India recently achieved the distinction of being the fifth largest economy in the world, and has been identified as a bright spot for global economic revival by the IMF. With the economy growing at a consistent rate and further in view of the Plus One strategy (ie, companies investing in China and another jurisdiction), a great deal of foreign organisations and investors have been looking to India as a substantial market for growing and diversifying their businesses in the region. Additionally, with the pandemic-induced digital nomad workforce presenting itself as a new model of engaging people across geographical boundaries, organisations have also been looking to engage workforce from outside their home jurisdictions.

However, the regulatory framework can make setting up a business presence and engaging a local workforce fairly challenging.

As India is a foreign exchange-controlled jurisdiction, a foreign entity needs to have a local presence (subsidiary, branch, liaison office, etc.) to engage employees. Foreign entities wanting to test the waters before establishing a presence have been engaging direct consultants, or – increasingly – engaging the services of a professional employer organisation (PEO) or an employer of record (EOR) (typically, the terms PEO and EOR are used interchangeably).

PEOs are third-party service providers that employ a foreign entity’s workers on their rolls in countries where the foreign entity doesn’t have a local presence, and provide the required client services through their own workforce under contractually agreed terms. For all legal purposes, the PEO is the employer of the workforce and accordingly takes care of all employment-related obligations – including payment of salary, employee benefits, etc.

India’s PEO market is expected to reach US$2.7 billion by the year 2027 and US$7.2 billion by 2030.

Challenges and risks

Exchange controls

Under the Foreign Exchange Management Act 1999 (FEMA), a foreign entity may carry on its business in India through a representative or branch office approved by the Reserve Bank of India, project office, an incorporated subsidiary, or a joint venture. If a PEO-engaged workforce is deemed to have a direct employment relationship with a foreign entity and work under the instructions and control of the foreign entity, then the PEO arrangement may be considered a sham, and the foreign entity could be in violation of FEMA provisions.

Several factors would be considered in determining the existence of an employer-employee relationship between a foreign entity and a PEO-engaged workforce, a prominent one being if direct control and supervision is exercised by the foreign entity over the India-based individuals. In making the determination, courts may consider role of the entity engaging the PEO in selecting the individuals, determining their remuneration and benefits, its authority to remove/dismiss them from service or initiate disciplinary action, and its control and supervision over their day-to-day work.

Deemed employment or misclassification risk

That brings us to the intertwined issue and risk of PEO-engaged employees raising claims of deemed employment/misclassification.

To mitigate these risks, a robust contractual agreement should include key provisions, namely:

(a) an assurance that the PEO will make timely and adequate statutory payments to employees

(b) an agreement that the foreign entity will clear its dues only once the PEO has submitted documents evidencing adequate and timely payment of wages and social security payments to employees

(c) a specification that the engagement is on a principal-to-principal basis; and

(d) minimal supervision and control by the foreign entity on employees of the PEO service provider to the extent feasible.

Permanent establishment / tax risk

If the PEO-engaged individuals are considered to be employed by the foreign entity, the foreign entity could be liable to pay tax in India through being deemed a permanent establishment. Permanent establishment analysis is fact-specific and would depend on the specific facts and circumstances of each case.

Intellectual property assignment

Another important legal aspect that warrants attention in such arrangements is the assignment of any potential intellectual property (IP) created by PEO-engaged individuals. In India, the employer is considered to be the first owner of certain categories of IP (like copyright), meaning that with consultancy/third party worker arrangements, the IP has to be specifically assigned. Therefore, having a contractual/intercompany agreement in respect of a PEO arrangement for assignment of IP becomes vital.

Employee transfers

Given that the workforce is employed by the PEO, should a corporate transaction occur at the foreign entity level, the transfer of workforce at the India level may need to be assessed by the buyer from a legal standpoint including risks related to misclassification, IP assignment, exchange controls, tax etc.

Equity-based incentives

Foreign organisations seeking to incentivise their PEO-engaged workforce by offering equity-based incentives like stock options, restricted stock units, stock appreciation rights etc, may not be able to do so under a PEO arrangement.

Conclusion

While a PEO arrangement can be an effective tool in reducing the administrative burden of a company in the process of corporate business setup or for testing Indian waters, it’s vital that the ensuing legal limitations are given considerable thought. Having a well-founded, holistic legal overview and understanding goes a long way in preventing any potential risks.

Prior to the adoption of such a hiring model, companies must assess their intent, purpose, manner, and duration for which the PEO services would be engaged to ensure mitigation of legal risks arising out of execution of a PEO arrangement in India.