5th Intensive Study Course on Transfer Pricing

Strictly Private and Confidential

4 April, 2015

5th Intensive Study Course on Transfer Pricing

Location Savings & Transfer Pricing

Presented by:

Mr. Darpan Mehta

April 2015Location Savings and Transfer Pricing

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Agenda

● Concept

● Global guidance

● India‟s position on Location Savings

● Case Studies

● Summary


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Section 1

Concept


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Concepts…

Location savings and Location Specific Advantages (LSAs)

• “Net cost savings” realized by a MNE as a result of relocating some of its operations from a “high cost” to a “low cost” location in order to obtain competitive advantage.

Location specific

advantages (LSAs)

Location specific benefits

Cost Savings

(Labour, material, business

environment, etc)

Cost dis-savings

(Transport, quality ,

capital, etc)

Net cost savings

Examples: 1) Access to factors of production to produce a product cheaper, better or with less risk.

Examples: 2) Proximity to local market and regulations, large customer base etc.


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…Concepts

Location rent

● Incremental / super profits (if any) derived from the existence and exploitation of the LSAs

● All LSAs do not lead to Location rent – for eg competitive market where competitors have access to the LSAs and the benefits are passed on to customers through lower prices

● LSAs dissipate over time due to competitive pressures

● Arm‟s length attribution of location rent depends upon realistic alternatives available to the parties given their respective bargaining power

Section 2

Global guidance


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Global guidance…

OECD View

Para 9.148 states that “Location savings can be derived by an MNE group that relocates some of its activities to a place where costs… are lower than in the location where the activities were initially performed, account being taken of the possible costs involved in the relocation …..”

Para 9.149 states that “Where significant location savings are derived further to a business restructuring, the question arises of whether and if so how the location savings should be shared among the parties. The response should obviously depend on what independent parties would have agreed in similar circumstances. The conditions that would be agreed between independent parties would normally depend on the functions, assets and risks of each party and on their respective bargaining powers.”


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Global guidance…

OECD Discussion Draft on TP aspect of Intangibles – Location savings

● In determining location savings to be shared between two or more AEs, consider:

(i) whether location savings exist;

(ii) the amount of any location savings;

(iii) the extent to which location savings are either retained by a member or members of the MNE group or are passed on to independent customers or suppliers; and

(iv) where location savings are not fully passed on to independent customers or suppliers, the manner in which independent enterprises operating under similar circumstances would allocate any retained net location savings

● OECD Recommendations and positions on BEPS & associated documentation to be aligned with the above positions


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…Global guidance…

OECD Discussion Draft on TP aspect of Intangibles – Location savings

● Where comparable entities and transactions in the local market can be identified, those local market comparables will provide the most reliable indication regarding how location savings not passed on to customers or suppliers should be allocated amongst two or more AEs

● Where reliable local market comparables are available and can be used to identify arm‟s length prices, specific comparability adjustments for location savings should not be required

● When reliable local market comparables are not present, determinations regarding the existence and allocation of location savings among members of an MNE group, and any comparability adjustments required to take into account location savings, should be based on an analysis of all of the relevant facts and circumstances, including the functions performed, risks assumed and assets used of the relevant associated enterprises, in the manner described in paragraphs 9.148 through 9.153


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US-IRS View

Treas. Reg. §1.482 -1(d)(4)(ii)(C ) “If an uncontrolled taxpayer operates in a different geographic market than the controlled taxpayer, adjustments may be necessaryto 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.”

“…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 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.”


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China SAT View

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

The chapter provides a detailed illustration to calculate location savings attributable to China in a contract R&D situation

* China Country Practices– UN‟s Manual (Chapter 10)


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Landmark International Rulings

● Compaq – US implicitly attributed the location savings to a low cost jurisdiction (Singapore) by applying the CUP method;

● Similar approach in Bausch & Lomb, Inc – US where low cost savings were attributed to Ireland

● Sundstrand – US where location savings were attributed to Singapore on the basis that subsidiary has a monopolistic power in the local market

● Eli Lilly – US where the location savings attributable to labor costs and tax saving were entirely attributable to local manufacturing subsidiary, with the remaining aggregated profit pro-rated with reference to respective intangible assets

Section 3

India’s position on Location Savings


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India Chapter in the UN TP Manual…

● Location savings – major aspect in comparability analysis

● Location savings - goes beyond the issue of relocating a business from „high to low cost‟ location and relates to any cost advantage

● Location Rent - Location Specific Advantages (LSAs) in addition to location savings, the incremental profit

● Following LSAs to Multinational Enterprises (MNE) in addition to location savings

● highly specialized skilled manpower and knowledge;

● access and proximity to growing local/regional market;

● large customer base with increased spending capacity;

● superior information network;

● superior distribution network;

● Incentives; and

● market premium.


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…India Chapter in the UN TP Manual

● Comparability analysis determines the price of a transaction - it does not take into account the benefit of location savings.

● It is possible to use the Profit Split Method („PSM‟) to determine arm‟s length allocation of location savings and rents in cases where comparable uncontrolled transactions are not available.

● Arm‟s length compensation for cost savings and location rents should be such that both parties would benefit from participating in the transaction.

It will be intriguing to see how the Indian Government aligns taxing increased savings on relocating to India with the “Make in India” campaign as they both clearly cannot coexist


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Definition – International transaction – Indian Income-tax Act, 1961

● Explanation to Section 92B of the Act states that the expression "intangible property" shall include location related intangible assets, such as, leasehold interest, mineral exploitation rights, easements, air rights, water rights

● Does the above definition indirectly tend to cover location related specific advantages as advocated by India Chapter in the UN Transfer Pricing Manual?

● No guidelines provided by the Guidance Note on Transfer Pricing issued by the ICAI

● View in the OECD Discussion Draft on Intangibles - corporate synergies and market specific characteristics are not intangibles per se and should be taken into account in a transfer pricing analysis


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Indian Tribunal Rulings on Location Savings

Principles emanating from GAP India and Watson Pharma Tribunal Rulings

● The advantage of location savings is passed on to the end customer due to competition – GAP

● Taxpayer and its AEs operate in a perfectly competitive market and as a result there is no unique advantage to the taxpayer over competitors – Watson Pharma

● The taxpayer had benchmarked the transaction using local Indian comparables, hence location savings, if any would be reflected in the profitability earned by comparables.

● The Tribunal relied on Action 8 of the BEPS Project which provides that where local market comparables are available, specific adjustment for location savings is not required.

● The Tribunal also noted that it is not bound by the views presented in the Indian chapter of the UNTP manual by the Indian tax administrators.


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Discussion points / Documents to be maintained where local market comparables are not available

● Whether any significant functions performed by the tax payer

● Whether the AE had an option to appoint another company in India

● Product and process know-how were transferred to the tax payer

● Document the functions performed and risks assumed (routine and non-routine) by the tax payer and its AE

● AE had the product and process intangibles

● To demonstrate that AE had the relative bargaining power

● AE to demonstrate that the benefit was passed on to the end customer by way of lower prices


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Summary

● Target of tax scrutiny by foreign jurisdictions

● Allocation of saving is driven by facts and circumstances

● Requires periodic review, because those savings may not be sustainable

● In arm‟s length situations, the allocation of location savings depends on their bargaining positions, which is determined by:

● Economic ownership of intangible property

● Bargaining power


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Thank you

Darpan Mehta

+91 (22) 6689 1344

5th Intensive Study Course on Transfer Pricing

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