No more tax breaks for offshoring?

Soon offshoring will no longer offer the considerable tax incentive it has to date. Lawyers Belinda Doshi and Nick Beecham explain how financial firms can protect their business.

Banks, insurance companies and other financial services providers should be aware of an important change to the VAT rules due to come into effect on 1 January 2010.

The change is to the place of supply rules that were adopted by EU finance ministers in February 2008.

Under the current VAT rules, where cross-border services are provided by one business to another, the basic place of supply rule for VAT purposes is to treat the supply as taking place in the country where the supplier is based. This means that when the supplier belongs outside the EU, no VAT is payable. This has produced a considerable tax incentive for offshoring.

There are a number of exceptions to the basic place of supply rule, for example in the case of consultancy services where the place of supply is already treated as being the country where the business customer belongs.

However the basic place of supply rule applies to certain cases of outsourcing back-office administrative services such as call centre operations. This has enabled call centre operations to be provided by suppliers belonging outside the EU free of VAT.

From 1 January 2010, for the first time business customers will have to account for the reverse charge to VAT on the costs of these services (unless they qualify for exemption in their own right as financial or insurance intermediary services).

Businesses with a wholly or partially exempt VAT status (typically businesses in the financial or insurance sectors) will not be able to make full recovery of this VAT. This could have significant cost repercussions given the recent boom in the offshoring of these types of services.

The changes are being phased in between 1 January 2010 and 1 January 2015 but the main changes will take effect on 1 January 2010.

So what should financial services and other exempt sector businesses be doing now?

If your financial services business has not already done so, it will need to calculate exactly how much these extra costs will be. In particular, in the immediate future do they outweigh any anticipated reduced costs from offshoring?

In the longer term, you will need to consider how this will impact on your outsourcing strategy as a whole. Do you wish to continue your current offshore arrangements or consider bringing certain services back 'onshore'? Do you wish to change location to a different offshore centre and/or use a different range of providers?

This will be a complex assessment based not only on cost reduction but also service elements and data security. The reality today is that many financial services providers use a portfolio of service providers and any change to these will need to be carefully thought through and negotiated.

Even if your cost savings will take an immediate hit from the VAT change, you can take action to mitigate these effects.

One way forward is to review your offshoring agreements to see whether you can squeeze extra value from your service providers. This may be particularly appropriate where an agreement was signed two or more years ago when the financial services market was in a very different place.

Before you approach your supplier, you will first need to gather information and get up to speed on your contractual rights. This will allow you to better assess your options on the best way forward.

You must ask:

• What rights do you, as a customer, have to see your service provider's costs and profit margin under any open book arrangements?
• Do you have any service review or additional reporting rights?
• At which governance board should strategic reviews and costs be raised?
• How are issues escalated?
• What are your rights regarding benchmarking?
• How do you exercise these? Can you de-scope certain services or change the offshore location?
• What are your termination rights?
• What are your risks and costs relating to these actions?

Even if you do decide to continue with your current offshoring arrangements on the same terms, the above information will be vital in considering your next strategic move when the current contract term comes to an end.

Nick Beecham is a tax partner and Belinda Doshi is a technology partner at law firm Field Fisher Waterhouse LLP.