of India’s National Association of Software and Services Companies (NASSCOM), tried to clear it up in remarks to reporters last week: “It has nothing to do with India.”

Perception: Obama’s plan will lead to less offshoring and more U.S. job creation.

Reality: Aside from the 800 IRS agents the president would like to hire “to detect and pursue American tax evaders abroad,” it is not clear how the administration’s plan to tighten lax tax laws would lead to an increase in American hiring.

Obama stated that he’d like to transform some of the revenue that would come from taxes on foreign subsidiaries into tax credits for companies that invest in domestic research and development “so that we can jump start job creation, foster innovation, and enhance America’s competitiveness,” but he offered no additional details.

“It is hard to tell if [Obama] is going to push to merely eliminate loopholes that allow tax-benefits for foreign-based subsidiaries, or actually regulate where companies perform their tasks,” says EquaTerra’s Moore. “The challenges to implement the latter will be immense.”

No companies with offshore subsidiaries have indicated that they would decrease their foreign presence if U.S. taxes on those operations increased. Setting aside those companies that relocate their corporate headquarters to Bermuda or the Cayman Islands, most multi-nationals set up shop overseas to access cheaper labor or new markets, not merely to dodge taxes. (They pay taxes—though often at lower rates than in the U.S.—to the foreign governments where they operate.)

In fact, some experts say if the U.S. government does seek more tax revenue from U.S. multi-nationals, the outcome could be more offshoring, not less, as those corporations use labor arbitrage to offset the bigger tax bill. The IT trade group Tech America called the plan “one step forward and two steps backward for the U.S. technology industry,” and warned that it could inadvertently encourage technology companies to relocate entirely overseas.

Perception: This new international tax policy is a done deal, and a sign of more protectionist policies to come.

Reality: The passage of any significant change in U.S. international tax policy is unlikely. “It would be viewed by the rest of the world as protectionist and would trigger a wave of retaliatory legislation,” says Mayer Brown’s Masur. “And it would be bad for American business.”

U.S. multinationals and industry lobbyists are hard at work to make sure the proposal dies an early death on Capitol Hill.

“However, given Congress’s propensity in recent months to write major legislation over a weekend and Congress’s preoccupation with populist sound bites, such a provision could be buried in the next stimulus or budget bill,” says Masur. “Even then, I think it would suffer the fate of the AIG bonus legislation—enacted by one house with much hoopla and then buried in committee by the other.”

Instead, Masur thinks similar legislation aimed at limiting offshoring—and perhaps even offshore outsourcing, too—will pass at state or local levels across the country.

Meanwhile, Senators Dick Durbin (D-Ill.) and Charles Grassley (R-Iowa) are pushing “The H-1B and L-1 Visa Fraud & Prevention Act of 2009,” aimed not at lowering the number of skilled worker visas awarded by the U.S. government each year, but at increasing program oversight.

Stephanie Overby is a Boston-based freelance writer.

This story was edited by Meridith Levinson. Follow me on Twitter @meridith. Follow everything from CIO.com on Twitter @CIOonline.