TAXATION FOR SOFTWARE INDUSTRY

INTRODUCTION:

 

“Collecting more taxes than is absolutely necessary is legalized robbery”.

 

As of today, there is massive increase in taxes and Government is imposing several taxes on a single item leading to the problem of double taxation. Recently, it has been observed that the Indian Government has imposed several taxes on Information Technology software (packaged or canned) which had added to the problem.

 

Until May 2008, Information Technology Software was subjected to VAT/Sales Tax as well as Customs or Excise duty, but in budget 2008-2009, Indian Government levied service tax on packaged or canned software. Levy of service tax on information technology software (packaged) created many issues and problems like double taxation. Subsequently, software industry had to pay both excise duty and service tax which resulted in igniting the problem of multiple taxation and various other controversies. The Government Ministries have issued various Notifications clarifying the taxation provisions in this regard. However, certain issues still remain unanswered which have added to the prevailing confusion and uncertainity in the Software Industry.

 

This Article commences with defining, classifying and explaining the concept of a “Software.” It further seeks to examine the various tax provisions to which the Software Industry is subject as well as the numerous interpretations of these provisions which have given rise to a lot of confusion. Last but not the least, this Article also provides certain suggestions which in our opinion, would be the remedy to this multiple taxation mess and would also bring the existing tax provisions in line with the provisions of the Constitution.

 

SOFTWARE- THE BASIC CONCEPT:

 

In general terms, a Computer software, or just software, is a collection of computer programs and related data that provide the instructions telling a computer what to do and how to do it. Section 2 (ffc) of the Copyright Act, 1957 defines the expression “Computer programme” as a set of instructions expressed in words, codes, schemes or in any other form, including a machine readable medium, capable of causing a computer to perform a particular task or to achieve a particular result. Thus, it can be stated that a software is a set of one or more computer programmes which performs the function of the program it implements, either by directly providing instructions to the computer hardware or by serving as input to another piece of software.

 

The basic distinction between a software and hardware is that while the latter has physical existence, a software is mainly ‘intangible’ and primarily consists of lines of code written by computer programmers that have been compiled into a computer program. Software programs are stored as binary data that is copied to a computer’s hard drive, when it is installed.

 

In 2008, Section 65 of the Finance Act, 1994 was amended to make service tax applicable to “Information Technology software” and bring it within the purview of “taxable services.” Section 65 (53a) was inserted which defines “information technology software” to mean any representation of instructions, data, sound or image, including source code and object code, recorded in a machine readable form, and capable of being manipulated or providing interactivity to a user, by means of a computer or an automatic data processing machine or any other device or equipment.

 

Types of Softwares:

 

For the purpose of levying taxes, software can be divided into the following types.

 

1.         Packaged Software: Packaged software can simply be referred to as ready- made application software. Packaged software are also commonly known as canned software, branded software, shrink- wrap software etc. These kind of software are sold off-the-shelf to customers at retail outlets or can also be downloaded electronically. They are designed to meet the requirements of a variety of consumers. The common examples of packaged software include Microsoft Office, Norton Anti-Virus, Picassa etc.

2.         Customized Software: Customized software are specifically created for a particular consumer to meet his special requirements. In other words, this type of software is tailored to satisfy the exact needs of a particular customer taking into account his preferences and expectations. For example, A website designed for a particular business organization. In the case of Steag Encotec, India,1CESTAT held that customization of pre- existing software to the needs of a particular customer is modified packaged software and not customized software. Customized software has to be developed from the basic building blocks, whereby a new software product should emerge as per the specific requirements of the client so as to qualify itself as a custom designed software.

 

The concept of Software Licence and the ‘Right to use’ a Software:

 

The nature of software is an extremely controversial issue. Whether a software is a goods or a service is not correctly ascertained till date. However, there is no dispute in the fact that regardless of being a “goods” or “service,” a software is basically an Intellectual Property as it is protected under the Copyright Act, 1957. It can downloaded electronically or can be transferred or transmitted through tangible medium such as CD’s, DVD’s, floppies etc.

 

The sale of a software is usually coupled with and conditional to the acceptance of a software licence agreement which gives the buyer the ‘right to use’ the software subject to the certain terms and conditions stated in the agreement. A buyer can therefore use, abstract, consume, deliver, store, possess, transfer and transmit such property in consonance with the licence agreement. However, he cannot resell or exploit it commercially for his own gain or profit. Thus, it may be noted that on purchasing the software, the buyer does not become the “owner” of the software but a mere “licensee.” This basic nature of a software distinguishes it from other forms of traditional goods and services.

 

APPLICABILITY OF TAXES:

 

A. VAT/SALES TAX

 

Sales tax is a tax which is imposed by State Governments and rate of sales tax may vary from one state to other. In simple words sales tax is a tax on sale or purchase of goods. In 2005, the Supreme Court held that the transfer of branded software constitutes a sale and is exigible to sales tax, levied by State Governments under Entry 54, Schedule VII of the Constitution (Tata Consultancy Services v. State of A.P2).In this context sales tax is applicable on the following:

 

•           transfer, otherwise than in pursuance of a contract, of branded software in any goods for cash, deferred payment or other valuable consideration.

•           transfer of the right to use any goods for any purpose (whether or not for a specified period) for cash, deferred payment or other valuable consideration.

•           supply of goods by any unincorporated association or body of persons to a member thereof for cash, deferred payment or other valuable consideration.

 

2009 TIOL 1776 CESTAT MUM AIR 2005 SC 371, (2004) 192 CTR (SC) 257, 2004 (178) ELT 22 (SC), [2004] 271 ITR 401 (SC), 2004 (9) SCALE 349, 2006 (33) PTC 652 (SC), (2005) 1 SCC 308, [2004] 137 STC 620 (SC)

 

B. CUSTOM/EXCISE DUTY

 

Custom duty is a tax or tariff levied on imports (and, sometimes on exports) by the custom authorities of Central Government of India. This duty is generally based on various factors like value of goods or upon weight, dimensions etc. of the item. In relation to branded software there is no basic customs duty but additional countervailing duty (CVD) is applicable on the import of branded software. Excise Duty is a tax levied on the goods produced or manufactured in India by the Central Government of India. Central Government in notification no. 49/2006 – CE imposed excise duty on the manufacture of Information technology software.

 

C. SERVICE TAX

 

Service Tax is a form of indirect tax imposed on specified services called “taxable services”. Service tax cannot be levied on any service which is not included in the list of taxable services. In 2008 Central Government introduced a new clause to section 65(105) of Finance Act,1994 which brought information technology software under the meaning of “taxable services”.

 

The provisions of Section 65(105)(zzzze) reads as under:-

 

“Section 65: In this chapter, unless the context otherwise requires,– (105) “taxable service” means any service provided or to be provided-

(zzzze) to any person, by any other person in relation to information technology software for use in the course, or in furtherance of, business or commerce, including—

 

(i) Development of information technology software,

 

(ii) Study, analysis, design and programming of information technology software,

 

(iii) Adaptation, upgradation, enhancement, implementation and other similar services related to information technology software,

 

(iv) Providing advice, consultancy and assistance on matters related to information technology software, including conducting feasibility studies on implementation of a system, specifications for a database design, guidance and assistance during the startup phase of a new system, specifications to secure a database, advice on proprietary information technology software.

 

(v) Acquiring the right to use information technology software for commercial exploitation including right to reproduce, distribute and sell information technology software and right to use software components for the creation of and inclusion in other information technology software products

 

(vi) Acquiring the right to use information technology software supplied electronically”.

 

D APLLICABLE TAX RATES ON INFORM ATI ON TECHNOLOGY SOFTWARE:

 

SALES TAX/ VAT	It is charged at the rate fixed by each state as it is a tax imposed by state governments.
CVD/EXCISE DUTY	It is charged at the rate of 10% approx.(10.3%) on MRP less 15% abatement.
SERVICE TAX	It is charged at the rate of 10% approx. (10.3%) on the total amount received from the buyer.

 

The abovementioned applicable taxes have given rise to various implications and problems which are discussed below:

 

A. THE ‘GOODSY- GOODSY’ SOFTWARE POSITION PRIOR TO 2008:

 

Before 2008, the tax provisions regarding Packaged Software were definite and unambiguous. Supply of packaged software as well as licence to use such software was taxable as ‘goods,’ i.e., it was subject to Excise duty/ CVD and VAT. No service tax was levied on canned/ packaged software. On the other hand, contract of customized software, its maintenance and other technical support was subject to service tax.

 

The Apex Court, in the case of Tata Consultancy Services (TCS) vs. State of Andhra Pradesh, 3 held that packaged software like Oracle, Masterkey, Lotus etc. are goods for the purpose of sales tax. It further explained that the test to determine whether a property is ‘goods’ for the purpose of sales tax, is not whether the property is tangible or incorporeal. The test is whether the concerned item is capable of abstraction, consumption and use, and whether it can be transmitted, transferred, delivered, stored, possessed etc. If the software, whether customized or branded, satisfies all these attributes, it would be goods.

 

The abovementioned principle of the Supreme Court was also approved and applied in the case of Bharat Sanchar Nigam Ltd. vs. UOI.4 Moreover, in the case of Associated Cement Companies Ltd. v. CC5 earlier, it was held that computer software is ‘goods’ even though it is copyrightable as intellectual property.

 

These Court rulings did to a certain extent, make the tax provisions relating to packaged software quite comprehensive. However, it was only after the Finance Act, 1994 was amended in 2008 that a hue and cry in the software industry was created.

 

B. THE POST 2008 SOFTWARE IDENTITY CRISIS:

 

In May 2008, an amendment was made to Section 65 (105), Chapter V of the Finance Act, 1994 whereby sub-clause (zzzze) was introduced which bought Information Technology (I.T.) Software under the meaning of ‘taxable service.’ Consequently, supply of packaged software as well as right to use packaged software licence became subject to both VAT and Service Tax.

 

This provision raised doubts as to the real identity of a software. It primarily gives an absurd impression that packaged software is a ‘goods’ as well as a ‘service’ and hence, is taxable as both. This not only creates the problem of double taxation but also goes against the very sense of reasonableness and logic. In the case of Imagic Creative Pvt. Ltd v. CCT, 6 the Court held that a transaction can either amount to a ‘sale of goods’ or ‘service’ for the purpose of taxation. Thus, by charging VAT and Service tax on packaged software, the Government is going against the principle laid down in this case. According to software dealers and manufacturers, the said amendment would force them to increase the cost of packaged software by almost 25%. This increased cost would ultimately be passed on to the consumers who would bear the brunt in the form of high prices. This, as a result, would also increase software privacy as consumers would refrain from purchasing highly priced original software.

 

It may be noted that Infotech Software Dealers Association (hereinafter referred to as “the ISODA), a society registered under the Societies Registration Act with its headquarters at Mumbai, filed a writ petition in this regard. However, the Madras High Court dismissed this petition in 2010, the details of which will be discussed later in this article. Meanwhile, as a response to the prevailing confusion, the Government issued certain notifications during the financial year 2009-10. These notifications provided certain tax exemptions on packaged software and hence, provided the software industry with some relief.

 

C. POSITION 2009-10: GOVERNMENT’S ATTEMPT TO CLARIFY TAX MESS:

 

During the financial year 2009-10, the Government sought to provide some relief to the tax burdened packaged software industry. On July 7, 2009, it issued Notification no. 2/2009-CE and Notification no. 80/2009-Customs for providing exemption to packaged software from levy of excise duty and CVD respectively. This exemption was, inter alia subject to the condition that the assessee shall be registered under the Finance Act, 1994 for the purpose of paying service tax. Furthermore, on February 27, 2010, the Government issued Notification no. 2/2010- ST and Notification no. 17/2010- ST which provided exemption from service tax to canned or packaged software subject inter alia, to the condition that appropriate duties of Excise or Customs, as applicable, have been paid. It is important to note that these exemptions have been provided on amount representing the actual transaction value as determined under Section 4 of the Central Excise Act, 1944.

 

These Notifications prima facie suggest that any person dealing with packaged software has a choice between paying service tax on one hand, or paying Excise/CVD (as applicable) on the other. Though this did not solve the identity crisis as both VAT as well as service tax continued to be applicable to packaged software, it provided certain amount of relief to software dealers from the multiple tax burden.

 

D. 2010-11: ADDITION TO CONFUSION:

 

I. INFOTECH CASE

 

Madras High Court in 2010 held that the software is goods and the question as to whether a transaction would amount to sale or service depends upon the individual transaction. High court explained that even though software is a “goods” but it may not amount to exclusive sale in all cases. Court asserted that the terms and conditions of EULA (a legal contract between software application author and user of that application) are material to find out as to whether there is an element of sale involved when software is delivered to its customer.

 

Cases where software does not amount to sales:

 

If the software is sold through the medium of internet in the form of downloadable, it does not fit into the ambit of “IT software of any media”. In that event, it is possible to hold that when an access control is given through an internet medium with a username and password and when there is no CD or other storage media for the item, it does not satisfy the requirement of being ‘goods’ or the entry used in the statute.

 

The original manufacturer, who creates the software, only licenses the software for the private use of the end user subject to the terms and conditions. If the end user agrees to the terms and conditions, such end user is given “right to use” (install, run and get updates) the software within the limits prescribed. At no stage an end user who runs the software installed in his computer becomes absolute owner of the software. The end user cannot tamper or modify, cannot improve and cannot rectify errors in the software and the end user should not sell the software to another person for commercial exploitation. In view of the specific licensing agreement between the original manufacturer of Standardised Software, namely, Microsoft and Symantec, and the end user, it would be clear that the software is not sold, but only licensed for the limited use for which it is licensed. In other words, in trade parlance, whenever a software product is launched, the original manufacturer releases what is known as End User License Agreement and Product Use Rights.

 

These aforementioned cases have been discussed by the high court in the Infotech case and HC made clear that the question whether the transaction of software being a goods would amount to sale or service depends on the rights given to the end user.

 

EXAMPLE:

 

X enters into a legal contract (EULA) with Y who is the original manufacturer for the transfer of packaged software.

 

Case A: Where X (end user) is allowed to re-sell (for commercial exploitation), tamper or modify the concerned software.

 

Case B: Where X (end user) has no right to re-sell (for commercial exploitation), modify or tamper the software.

 

Now, In Case A transaction would amount to sale as the manufacturer has given all the rights to X including right to resell. Thus in this case it makes X an absolute owner having all rights over the software.

 

Whereas in Case B, X has no right to resell the software as he has only licensed for the limited use of the software. Thus, in this case it does not make X an absolute owner of the software and therefore transaction would amount to service and not sale.

 

II. THE PRESENT MRP VALUATION HAUNT:

 

On December 21, 2010, the Govt. rescinded Notifications bearing No’s. 17/2010-ST and 2/2010-ST. Simultaneously, Notifications bearing Nos. 30/2010- CE and 53/2010- Service Tax were issued. According to these notifications, service tax exemption can be availed on packaged software subject inter alia to the condition that appropriate duties of Excise or Customs have been paid on the value representing the Maximum Retail Price (MRP) less 15% abatement.

 

There have been a lot of questions raised with regard to the implementation of these notifications. While service tax exemption based on MRP valuation can easily be claimed on retail sale of packaged software, it is not clear as to how such exemption can be availed by manufacturers, importers and other institutional buyers since it is not possible for middlemen to determine the ultimate selling price and accordingly pay Excise/CVD. Determination of MRP when software licenses pass through multiple trading channels is indeed an impracticable requirement imposed by the Government.

 

It is also pertinent to note that electronic transfer of packaged software would be outside the scope of MRP based excise levy which has further lead to negative interpretations. Earlier, manufacturers and importers were either paying Excise/CVD on physical supply or Service tax on electronic supply, which did not matter as the rates for service tax and Excise/CVD were based on the transaction value and hence, were the same. Now, with the MRP based valuation being implemented, the software dealers would find it better to shift to electronic mode of software supply, as paying service tax on the transaction value would be cheaper than paying Excise/CVD on MRP less 15% abatement and also considering the complications of finding out MRP. One cannot understand as to how the mode of delivery can determine the amount of taxes a person has to pay. It is also a complex requirement imposed on a software dealer who handles both modes of delivery.

 

It may be submitted that the Government, in public interest, should restore the original valuation method and bring packaged software outside the scope of MRP based excise levy. This would simplify the tax provisions and further avoid unnecessary complications and impracticable interpretations.

 

ON A CONCLUDING NOTE…

 

The software industry has been bearing the multiple tax muddle for a long time. It is necessary that the Government takes up this issue and makes suitable amendments so as to simplify the tax provisions which have been haunting the software industry. It is recommended that the Government amends Section 65 (105) (zzzze) of the Finance Act, 2008 to include merely “services in relation” to I.T. software as a taxable service and not the Development of software and “right to use” software license per se. Secondly, packaged software should be brought outside the scope of MRP based valuation and levy of Excise duty should be on the basis of transaction value. This would avoid unnecessary confusion and complication. It is also necessary not to let the mode of delivery determine the amount of taxes payable by an assessee.

 

It must be remembered that simplified and unambiguous tax provisions lead to smooth implementation as well as less tax evasion. On the other hand, confusing the public and collecting excessive taxes goes against the very principles of equality laid down in our Constitution. Thus, it is necessary that the Government clarifies all the issues and questions this article addresses, for it is the only way the software industry can be rescued from falling deeper and deeper into the tax muddle.

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Why is China expensive?

A declining labor supply, rising wages and an appreciating currency are among the key reasons production costs are rising fast in China. Increasing land costs and the fact that SMEs find it difficult to obtain capital, are making the situation worse.

This article, which is an excerpt from the report “The End of Made-in-China?” published by Silk Road Associates, examines the top five factors that are pushing up China’s manufacturing costs.

China’s youth labor supply has started to decline

It was once popular to talk of China’s endless supply of cheap labor. Not anymore. Labor supply has shrunk dramatically over the past decade.

China’s youth demographic is expected to decline by 44 million over the next 10 years, according to the United Nation’s population projection division. Indeed, the average Chinese national is 35-years-old, compared to the average Cambodian (23 years) and average Bangladeshi (24 years).

The result is massive labor shortages. Officials in the southern Pearl River Delta, for instance, estimate the region suffers a shortfall of 600,000 workers. Or take the example of a major manufacturer of butane lighters who recently remarked to us that in spite of automating part of his factory floor and cutting his employee numbers in half, the average age of his staff has gone from 20-years, to 30-years, and now 50-years, as he struggles to find enough labor.

The situation is especially worse for factories producing low-value goods as they are either unwilling or unable to pay higher wages and it is common to hear of suppliers turning down orders from foreign buyers for fear that they will be unable to attract sufficient staff to fill the order on time.

China’s wages are rising

Labor shortages have contributed to rising wages. Today, China’s average manufacturing wage ranges from $200 to $550 (or higher). Moreover, the total monthly salary is likely higher as benefits-ranging from starting bonuses, performance bonuses, and marriage leave-are rising faster than monthly wages.

The result is that China’s wages are now on par, or significantly higher, than wages in the rest of the region. For instance, monthly wages in Bangladesh are around $55 per month and similarly low in Cambodia ($100) and Vietnam ($100). Only Thailand, among the low-cost producers, has higher wages.

China’s government has added to the pressure by hiking minimum wages in an effort to reduce income inequality, thus adding to wage cost pressure. Minimum wages have, on average, risen from $59 a month in 2000 to $166 a month in 2011. (The figures are calculated at constant 2011 USD/CNY rates; otherwise the increase in wages would be even larger, from $45 to $166).

To be fair, wage rates do vary across the country. Minimum wages are 30% higher in the coastal provinces ($187) than they are in the western provinces ($143). Wages can even differ between cities with minimum wages in Shenzhen at $234 in 2011 as against $203 in the rest of Guangdong province.

Nonetheless, the pressure on wages is clear and growing, whether because of market forces or government policy.

China’s currency is appreciating rapidly

The Chinese renminbi has meanwhile appreciated a median 22% against 13 Asian currencies in the past five years, so impacting the country’s competitiveness. The gains are even larger against some of China’s lowcost competitors. For instance, the Chinese renminbi has appreciated by more than 44% when compared to the currencies of Bangladesh, Cambodia, India, Laos and Vietnam (as the graph shows), a significant move when added to the country’s rising wages costs.

Such rapid appreciation may slow in the coming years, as the trade surplus narrows and the currency nears its fair value. Indeed, while nominal appreciation has been slower than critics in Brussels and Washington might like, real appreciation (adjusting for the country’s relatively faster inflation rate) has been rapid. Nonetheless, the damage is already done and a strong Chinese currency is another reason for the gains made by other low-cost manufacturers.

 

China’s land and other production costs are rising

 

China’s economy is also starting to face serious shortfalls in a variety of production inputs, resulting in rising production costs.

For a start, a large share of the population is concentrated along the coastal provinces (27% of the population) intensifying competition for inputs. Export production is even more concentrated, with just three coastal provinces- Guangdong, Zhejiang, and Jiangsu-accounting for 60% of total exports.

Land scarcity has inflated land prices and is pushing manufacturers further into the interior. Of course definitions of the ‘interior’ can differ widely: to some that might mean 100 kilometers west of the city of Guangzhou, while to others it implies moving 1,000 kilometers to an inland province.

Higher land prices are just one reason for the overall rise in China’s production costs. But relocating factories further away from coastal ports also raises transport costs and lengthens supply chains. The latter is especially important given that China’s ability to deliver rapidly is a major competitive advantage.

Restrictions on polluting industries are also tightening in part because of water scarcity. The authorities in southern Guangdong province, for instance, are relocating heavy metal factories to purpose-built industrial parks further inland where waste-water treatment facilities are more readily available.

China’s SMEs find it difficult to obtain capital

Automation is a logical response to rising wages. Yet, most SMEs find it difficult to obtain bank credit, as the state-banks prefer to lend to blue-chip state-owned firms. Indeed, recent surveys show that borrowing from family and friends accounts for 25% of SME financing in Zhejiang province.

Unofficial banks account for 21% of SME financing, but their interest rates can range from between 30% to 100%, or more, implying that such credit is more likely used as working capital to fill orders, rather than finance capital equipment, such as buying arc welders in order to automate production lines.

In the past, firms might more readily invest their free cash flow in capital equipment. But the pressure on margins as a result of rising production costs means there is less cash available. (Equally, many firms would rather invest in the property market where returns were, until recently, much higher.)

Zhou Guanxin, head of Zhejiang’s Federation of Commerce and Industry, summed up the challenges recently while speaking with reporters from the 21st Century Business Herald last month: he noted that China’s SMEs have “no heart to turn, no ability to turn, and nowhere to turn to”.

Legal Process Offshoring Regulation – US State Bills

Another assault on the legal process outsourcing industry—state Representative Patricia Dillon’s (D-New Haven) proposed legislation to bar Connecticut law firms from outsourcing legal work—faces stiff odds as the industry continues to grow despite real and imaginary obstacles.

Under the legislation, offshore, unlicensed workers who engage in the drafting, reviewing or analyzing of legal documents for clients in Connecticut could be charged with the offense of the “unauthorized practice of law.”

Many experts feel the bill is nothing but a way to gain votes and that the legislation actually is contrary to the U.S. bar rules. The LPO market in the U.S. and Europe, combined, will be around $4 billion, of this only about $1 billion worth of work comes to India. Every state in the U.S. allows lawyers to hire anybody they need to assist in their work, irrespective of geography, the experts say.

The just-around-the-corner boom in the U.S. market, however, continues to be constrained by such political considerations. Ongoing discussions in Congress continue to create an environment in which potential buyers of LPO services are treading cautiously. This will remain an issue until at least 2012 and is holding back U.S. organizations from getting the full value of outsourcing.

Reputation risk and political considerations still will benefit low-cost, onshore locations, namely Northern Ireland for the U.K. and relatively low-cost U.S. states, e.g., Utah and Oklahoma, while India continues to be the preferred offshore delivery location, with countries such as the Philippines and South Africa hampered by relatively low volumes of skilled resources.

Don’t get the wrong impression, however. The long-term strength of the LPO market looks very robust. LPO firms in India a few years ago had predicted an annual growth of 200 percent due to recession-related litigation and the increased need to save costs in the U.S. Those early expectations have not been met. Another reason for this is that U.S. lawyers themselves have started looking at alternative fee structures due to the recession and job losses. In spite of some setbacks, the LPO industry has seen growth of about 40-60 percent in 2010. Although some areas of practice, such as real estate, have drastically collapsed due to the recession, areas such as litigation, document review, and corporate compliance, among others, have gained ground, resulting in a good amount of business directed to LPO firms in India.

The Great Recession has put pressure on law firms to reduce their overheads related to marketing and sales, general administration, Information Technology, accounting, clerical, paralegal, and knowledge management. These overhead expenses account for about 17 percent of the total overhead expenses (of approximately 41 percent) that a typical law firm with 20 or more lawyers incurs in the U.S. By moving most of this work, which is nonbillable, offshore, these firms can reduce this cost to approximately 7 percent.

One of the major concerns about legal outsourcing with critics is the potential for breach of clients’ confidentiality. A second concern is that the people performing legal work may not be bound to the necessary ethical standards.

However, there have been ethics opinions from various state and county bar associations (such as New York and San Diego) and, recently, the American Bar Association (ABA) that put those worries to rest.

In New York state, the bar association has said that a New York lawyer may ethically outsource legal support services overseas to a nonlawyer, if the New York lawyer: (a) rigorously supervises the nonlawyer, so as to avoid aiding the nonlawyer in the unauthorized practice of law and to ensure that the nonlawyer’s work contributes to the lawyer’s competent representation of the client; (b) preserves the client’s confidences and secrets when outsourcing; (c) avoids conflicts of interest when outsourcing; (d) bills for outsourcing appropriately; and (e) when necessary, obtains advance client consent to outsourcing.

In “Ethics Opinion 2007-1,” a committee of the San Diego (California) County Bar Association concluded “that outsourcing does not dilute the attorney’s professional responsibilities to his client, but may result in unique applications in the way those responsibilities are discharged. California attorneys may satisfy their obligations to their client in the manner in which they used [an Indian firm], but only if they have sufficient knowledge to supervise the outsourced work properly and they make sure the outsourcing does not compromise their other duties to their clients. However, they would not satisfy their obligations to their clients unless they informed the client of [the Indian firm’s] anticipated involvement at the time they decided to use the firm.”

In addition, the California opinion’s footnotes compare privilege in the U.S. with that in India: “Under India’s attorney–client privilege, no attorney may: ‘(i) disclose any communication made to him in the course of or for the purpose of his employment as such attorney, by or on behalf of his client; (ii) state the contents or condition of any document with which he has become acquainted in the course of and for the purpose of his professional employment; or (iii) disclose any advise [sic] given by him to his client in the course and for the purpose of such employment.’ (Indian Evidence Act of 1972, quoted at http://www.lexmundi.com, India.)”

“The attorney–client privilege is more limited than in America. For example, ‘[a]n in-house counsel is not recognized as an ‘attorney’ under Indian law. Thus, professional communications between an in-house counsel and officers, directors and employees are not protected as privileged communications between an attorney and his client…’ (lexmuni.com, India. Compare: ‘In Upjohn Co. v. United States (1981) 449 U.S. 383, 101 S.Ct. 677, 66 L.Ed.2d 584, the U.S. Supreme Court expanded the previous ‘control group test’ and held that all confidential communications concerning the scope of their employment between corporate employees and the corporation’s in-house counsel are covered by the attorney–client privilege.’ Chicago Title Ins. Co. v. Superior Court (1985) 174 Cal.App.3d 1142, 1151 holding that attorney–client privilege did not apply where in-house counsel merely acted as a negotiator, gave business advice, or otherwise acted as company’s business agent. (Ibid).)”

Finally, there is criticism that LPOs are in effect practicing U.S law without a license or a U.S law degree. (e.g., writing memorandum, briefs, etc). This is work traditionally given to a junior associate in a law firm.

But the American Bar Association, Ethics Opinion 08-451, dated Aug. 5, 2010 “states that sending legal work overseas is ethically permissible as long as the lawyer doing the outsourcing takes steps to ensure the protection of client confidences and preservation of attorney–client privilege. The advisory also states that attorneys should check to make sure that foreign lawyers are suitably trained and competent and that bills for outsourced work be reasonable.”

Attorney–client privilege is a doctrine that says anything conveyed between an attorney and his client shall be treated with utmost confidentiality and is exempted from disclosure even in a court of law. However, when either party discloses confidential information to a third party or the opposite party, the privilege is deemed to be waived.

LPO critics say that since communication is being sent to a country other than United States, the confidentiality is broken; hence, the privilege has been waived. However, ABA clarified this, clearing the way for the development of legal process outsourcing.

A full quote from the ethics opinion is as follows: “The outsourcing trend is a salutary one for our globalized economy. Labor costs vary greatly across the United States and throughout the rest of the world. Outsourcing affords lawyers the ability to reduce their costs and often the cost to the client to the extent that the individuals or entities providing the outsourced services can do so at lower rates than the lawyer’s own staff. In addition, the availability of lawyers and nonlawyers to perform discrete tasks may, in some circumstances, allow for the provision of labor-intensive legal services by lawyers who do not otherwise maintain the needed human resources on an ongoing basis. A small firm might not regularly employ the lawyers and legal assistants required to handle a large, discovery-intensive litigation effectively. Outsourcing, however, can enable that firm to represent a client in such a matter effectively and efficiently, by engaging additional lawyers to conduct depositions or to review and analyze documents, together with a temporary staff of legal assistants to provide infrastructural support.”

Legal process outsourcing may be—for the moment—a political flashpoint for some state politicians and the U.S. Congress, but LPO is not a new concept, Michael Ford, executive vice president of UnitedLex Corp., told the ABA Commission on Ethics at a public hearing during the 2010 ABA Annual Meeting in San Francisco.

In fact, Ford said, outsourcing is a fundamental division-of-labor principle at the foundation of the client-law firm relationship, a supply system optimization. In-house legal departments and law firms cannot support the range of services needed to address the variety of legal issues arising in daily business operations, on the scale that may be needed. They typically outsource specific tasks—or legal functions—to paralegals, document reviewers, e discovery experts, copy services and expert witnesses.

Multinational law firms and corporations have sent legal work across borders for decades, Ford continued. Estimating that 85 percent of his company’s work is performed for U.S. lawyers, Ford questioned the importance of geographic barriers when law firm clients or the firm’s supervision is appropriate and meets all standards.

Mark Ross, a solicitor in the United Kingdom and vice president for legal services at Integreon, Inc., opened his testimony by noting that his firm does “not, in any jurisdiction, practice law,” but rather, works under the strict supervision of counsel.

Concern about legal process outsourcing taking over the legal practice in the United States is smoke and mirrors. Ross stated, “You need to be aware of the reality of this industry.” Even if LPO achieves a $4 billion annual market, it still is only “approximately 1 to 1½ percent of the legal market.” Concern about moving LPO “up the market chain” also is misplaced, believes Ross, suggesting the real path shifts legal service-related functions “down the market chain.” In the United Kingdom, Ross said, solicitors who once received 1,000₤ for refinancing a mortgage now may earn only 50₤.

Peter D. Ehrenhaft, of Washington, D.C., addressed a different issue—fly in/fly out (FIFO) lawyering on an international scale, and its implications for unauthorized practice concerns. Ehrenhaft has practiced transactional law for both U.S. and foreign clients most of his 50 years as a lawyer. While he suggested his career “has not been run-of-the-mill … neither has it been unusual.” There are hundreds of U.S. lawyers, he speculated, “engaged in FIFO practice around the globe.” Ehrenhaft continued, “Not once during [my 50 years] has any question been raised by any regulatory body overseeing the delivery of legal services in this country or overseas about either my services or those of counsel” working on my side or on the opposite side of the table.

That is true despite the fact “none of the ‘foreign’ lawyers in the room (either I or another) had in, any way, been authorized to provide such services in the jurisdiction in which we were working.” He cited the example of a meeting at the Amsterdam Airport between the CEOs of a Swiss firm and the Italian client he represented, during which the Italian client’s acquisition of a division of the Swiss company operating in Germany was discussed.

Ehrenhaft served on an ABA Commission on Multijurisdictional Practice that addressed domestic lawyers traveling around the United States. While he noted that most U.S. jurisdictions have adopted that commission’s recommendations regarding domestic cross-border practice, the commission’s suggestions regarding FIFO by foreign lawyers have not been adopted. He said, “The sole license to be required for any lawyer should be modeled on our driver’s licenses — issued on a showing of competence to an authority in the place of the driver’s residence and valid almost globally for ‘FIFO’ driving.”

LEGAL PROCESS OFFSHORING

The median annual salary of a lawyer in the United States is around $95,000. The median annual salary of a lawyer in India is around $20,000 per year.

This significant salary differential is prompting a growing number of U.S. employers to export legal work to low-wage, developing countries overseas. The transfer of legal services to overseas markets, called Legal Process Off-shoring (LPO), is a growing trend in the legal industry. U.S. firms and corporations are embracing LPO as an effective and efficient way to reduce legal costs.

The Growth of Legal Process Off shoring

The advent of the Internet, increased automation of legal processes, developments in data security, new technology tools, economic changes and the availability of well-educated low-cost foreign labor have combined to instigate and energize the LPO phenomenon.

Legal Processing Off-shoring is occurring in nearly all sectors of the legal services industry. The work of lawyers, paralegals, legal secretaries and litigation support personnel is increasingly being performed by legal service providers on the other side of the globe.

Legal Secretarial and Administrative Functions

Legal secretarial tasks and repetitive legal administrative functions, termed “back office operations,” were one of the first functions exported to low-wage markets. As data processing, customer service and call centers sprung up across foreign landscapes, legal secretarial tasks soon joined the ranks of exported commodities.

The range of secretarial and administrative services provided by offshore back office operations is growing by an estimated 20% annually as developed countries seek to lower costs by outsourcing routine office functions. Legal secretarial tasks outsourced overseas include data entry, proofreading, legal transcription, and simple filings, cite-checking and remote secretarial services.

Litigation Support Functions

The advent of e-discovery and changes in the Federal Rules of Civil Procedure have encouraged the offshoring of high-volume, labor-intensive litigation support functions . In fact, litigation support functions are the bread and butter of many foreign legal service vendors.

In lieu of paying armies of high-priced U.S. attorneys and paralegals to code and review millions of discovery documents, highly trained workforces overseas perform the work at a fraction of the cost. Typical litigation support tasks performed by overseas legal service providers include imaging, scanning, coding, abstracting, indexing, data entry and document review.

Lawyer Functions

The work of lawyers is not immune to the offshoring phenomenon. Overseas legal service vendors are performing sophisticated legal tasks formerly reserved for high-priced U.S. attorneys. Technological tools such as the internet, electronic legal research, e-mail, text messaging and remote document retrieval make it easy for lawyers to communicate across the globe. Complex legal research, due diligence, contract management and negotiation, appellate briefs and research, and intellectual property services are among the legal tasks being exported to low-wage markets, where attorney rates are as little as 1/30th the cost of U.S. lawyers.

Paralegal Functions

Legal processing outsourcing is also making an impact on the paralegal industry. In India and other low-cost markets, paralegals earn between $6 and $8 an hour, compared with the $20+ an hour earned by their U.S. counterparts. A study at the University of California at Berkeley cites the paralegal field as one of the top occupations most at risk of being outsourced abroad.

In the beginning, the types of paralegal tasks outsourced were primarily low-end, high-volume work including deposition summaries; document review; electronic discovery; document organization, summarizing, indexing, categorizing and abstracting; document imaging, scanning and coding; and routine research such as multi-jurisdictional surveys.

As offshoring gains momentum, more sophisticated and complex paralegal tasks are being sent overseas such as complex legal research; contract drafting, monitoring and review; business research services such as reviews of SEC filings and corporate financial research; and drafting of legal documents such as legal memorandums, pleadings, briefs, discovery requests and jury instructions.

In India and other developing countries, the title of “paralegal” does not exist. Employees performing paralegal tasks are trained law school graduates who deliver a high-end work product at a fraction of the cost of U.S.-based paralegals.

LPO Destinations

India is currently the leading destination for offshoring legal services. With tens of thousands of students graduating from India’s law schools each year, India boasts an enormous labor pool of highly trained, English-speaking lawyers. Like the U.S., India’s legal system is based on British common law, reducing the learning curve for Indian legal employees who work for U.S. clients. Moreover, the ten-hour time difference between India and the United States permits overnight and 24/7 operations. A U.S. attorney can assign a project at the end of his workday to an Indian employee and find the completed project on his desk the following morning.

Although most off shored work is exported to India, other countries are competing for a share of the LPO market, including China, South Korea, Australia, New Zealand, Sri Lanka, Israel, and the Philippines.