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LOCATIONAL SAVINGS – A DEVELOPING COUNTRY’S PERSPECTIVE

Sunil Agarwal1

1. Transfer Pricing (“TP”) is about a decade old in India. The trend of Multinational Enterprises

(“MNEs”) relocating at least some of their manufacturing or service operations to India is about 2

decades old, ever since India gradually opened up its economy to MNEs in the 1990s. These two

factors have combined to produce a heady mix of TP adjustments and consequent TP disputes.

With every passing TP audit cycles, Indian TP administration has been progressively getting

better informed in not only dealing with relatively simple issues (e.g. mark-up to a de-risked

captive service provider subsidiary), but also identifying newer and admittedly more complex

issues.

2. Locational Savings (“LS”) is one such relatively new issue which India TP administration has

been trying to grapple with. Some cases have already reached up to the Income-tax Appellate

Tribunal level2, however, as yet, there is no judicial precedent in India, which has dealt with the

issue in a comprehensive manner. The importance the Indian Government attaches to this issue

can be gauged from the flurry of circulars issued in the context of profit allocation to R&D Centres

operating in India.3

3. With increasing pace of globalization of US and European MNEs towards Asia, in particular

towards India and China, this issue is expected to gain momentum in future. Developing

economies would like to ensure that they get their fair share of taxes keeping in mind the

locational advantages they offer like relatively inexpensive trained manpower, low cost of labour,

low rents etc.

4. Before dealing with the qualitative and quantitative aspects of the issue, it would be worthwhile to

have, in simple terms, a snapshot of what the issue of LS is. Let us assume that Microsoft, a US

1 Senior Tax Partner, AZB & Partners (Formerly Commissioner of Income-tax). The views are personal.

2 Li & Fung (India) (P.) Ltd. [2011] 16 taxmann.com 192 (Delhi); GAP International Sourcing (India) (P.) Ltd. [2012] 25 taxmann.com

414 (Delhi); Sojitz India (P.) Ltd. [2013] 33 taxmann.com 299 (Delhi - Trib.).

3 Circular No. 03/2013 dated March 26, 2013 read with Circular No. 06/2013 dated June 26, 2013 and Circular No. 02/2013 dated

March 26, 2013 read with Circular No. 05/2013 dated June 26, 2013. Incidentally, Indian TP regime is not alone in applying this principle amongst the developing countries. In February 2010, the Chinese State Administration of Taxation (“SAT”) has issued Circular No. 84 stating that “with China being one of the countries whose market is emerging, there are unique competitive advantages as compared to the developed countries. The unique competitive advantages include the continuously increasing purchasing power, cheap land and labour, and etc…..; tax authorities should …., to strengthen study on location saving, marketing intangibles assets and other issues in favour of developing countries ….”.

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software giant, wishes to outsource some software development operations to a Low Cost

Jurisdiction (“LCJ”) like India. There are two possibilities:

i. Scenario 1 – The software development to be outsourced is such that a large number of

software development companies in India have the necessary qualified and experienced

software engineers with them and compete for the assignment on offer. In such a case, the

competition among them is likely to drive down their quotes for the assignment.

ii. Scenario 2 – Only few big names in India, say Infosys or TCS, have the necessary skilled

and experienced manpower to do the job.

4.1 If the case is covered by Scenario 1, the chances are that only a routine mark-up on cost/ assets

will be expected by Indian competitor companies. In such a situation, in case Microsoft awards

the assignment to its controlled subsidiary in India, the controlled subsidiary should expect only a

routine compensation. The question of attribution of LS, if any, should not arise.

4.2 If the case is covered by Scenario 2, the chances are that Infosys/ TCS, the uncontrolled entities,

would demand a price consistent with the unique competence/ expertise they only have, not

others. Such price may be well above a routine mark-up on their costs/ assets. In such a

situation, the controlled Indian subsidiary of Microsoft is expected to receive the same mark-up as

would have been paid to uncontrolled Infosys/ TCS, had they been engaged for the assignment.

In this manner, LS, if any, would be shared with the LCJ and the issue addressed.

5. Now let us have a look at what the expression “Location Savings” refers to:

i. US TP Regulations on LS

“If an uncontrolled taxpayer operates in a different geographic market than the

controlled taxpayer, adjustments may be necessary to account for significant

differences in costs attributable to the geographic markets. These adjustments

must be based on the effect such differences would have on the consideration

charged or paid in the controlled transaction given the relative competitive positions

of buyers and sellers in each market. Thus, for example, the fact that the total

costs of operating in a controlled manufacturer’s geographic market are less

than the total costs of operating in other markets ordinarily justifies higher

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profits to the manufacturer only if the cost differences would increase the

profits of comparable uncontrolled manufacturers operating at arm’s length,

given the competitive positions of buyers and sellers in that market.”

[§1.482–1(d)(4)(ii)(C)]

ii. Chapter IX - OECD TP Guidelines

“E. Location savings

9.148 Location savings can be derived by an MNE group that relocates some of

its activities to a place where costs (such as labour costs, real estate costs,

etc.) are lower than in the location where the activities were initially

performed, account being taken of the possible costs involved in the

relocation (such as termination costs for the existing operation, possibly

higher infrastructure costs in the new location, possibly higher

transportation costs if the new operation is more distant from the market,

training costs of local employees, etc.)….”

iii. Rule 10B(2)(d) of Indian Income-tax Rules, 1962 dealing with comparability

analysis

“10B. Determination of arm’s length price under section 92C

………………

(2) For the purposes of sub-rule (1), the comparability of an international transaction

with an uncontrolled transaction shall be judged with reference to the following,

namely:-

……….

(d) conditions prevailing in the markets in which the respective parties

to the transactions operate, including the geographical location and

size of the markets, the laws and Government orders in force, costs

of labour and capital in the markets, overall economic development

and level of competition and whether the markets are wholesale or

retail.”

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iv. India’s position as per UN TP Manual

“10.4.7 Location Savings

10.4.7.1 It is the view of the Indian transfer pricing administration that the concept of

“location savings” — which refer to cost savings in a low-cost jurisdiction such

as India — should be one of the major aspects to be considered while carrying

out comparability analysis during transfer pricing audits. Location savings has a

much broader meaning; it goes beyond the issue of relocating a business from

a “high-cost” to a “low-cost” location and relates to any cost advantage. MNEs

continuously search for options to lower their costs in order to increase profits.

In this respect, India provides operational advantages to the MNEs such as

labour or skilled employee cost, raw material cost, transaction costs, rent,

training cost, infrastructure cost, tax incentive etc.

10.4.7.2 It has also been noticed that India provides the following Location Specific

Advantages (LSAs) to MNEs in addition to location savings:

Highly specialized and skilled manpower and knowledge;

Access and proximity to growing local/regional markets;

Large customer base with increased spending capacity;

Superior information networks;

Superior distribution networks;

Incentives; and

Market premium.

…………..

10.4.7.5 Hypothetically, if an unrelated third party had to compensate another party to

the transaction in a low-cost jurisdiction by an amount that was equal to the

cost savings and location rents attributable to the location, there would be no

incentive for the unrelated third party to relocate business to a low-cost

jurisdiction. Thus, the arm’s length compensation for cost savings and

location rents should be such that both parties would benefit from

participating in the transaction. In other words, it should not be less than

zero and yet not greater than the value of cost savings and locations

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rents combined. Moreover, it should also reflect an appropriate split of

the cost savings and location rents between the parties.”

6. A close examination would show that there is no fundamental difference in the position of all i.e.

USA, OECD and India. All recognize that LS as a TP issue does indeed exist. So the only

question is the methodology to apply the concept.

7. LCJs offer some cost advantages, e.g. relatively cheap skilled manpower, lower cost of land/

rents etc. At the same time, one has to keep in mind the cost dis-savings also, to name a few, low

productivity of labour, infrastructural bottlenecks, governmental controls/ licenses etc. Therefore,

the term LS, as used in this article, refers to “Net Positive Location Savings”. Consistent with the

objective of this article, i.e. to present the concept in an easy-to-understand and easy-to-apply

manner, jargon one normally comes across in TP literature, has intentionally been avoided.

8. Before attempting an attribution to LCJ, the following step-wise analysis needs to be carried out:

Step 1 What is the level of competition the controlled subsidiary faces in LCJ? Assuming there

is a large number of uncontrolled entities competing with controlled subsidiary in LCJ,

no LS benefit to go to controlled subsidiary in LCJ.

Step 2 Computation of LS whether they indeed exist i.e. locational net savings after factoring

location dis-savings. In case, net locational savings can be shown to be non-existent,

this issue does not survive.

Step 3 Assuming net location savings indeed exist, what are the competitive pricing pressures

the MNE faces in pricing its products to consumers? Consequently, whether such LS

are passed on to ultimate consumers in the form of reduced sale price or whether they

enrich the MNE group?

Step 4 Assuming LS enrich the MNE group, what are the principles to share them with the

subsidiary in LCJ, keeping in mind what an uncontrolled taxpayer comparable to

controlled subsidiary would have retained?

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9. Practical application of the above principles

i. Step 1: Large number of uncontrolled entities competing with controlled

subsidiary in LCJ

High Cost Jurisdiction

(“HCJ”)

LCJ

A B

Premium Product Low value-added services

Lot of Competition

Sequitur: LS, even if available to A, not to be shared with B.

ii. Step 2: Computation of LS (i.e. locational net savings) after factoring the location

dis-savings

Particulars Savings Dis-savings

Labour 500

Duties 100

Freight 100

Training 100

Income-tax 100

Creation of infrastructure 100

500 500

Sequitur: The issue of LS does not arise.

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iii. Step 3 - Assuming net location savings are passed on by the MNE group to

ultimate consumers in the form of reduced sale price

Particulars Without transfer

to LCJ

After transfer to

LCJ

Total cost of goods sold 900 700

Selling price of product 1000 800

Net Profit 100 100

Sequitur: LS realized by MNE group is Rs. 200. Because of competitive pricing

pressures, entire LS is passed on to the ultimate consumer in the form of reduced sale

price to the extent of LS realized. Therefore, no LS is available for sharing with

subsidiary, i.e. B, in LCJ

iv. Step 4 - Assuming net location savings are retained by the MNE groups in the form

of incremental profits

Particulars Without transfer

to LCJ

After transfer to

LCJ

Total cost of goods sold 900 700

Selling price of Product 1000 1000

Net Profit 100 300

Sequitur: LS realized and retained by MNE group is Rs. 200. This LS is available for

sharing with subsidiary, i.e. B, in LCJ. Question will arise how much of the LS is to be

shared between A and B.

10. Once it is established that because of relocation of functions to LCJ, LS have indeed been

realized and also retained by the MNE group, the issue of attribution of LS between parent in HCJ

and subsidiary in LCJ has to be dealt with in accordance with normal principles of arm’s length

pricing. As the purpose of TP analysis is to place controlled entities on tax parity with uncontrolled

entities, the allocation of LS to subsidiary in LCJ is to be carried out by usual TP methods, namely

CUP, TNMM or PSM, on the basis of availability of data. In the absence of reliable data

necessary for exact attribution, a 50:50 division should be considered. This approach is

consistent with India’s position as stated in UN TP Manual (discussed supra).

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11. Now a word of caution to tax-payers. To be fair to the concerns of developing countries and to

avoid long-drawn litigation, the tax-payers will be well-advised to upfront have a robust analysis of

LS in their TP documentation. This will provide a contemporaneous defense to their position in

the event of claims of TP authorities, usually exaggerated. Indian law in this regard is fairly

certain. Section 92C(3) of Indian Income-tax Act, 1961, read with Central Board of Direct Taxes

Circular No. 12/2001 dated August 23, 2001 and Circular No. 14/ 2001 dated November 9, 2001

categorically state that the TP authorities cannot reject tax-payer’s TP, unless by leading cogent

evidence they demonstrate some sustainable defect in either the TP methodology or in the TP

documentation maintained by the tax-payer.

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