What is offshoring?
Outsourcing offshore (or offshoring as it is commonly known) is the outsourcing of a business function to a third party supplier overseas or the establishment of a joint venture or a captive facility overseas primarily to provide services internally to the client business. Many of the commercial and legal issues that a business needs to consider for an onshore outsourcing are just as relevant to an offshore model. However, offshoring raises its own unique issues.
Why offshore?
The key drivers behind the majority of outsourcings are the desire to reduce costs, transform processes and improve service quality.
Using offshore locations with a lower cost base is clearly an attractive option in the search for cost reductions. However, customers and suppliers are also increasingly advocating the benefits of improved processes and service quality as equally important reasons in the choice of an offshore location. More flexible work practices and the exploitation of different time zones can, for example, create 24-hour processes which were previously limited to certain parts of the day. Access to highly qualified and motivated staff in some locations also assists in the improvement of service quality.
"They come for the price, but stay for the quality" is the mantra which many offshore providers currently like to use.
Choice of business function
The UK market is currently witnessing the offshoring not only of IT functions, but also a number of business processes.
For IT offshore outsourcing the predominant areas outsourced are system maintenance, software implementation and support and bespoke development. For business process outsourcing the predominant areas include finance, human resources, industry-specific processes, and call centre functions.
In the UK, considerable offshore activity has been taking place in the financial services sector, particularly for transaction processing and customer services.
Choosing a location
Inevitably a number of factors are taken into consideration when choosing an offshore location. Important factors are cost, labour pool, expertise, language skills, government support, infrastructure, political stability, data/IP security and the location of the customer. Selected locations for UK businesses include India, China, Israel, South Africa, Ireland and Eastern Europe. The use of locations near and far has spawned a further distinction in outsourcing terminology between "near-shore" for countries in Europe and "offshore" for those which are geographically distant such as India and China.
Commercial and legal issues in offshoring
When structuring and preparing the legal documentation for an offshoring, many of the considerations will be similar to those in an onshore outsourcing. The customer and supplier, in particular, will concentrate on issues such as competitive pricing and gain share, service quality and performance incentivisation, flexibility and improvement.
However, offshoring raises its own unique commercial and legal issues. The most common structures used, and some of the legal issues raised, are touched on below.
Offshoring models
There are a number of different ways of structuring an offshore arrangement.
- Direct/indirect outsourcing
The first is a classic customer – supplier arrangement, where the customer enters into a supply contract with the third party supplier. These contracts may either be direct with the offshore supplier or with a UK entity of the offshore supplier, which then subcontracts the performance to its offshore affiliates. This model has the obvious advantage of establishing a true customer-supplier arrangement.
- Joint ventures
The second category is the joint venture model. A customer and offshore supplier may set up a joint venture vehicle, which will predominantly service the customer's business. The offshore supplier brings the local expertise and service skills while the customer brings its knowledge of its existing business function and maintains greater management control.
- Build Operate Transfer arrangements
"Build Operate Transfer" or "BOT" arrangements are being increasingly used in establishing offshore centres, particularly in India. The customer and supplier set up a joint venture, which is contracted to establish the operation, such as the acquisition of facilities and staff, and then to provide the services for a defined period. At a point where the centre and services are properly established, management and ownership is transferred to the customer.
- Captive facility
This is where the business sets up its own subsidiary offshore so that all assets and staff are owned by the customer business. The customer business is likely to enter into a consultancy arrangement with a local service provider to assist in the establishment of the function. This model has the advantage of the customer having ownership and operational control (useful in a regulated industry), and the legal structure is relatively easy to set up.
The choice of model depends on a number of factors. In broad terms, a traditional outsourcing arrangement will usually be the preferred option where cost-savings and local supplier expertise are important and/or the customer wishes to limit risk. A joint venture or captive facility approach may be of interest where operational and management control is important and/or there is a long-term commitment to the region and the business is looking for the function to become a profit centre.
Transition and pilot schemes
Offshoring rarely includes the transfer of existing assets of the outsourced business function or the wholesale transfer of existing staff. Businesses are also more cautious about the wholesale transfer of a function to a new location, particularly in view of the difficulties of exiting the arrangements.
Both these factors mean that pilot schemes are commonly used, where the proposed arrangements are tested on a smaller scale, before the full scale outsource. Offshore arrangements are also often structured to take place in phases and with a longer transition process compared to an onshore model.
Employment
Typically, few existing staff will be transferred to the new supplier in an offshore outsourcing, and therefore the business will need either to find other jobs for existing staff or make them redundant. In broad terms the Transfer of Undertakings (Protection of Employment) Regulations are unlikely to be relevant where a UK business outsources to another country. The business will still need, however, to comply with employees' employment rights when making them redundant.
Regulatory issues
Regulated businesses must ensure that the offshoring is undertaken in compliance with the requirements of the relevant regulatory body. In the financial services sector, for instance, businesses will need to be aware of the FSA's risk assessment framework, and the FSA rules on notification of material outsourcings.
Regard also needs to be given to compliance with the local law in the location of the offshore supplier.
Intellectual property
The law applicable to the creation of intellectual property rights, such as copyright, normally depends on the residence of the creating entity. Software developed in India will therefore be subject to Indian copyright laws. Where continuing monopoly ownership or right of use of know-how and intellectual property rights is of importance to the customer, the customer will need to ensure that it has the appropriate contractual rights in the services agreement.
Beware that local law may override certain contractual arrangements. For example, in China legislation exists which allows Chinese companies in certain circumstances unfettered use of certain intellectual property after a period of time. In other jurisdictions it is not possible for specific intellectual property rights to be assigned. In such circumstances alternative arrangements may need to be agreed, such as perpetual licences.
Data protection
Offshoring to a country outside the EEA will require compliance with the principles of the Data Protection Act 1998. This Act provides that personal data shall not be transferred to a country or territory outside the EEA unless that country or territory ensures a level of protection for the rights and freedoms of data subjects in the processing of personal data.
UK business can normally ensure appropriate compliance by controlling the data processing and including appropriate contractual provisions in the services contract.
Business contingency and exit
Appropriate business contingency arrangements need to be put in place to ensure supply alternatives if service provision becomes impossible or is limited due to disasters and other external intervening events.
If a traditional outsourcing model is used the customer may wish to be able to transfer the existing facility / staff to a new provider or in-house. A full scale onshoring arrangement will obviously require the acquisition of new staff, assets and facilities.
Tax issues
When offshoring, consideration should be given to taxation issues such as corporation tax, sales tax and transfer pricing.
Choice of law and jurisdiction
A UK business will normally choose to contract under English Law. Avoiding lengthy, costly and unpredictable court processes in foreign jurisdictions such as India will be important to UK businesses. Therefore it will be preferable to include arbitration provisions in the contract. Arbitral awards are enforceable in most foreign jurisdictions.
For further information on offshoring or outsourcing please contact Yuban Moodley at yuban.moodley@cms-cmck.com or on +44 (0)20 7367 3453 or David Day at david.day@cms-cmck.com or on +44 (0)20 7367 2948.
