The revenue department has created needless uncertainty on the tax liability of foreign parents and principals of business entities in India, by suddenly withdrawing a 40-year old circular. It needs to bring out another circular at the earliest, clarifying that its intention is not to endanger Indias thriving outsourcing industry, particularly the captive units which generate about 35% of the sectors revenue.

The Income Tax Act requires foreign companies to include in their income taxable in India any income arising from or through its business connection in India.

There are no clear-cut rules to define a business connection. The circular that has now been withdrawn had been successfully interpreted, to the chagrin of the tax department, to put the income generated for a foreign company by a business process outsourcing unit in India outside the ambit of taxation in India.

The only condition was that the foreign client should fully compensate the Indian BPO for its services, something that is not readily guaranteed if the Indian BPO is a subsidiary of the foreign client.

Now, with the withdrawal of that circular, a captive BPO or a BPO that has a substantial part of its work coming from a single foreign client, runs the risk of being classified as a business connection a dependent agent is a business connection.

And then, a portion of the income the foreign client derives from the activities of the Indian BPO could be liable to tax in India. Now, such a situation would discourage foreign companies to outsource work to India, particularly to captives.

Such actions by the revenue department only help to make the tax environment unstable and hinder investment. More significantly, the withdrawal of the circular creates uncertainty for Indias booming IT/ITeS industry which thrives on activities outsourced by foreign companies.

The captive BPOs of foreign companies as well as those that earn a greater portion of their income from a single foreign entity, and thus could be construed as a business connection, may find their survival threatened by this single act of the tax authorities. Revenue must make amends.