Transfer Pricing - Location savings - basic concepts and global guidance

Location Savings – Basic concepts and Global guidance

August 2014

Presented by:

Rakesh Mishra

Price Waterhouse & Co. LLP

Contents

August 2014Location savings – Basic concepts and Global guidance

Slide 2

Concepts and Definitions on location savings

Global guidance available on location savings

Existing Regulations on location savings

Illustration

Case laws

Case studies



Slide 3




Location savings• “Net cost savings” realized by a MNE usually as a result of relocating some of its

operations from a “high cost” to a “low cost” location in order to obtain competitive advantage, because of price differences in the factors of production.

• Factors to be considered to derive net location savings:

- Sources of cost savings: labour (wages, training, conditions, availability); material (cost, access, reliability); capital (cheaper/ subsidised); technology; infrastructure, logistics and business environment (government subsidies; tax incentives; reduced environmental costs etc.); and

- Sources of dis-savings to be accounted for (to achieve net savings), such as transportation cost; quality control cost; warranty costs and capital costs

Cost Savings

Cost dis-savings

Net cost savings

Slide 4



Concepts and Definitions (Contd…)

Location Specific Advantages (LSAs)

• Location specific advantageous access to factors of production and distributionthat can be exploited to produce a particular product or service cheaper, better or with less risk, or to increase the ability of a company to sell more product or achieve a larger market share

• Examples: Access and proximity to the growing local / regional market, large customer base with increased spending capacity, advanced infrastructure etc.

Net cost savings

Location specific benefits

Location specific

advantages (LSAs)

Slide 5



Concepts and Definitions (Contd..)

Location rent

• Incremental / super profits (if any) derived from the existence and exploitation ofthe LSAs

Location rent exists if the following two conditions apply:

• There is a quantifiable net location specific advantage; and

• Certain location specific conditions or market characteristics prevent the advantages /savings from being passed on to ultimate customers or claimed by unrelated suppliers

Points to be noted:

• LSAs dissipate over time due to competitive pressures; and

• Arm’s length attribution of location rent depends upon realistic alternatives availableto the parties given their respective bargaining power

Slide 6




Slide 7




UN Manual

Para 5.3.2.39 states that “an example of a potential issue relating to geographic locations isthat of location savings, which may come into play during a transfer pricing analysis.Location savings are the net cost savings that an MNE realises as a result of relocation ofoperations from a high cost jurisdiction to a low-cost jurisdiction. Typically, the possibility toderive location savings may vary from one jurisdiction to another, depending for example onthe following:

Labour costs; Raw material costs; Transportation costs; Rent; Training costs; Subsidies; Incentives including tax exemptions; and Infrastructure Costs”It is quite possible that a part of the cost savings may be offset at times by “dis-savings” onaccount of the poor quality and reliability of the power supply, higher costs fortransportation, quality control etc. Accordingly, only the net location savings may give rise toan extra profit arising to an MNE due to the relocation of its business from a high cost to a lowcost jurisdiction.

Slide 8



Global guidance (Contd..)

UN Manual

Para 10.3.3.2 states that “Location savings are the net cost savings derived by amultinational company when it sets up its operations in a low-cost jurisdictions. Net costsavings are commonly realised through lower expenditure on items such as raw material,labour, rent, transportation and infrastructure even though additional expenses (so called dis-savings) may be incurred due to the relocation, such as increased training costs in return forhiring less skilled labour.”

OECD View

Para 9.148 states that “Location savings can be derived by an MNE group that relocatessome of its activities to a place where costs… are lower than in the location where theactivities were initially performed, account being taken of the possible costs involved in therelocation….. Where a business strategy aimed at deriving location savings is put forwardas a business reason for restructuring, the discussion at paragraphs 1.59-1.63 is relevant.”

Para 1.63 states that “….it is recognised that a business strategy such as marketpenetration may fail, and the failure does not of itself allow the strategy to be ignored fortransfer pricing purposes. However, if such an expected outcome was implausible at the timeof the transaction, or if the business strategy is unsuccessful but nonetheless is continuedbeyond what an independent enterprise would accept, the arm’s length nature of the businessstrategy may be doubtful..”

Slide 9



Global guidance (Contd..)

OECD View

Para 9.149 states that “Where significant location savings are derived further to abusiness restructuring, the question arises of whether and if so how the locationsavings should be shared among the parties. The response should obviously depend onwhat independent parties would have agreed in similar circumstances. The conditionsthat would be agreed between independent parties would normally depend on thefunctions, assets and risks of each party and on their respective bargainingpowers.”

OECD’s Revised discussion draft on intangibles (“RDD”) issued onJuly 30, 2013

RDD highlights that where reliable local market comparables are available andcan be used to identify ALP, specific comparability adjustments for locationsavings should not be required. However, when not available, allocation of locationsavings among AEs and any comparability adjustments to consider location savings,should be based on an analysis of all of the relevant facts and circumstances.

Slide 10



Existing Regulations available on location savings

Slide 11



Chinese Regulation on location savings

China State Administration of Taxation (“SAT”)

“10.2.3.1. The globalisation of trade and economies has given rise to concepts such as “locationsavings”, “market premium” and more generally Location Specific Advantages (“LSAs”). TheLSAs are advantages for production arising from assets, resource endowments, governmentindustry policies and incentives, etc. which exists in specific localities. For example, householdelectronics manufacturers invest in China to take advantage of a large pool of well educatedlow cost labour and a well developed network of suppliers…..; it has been seen thatcertain issues such as location savings and market premium arise morefrequently in China and other developing economies rather than in establishedand developed economies..”

“10.2.3.2. Location savings are the net cost savings derived by a multinational company whenit sets up its operations in a low cost jurisdiction. Net cost savings are commonly realisedthrough lower expenditure on items such as raw material, labour, rent, transportation andinfrastruture even though additional expenses (“dis-savings”) may be incurred due to therelocation, such as increased training costs in return for hiring less skilled labour.”

“10.2.3.3. In dealing with Chinese taxpayers, the Chinese tax administration hasadopted a four step approach on the issue of LSAs:

Slide 12



Chinese Regulation (Contd..)

Four-step approach for determining LSAs:

Slide 13


• Identifying whether the LSAs existsStep 1

• Determining whether the LSAs generate super profits (i.e. LSAs translate into location rent)

Step 2

• Quantifying and measuring the additional profits arising from the LSAs

Step 3

• Determining the transfer pricing method to allocate the profits arising from the LSAs

Step 4


US Regulation on location savings

Section 1.482-1(d)(4)(ii)(C) of Treas. Reg. states that:

“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 cost of operating in [an] other market, ordinarily justifies higher profits to the manufacturer only if the cost difference would increase the profits of comparable uncontrolled manufacturer’s operating at arm’s length, given the competitive position of buyers and sellers in that market.”

Slide 14



Illustration

Slide 15



Illustration

Chinese taxpayer’s cost base = 100Average cost base in developed countries = 150Median of the Comparables in the developed Market = 8%

Sl.No. Steps Calculations

1 Calculate the arm’s length range based on foreign comparables in developed countries

8%

2 Calculate the difference between the cost base of China (100) and developed countries (150)

150-100=50

3 Multiply the arm’s length median (8%) with the difference in the cost base (50)

0.08*50=4

4 Hence, the resultant profit is the additional profit attributable to China for location savings

4

5 Determine the arm’s length profit for the Chinese taxpayer

4+0.08*100=12

6 Determine the adjusted arm’s length mark up for the Chinese taxpayer

12/100=12%

Slide 16



Case laws

Slide 17



Case laws – Indian ruling - GAP RulingBackground

• GAP India is engaged in facilitating the sourcing of apparel from India to its group companies.;

• Main functions are - assistance in identification of vendors, assistance to vendors in procurement ofapparel, inspection and quality control, and ensure timely delivery;

• All technical and intellectual input provided by overseas entity; and

• Characterised as a limited risk provider earning a cost plus 15% mark up

Revenue’s contentions

• The TPO rejected the FAR analysis and characterised GAP as high risk service provider;

• TPO ascertained that GAP ought to have earned a commission of 5%; and

• Revenue contended that location savings should be attributable to GAP India since GAP US savedhuge costs by procuring such services from a low cost economy like India

Tax Payer’s contentions

• Tax payer was not involved in end customer pricing; and

• The intent of GAP US to source from a low cost economy like India was to pass on the benefit ofsaved costs to the ultimate customer

Slide 18



GAP Ruling (Contd..)

Tribunal Ruling

• Generally, the advantage of location savings is passed on to the end customer via acompetitive sales strategy;

• The arm’s length principle requires benchmarking to be done with comparables in thejurisdiction of the tested party and the location savings, if any would be reflected in theprofitability earned by comparables; and

• No separate/additional allocation is called for location savings


Slide 19

The Tribunal does not echo the views of the Indian administration in the Emerging Transfer Pricing Challenges in India – UN’s draft

Practical Manual (Chapter 10)


Case Laws – International Rulings

Slide 20

August 2014

Cases Background Outcome

Eli Lily & Co v.US (1971-72)

US parent purchased pharmaceuticals from PuertoRican subsidiary and resold them in the US.Combined profits split as follows: returns to routinefunctions (production -100% to Puerto Rico- andselling-100% to US), Location savings (100% toPuerto Rico) and return on intangibles (55% PuertoRico for IP– 45% US for marketing intangibles).

Location savings: 100% tolow cost Manufacturer

SundstrandCorp. & Subs v. Comm. (1977-78)

Location savings estimated with the costs of settingup/operating new hypothetical US factory.Manufacturing licence agreement gave to Singaporesubsidiary a “monopolistic position”: a third partywould have kept all location savings (after payingappropriate royalty for the technology license).

Location savings: 100% tolow cost Manufacturer

NationalSemiconductorCorp. v. Comm.(1976-81)

Mutually dependent business relationship:NSC US needed the labour cost savings provided byNSC Asia to remain competitive and NSC Asianeeded a high and steady volume of orders to justifyheavy investments in equipment, etc. At arm'slength, NSC Asia could not afford to risk losing NSCUS's business by allowing NSC to suffer heavylosses.

Mutually dependentbusiness relationshipimplies that locationsavings should beshared between parent andsubsidiary

Location savings – Basic concepts and Global guidance


Case Laws – International Rulings

Slide 21

August 2014

Cases Background Outcome

Bausch & Lombv. Comm. (1980)

Implicitly allocated location savings tosubsidiary by rejecting its characterisation as amere subcontractor given that neither volumesnor prices were guaranteed.

Location savings:100% to low cost Manufacturer

CompaqComputer Corp& Subs v. Comm. (1986-92)

Electronic circuits market is global and a worldprice should have been produced by competitionwithin the market; moreover Compaq Asia hadmarket power resulting from its ability to meetthe product quality and flexibility requirementsof its customer. Thus, relevant market was theUS and Court accepted CUPs paid by Compaq tounrelated subcontractors (mostly located in theUS).

Location savings:100% to low cost Manufacturer

Finnish Supreme Administrative Court (SCA) Landmark decision (March 4, 2013)

Finnish parent claimed location savings @ 7.5%of purchase cost as additional deduction fromincome. SCA found that the functionsperformed by Estonian subsidiary (Low costjurisdiction entity) were not very same as earlierperformed by Finnish Parent. Hence, no actualtransfer of functions.

The claimed location savingscannot be determined bycomparing the manufacturingexpenses at the parent andsubsidiary company level.Implicitly making clear that if thefunctions are very same then theclaim of location savings standsgood.

Location savings – Basic concepts and Global guidance


Case Study

Slide 22



Case Study I

US Inc – Parent

(“Lotus” Brand)

India Ltd. – Sub.

(Contract manufacturer)

US Inc.:

• Lotus is a leading apparel brand in US; and

• Manufacturing and sale of apparels at a premium price

India Ltd.:

• US Inc sets up a subsidiary in India;

• Manufacture clothes under the “Lotus” label and sell to US Inc.;

• Remunerated on cost plus basis; and

• Don’t require any unique expertise

Facts of the case:

Due to the presence of competitors, India Ltd may not be in a bargaining position to justify the allocation of ‘location savings’ to it

Slide 23



Case Study II

AB US:

• Engaged in manufacturing and sale of

power transmission, spare parts, etc; and

• Owns advanced manufacturing technology

AB US – Parent

(Engineering co.)

AB Singapore – Sub.

(Full fledged manufacturer)

Facts of the case:

AB Singapore:

• Sets up a subsidiary of AB US;

• Manufacturing of power transmission, spare parts and sell to US Inc.; and

• AB US licenses requisite manufacturing technology

In the presence of monopolistic situation, AB Singapore may be in a bargaining position to justify the allocation of ‘location savings’ post

providing arm’s length royalty to AB US

Slide 24



Existence of location saving?

Industries/ Business models Existence

1. Manufacturing

a) For Export sale √

a) For Domestic sale

2. Distribution ?

3. Contract R&D √

4. IT and ITES √

5. Sourcing services √

6. KPO and LPO √

Slide 25


X


Conclusion

Slide 26



Conclusion

Slide 27


Location savings

and LSAs

Allocation of location

rent

Location rent

FAR analysis

Bargaining power

Perfect competition/ monopolistic advantage..

Unique Intangibles…

Benefit passed on to the

customers…

Thank You

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Transfer Pricing - Location savings - basic concepts and global guidance