On Sept. 28, India shot its outsourcing market in the foot. On that date, India's finance ministry announced an income tax of more than 36% on foreign firms that have software, R&D, or customer service operations in India. The tax was enacted ostensibly to discourage foreign-owned service providers, such as EDS and Perot Systems, from establishing wholly owned operations in the country. Instead, the theory goes, these companies would send offshore outsourcing work to service providers owned by native Indians in order to avoid the tax.

This tax could potentially affect a number of U.S. outsourcers that have set up shop in India. EDS, for example, has more than 1,000 employees in India providing business process outsourcing and help desk/call center outsourcing services as part of its "Best Shore" program. Perot Systems also has a large presence in India, which was expanded in December 2003 when it bought out its Indian joint-venture partner, HCL Technologies, for $105 million.

The tax is not the end of new taxes in the country, however. India also has taxes on the drawing board that would tax activities conducted over international private leased connections, which would affect nearly every company that must transmit voice and data to and from India. The country is also considering the introduction of a national value-added tax, which would replace state-to-state customs duties known as octroi. (And how much do you want to bet that the new taxes will be higher than the ones they replace?)

In my opinion, this approach is inherently flawed and will result in a flood of the country's foreign-owned services operations moving elsewhere. These companies located their offshore subsidiaries in India to help their customers save costs and take advantage of "follow-the-sun" time zone differences. Critics of offshore outsourcing fear higher risks in terms of potential loss of intellectual property and loss of control over projects, but these risks were mitigated to some extent through the creation of wholly- or majority-owned offshore subsidiaries. These units allowed the U.S. parent companies to exert a substantial amount of control - more than if the work was outsourced to native Indian firm.

My impression is that India's government reasoned that if it exacted a large tax on these companies, they would feel encouraged to either send the work to wholly-owned Indian companies or to take on majority partners that are native Indians. This approach is fundamentally flawed-and this is why.