Paper.doc Page 1 of 28 Last printed 5/7/2008 9:36:00 PM

Law of E-Commerce

OUTSOURCING TO INDIA: LEGAL AND BUSINESS IMPLICATIONS FOR U.S.

SOFTWARE COMPANIES

Chuck Summers

A group of U.S. doctors have come to your firm for assistance in setting up a software

business to capitalize on either Hillary Clinton1 or Barack Obama‟s

2 2008 Presidential campaign

promise requiring that all U.S. health care providers institute paperless health information

technology systems. These doctors are experts on how health care functions in the U.S. They

are confident that they can build a cost efficient electronic health care management system that

operates as a secure internet service for U.S. hospitals, physicians, and their patients. They

envision the system will be founded on innovative software protocols and record formats for

patient data interchange. U.S. customers will be sold licenses to use the service.

The doctors are not software developers or information technology experts. However, they

have some start-up money and have identified interested investors for potential funding. They

are confident they can provide enough of the high level details such that a software team can

implement the service and its underpinning intellectual property. They hope to establish a U.S.

corporate leadership position in what will be a lucrative and fiercely competitive segment of e-

commerce. As an internet based service offering, these doctors do not see how the location of

software development or the hosting of the service could impact their U.S. business plan. In fact,

they have already secured a world-wide domain name: http://www.healthcare.com. They have

heard India is the leading export of software development and services. They are very interested

in exploiting the cheapest workforce they can find to make their money go the farthest. Costs are

of foremost concern to them. Their primary goal is build up the business and cash out for

maximum profit.

I. INTRODUCTION

E-commerce came to life in the late 1990s. It evolved from the distributed computing

movement of the 1990s and was guided by the vision that “[t]he [n]etwork is the [c]omputer.”3

Its emergence brought new internet protocols and languages that changed the face of corporate

computing.4 Advancement in technology made the physical location of a company‟s storefront

and computer center far less important than ever before. Alternate forms of business models

arose, ones that had no physical store front. Access to the internet became the only firm

requirement to carry out e-commerce business on a world-wide basis.

1 Hillary Clinton, Hillary Clinton Announces Agenda to Lower Health Care Costs and Improve Value for All

Americans, http://www.hillaryclinton.com/feature/healthcare (last visited Mar. 22, 2008).

2 Barack Obama, Barack Obama’s Plan, http://www.barackobama.com/issues/healthcare (last visited Mar. 22,

2008).

3 Sun Microsystems, Company Profile, http://www.sun.com/aboutsun/company (last visited Apr. 15, 2008).

4 HTTP is the protocol and HTML, Java, JavaScript, XML are the languages of e-commerce systems.

Paper.doc Page 2 of 28 Last printed 5/7/2008 9:36:00 PM

Software applications were retooled to fit into the internet oriented world. This retooling

made it possible to outsource a company‟s information technology (“IT”) need in part or in its

entirety. Outsourcing was not unfamiliar. U.S. companies had been outsourcing labor intensive

product manufacturing to lower wage rate countries for many years. Because of the advances in

internet technology, it became feasible for U.S. companies to outsource labor intensive business

computing to low wage rate countries also. IT and business process outsourcing (“BPO”)

quickly emerged. India became the perfect outsourcing destination. India has a large pool of

young, well educated, and English speaking IT professionals.5 IT professionals in India earn one

fifth to one third of their U.S. counterparts and they are willing to work 12-hour days, six days a

week.6 Across the internet, India workers can operate the computer systems and business

processes for any U.S. companies willing to let them. In the early 2000s, many U.S. companies

started to let them.

According to NASSCOM7, India‟s premier trade body and chamber of commerce of the IT-

BPO industry, India is currently “…the nerve-center for global sourcing with 2/3rd of the

Fortune 500 and a majority of Global 2000 firms leveraging global service delivery.”8 India‟s

IT-BPO industry is targeting $60 billion in software and services exports and $73-75 billion in

overall software and services revenue by 2010.9 Direct employment in India‟s IT-BPO industry

is expected reach 2 million in 2008 (375,000 over the prior year) and yield a net-value add to

India‟s gross domestic production of 3.3-3.9 percent.10

NASSCOM claims that clients that

outsource their IT and business processes to India will realize a savings of 25-50 percent of U.S.

costs.11

In the context of the hypothetical problem introduced in the beginning of this paper,

corporate balance sheet projections at a $100M software license sales rate confirm NASSCOM‟s

cost saving claim. The following reveals that by outsourcing the entire strategic R&D and

operation of the U.S. doctor‟s envisioned electronic health care system to India they can increase

their bottom line profit by $22.7M when compared to a U.S. only offering.

5 NASSCOM, Strategic Review 2008 (“the typical worker is 25 years or younger and English speaking from the

legacy effects of British colonization”).

6 Interview with Madhu Ramarao, Finance Director, i2 Technologies India Pvt Ltd., in Dallas, TX. (Feb. 28, 2008)

(a software engineer in India with 3-5 years of experience presently earns between $24K to 31K US with yearly

wage increases of 15 percent as compared to U.S. wage increases of 4 percent); see also Naughton, Outsourcing:

Silicon Valley East.

7 NASSCOM, About NASSCOM, http://www.nasscom.in/Nasscom/templates/NormalPage.aspx?id=5365 (last

visited Mar. 23, 2008) (“…NASSCOM is a global trade body with more than 1200 members, of which over 250 are

global companies from across US, UK, EU and A-Pac. NASSCOM's member and associate member companies are

broadly in the business of Services, Products, IT Infrastructure Management, R&D services, E-commerce & web

services, Engineering services offshoring and Animation and gaming. NASSCOM‟s membership base constitutes

over 95% of the industry revenues in India and employs over 2 million professionals.”).

8 NASSCOM, Strategic Review 2008, http://www.nasscom.in/Nasscom/templates/ NormalPage.aspx? id=53454.

9 Id.

10 Id.

11 NASSCOM, Strategic Review 2007, http://www.nasscom.in/Nasscom/templates/NormalPage.aspx?id=50856.

Paper.doc Page 3 of 28 Last printed 5/7/2008 9:36:00 PM

Table 1. U.S. only U.S. parent India subsidiary*

Gross Income $100 Gross Income $100 $15 (20% profit**)

Cost of R&D

and operations $50

Cost of R&D

and operations $15 $12.5 (1/4 U.S. rate)

Taxable

Income

$50 Taxable

Income $85 $2.5

Taxes $17.5 (35% U.S.) Taxes $29.8 (35% U.S.) $0.8 (34% India)

Profit $32.5M Profit $55.2M $1.7M

*Assumed to be under income tax exempt economic zone

* 20% over cost is arm‟s length price charged U.S. parent

In addition, e-commerce businesses are based upon complex software systems. These

systems take large numbers of people to create. For equivalent U.S. cost, the U.S. doctors can

hire four times the number of software engineers in India to accelerate start-up if they need to.

Consequently by outsourcing to India the U.S. doctors can bring their electronic health care

system to market faster, at lower total cost of ownership, and subsequently they can offer lower

license costs to customers when compared to a U.S. only alternative.

NASSCOM claims that India is ready to move beyond the service oriented activities of IT-

BPO.12

They claim the outsourcing of legal services, software research and development

(“R&D”), medical diagnosis, pharmaceutical R&D, and investment analysis to India is next to

occur in today‟s global economy. Referred to as knowledge process outsourcing (“KPO”), it

presents U.S. companies with the potential to move the high priced work of lawyers, software

engineers, doctors, research scientists, and investment analysts to the lowest global bidder. The

worldwide revenue from KPO is expected to be $16.7 billion by 2010-2011 and it is growing at

an annual rate of 39 percent.13

India is projected to drive $11.2 billion of this revenue.14

This paper argues that despite India‟s claims of readiness for KPO of software R&D and e-

commerce site operation, India offers little asset protection to U.S. software companies who do

so. Those who seek bottom line cost savings from cheap India labor must be “ready, willing, and

able” to put their intellectual property (“IP”), data, and global income from India operations at

unbalanced legal risk.

This paper will proceed as follows. Section II will examine and analyze the relevant IP and

data protection laws India offers U.S. software companies. Section III will examine the political

and legal environment India presents for enforcement of its laws. Section IV will examine,

analyze, and evaluate how India‟s interpretation of its income tax laws impacts U.S. companies

producing software there. Section V will propose what must change to make India become a

more legally balanced outsource location for strategic software R&D and e-commerce site

12

IT-BPO typically involves service oriented activities such as: system management, monitoring, and testing; back-

office operation; call-center operation; data entry; and IT oriented consulting.

13 India to Dominate Global KPO Market, THE TIMES OF INDIA, Jul. 23, 2007, http://timesofindia.indiatimes.

com/India_to_dominate_global_KPO_market/articleshow/2227383.cms (according to the study by business research

and analytics firm Evalueserve).

14 Id.

Paper.doc Page 4 of 28 Last printed 5/7/2008 9:36:00 PM

operation.

II. THE FEW RELEVANT LAWS ARE UNTESTED

The source code for strategic offerings of a software company is particularly vulnerable to

piracy. Characteristically, it is a form of IP that is of high value to competitors, very costly to

create, usable as is by competitors, hard to prove when in use by others, readily copied, and

easily transported.

i2 Technologies, a software company, that has average annual revenues of $260M for license

sales of software products and services.15

They have invested over $1 billion in development

and acquisition of their software code base over the past 15 years. The entire source code can fit

on four 250 GB disk drives. All 600 of i2 Technologies‟ software developers have unrestricted

access to the internet, email, i2 facilities, and source code. Any one of them could email, FTP

across the internet, or copy to CD and carry out of the facilities any portion of the source code

they desire. i2 Technologies‟ open access policy for its R&D staff is not unusual. Many U.S.

based software companies behave in the same way.

IP theft is not unusual in India. India has maintained a steady business software piracy rate

around 70 percent from 2003 to 2006 according to the Business Software Alliance (“BSA”)

organization, a leading voice of the world's commercial software industry and its hardware

partners.16 See the table below.

Table 2. Piracy Rates Losses ($M)

2006 2005 2004 2003 2006 2005 2004 2003

India 71% 72% 74% 73% $1,275 $566 $519 $367

China 82% 86% 90% 92% $5,429 $3,884 $3,565 $3,823

U.S. 21% 22% 22% 23% $7,289 $6,895 $6,645 $6,496

European Union 36% 36% 35% 37% $11,003 $12,048 $12,151 $9,786

Total Worldwide 35% 35% 35% 36% $39,576 $34,482 $32,778 $28,803

Just because a country has established IP laws does not mean those laws are adequate, will be

interpreted by its courts as plainly written, or enforced by legal authorities.17

In those cases

15

i2 Technologies, Inc., Financial Metrics, 2005-2007, http://www.shareholder.com/itwo/downloads/

FinancialmetricsQ42007.pdf (last visited Apr. 3, 2008).

16 Business Software Alliances, 2006 Global Software Piracy Study, May 2007, available at http://w3.bsa.org/

globalstudy/upload/2007-Losses-Global.pdf (last visited Apr. 3, 2008) (The data in Table 2 has been extracted from

BSA‟s 2006 global software piracy study. BSA is the leading voice for the high tech industry in capitals around the

world and before multilateral organizations, advocating innovation and competition in the commercial software

industry, stronger intellectual property protection, cyber security, reduction of trade barriers, liberal use of

encryption technology and other emerging technology issues.).

17 Office of the U.S. Trade Representative, 2007 Special 301 Report, available at http://www.ustr.gov/ Document_

Library/Reports_Publications/2007/2007_Special_301_Review/Section_Index.html (last visited Apr. 3, 2008) (India

Paper.doc Page 5 of 28 Last printed 5/7/2008 9:36:00 PM

where contractual remedy for infringement or theft of software IP and data is not available, India

laws must be relied upon. The following subsections examine and analyze what relevant IP and

data protection laws India does and does not offer U.S. software companies.

A. No patents for software and business methods

The first missing prong in India‟s IP rights (“IPR”) regime is its lack of patentability for

software and business methods. In today‟s world, a patent portfolio is a requirement for any

software company looking to maximize its valuation. Patent protection is far more desirable

than copyright protection. First, the scope of infringement under patent law is broader under the

doctrine of equivalence. Second, patent rights are not subject to fair use exception as under

copyright law. In practice it is patent law that drives large damage awards in case of software

infringement, not copyright law.18

India‟s patent system is governed by the Patent Act of 1970. Under the original Act,

computer programs were not explicitly excluded from patentable subject matter.19

However,

later amendments have been made specifically to exclude “a business method or a computer

program per se or algorithm.”20

Back to the hypothetical problem, the U.S. doctors will need to seek software and business

method patents on any innovative patient data exchange protocols and formats developed in

India under U.S patent law. Any U.S. software or business methods patents they acquire in the

U.S. will not be enforceable in India to stop infringement by others there. Further, because their

electronic health care system directs its services at a U.S. customer base, the U.S. doctors will

also need to pay attention to the extraterritorial expansion of U.S. patent law. The holding of

has been on the Office of the U.S. Trade Representative‟s Priority Watch List since 2003. The 2007 Special 301

Review points out that “[p]iracy of copyrighted works remains rampant in India … criminal IPR enforcement

regime remains weak, with improvements needed in the areas of expeditious judicial dispositions for copyright and

trademark infringement, border enforcement against counterfeit and pirated goods, police action against pirates and

counterfeiters, and impositions of deterrent sentences for IPR infringers.”).

18 Noric Dilanchian, Patent Infringement Damages Skyrocket, DILANCHIAN LAWYERS & CONSULTANTS, Jan. 6,

2007, http://www.dilanchian.com.au/content/view/177/36 (last visited Apr 3, 2008) (Z4 Technologies wins $133M

in patent infringement damages from Microsoft and Autodesk); see also Saul Hansell, Microsoft Ordered to Pay

$1.52 Billion in mp3 Patent Lawsuit, INTERNATIONAL HERALD TRIBUNE, Feb. 23, 2007, http://www.iht.com/

articles/2007/02/23/ business/web-0223microsoft.php (last visited Apr. 3, 2008).

19 India Patents Act, 1970 § 3.

20 India Patents (Amendment) Act, 2002 § 3(k) (Subsequent to this amendment, specifically excluding business

methods and computer programs from patentable subject matter, a temporary presidential decree was issued in 2004

that widened the scope of patentable subject matter to include pharmaceuticals and embedded software to meet

India‟s January 1, 2005 TRIPS compliance deadline. 150 software patents came thru the India‟s patent office as a

result. India‟s parliament debated the widening of patentable subject matter under the 2004 decree. In 2005, the

parliament issued an amendment to the Patent Act that repealed the 2004 decree. This effect of the amendment was

to remove business methods and computer programs from patentable subject matter along with narrowing the scope

of patentable pharmaceuticals. The India patent office appears to have reversed any software patents that issued.);

see also Clean-up in India – Software Patents Slipped Through During Brief Period of Patentability, PROMOTE THE

PROGRESS, Mar. 30, 2005, http://www.promotetheprogress/archives.com/2005/03 (last visited Apr. 3, 2008).

Paper.doc Page 6 of 28 Last printed 5/7/2008 9:36:00 PM

NTP, Inc. v. Research in Motion, Ltd is applicable to them.21

In the U.S. Federal Circuit‟s view,

patent infringement is not precluded under 35 U.S.C. § 271(a) simply because an infringing

component in a system is located outside the U.S. when “control is exercised and beneficial use

of the system [as a whole] is obtained in the U.S.” Even though the U.S. doctors intend to

operate their electronic health care system entirely from India, they will need to develop it in

such a way that it does not infringe on pertinent U.S. system patent claims.

A relevant question is “are U.S. software and e-commerce companies doing strategic

software R&D in India?” A rough sense of this can be obtained via searches thru filings in the

U.S. patent office counting those software patents with and without India inventor(s). The

results are:

Table 3.

Software Patents (all companies)

1970-79 1980-89 1990-94 1995-99 2000-01 2000-02 2004-05 2006-08

Indian 0 0 3 15 26 46 11 0

Non-Indian 91 1027 2027 7163 4097 2809 1044 100

Software Patents (major U.S. software companies and e-commerce providers)

Microsoft Oracle BEA Adobe Autodesk Google Yahoo eBay

Indian 21 13 0 9 0 0 2 0

Non-Indian 8466 1078 149 469 275 84 106 30

This data suggests that there is not a significant amount of strategic software R&D done by

U.S. software companies via India outsourcing. A few possible reasons for this are, U.S.

software companies feel that India‟s legal challenges outweigh the cost savings it offers or

alternatively that outsourcing of U.S. strategic software R&D to India is still in its infancy.

B. Copyright laws for software poorly defined

The second missing prong in India‟s IPR regime is its lack of definition for what constitutes

software copyright infringement under India law. India‟s copyright laws are embodied in the

Copyright Act of 1957.

Like the U.S., India copyright law provides for the automatic ownership rights by the author

of a work arising upon creation.22

A work made for hire exception is recognized granting first

ownership rights to employers of authors of works created within the employment context.23

21

NTP, Inc. v. Research In Motion, Ltd., 418 F.3d 1282, 1317 (Fed. Cir. 2005) (35 U.S.C. §271(a) provides

“…whoever without authority makes, uses, offers to sell, or sells any patented invention, within the United States or

imports into the United States any patented . . . infringes the patent.” In this case NTP alleged that Research In

Motion infringed its patent‟s system claim under § 271(a), despite the fact that the component involved in the

infringing activity was located in Canada. In the court‟s view, the location of component collectively used in a

system does not preclude infringement as a matter of law under § 271(a) when control and beneficial use of a system

is obtained in the U.S. One cannot avoid infringement under §271(a) simply by moving a component of an

infringing system outside of the U.S.) .

22 India Copyright Act, 1957 §17 (amended 1999).

23 Id. §17(c).

Paper.doc Page 7 of 28 Last printed 5/7/2008 9:36:00 PM

Present and future assignment of copyrights is allowed.24

An optional system of copyright

registration is provided to secure a presumption of ownership.25

A fair use exception from

infringement is granted upon copyrighted works.26

Civil remedies and criminal penalties are

provided for copyright infringement27

.

Unlike the U.S., India copyright law limits its work made for hire exception to only

employee and not contractor created inventions.28

The only assignments that are valid are those

in writing that identify the work, specify the rights assigned, specify the duration and territorial

extent of the assignment, and are signed by the assignor or his authorized agent.29

Unless

specified otherwise, an assignment will lapse if the assignee does not exercise the rights assigned

him within one year.30

An author of a work retains an inalienable moral right that survives

assignment. The author can exercise his moral right to seek civil remedy to restrain or claim

damage for any distortion, mutilation, modification, or other act that would be prejudicial to his

honor or reputation. 31

Fair use is broadly defined as any form of private use, including research.

In the context of software, India‟s copyright statute provides protection for the “expressions

embodied in a “computer programme.”32

However, there are no published India court opinions

that illustrate how this statute would be applied to a claim of source code infringement. It is

possible that India courts could narrowly interpret “computer programme” to mean object code.

First, the India copyright office‟s definition of software piracy suggests they feel only object

code falls under their copyright law.33

Second, India courts have not dealt with the complex legal

determination of what constitutes an infringing copy of source code under copyright law like

U.S. courts have. Third, there are only three relevant copyright infringement cases in the entire

judgment databases of the India Supreme and High Courts to speculate on what India courts

might decide when dealing with software source code.

Microsoft v. Deepak Ravel is a software piracy case. This case is unenlightening. The Delhi

High Court applied India copyright law to the copying of object code.34

R.G. Anand v. Delux

24

Id. §18.

25 Id. at ch. X, Registration of Copyright.

26 Id. § 52(a), (b).

27 Id. at ch. XII, Civil Remedies; ch. XIII, Offences; ch. XI, Infringement of Copyright.

28 Id. § 17(c).

29 Id. § 19(1)-(5) (the duration or territorial extent of an assignment to be only five years and is presumed within

India, if not otherwise specified).

30 Id. § 19(4).

31 Id. § 5.

32 Id. § 2(ffc) (“‟computer programme‟ means 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

achieve a particular result”).

33 Computer Piracy in India: Computer Software, Chapter V, India Copyright Office, Dec 15. 1999, available at

http://www.copyright.gov.in/maincpract5.asp (last visited Apr. 6, 2008).

34 Microsoft Corp. v. Deepak Raval, MANU/DE/3700/2006, at 24, 28-9.

Paper.doc Page 8 of 28 Last printed 5/7/2008 9:36:00 PM

Films is a motion picture case. In that case, the India Supreme Court stated some guiding

principles. First, the Court said “there can be no copyright in an idea … copyright is confined to

the form, manner, and arrangement and expression of an idea.”35

Since India currently equates a

computer program to an idea under patent law, it is arguable Delux Films is not supportive of

strong copyright protection for source code. Second, any astute competitor that gets a copy of

other company‟s source code will quickly absorb the idea, modify, and rewrite it. If the basis of

your copyright claim is that the infringer‟s source code is substantially similar to your own,

Delux Film teaches that the way to differentiate between a literal and non-literal copy is by

ordinary observation.36

Any court applying Delux Film’s “ordinary observer” test will rarely

find an infringing source code copy in an astute competitor‟s hands. This test is so distant from

the modern day U.S. tests of “structure, sequence, and organization”37

or “abstraction, filtration,

and comparison”38

that it is unworkable. Gramophone Co. of India Ltd. v. Mars Recording Pvt.

Ltd. is a cover song case. In Gramaphone, the India Supreme Court held there is no copyright

infringement when others perform and re-record an original artist‟s song. The Court stated that

“only when the same signal has been kept, would there be a violation…[i]f another signal is

created, such as in the case of version recording, it is not an infringing copy.”39

This is a

completely opposite holding to what has developed under U.S. case law.40

Further, it is

completely unexpected under any plain language interpretation of India‟s Copyright Act.41

What

Gramaphone suggests is that under India copyright law the only copying that matters is of

physical things (i.e. the final CD recording of a song) not the copying of the ideas the physical

things originate from (i.e. lyrics and notes of a song). If the analogy of Gramaphone is strictly

applied to software, object code would be protected under India copyright law but source code

would be not.

Back to the hypothetical problem, at present it would be unwise for the U.S. doctors to count

on India copyright law to mitigate infringement or loss of any ideas embodied in the software

source code of their electronic health care system. It is inevitable that, snippets of their source

code and some former employees will turn up in the hands of India based competitors. If

35

R.G. Anand v. Delux Films & Ors., (1978) 4 SCC 118 (1978), at 1.

36 Id. at 3, 4 (“One of the surest and the safest test to determine whether or not there has been a violation of

copyright is to see if the reader, spectator or the viewer after having read or seen both the works is clearly of the

opinion and gets an unmistakable impression that the subsequent work appears to be a copy of the original. Where

the theme is the same but is presented and treated differently so that the subsequent work becomes a completely new

work, no question of violation of copyright arises.”)

37 Whelan Associates, Inc. v. Jaslow Dental Laboratories, Inc., 797 F.2d 1222, 1240 (3d Cir. 1986) (The court

develops structure, sequence, and organization test to decide between literal and non-literal copyright infringement

of software source code; court finds ordinary observer test to be of no value in this context.)

38 Computer Associates International, Inc. v. Altai, Inc., 982 F.2d 693, 706 (2d Cir. 1992) (The court proposes

abstraction, filtration, and comparison test instead of structure, sequence, and organization test under Whelan).

39 Gramophone Co. of India, Ltd. v. Mars Recording Pvt. Ltd., (2002) 2 S.C.C. 103, at 8.

40 Milene Music, Inc. v. Gotauco, 551 F.Supp. 1288, 1295 (D.R.I.1982) (The owner of a copyrighted musical

composition has the exclusive right both to perform the work publicly and to authorize the public performance of the

work).

41 India Copyright Act § 13 (works in which copyright subsists); § 14 (meaning of copyright), § 38 (performer‟s

rights).

Paper.doc Page 9 of 28 Last printed 5/7/2008 9:36:00 PM

possible, the U.S. doctors should design their software in independent segments. The India

outsourcing entity should implement physical security barriers between the segments. If email

or internet access is not required for software development, it should be removed from employee

accessibility. Email and internet traffic should be filtered to check for unauthorized source code

movement. Finally, a working copy of all software source code should be extracted from the

India entity on a daily basis as an integral part of a disaster recovery plan.

C. No trade secret protection

The third missing prong in India‟s IPR regime is its lack of national or state laws for

protection of trade secrets. The only form of protection for trade secrets place or developed in

India will be contract. The typical contracts used to contain or stop others from readily drawing

out trade secrets from a company are: non-disclosure, non-compete, and non-solicitation

agreements.

During the period of employment, India courts recognize negative covenants that are

“reasonable and necessary” for the protection of the companies interests.42

Once employment

ends, the courts will analyze those same clauses under § 27 of the India Contract Act of 1872.

This Act declares void every agreement which restrains anyone from exercising a lawful

profession, trade, or business.43

Whether a negative covenant is a restraint of trade is a decision

for the court as a matter of law.44

There is no exhaustive list of what constitutes restraint of

trade.45

However, the India Supreme Court believes this is a well settled area of law and has

provided the following guidance.46

Negative covenants outside of the period of employment are

viewed with disfavor and are to be construed narrowly.47

Regardless of each party‟s freedom to

contract, post-employment covenants that are unconscionable, unduly harsh or one-sided, that

drive the former employee to idleness, that are unreasonable and unnecessary, or injurious to

public interest will be viewed as a restraint of trade.48

Consequently, these kinds of covenants

will be held void and unenforceable. The doctrine of restraint of trade is not confined to just

42

Niranjan Shankar Golikari v. The Century Spinning & Mfg. Co. Ltd., (1967) 2 S.C.R. 378, at 20 (confidentiality

and non-use clause during employment period that are reasonable and necessary for the protection of the companies

interest are enforceable).

43 Percept D‟Mark Pvt. Ltd. v. Zaheer Khan, (2006) 4 S.C.C. 227, at 41 (“…the doctrine of restraint of trade does

not apply during the continuance for employment and it applie[s] only when the contract comes to an end.”).

44 Gujarat Bottling Co. Ltd. v. Coca Cola Co. (1995) 5 S.C.C. 545, at 21 (“The court has to decide, as a matter of

law, (i) whether a contract is or is not in restraint of trade, and (ii) whether, if in restraint of trade, it is reasonable.”).

45 Id. at 24-35.

46 Percept D‟Mark Pvt. Ltd. v. Zaheer Khan, at 38 (“The legal position with regard to post-contractual covenants or

restrictions has been consistent, unchanging, and completely settled in our country.”).

47 Superintendence Co. of India Ltd. v. Krishnan Murgai, (1982) 2 S.C.C. 246, at 62 (non-compete clause at issue….

Courts are to interpret the covenant under ordinary rules of construction with fair meaning to the parties. “If there is

any ambiguity in a stipulation between employer and employee imposing a restriction on the latter, it ought to

receive the narrower construction rather than the wider…”).

48 Gujurat Bottling Co. Ltd. v. Coca Cola Co., at 24-35.

Paper.doc Page 10 of 28 Last printed 5/7/2008 9:36:00 PM

employment agreements, rather it extends to all agreements.49

Temporary and permanent injunctions may be sought for contracted non-disclosure of

confidential information under the Specific Relief Act of 1963.50

In circumstances where the

existence of a non-disclosure agreement is unclear, precedence exists in India common law for

injunctive relief for breach of confidence based on equity.51

Further, other India laws may be

circumstantially applicable when trade secrets are stolen. However, these laws were not written

to take into consideration the valuation of trade secrets.52

Consequently, the remedies these laws

provide will likely be inadequate

Back to the hypothetical problem, the U.S. doctor‟s will need to rely exclusively on

contracts, physical security, and strict management oversight to safeguards any trade secrets

developed or placed in India. The steps required to affirmatively protect trades secrets via

contract will be no different in India than in the U.S. with respect to employees, subcontractors,

or any other entity exposed to them. The difference is that India law provides no backstop to

catch errors or omissions. Confidentiality clauses during and after employment are recognized

under India law.53

To be enforceable, the U.S. doctors should draft them to be no greater than

necessary, limited in scope and duration, and provide for payment if a former India employee

would have to sit idle to comply with them.54

These legal standards are similar to those by U.S.

49

Id. at 36 (“We find no rational basis for confining [the principle of restraint of trade] to a contract for employment

and excluding its application to other contracts. The underlying principle governing contracts in restraint of trade is

the same and as a matter of fact that courts take a more restricted and less favorable view in respect to a covenant

entered into between an employer and an employee as compared to a covenant between a vendor and a purchaser or

partnership agreements.”).

50 India Specific Relief Act, 1963 § 42 (injunction to perform negative agreement in contract).

51 John Richard Brady v. Chemical Process Equipment Pvt. Ltd., A.I.R. 1987 (Del.) 372 at 1-2, 5, 17, 21, 22, 39

(granting equitable injunction against defendant until final disposal of copyright infringement suit from the sale and

manufacture of machines allegedly re-created from plaintiff‟s drawings shared under strict confidentiality).

52 India Information Technology Act, 2000 §72 Penalty for breach of confidentiality and privacy (“…any person

who … has secured access to any electronic record, book, register, correspondence, information, document or other

material without the consent of the person concerned discloses such electronic record, book. register,

correspondence, information, document or other material to any other person shall be punished with imprisonment

for a term which may extend to two years, or with fine which may extend to one lakh rupees [$2493 US as of

03/06/08], or with both”); see also India Penal Code § 406 Punishment for criminal breach of trust (“Whoever

commits criminal breach of trust shall be punished with imprisonment of either description for a term which may

extend to three years, or with fine, or with both); see also § 420 Cheating and dishonestly inducing delivery of

property (“Whoever cheats and thereby dishonestly induces the person deceived to deliver any property to any

person, or to make, alter or destroy the whole or any part of a valuable security, or anything which is signed or

sealed, and which is capable of being converted into a valuable security, shall be punished with imprisonment of

either description for a term which may extend to seven years, and shall also be liable to fine”).

53 Niranjan Shankar Golikari v. The Century Spinning & Mfg. Co. Ltd., at 22 (court grants injunction against former

employee for violation of covenant to not use or divulge former employer secrets).

54 Id. at 21 (“There is also nothing to show that if the negative covenant is enforced the appellant would be driven to

idleness or would be compelled to go back to the respondent company. It may be that if he is not permitted to get

himself employed in another similar employment he might perhaps get a lesser remuneration…[b]ut that is no

consideration against enforcing the covenant. The evidence is clear that the appellant has torn the agreement to

pieces only because he was offered a higher remuneration. Obviously he cannot be heard to say that no injunction

should be granted against him to enforce the negative covenant which is not opposed to public policy. The

Paper.doc Page 11 of 28 Last printed 5/7/2008 9:36:00 PM

courts.55

U.S. styled legal confidentiality, non-compete, and non-solicitation should suffice.

Beyond legal matters, the U.S. doctor‟s should be made aware of the chaotic employment

environment they will be placing their trade secrets. In India, employee turn-over rates in

software companies average 35 to 40 percent annually.56

Further, the more market leading

offerings a software company creates, the higher the turn-over rate it can expect. Indian workers

are desperate for new technology exposure and training. Once trained, other Indian employers

are eager to entice them away to capitalize on the rapid growth of the IT-BPO and KPO industry.

Until IT-BPO and KPO industry growth stalls, this turmoil will likely continue.

High staff turn-over rates together with the ease in which source code can be sent across the

internet will mean that any software trade secrets placed or develop in India will be very hard to

contain. Once a trade secret is exposed in India, absent privity of contract, there will be no legal

recourse against competitors into whose hands it falls.

D. No privacy rights in data

In both India and U.S. there is no recognition of an individual‟s fundamental privacy rights in

personal data involved in the context of computer processing.57

In fact, in a 2004 U.S.-India

forum hosted by the U.S. Department of Commerce the U.S. private sector participants felt they

injunction issued against him is restricted as to time, the nature of employment and as to area and cannot therefore

be said to be too wide or unreasonable or unnecessary for the protection of the interests of the respondent

company.”); see also Superintendence Co. of India Ltd. v. Krishnan Murgai, at 63 (“The restraint may not be

greater than necessary to protect the employer, nor unduly harsh and oppressive to the employee.”).

55 Richard S. Gruner, Shubha Gosh & Jay P. Kesan, Intellectual Property in Business Organizations Cases and

Materials, 344, (LexisNexis 2006) (2006) (“A nonuse and nondisclosure agreement is enforceable if it (1) exists at

the time of the confidential disclosure, (2) is reasonable in scope, and (3) uses language that is clear and

unambiguous. If an agreement places too onerous of a burden on an employee, the agreement will be invalidated…

In general, the law disfavors agreements that tie the employee‟s too far or too broadly limits the scope of usable

information.” ); see also Nike, Inc. v. Eugene McCarthy, 379 F.3d 576, 584-5 (A contract in restraint of trade

“…must meet three requirements under Oregon common law to be enforceable: (1) it must be partial or restricted in

its operation in respect either to time or place; (2) it must be on some good consideration; and (3) it must be

reasonable, that is, it should afford only a fair protection to the interests of the party in whose favor it is made, and

must not be so large in its operation as to interfere with the interests of the public….[t]o satisfy the reasonableness

requirement, the employer must show as a predicate “that [it] has a „legitimate interest‟ entitled to protection.”).

56 Telephone Interview with Surku Sinnaduari, Chief Information Officer & Managing Director of i2 India, i2

Technologies, Inc. (Mar. 27, 2008) (The employee turn-over rates for the i2 Bangalore, India office averages 35-40

percent annually. Rates have been as high as 60 percent. Enforcing confidentiality, non-compete, and non-

solicitation agreements is “hopeless”. Even if an injunction is obtained, it takes 10 years for a court date. There is

no way to contain the damage done by relying on these agreements alone. To slow down turn over, i2 uses up-front

bonus payment for later performance. The receiving employee in i2 India is expected to pay back the money if they

accept other employment during the bonus period. Even this does not work that well. The future employers are

now paying back the money for exiting i2 employees. Unlike Infosys, Wipro, or Tata Consulting which are IT

“body shops”, i2 employees receive direct exposure to software development and tools. This rapidly increases their

skill set and value to others. This consequently increases i2‟s employee turn-over rate. )

57 In the U.S. any privacy rights in data must be drawn from federal or state statutes regulating specific industries or

common law based on factual circumstances.

Paper.doc Page 12 of 28 Last printed 5/7/2008 9:36:00 PM

would rather India not adopt European Union style regulations58

“…as its restrictive nature

would cause many [U.S.] companies to send data service work to markets other than India.” 59

There has been some recent movement in India to legally recognize electronic transactions. This

movement appears to be in response to industry pressure upon India‟s Ministry of Information

Technology to alleviate U.S. fears over alleged security breaches in its IT-BPO companies.

Fears that, left unaddressed, could irreversibly harm India‟s IT-BPO growth and kill off its

golden goose.

India cyber law is the Information Technology Act of 2000 (“IT Act”).60

The IT Act makes

hacking, physical damage to source code, data or computer systems, publishing of obscene

information, breach of confidentiality and privacy61

, and digital signature fraud punishable by

imprisonment, fines, or both. There are a few unique things about the Act. First, it makes

bringing a claim easier. It does so by bypassing congested India courts thru the establishment of

an independent tribunal to intake and adjudicate claims.62

Second, it makes high ranking police

officers responsible for investigation of offenses.63

Third, it holds companies as wells as every

person in charge liable for any wrongdoings that they consented to or were negligent in

preventing.64

Fourth, any judgments the tribunal makes are enforceable under India‟s Civil

Procedure and Penal Code.65

Back to the hypothetical problem, the U.S. doctors will not encounter any data privacy laws

preventing them from outsourcing U.S. patient data to India. However, because their electronic

health care system will be involved in the treatment, payment, or health care operation of U.S.

patients, they will be subject to industry specific U.S. federal and U.S. state health care provider

regulations. The Health Insurance Portability and Accountability Act (“HIPAA”) will apply

regarding the “use or disclosure of protected health information” (“PHI”) to any business

58

Directive 95/46/EC of the European Parliament and of the Council of 24 October 1995 on the protection of

individuals with regard to the processing of personal data and on the free movement of such data § 2, 4, 57, Nov. 23,

1995, available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:31995L0046:EN:HTML (last

visited Apr. 4, 2008) (this broad directive requires that EU member states adopt legislation to “respect [the]

fundamental rights and freedoms” of natural persons “notably the right to privacy” with respect to the “processing of

personal data in various sphere and social activity” and prohibits the “transfer of personal data to a third country

which does not ensure an adequate level of protection.”).

59 Data Privacy Roundtable, HTCG Dialogue on Defense Technology, Data Privacy, and Export Licensing, Bureau

of Industry and Security U.S. Dept. of Commerce, Nov. 18, 2004, available at http://www.bis.doc.gov/

internationalprograms/htcg_dialogue.htm (last visited Apr. 4, 2008).

60 India Information Technology Act (India‟s cyber law).

61 Id. § 72 (this provision addresses breach of confidentiality and privacy by “any person who has secured access to

any electronic record… [who] without consent …discloses such electronic record …shall be punished with

imprisonment for a term which may extend to two years, or with fine which may extend to [$2349 US as of

03/06/08], or with both.”).

62 Id. §§ 48, 58.

63 Id. § 78.

64 Id. § 85.

65 Id. § 58(3).

Paper.doc Page 13 of 28 Last printed 5/7/2008 9:36:00 PM

associate they use in India.66

However, HIPAA provides no barrier to India outsourcing.

HIPAA will not require the U.S. doctor‟s to get U.S. patient consent to transmit any PHI to

business associates in India. HIPAA only requires the U.S. doctors to put business associates

under contract that stipulate that they will “not use or further disclose” and will “use appropriate

safeguards to prevent use or disclosure” of any PHI.67

The security standard for “appropriate

safeguards” under HIPAA is reasonableness. Encryption of electronic health information is

currently not required, rather it is merely needs to be addressable.68

Unregulated mass market

commodity 64-bit key length encryption will exceed the current HIPAA requirement.69

66

Health Insurance Portability and Accountability Act of 1996, Pub. L. No. 104-191, 110 Stat. 1936 (1996) § 264

(codified as 45 C.F.R §§ 164.102-6, 164.302-18, 164.500-34) (The Health Insurance Portability and Accountability

Act of 1996 (HIPAA) required the Department of Health and Human Services (HHS) to make recommendations

with respect to privacy of certain health information. HHS promulgated privacy regulations requiring that a covered

entity not use or disclose protected health information (PHI) except as necessary to carry out treatment, payment, or

health care operations. Covered entities included a health care provide who transmits any health information in

electronic form. HHS also promulgated security regulations requiring that a covered entity protect against any

reasonably anticipated used or disclosures of electronic PHI that are not permitted or required under HIPAA

regulations. These regulations do not specify particular technologies that must be used to comply. Rather, they set

out standards that are to be met in the form of implementation specifications. The specifications are either required

to be implemented, addressable (but not implemented), or may be implemented depending on reasonable and

appropriate judgment of the covered entity. In the context of a business associate or subcontractor, the covered

entities contract with them must provide that a clause that requires them to implement safeguards to reasonably and

appropriately protect the confidentiality of the electronic protected information that it creates, receives, maintains, or

transmits on behalf of the covered entity. Encryption of electronic PHI is not required under current the

transmission security standard rather it is merely needs to be addressable. Non-compliance with HIPAA provisions

carry the possible penalty of a civil fine and criminal charges for either the covered entity or any contracted business

associate. There is no private right of action for breach of HIPPA privacy provisions. The authority to enforce them

only lies with HHS. ).

67 45 C.F.R. § 164.504(e)(1)-(3).

68 Id. § 164.312(e)(1) (even if the HIPAA transmission security standard should change to require encryption, mass

market commodity encryption up to 64-bit should suffice to meet its requirements as currently written without

running into U.S. export restrictions on technology due to reasons of national security).

69 Export Administration Regulations (EAR) of the U.S. Department of Commerce, 15 C.F.R. §§ 7301.-774.1 (2007)

(regulating the export and re-export of most commercial items, software, and technology); see also International

Traffic in Arms Regulations of the U.S. Department of State, 22 C.F.R. §§ 120.1-130.17 (2007) (regulating export

of defense articles and defense services); see also Office of Foreign Assets Control Regulations of the U.S.

Department of Treasury, 31 C.F.R. § 500.101-500.901 (2007) (regulating financial and commercial transactions

with foreign countries); see also U.S. Department of Commerce, Bureau of Industry and Security, Introduction to

Commerce Department Export Controls, http://www.bis.doc.gov/licensing/exportingbasics.htm (last visited Mar. 7,

2008). (U.S. software companies that supply India affiliates with technology must be careful not to violate U.S.

export regulations due to reasons of national security. Under U.S. laws, any item sent from the U.S. to a foreign

destination is considered to be an export. “Items” include high performance computers, software packages, source

code, design plans, and all forms of technical information irrespective of how it is transported (i.e. email, regular

mail, communicated during a phone conversation, download from a website). If the item falls under regulation due

to reasons of national security, a license is required before export is allowed. Encryption is specifically addressed

by these regulations.); see also U.S. Department of Commerce, Bureau of Industry and Security, Review of Mass

Market Encryption Commodities and Software Employing Symmetric Keys Greater than 64-bits under ECCNs

5A992, 5D992 and 5E99, http://www.bis.doc.gov/encryption/massmarket_keys64bitsnup.html (last visited Mar. 7,

2008) (The general guideline for mass market encryption commodities and software is that those employing a key

length greater than 64 bits are subject to regulation, but, lesser key lengths are not.); see also India Foreign Trade

Policy, 2007-2008 available at http://dgft.delhi.nic.in (last visited Mar. 25, 2008) (All software or services produced

by and capital goods loaned or leased to an India affiliate fall under India‟s current foreign trade policy. Unlike the

Paper.doc Page 14 of 28 Last printed 5/7/2008 9:36:00 PM

Outsourcing data to an India entity is legally no more difficult than to a U.S. entity. Security

and privacy provisions applicable to any U.S. styled outsourcing arrangement should suffice.70

The enforceable protection that India‟s cyber law actually offers the U.S. doctors for breach of

confidentiality, damage to, or loss of U.S. health care data placed in India is unclear. There are

only three cases in the entire judgment database of the India Supreme and High Courts that cite

India‟s IT Act.71

None of these cases involve e-commerce data. No case illustrates how far

India courts are willing to go in imposing civil fines or damage awards. Under the IT Act, all

fines and awards are subject to court discretion. The Act currently limits the fine for breach of

confidentiality to $2349 and total damage award to $251,256 US.72

III. LAWS ARE HARD TO PRACTICE

Those U.S. software companies that decide to proceed with India outsourcing will take on the

hidden costs and legal challenges of enforcement of any laws in India. The current

recommendation from India legal authorities is easily summed up. Do not rely on the

overburdened India courts, contract for arbitration or mediation instead. The following examines

the political and legal climate India presents to U.S. software companies.

A. Legal system is in crisis

India is a democratic union of 25 states and 7 self-governing territories established under the

country‟s constitution adopted in January 26, 195073

. India gained independence from British

colonial rule in 1947.74

India has a parliamentary form of government and judiciary system

U.S., India has no export regulations concerned with nation security when it comes to technology or software

exchanged with U.S entities.).

70 Security and privacy provisions that should be written into a Master Service Agreement (“MSA”) by a U.S.

software company outsourcing work to any U.S. or India entities would include a: (1) requirement to deploy

industry standard physical and electronic system security measures regarding all access to their facilities; (2)

requirement to adopt and deploy an information privacy policy written and governed by the controlling party; (3)

requirement to allow the controlling party to monitor and terminate the contract at-will, if security standards or the

privacy policy are not met or being adhered to; (4) definition of the security standards and privacy policy to be

deployed; (5) requirement to allow the controlling party to re-define, thru contract amendment, the security

standards and privacy policy based on to changes in business need or applicable laws; and (5) disallows the

subordinate entity “use of” or “access by” subcontractors to any facilities, network, computer systems, work in

progress, data, information, …under the “scope of” or “used in” at any time in executing the outsourcing

agreement, without the explicit approval of the controlling party.

71 State of Punjab v. Amritsar Beverage Ltd., MANU/SC/3484/2006 (no discussion of IT Act); Fatima Riswana v.

State Rep. by A.C.P., Chennai and Ors., (2005) 1 SCC 582 (Supreme Court holds High Court unjustified in making

court transfer decisions on the basis of whether the presiding lady judge will be offended by pornographic material

to be presented); Dr. L. Prakash v. State of Tamil Nadu, MANU/TN/0676/2002 (no discussion of IT Act).

72 Information Technology Act, § 72 supra note 60; see also § 43 Penalty for damage to computer, computer system,

etc. (“If any person without permission … shall be liable to pay damages by way of compensation not exceeding one

crore rupees [$251,256 US as of 04/19/08] to the person so affected.”).

73 Sonia Baldia, Knowledge Process Outsourcing To India: Important Considerations for U.S. Companies, 1587

PLI/Corp 171, 179 (2007) (this article discusses the up-front legal issues for U.S. companies considering India

outsourcing and sets forth legal how-to‟s to manage with them.).

74 Id.

Paper.doc Page 15 of 28 Last printed 5/7/2008 9:36:00 PM

modeled after Britain‟s.75

India‟s judiciary branch of the government resembles English common law in terms of

procedure and court policy of stare decisis.76

The highest court is India‟s Supreme Court. Under

it reside 21 High Courts over a state or group of states. A hierarchy of lower courts of general

jurisdiction exists under each High Court.77

Lower court decisions are subject to review by the

High Court. The High Court decisions are review by the Supreme Court78

. Judgments from the

Supreme and several High courts are posted on India‟s Judicial Information System (“JUDIS”)79

.

India‟s laws are based on its Constitution, legislated statutes and regulations, and case law. The

common working language in public and private sectors is English. All official publications are

available in English.

Though they may appear structurally familiar to U.S. attorneys, India courts do not operate

the same as U.S. courts.80

The backlogs are horrendous. India‟s Law and Justice Minister, H.

R. Bhardwaj recently stated that in 2007 there were a total of 28,986,205 pending cases in

various district and subordinate courts, 3,700,223 in High Courts, and 49,926 in the Supreme

Court.81

It has been reported “…if there are absolutely no new cases, it will take 124 years to

clear the backlog”.82

In the High Courts, 40 percent have been pending for more than 5 years.83

75

Id. (“India‟s president is the constitutional head of the executive branch of government.… India‟s constitution

governs the sharing of legislative power between parliament and India‟s 25 state legislatures. The Parliament has

exclusive jurisdiction over matters of nation interest enumerated in what is known as the Union List. This list

includes defense, foreign affairs, currency, income tax, railways, shipping, posts and telegraphs. States legislatures

have exclusive jurisdiction over matters enumerate in what is known as the State List. This list includes public

order, police powers, public health, communications, and education. The Parliament and state legislature share

concurrent jurisdiction over matters enumerate in what is known as a Concurrent List. This list includes criminal

law, marriage and divorce, trade unions, and price controls”)

76 Id.

77 Indian Courts Home Page, http://www.indiancourts.nic.in.

78 Jurisdiction of the Supreme Court, India Courts, http://www.indiancourts.nic.in/courts/indian_jud.html (last

visited Mar. 23, 2008).

79 Indian Judgments Information System Home Page, http://www.judis.nic.in (last visited Mar. 23, 2008)

(Judgments are published in the official Supreme Court Reporter (“SCR”) and the All India Report (“AIR”)).

80 Jayanth K. Krishnan, Outsourcing and the Globalizing Legal Profession, 28 WM. & Mary L. Rev. 2007

available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=910338 (in depth exploration of possible causes

why India‟s legal system is in crisis and suggesting that legal outsourcers help pay for its reform).

81 India Courts Grappling with Backlog of Over 3 Crore Cases, WEBINDIA123.COM, Mar. 3, 2008, http://news.

webindia123.com/news/Articles/India/20080303/899412.html (last visited Mar. 23, 2008) (“Law and Justice

Minister H R Bhardwaj said a total of 28,986,205 cases were pending in various district and subordinate courts as in

September last year out of which the High Courts accounted for 3,700,223. In the Supreme Court, the pending cases

touched a figure of 46,926 as on December 31 last year…The Allahabad High Court has the dubious distinction of

leading the high courts in pendency of cases (as on September 30, 2007) with a figure of 808226 -- 604450 civil

cases and 203776 criminal cases… followed by Madras High Court (426347 cases), Bombay High Court (367409

cases), Calcutta High Court (279318 cases), Punjab and Haryana High Court (255696 cases), Orissa High Court

(227752 cases) and Rajasthan High Court (214451 cases.”).

82 Bibek Debroy, Let’s Not Throw the Baby Out, THE INDIAN EXPRESS, DEC. 13, 2007, http://www. indianexpress.

com/story/249676.html (last visited Mar. 23, 2008) (“The backlog figures are horrendous… there is a back-of-the

envelope-figure that floats around ... [even] if there are absolutely no new cases, it will take 124 years to clear the

Paper.doc Page 16 of 28 Last printed 5/7/2008 9:36:00 PM

By itself, prominent foreign investment in jurisdictions where IT-BPO and KPO is

flourishing has not motivated India to improve the court backlogs there.84

See the table below.

Table 4.

City Firms Focus Jurisdiction

Cases Pending Time to

Hear

Appeal85

Lower

Courts

High

Court

Bangalore

Infosys, Wipro, Intel,

IBM, SAP, SAS, Dell,

Tisco, Texas Instruments,

Motorola, HP, Oracle,

Yahoo, AOL, E&Y,

Google, Accenture, i2

Technologies

Chip design, software,

call center, IT

consulting, tax

processing

Karnataka 1.08M 129,653 2.9 yrs

Delhi

GE, American Express,

STMicroelectronics,

Wipro, Spectramind,

Convergys, Daksh, ExL

Call center, transaction

processing, chip

design, software

Delhi 0.95M 113,785 2.52 yrs

Mumbai

TCS, MphasiS, i-flex,

Morgan Stanley,

Citigroup,

Financial research,

back office, software

Bombay 3.05M 366,495 8.1 yrs

Pune

MsourcE, C-DAC,

Persistent Systems,

Zensar

Call centers, chip

design, embedded

software

Chennai

Cognizant, World Bank,

Standard Chartered,

Polaris, EDS, Pentamedia

Software, transaction

processing, animation Madras 3.55M 426,347 2.76 yrs

Hyderabad HSBC, Satyam, Microsoft Software, back office,

product design

Andha

Pradesh 1.24M 148,512 3.29 yrs

Kolkata PwC, IBM, ITC Infotech,

TCS Consulting, software Calcutta 2.33M 279,318 6.19 yrs

backlog.” Two-thirds of civil cases involve the government as litigants, yet in 1997 it was supposedly decide that

government v. government cases should not end in court. The author asks “[w]hy wasn‟t this implemented?”).

83 Centre for Media Studies, India Corruption Study 2005 to Improve Governance, Vol. II (Eleven Public Services)

Corruption in Judiciary, available at http://www.cmsindia.org/cms/events/judiciary.pdf (last visited Mar. 27, 2008)

§ 6.2 Pending Cases (“87% of are pending in lower courts, while 12% of them are pending in High Courts. Of the

cases pending in High Courts, almost 40% [have been] pending for more than 5 years.”); see also Judge Me Not,

BUSINESS & ECONOMY, Feb. 23, 2006 (“[a]cording to the Ministry of Law and Justice, 650,000 case have been

pending in the High Courts for more than 10 years, while 630, 000 have been pending between 5 and 10 years.”),

http://www.businessandeconomy.org/tresult.asp?sin=Judge &pageno=1 (last visited Mar. 27, 2008).

84 The data for the table came from the following sources: Jayanth K. Krishnan, Outsourcing and the Globalizing

Legal Profession; Patna High Court does Bihar Proud, BIHAR CHRONICAL, Sept. 4, 2007, http://

biharchronicle.blogspot.com/2007/09/patna-high-court-does-bihar-proud.html (last visited Mar. 29, 2008); Rana

Ajit, With Low Backlog, Patna High Court does Bihar Proud, INDIA ENEWS, Aug. 26, 2007, http://indiaenews.com/

india/20070826/67219.htm. (last visited Mar. 29, 2008); India Courts Grappling with Backlog of Over 3 Crore

Cases, WEBINDIA123.COM.

85 India Needs 124 years for Clearing Pending Cases in its Courts, SUPER HINDUS AROUND THE GLOBE, May 3,

2007, http://superhindus.wordpress.com/2007/05/03/india-needs-124-years-for-clearing-pending-cases-in-its-courts

(last visited Mar. 29, 2008) (The “national Indian average is 188 cases disposed of among 21 high courts everyday.

The Madras High Court leads in terms of speedy disposal of 648 cases, on an average, each day.”).

Paper.doc Page 17 of 28 Last printed 5/7/2008 9:36:00 PM

Facing many years before coming to trial due to India court backlogs, U.S. software

companies will either give up or seek U.S. judgment.86

Unfortunately, India courts do not

recognize U.S. judgments.87

Further, even when some basis for jurisdiction of U.S. courts can be

invoked, the astute defendant will motion for dismissal of claims that arise under India law or

involve an India entity on the grounds of forum non conveniens. Under existing U.S.

precedence, the motion will likely be granted if the only opposing argument the respondent can

make is “the backlog of cases and continuing congestion [in India courts] will prevent

meaningful relief.”88

B. Legal system is corrupt

According to the largest corruption study ever undertaken in India there is widespread belief

that the India judiciary is corrupt.89

“[T]he former Chief Justice of Supreme Court Same Piroj

Bharachua has suggested that „up to 20 percent of judges in India were corrupt.‟”90

Bribes to

legal authorities are viewed as the way to get things done.91

Jolly Technologies, a U.S. software company, claims to have encountered this. After opening

an R&D facility in Mumbai one of the employees was caught uploading and sending both source

code and design documents outside the facility from her Yahoo e-mail account. When

confronted, the employee disappeared. Jolly immediately sought help from the cyber crime unit

of the Mumbai police force. They refused to investigate or register the crime. Jolly stated

“[w]e have learned that the police will not file a FIR [first information report] until they are

86

Usha (India), Ltd. v. Honeywell Int'l Inc., 2004 WL 540441, 5-7 (S.D.N.Y. Mar. 17, 2004) (The fact that a U.S.

corporation holds an interest in a India joint venture does not mean a U.S. court has interest in settling a dispute

based upon India law that might take 10-15 year in the alternate forum, the New Dehli High Court. Case dismissed

on grounds of forum non conveniens.).

87 Digital Filing Systems Inc. v. Akhilesh Agarwal and Anr., MANU/DE/0297/2005 at 9-10 (“…the Court in this

country may restrain person who actually recovered judgment in a foreignCourt from proceeding to enforce that

judgment.”); see also Sonia Baldia, Knowledge Process Outsourcing To India: Important Considerations for U.S.

Companies, at 15 (“Under the Indian Civil Procedure Code, a U.S. judgment is not directly enforceable in India.

Rather, it can only be enforced by filing a fresh lawsuit in an Indian court based on the U.S. judgment, which will be

treated as evidence, among other evidence, against the Indian defendant.”).

88 USHA (India), Ltd. v. Honeywell Int'l, 421 F.3d 129, 135 (2d Cir.2005) (The high backlog of cases in New Dehli

High Court not sufficient reason to overturn lower U.S. court‟s dismissal on grounds of forum non conveniens.)

89 India Corruption Study 2005, Transparency International, http://www.transparency.org/regional_pages/

asia_pacific/newsroom/news_archive__1/india_corruption_study_2005 (last visited Apr. 18, 2008) ("India

Corruption Study - 2005" is the largest corruption study ever undertaken in the country with a sample of 14,405

respondents spread across 20 States. More than 525 respondents were interviewed in each state. Designed and

conducted by CMS, the study covered 151 cities and 306 villages. It was based on a combination of research

methodologies, including exit polls at the public offices covered and household studies.”).

90 Centre for Media Studies, India Corruption Study 2005 to Improve Governance, at 1.

91 Id. § 6.4.2 (86% of those interacting with the India judiciary have paid bribes to get work done by the court); §

6.4.3 (23% paid bribe to get favorable judgment; 13% to manipulate the public prosecutor; 9% to advance or delay

the case); § 6.4.5 (5% of brides where paid to the judge, 59% to the lawyers, 30% to court officials, 8% to public

prosecutors).

Paper.doc Page 18 of 28 Last printed 5/7/2008 9:36:00 PM

heavily bribed, as they know that there has been a huge loss to the company."92

C. Does anyone try?

Despite backlogs and corruption allegations, two relevant questions are “do any software

companies try to use the India judicial system for enforcement of their IPR” and if they do “with

what outcome?”

The International Intellectual Property Alliance (“IIPA”) 2007 and 2008 Special 301 reports

provide some insight. These reports reveal that. “India is not viewed as a country with a damages

culture, there are few such examples in the copyright area.”93

From 1988 to 2006 there has only

been a total of 16 software copyright infringement cases filed in India.94

In 2006, there were 4

raids conducted for software copyright infringement by India authorities. Since then there has

been a significant decrease in all forms of copyright infringement raids.95

In 2007, the “software

industry [filed] ten civil end-user actions, the most ever in one year in India.”96

Finally, while

“[c]corporate end-user piracy…of business software…continues unabated in large and small

Indian companies…there were no software convictions in 2007—in fact, there has never been a

successful criminal conviction for software piracy in India.”97

Search results of the published India Supreme and High Court judgments are consistent with

the IIPA findings. Only five cases of software copyright infringement exist.98

All of the five

cases deal exclusively with the repeated unlicensed copying and distribution of Microsoft

products. All five decisions come from the Delhi High Court. The case of Microsoft v. Deepak

Raval is of interest. In that case, the court took specific note of the growing menace of software

92

John Ribeiro, Source Code Stolen from U.S. Software Company in India, COMPUTERWORLD, Aug. 5, 2004,

http://www.computerworld.com/softwaretopics/software/story/0,10801,95045,00.html (last visited Mar. 30, 2008);

see also John Ribeiro, Police Question Report of India Code Theft, COMPUTERWORLD, Aug. 31, 2004, http://www.

computerworld. com/printthis/2004/0,4814,95615,00.html (last visited Mar. 30, 2008); see also Karl Shoenberger,

Alleged Code Theft Highlights Foreign Risk, OFFSHORINGFORUM, Sep. 10 , 2004, http://www. Offshoringforum.

com/topic.asp?TOPIC_ID=69&FORUM_ID=15&CAT_ID=5 (last visited Mar. 30, 2008); see also Jolly

Technologies Announces Soaring Q1 Results, JOLLY TECHNOLOGIES, Oct. 30, 2007, http://www.jollytech.com/

company/press/release/10_30_2007.php (last visited Mar. 30, 2008) (announcing the shutting down of India

operations and shifting all development back to the United States).

93IIPA 2007 Special 301 Report INDIA, INTERNATIONAL INTELLECTUAL PROPERTY ALLIANCE, Feb. 12, 2007, at 53,

available at http://www.iipa.com/rbc/2007/2007SPEC301INDIA.pdf

94 Id. at 52

95 Id.

96 IIPA 2008 Special Report INDIA, at 43.

97 Id. at 45.

98 Microsoft Corp. v. Yogesh Papat, MANU/DE/0331/2005 (compensatory damages for repeated copying of

Microsoft products); Microsoft Corp. v. Deepak Raval, MANU/DE/3700/2006 (compensatory and punitive damages

for repeated willful, intentional, and flagrant copying of Microsoft products); Microsoft Corp. v. Mayuri,

MANU/DE/2068/2007 (compensatory and punitive damages for blatant copying of Microsoft products); Microsoft

Corp. v. A. Jain, MANU/DE/8867/2007 (compensatory damages award for copying of Microsoft products);

Microsoft Corp. v. Mitesh Jain, MANU/DE/0450/2008 (accepting settlement between parties for copying of

Microsoft products).

Paper.doc Page 19 of 28 Last printed 5/7/2008 9:36:00 PM

piracy and opened the door to punitive damage awards in cases where software copying is shown

to be “willful, intentional, and flagrant”.99

At present, the Delhi High Court is the only India

court on record to have granted any form of damages for software copyright infringement.

Back to the hypothetical problem, a reasonable conclusion is that India‟s current legal system

will be of marginal utility to the U.S. doctors for enforcement of their IPR in software and data

when infringed or stolen from them in India by others. At present, Delhi appears to be best legal

jurisdiction to bring software copyright infringement claims.

D. ADR is recommended

It is commonly known by India judges and lawyers that the existing court system is not able

to keep up.100

Alternate disputed resolution (“ADR”) is their recommended alternative.101

Working together, the India Supreme Court and legislature enacted the Arbitration and

Conciliation Act of 1996. It is based on the international commercial arbitration model law

adopted by UNCITRAL in 1995. Under India laws, the parties subject to an arbitration

agreement are free to select the place of arbitration, the procedural aspects, the number of

arbitrators, and the substantive law to apply.102

There is a three year statute of limitation to bring

arbitration from the time of the cause of action arises.103

Arbital awards must be in writing and

signed by the tribunal.104

India is a member of the two main conventions that facilitate the enforcement of foreign

arbitral awards in the international commercial contract context. These are the Geneva

99

Microsoft Corp. v. Deepak Raval, at 24, 28-9 (“…in India, a positive trend has started … [c]ourts are becoming

sensitive to the growing menace of piracy and have started granting punitive damages even in cases where due to

absence of the defendant‟s exact figures of sales by the defendant‟s under the infringing copyright and/or trade

mark, exact damages are not available.” Court awards both compensatory and punitive damages for willful,

intentional, and flagrant violation by defendant of plaintiff‟s copyright in MS DOS, MS WINDOWS and trade mark

in “Microsoft.”).

100 Chief Justice Suggests Out-of-Court Settlement of Cases, THEEARTHTIMES, Dec. 03, 2007, http://www.

earthtimes.org/articles/show/152459.html (last visited Mar. 29, 2008) (“Expressing concern over the increasing

backlog of cases in courts and the slow rate of disposal, Chief Justice of India K.G. Balakrishnan Monday said

lawyers could try to settle most of the cases outside courts 'as the present establishment cannot keep up.'”).

101 Salem Advocate Bar Association of Tamil Nadu vs. Union of India, (2003) 1 SCC 49 (India Supreme Court order

committee formed to implement court ordered mediation, conciliation and arbitration under newly added § 89 of the

Code of Civil Procedure); see also Praveen Dalal, ADR: The Ultimate Solution of Backlog, IMCINDIA, May. 24,

2005, http://india.indymedia. org/en/2005/05/210588.shtml (last visited Mar. 28, 2008) (“The backlog of cases is

increasing day by day but …the backlog is a product of “inadequate judge population ratio” and the lack of basic

infrastructure. The government is not very keen in increasing and improving either. It has, however, been wise

enough to amend the existing provisions of [Civil Procedure Code, 1908 (CPC)] to take care of the requirements of

ADR in India. The CPC has been amended … to make ADR an integral part of the judicial process … [W]here it

appears to the court that there exist elements, which may be acceptable to the parties, the court may formulate the

terms of a possible settlement and refer the same for arbitration [or] conciliation…”).

102 India Arbitration and Conciliation Act, 1996 §§ 10, 11, 19, 20, 31, 34.

103 Id. § 43; see also India Limitations Act, 1936, sched. Period of Limitations.

104 Arbitration and Conciliation Act §31.

Paper.doc Page 20 of 28 Last printed 5/7/2008 9:36:00 PM

Convention on Execution of Foreign Arbitral Awards, 1927 and the New York Convention,

1958. Accordingly, a local or foreign award under either convention is generally binding on the

parties.105

Back to the hypothetical problem, lawyers for the U.S. doctors drafting any agreements

involving India entities (i.e. employees, subsidiaries, contractors, joint partners, vendors …etc.)

should insert arbitration provisions in the agreements to avoid the backlog of India courts.106

The

U.S. doctors can have the provisions drafted to allow them to retain the right to either arbitrate or

litigate. The mechanics involved will be familiar to U.S. contract attorneys.

A court in India can overturn an arbital award if it finds the subject matter of the dispute is

not capable of settlement by arbitration under India law or if the award is in “conflict with a

public policy of India”.107

In Oil & Natural Gas Corp. Ltd. v. Saw Pipe, Ltd., the Supreme Court

of India broadly interpreted the definition of “public policy” to permit domestic award

challenges if the relief in the award violates any India laws.108

In Venture Global Engineering v.

Satyam Computer Services, Ltd., the Court extended the Saw Pipe holding to apply to foreign

award challenges also.109

Back to the hypothetical problem, the recent India Supreme Court holdings mean the U.S.

doctors cannot blindly draft in U.S. choice of law provisions into their outsourcing agreements

and expect them to govern arbitration outcome. For example, if the India IT Act would limit

breach of confidence by a person with access to an electronic transaction to $2346 US, then an

arbital award granted under similar circumstances cannot exceed this amount either. All awards

must be consistent with how India law would analyze and decide any issue subject to agreed

ADR.

IV. INCOME EARNED IN THE GLOBAL ECONOMY

Taxation is always a concern for U.S. companies. India has not attracted foreign investment

in its IT-BPO industry solely on an offer of cheap labor. India has also provided specialized tax

105

Id. pt. I ch. VIII (enforcement of local awards ); pt. II chs. I & II (enforcement of foreign awards under the New

York and Geneva Conventions).

106 Kurian Mathew, Median India, http://www.kurianmathew.com/Mediation%20India.html (last visited Mar. 30,

2008) (Median India suggest the following provision be inserted into contracts “Any dispute or difference arising

out of or in connection with this contract shall first be referred to mediation in accordance with the then current

Indian Institute of Arbitration and Mediation (IIAM) Mediation Rules and as per the Arbitration & Conciliation Act,

1996. If the mediation is abandoned by the mediator or is otherwise concluded without the dispute or difference

being resolved, then such dispute or difference shall be referred to and determined by arbitration as per the

Arbitration & Conciliation Act, 1996 by IIAM in accordance with its Arbitration Rules.”).

107 Id. § 34(2)(b).

108 Oil & Natural Gas Corp., Ltd. v. SAW Pipes, Ltd., (2003) 5 S.C.C. 705, at 72 (public policy violations

interpreted broadly under §34(2) of the Arbitration and Conciliation Act to allow courts to set aside domestic awards

if they violate any India laws).

109 Venture Global Engineering v. Satyam Computer Services, Ltd., MANU/SC/0333/2008, at 29 ((public policy

violations interpreted broadly under §34(2) of the Arbitration and Conciliation Act to allow courts to set aside

foreign awards if they violate any India laws).

Paper.doc Page 21 of 28 Last printed 5/7/2008 9:36:00 PM

incentives that bypass its domestic income taxation laws for export-oriented foreign investors.

International taxation issues in the context of e-commerce are rapidly emerging in India. The

most troublesome of issues arising in the context of U.S. companies involved with India

outsourcing. India‟s taxing authorities have taken the position that all global income earned

from any software or services produced or sold in India is “deemed to accrue or arise in India”

under India‟s Income Tax Act of 1961.110

They argue that, unless an exemption applies, all non-

resident income earned directly or indirectly from software and IT services outsourced to India is

subject to India taxation first under the U.S.-India Double Taxation Avoidance Agreement of

1990 (“DTAA”).111

Based on this viewpoint, India taxing authorities have begun issuing notices of income tax

deficiency to U.S. companies outsourcing software driven activities to India WOS.112

The

amount assessed in these notices is the unpaid India taxes on any global income the taxing

authorities decide arose in India, plus penalties. Like in the U.S., the penalties for underpayment

of taxes can be very large. Over the span of years, cumulative tax deficiencies can erase a large

portion of the cost savings attributed to India outsourcing. Since this is an emerging and

unsettled issue in India, U.S. software companies engaging in India outsourcing must be cautious

how they characterize where their global income is earned. With few guideposts to follow, this

will be difficult.

Once the India tax authorities present a U.S. company with a notice of tax deficiency they

have two choices. They can pay the deficiency or they fight it out in India courts in hope of

establishing favorable legal precedence. Further, tax payments made to wrong government may

not be refundable due to statute of limitations. Ironically, because of refund limitations a

company could pay taxes on income twice.

Unplanned taxes will impact cash flow impact. Cash flow is a dominate factor in corporate

valuation. Small changes in cash flow can have large effect on a company‟s stock price and

credit worthiness. For a start-up software company, these effects could inhibit their ability to

obtain further investor funding. This could threaten their survival. These hidden cost and legal

challenges are not what U.S. software companies want or expect.

110

India Income Tax Act, 1961 § 9(1), amended by Finance Act, 2008 (“The following income shall be deemed to

accrue or arise India: (i) all income accruing or arising, whether directly or indirectly, through or from any business

connection in India, or through or from any property in India, or through or from any asset or source of income in

India, or through the transfer of a capital asset situate in India. Explanation For the purposes of this clause (a) in

the case of a business of which all the operations are not carried out in India, the income of the business deemed

under this clause to accrue or arise in India shall be only such part of the income as is reasonably attributable to the

operations carried out in India.”).

111 US-India Double Taxation Avoidance Agreement (Dec. 20, 1990), available at http://law.incometaxindia.gov.in/

TaxmannDit/IntTax/Dtaa.aspx (last visited Mar. 31, 2008).

112 Microsoft Asked to Pay Rs 700 cr Tax, THE TIMES OF INDIA, Apr. 3, 2008, http://timesofindia.indiatimes.com/

Microsoft_asked_to_pay_Rs_700_cr_tax/articleshow/2921327.cms (“Microsoft India has been asked to pay Rs 700

crore tax [$174M US as of 04/18/08] including penal interest for the financial year 1998-99 to 2003-04, by

Commissioner of Income Tax (CIT), dealing in international taxation cases, in its recent judgment.”).

Paper.doc Page 22 of 28 Last printed 5/7/2008 9:36:00 PM

The section will proceed as follows. Subsection A will establish the needed background to

comprehend Subsections B and C. Subsection B will examine, analyze, and evaluate the tax

impacts on U.S. software companies producing software or operating an e-commerce site in

India; Subsection C will examine, analyze, and evaluate the tax impacts for U.S. software

companies intending to sell software in or e-commerce services from India.

A. Background

A foreign company can commence operations in India by incorporating a wholly owned

subsidiary (“WOS”); by joint venture with India partners; by self-presence thru a liaison, project,

or branch office; by contract with an independent India entity; or by contracting to build, operate,

and transfer (“BOT”) the ownership interest in an India entity upon established operation.

Corporate forms in India are either private or public limited companies.113

The majority of U.S.

software companies involved in any form of India outsourcing do so thru establishment of a

WOS in India. This business form allows them to retain the tightest control over IP, data, and

operations placed in India.114

There have been are numerous articles written in the recent years

focusing on the up-front hidden costs and legal challenges in the establishment of U.S-India

outsourcing arrangements.115

Exploration of them is encouraged. However, this paper will not

focus on them further.

India corporate tax rates are an effective flat rate of 34 percent for domestic companies

earning over 1M rupees ($25,214 US as of 03/30/08) and 41.2 percent for foreign companies.116

In general, entities incorporated in India will be treated as domestic companies for the purposes

of taxation. In comparison, U.S. corporate tax rates vary between 15 to 35 percent based on the

amount of income earned.117

The DTAA‟s purpose it to avoid double taxation and prevent evasion of taxes by entities in

113

India Companies Act, 1956 § 3(1)(ii) (a private company is not open to the public and has up to 50 shareholders;

§ 3(1)(iv) (a public company not a private company).

114 See table 4.

115 Fred Greguras, Steven Levine & S.R. Gopalan, Legal Structures for Outsourcing, FENWICK & WEST LLP (2004),

http://www.fenwick.com/docstore/Publications/Corporate/Outsourcing.pdf; see also Sonia Baldia, Intellectual

Property In Global Sourcing: The Art of the Transfer, 38 Geo. J. Int‟l L. 499 (2007); see also John Funk, Risk

Mitigation in Sourcing, July 14, 2005, available at http://www.ismdallas.org/archive/200507_Risks

_and_Mitigation_ISM_Dallas_Pres.ppt (last visited Mar. 31, 2008).

116 Embassy of India Wash. D.C., Taxation System in India, http://www.indianembassy.org/newsite/

doing_business_in_india/fiscal_taxation_system_in_india.asp (last visited Mar. 25, 2008) (“Companies residents in

India are taxed on their worldwide income arising from all sources in accordance with the provisions of the Income

Tax Act. Non-resident corporations are essentially taxed on the income earned from a business connection in India

or from other Indian sources. A corporation is deemed to be resident in India if it is incorporated in India or if it‟s

control and management is situated entirely in India. Domestic corporations are subject to tax at a basic rate of 35%

and a 2.5% surcharge. Foreign corporations have a basic tax rate of 40% and a 2.5% surcharge. In addition, an

education cess at the rate of 2% on the tax payable is also charged. Corporat[ions] are subject to wealth tax at the

rate of 1%, if the net wealth exceeds Rs.1.5 mn (approx. $33333 [US]”)).

117 26 U.S.C. §11(b)(1); see also IRS, 2007 Instructions to Form 1120, available at http://www.irs.gov/pub/ irs-

pdf/i1120.pdf (last visited Mar. 25, 2008).

Paper.doc Page 23 of 28 Last printed 5/7/2008 9:36:00 PM

one country earning income in the other. Under the DTAA, income earned and taxed in India

will avoid further taxation in the U.S. The DTAA is implemented in the U.S. income tax system

by provision of a foreign tax credit in the amount of India income taxes paid by a U.S. taxpayer.

The DTAA does not increase tax liability. Rather, it controls in what country different types of

income is taxed.118

Consequently, how DTAA provisions are interpreted can directly impact

where taxes on global income are paid—in India or the U.S. The DTAA is subject to

interpretation by India‟s taxing authorities and its courts. The India Supreme Court has held that

when there is conflict between the DTAA and the India Income Tax Act, the DTAA will

prevail.119

To attract foreign investment, India has implemented numerous tax schemes specifically for

export-oriented businesses.120

These tax schemes bypass all obstacles of the domestic India

economic for limited duration, generally 10 to 15 years. A U.S. software company can either

establish their India WOS in a Special Economic Zone (“SEZ”)121

or a Software Technology

Park (“STP”).122

SEZs offer an income tax exemption (“tax holiday”) on profits from export-

oriented production of “articles or things or computer software” spread out over a graduated 15

118

US-India Double Taxation Avoidance Agreement, art. 7. (controlling which country can tax different business

profits in a US-India enterprise).

119 Commissioner of Income Tax v. P.V.A.L. Kulandagan Chettiar, (2004) 6 SCC 235, at 5-8.

120 India Foreign Trade Policy, 2007-2008, available at http://dgft.delhi.nic.in (last visited Mar. 25, 2008) (the India

Ministry of Commerce and Industry has implemented many tax beneficial schemes that both local and foreign

owned export-oriented businesses can establish themselves under. The schemes are: Export Oriented Units (EOU);

Free Trade Zones (FTZ), Export Processing Zones (EPZ), Special Economic Zones (SEZ), Electronic Hardware

Technology Parks (EHTP), Software Technology Parks (STP)). see also India Minister of Commerce and Industry,

Manual on Foreign Direct Investment 2006, available at http://dipp.nic.in/manual/fdi_manual_11_2006.pdf (last

visited Mar.17, 2008).

121 India Minister of Commerce and Industry, Investing In India, Foreign Direct Investment Policy & Procedure,

Nov. 2006, available at http://dipp.nic.in/manual/fdi_manual_11_2006.pdf (last visited Apr. 14, 2008) (SEZs came

about from the Special Economic Zones Act of 2005. The tax concessions are available to developers of the

economic zones and export-oriented companies that located within them. SEZs are regarded as foreign territory for

the purpose of duties and taxes and operate outside the domain of the custom authorities. SEZs enjoy duty free

import on all types of capital goods, raw material, and consumables that may be needed by a manufacturer. SEZs

also exempt a manufacturer from central government excise, sales tax, and service tax. SEZs offer a 15-year tax

holiday on export profits: 100 percent for the first five years, 50 percent for the next five years, and up to 50 percent

for further five years, subject to creation of reserves when manufacturing or producing “any articles or things or

computer software” for exportation. Companies with a SEZ are expected to be a positive foreign exchange earner

within 5 years from the commencement of production. Generally, all final production should be exported, except

product rejects up to a prescribed limit. Any sales made within India are subject to an excise duty equal to the

normal customs duty which would be payable on such goods, if imported.); see also India Foreign Trade Policy; see

also India Ministry of Commerce and Industry, Background Note on Special Economic Zones in India, http://

sezindia.nic.in (last visited Mar. 25, 2008).

122 Id. (Unlike SEZs, a STP is unique in that it focused exclusively on one product sector, computer software.

Within a STP a company can carry out export-oriented: development of computer software, data entry and

conversion, data processing, data analysis and control, data management, call center, and consultancy services over

data communication lines. Companies within a STP can import goods on loan from a client or parent company for a

specified period. From a taxation perspective, STPs are similar to the EOU/SEZ scheme. They differ in that they

have a 10 year tax holiday on profits from exports: 100 percent for all ten years. Currently, this tax holiday is set to

expire March 31, 2009. In contrast, the tax regime under the SEZ scheme is open-ended.); see also India Foreign

Trade Policy.

Paper.doc Page 24 of 28 Last printed 5/7/2008 9:36:00 PM

year period123

STPs are similar, except they offer a 10 year tax holiday on 100 percent of profits

on export-oriented “development of computer software, data entry and conversion, data

processing, data analysis and control, data management, call center, and consultancy services

over data communication lines.”124

B. When export-oriented tax incentives expire

The export-oriented tax incentives India offers will expire. Once that happens, moving into

another tax holiday is prohibited by interlocking provisions in the India income tax code.125

A

relevant question is “what impact does the expiration of an export-oriented tax holiday have on a

U.S. software company that has outsourced its entire software R&D and e-commerce site

operation to India?”

The majority of U.S. or India companies involved in IT-BPO and KPO activities are

established in STPs. The tax holiday for all STPs is set to expire on March 31, 2009.126

Morgan

Stanley sought an advanced revenue ruling on how this would change taxation of the WOS it had

established in India to perform back office services for U.S. Morgan Stanley‟s global financial

services.127

The India tax authorities responded that all global income that India helped to

generate should be taxed in India. Morgan Stanley disagreed and appealed this ruling thru the

India courts. In DIT (International Taxation), Mumbai v. Morgan Stanley & Co, Inc, the India

Supreme Court finally settled the dispute.128

The Court decided the back-office activities

Morgan Stanley‟s WOS performed in India were “preparatory and auxiliary in character” to U.S.

Morgan Stanley‟s front-office activities.129

The Court held that under the DTAA, resident

income (i.e. India income) that preparatory and auxiliary activities generate is taxable in India.

However, non-resident income (i.e. U.S. income) that preparatory and auxiliary activities help to

generate is not taxable in India.130

The Court stated the “economic nexus” in a US-India

123

India Income Tax Act §10(AA)(1) (provides an income tax deduction of such profits and gains as are derived by

a hundred per cent export-oriented undertaking from the export of articles or things or computer software of 100

percent for the first five years, 50 percent for next five years; and 50 percent in the next years for specified re-

investment).

124 Id. §10(B)(1) (providing income tax deduction of such profits and gains as are derived by a hundred per cent

export-oriented undertaking from the export of articles or things or computer software of 100 percent for the first ten

years).

125 India Income Tax Act §§ 10(AA), 10(B) (“this [export-oriented deduction] applies to an undertaking …

providing it is not formed by the splitting up, or the reconstruction, of a business already in existence… or formed

by the transfer to a new business of machinery or plant previously used for any purpose.”).

126 2008 Will Be a Crucial Year for the Indian BPO Industry, SILICONINDIA, Dec. 31, 2007, http://www.

siliconindia.com/print_article.php?38484 (last visited Mar. 31, 2008).

127 Morgan Stanley Comes Out on Top, INTERNATIONAL TAX REVIEW, July 12, 2007,

http://www.internationaltaxreview.com/default.asp?Page=9&PUBid=210&ISS=23959&SID=689609 (last visited

Apr. 24, 2008).

128 DIT (International Taxation), Mumbai v. Morgan Stanley & Co., Inc., (2007) 7. S.C.C. 1.

129 Id. at 8.

130 Id. at 12.

Paper.doc Page 25 of 28 Last printed 5/7/2008 9:36:00 PM

enterprise was an important aspect of attribution of profits.131

The Morgan Stanley decision was a welcome relief to U.S. companies outsourcing back-

office operations to India. The decision was a setback to India taxing authorities seeking strict

source based interpretation on taxability of non-resident income.

Back to the hypothetical problem, the Morgan Stanley opinion should provide little comfort

to the U.S. doctor‟s. Once their tax holiday expires, the India tax authorities will claim the entire

global income earned by their electronic health care system should be taxed in India. The Court

in Morgan Stanley gave no guidance on how to decide if an activity is “preparatory and auxiliary

in character.” Further, the Court never explained how an “economic nexus” analysis should be

conducted to properly attribute an international enterprise‟s global income to either US or India.

Just by ordinary observation, the India taxing authorities will point out that by outsourcing all

software R&D and e-commerce site operation to India the activities performed there are more

than preparatory or auxiliary in character to the U.S. doctor‟s enterprise. They will argue the

economic nexus of their enterprise is India, not the U.S. Therefore, global profits from operation

should be taxed in India under the DTAA. Assuming the India taxing authorities are correct,

corporate balance sheet projections on a $100M license sales rate after the U.S. doctor‟s tax

holiday expires would be as follows:

Table 5. U.S. only U.S. parent India subsidiary

Gross Income $100

Gross Income $100 $85 (export sales) +

$15 (20% profit*)

Cost of R&D

and operations $50

Cost of R&D

and operations $15 $12.5 (1/4 U.S. rate)

Taxable

Income $50

Taxable

Income $0 $87.5

Taxes $17.5 (35% U.S.)

Taxes $0 (foreign tax

credit applies) $29.8 (34% India)

Profit $32.5M Profit $0M $57.7M

* 20% over cost is arm‟s length price charged U.S. parent

By comparing table 5 with table 1, one can observe that the overall profit and tax burden of

the U.S. doctor‟s enterprise has not changed. This is as expected under the DTAA. However,

from this point forward, all deducible expenditures must be taken in the India subsidiary, not the

U.S parent, to reduce the overall international tax burden. Should the U.S. doctors not be

prepared for this change, the impact will be very unsettling. Further, to what degree India taxing

authorities will allow deduction by the India subsidiary for the salaries and bonus awards of

highly compensated U.S. executives is uncertain. The DTAA allows for “reasonable allocation

of executive … expenses” for the purpose of the business of the U.S. doctor‟s WOS in India.132

In the context of a global e-commerce business, this is uncharted territory. India‟s foreign

131

Id. at 34.

132 US-India Double Taxation Avoidance Agreement, art. 7. § 3.

Paper.doc Page 26 of 28 Last printed 5/7/2008 9:36:00 PM

investment incentives for IT-BPO and KPO came into existence in the late 1990s, no export-

oriented tax holidays have every expired.

Finally, until clear guidelines evolve in India the U.S. doctors might consider outsourcing

only a portion of their software R&D to India and keeping the final assembly and operation of

their electronic health care system in the U.S. That way they could retain a reasonable basis to

argue against India taxing authorizes that the software R&D activities they are performing in

their WOS in India are only “preparatory and auxiliary in character” to their overall e-commerce

enterprise. Therefore, the non-resident income India helped to generate would not be subject to

India taxation.

C. Selling software in or e-commerce services from India

It is undisputed that the income from selling of software by an India entity to India customers

is “deemed to accrue or arise in India.” Therefore, subject to India taxation. To avoid this, U.S.

software companies typically make the contractual sale of software in the U.S. and then provide

it to India customers via the internet. Technically the income from the sale would not have

accrued or arisen in India. Therefore, the income earned would be subject to U.S. taxation, not

India. U.S. software companies do this to align their income and expenses under just the U.S.

tax system to minimize their overall corporate tax burden. Unfortunately for India customers

subject to sales in this manner, they have to pay India import tax upon receipt of the software.

To cover the added import tax, U.S. software companies are willing to discount the software

accordingly to keep the sale from occurring in India.

India tax authorities do not like the above tactics. It defeats their strict source based

interpretation on taxability of income. In 2008, the India tax authorities presented Microsoft a

tax deficiency notice of $154M on $555M software sales to India customers.133

The India tax

authorities reasoned that since Microsoft was selling a “license for use” of their software the

income they earned was a royalty under a combined interpretation of India‟s income tax code

and the DTAA.134

Under the India income tax code, royalty income earned by a non-resident

thru payment by an India resident is deemed to accrue or arise in India.135

Therefore, the non-

resident income Microsoft generated from software license sales to India customer is entirely

taxable in India. Microsoft has gone thru administrative appeal of their notice of deficiency

with the India tax authorities.136

So far, they have lost on appeal.137

Like in Morgan Stanley, the

next step is appeal thru the India courts. The India tax authorities have begun issuing similar

133

Topic: Licensing: Microsoft Liable for Income Tax, SEARCHFORDATA, Mar. 31, 2008, http://www.

searchfordata.com/forums/forum_posts.asp?TID=2228&PID=2485 (last visited Apr. 15, 2008).

134 S. Sivakumar, Microsoft Case Macro-Hard Implications!, ONEINDIA, Apr 7, 2008, http://news.oneindia.in

/2008/04/07/microsoft-case-macro-hard-implications.html (last visited Apr. 15, 2008)

135 India Income Tax Act § 9(vi) (income deemed to accrue or arise in India by way of royalty).

136 S. Sivakumar , Microsoft Case Macro-Hard Implications! at 1.

137 Id.

Paper.doc Page 27 of 28 Last printed 5/7/2008 9:36:00 PM

notices to other U.S. software companies selling software licenses to India customers.138

Back to the hypothetical problem, the U.S. doctor‟s will need to pay specific attention to

how India eventually decides how global income from software license sales is to be attributed to

under the DTAA. If the U.S. doctors make direct software license sales from their e-commerce

site in India, that income will be subject to India taxation. If the U.S. doctors make software

license sales first in the U.S. and then provide customer access to their e-commerce site in India

an independent second step, that income may be taxable in the U.S. or India—depending on

outcome of the Microsoft case. To avoid the uncertainty, the U.S. doctors might consider

operating their e-commerce site in the U.S. only. Under U.S. law, there is established

precedence that software license sales are equivalent to the sale of goods. Therefore, for a U.S.

operated e-commerce site the point of sale would be considered the U.S. and the income earned

from it would be taxed there also.

V. MOVING FROM PAPER TIGER TO REAL TIGER

From a U.S. software company‟s perspective, India is currently a paper tiger with respect to

IP protection for strategic software R&D and e-commerce site operation outsourced there. Jolly

Technologies sums it up best “[w]e were misled by lawyers we consulted before opening the

[Mumbai, India] facility...[w]e were told that there are patent, copyright, and IP protection laws

in India. They failed to mention the laws are impossible to enforce.”139

What must change to

make India become a more legally balanced outsource location?

A. IT-BPO and KPO growth must stall

India likely has a glass ceiling that limits the amount of strategic software development and

e-commerce site operation it can attract from U.S. companies. This limit is rooted in the legal

imbalance India‟s untested IP laws and in-crisis legal environment present to them.

Despite what U.S. software companies might want India to do, it is hard to see why India

would change. The majority of Indian IT and software professionals view things as not broken.

Growth in the IT-BPO industry has been undeniably successful. No India IP laws changed to

bring about this success. In fact, the only changes made were to a few income tax provisions.

This paper suggests that until the growth in the IT-BPO and KPO industry stalls out, India IP

laws and enforcement actions regarding infringement or loss of software and data will not

change either. There is no motivation to improve U.S. company interests until India‟s own

interests are put under pressure.

138

Interview with Surku Sinnaduari, Chief Information Officer & Managing Director of i2 India, i2 Technologies,

Inc., in Dallas, TX. (Apr. 18, 2008) (i2 Technologies has been presented a $250K US tax deficiency notice from

India‟s taxing authorities under the same reasoning as Microsoft recently was).

139 IDG New Service, Outsourcer Beware, ITWORLD.COM, Oct. 26, 2004, http://www.itworld.com/Man/2701/

041026indiaip (last visited Apr. 1, 2008).

Paper.doc Page 28 of 28 Last printed 5/7/2008 9:36:00 PM

B. A globally valued software portfolio must arise

It has been argued by one scholar that U.S. legal firms benefitting from legal outsourcing

have an ethical obligation to help pay for the reform of India‟s in-crisis legal system.140

A

similar argument would apply to U.S. companies benefiting from the cost saving of IT-BPO and

KPO activities to India. A fraction of the tens of billions of dollars presently spent on India

outsourcing would go a long way to fund improvement to India‟s legal system.

However, it is likely a U.S. company‟s willingness to fund India‟s legal improvement will

vary in direct relation to how much these improvements decrease the company‟s hidden costs

India outsourcing actually presents to them. In general, U.S. software companies would be

willing to fund more improvements since the IP value of strategic software is high and the IP

asset protection India‟s legal system now provides to them is minimal. Whereas, U.S. legal

outsourcing companies would be willing to fund less improvement since the IP value of legal

documents is low and the IP asset protection India‟s legal system now provides them is likely

irrelevant.

This paper suggests that even if money was made available for judicial improvement, it is too

early in India‟s global development to expect it to tighten up its IP laws and enforcement with

respect to strategic software R&D and e-commerce site operation. This will not occur until India

itself establishes a hefty portfolio of globally valued software IP and e-commerce services

similar or what Microsoft, Oracle, Google, or Yahoo have. There is no motivation to improve

U.S. company interests until India can compete against them.

C. Wish list

There are many things that would be helpful to U.S. software companies outsourcing work to

India. The wish list is as follows. Statutory minimum copyright infringement damages that

could be opted for on a fast track case management pathway. A dedicated judiciary path for IPR

suits that bypasses the backlogs of India courts. A dedicated police force to assist U.S.

companies in investigation and retrieval of stolen software, trade secrets, and data. An

aggressive public prosecution campaign against all forms of software piracy. Adoption of more

U.S. legal tests by India courts for analysis of software copyright infringement cases. Creation

of national trade secret laws modeled upon U.S. law. Amendment of India‟s Patent Act to

include software and business methods within the scope of patentable subject matter.

Then again, maybe U.S. software companies should accept India for what it is, not what they

want it to be.

VI. CONCLUSION

Today, India outsourcing offers significant economic reward for U.S. companies willing to

take on its legal challenges. In the future, each legal challenge India eliminates will serve to

directly increase its ultimate share of the global e-commerce economy.

140

Jayanth N. Krishnan, supra note 80.