location savings - basic concepts and guidance · · 2017-09-08location savings – basic...

Location Savings - Basic concepts and guidance

February 2016

Presented by:

Arun Saripalli

Gaurav Haldia

Contents

Location savings – Basic concepts and guidance

Slide 2

Concept

Identification of LSAs and allocation of location rent

Global guidance

Base Erosion and Profit Sharing

Indian Judicial Ruling on Location Savings

Key takeaways

Concept


Concept…

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

• 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 and logistics and business environment (government subsidies; tax incentives; reduced environmental costs)

- 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


Concept…

Location Specific Advantages (LSAs)

• Location specific advantageous access to factors of production and distribution that 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


Concept…

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 e.g. competitive market where competitors have access to the LSAs and the benefits are passed on to customers through lower prices

● LSAs dissolve 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

Identification of LSAs and allocation of location rent


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What forms part of location savings?

Particulars Remark

Cost of material

Cost of labor

Favorable business environment tax incentives, entry barriers, access to market

Transportation cost

Quality control cost

Environment compliance cost

Slide 8


Existence of location rent

Slide 9


COGS

Overheads

Other Costs

Actual Local Costs

Operating Profit

COGS

Overheads

Other Costs

Actual Local Costs

Operating Profit

Super Profits (A)

COGS

Overheads

Other Costs

Actual Local Costs

Operating Profit

Subsidiary Company

Price level

Parent Company Subsidiary Company

Location Savings

Scenario: 2 Scenario: 1

Benefit pass on to customer.

• Allocation of location rent depends upon the “bargaining power” of the related parties

• Factors to be considered for bargaining power:

Allocation of location rent…

Market competition

Access to LSAs

Intellectual property – ownership, exclusivity

Realistically alternative available

Switching cost

• Should location rent be attributed to associated enterprise (‘AE’) located in low cost location, while determining the ALP?

Slide 10


Allocation of location rent

Case I Super Profit > 0

Rents accrue to the party that

secures protection from competition in final markets

(usually the parent)

Case IV Super Profit = 0

No rents – competition forces prices down, benefits accrue to

customers

Case II Super Profit > 0

Rents allocation depends on

reasons for restricted competition & access to advantages

(shared local company /

parent)

Case III Super Profit > 0

Rents accrue to party that secures

access to location advantages

(local company)

Generally Available

Availability of LSAs

Exclusive Access

Protection from Competition

Degree of Competition in Product Market

Competition

Slide 11


Case Study

US Inc - Parent

(“Lotus” Brand)

India Ltd. - Sub.

(Contract manufacturer)

US inc.:

• Lotus is a leading apparel brand in US

• 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

• 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 12 Location savings – Basic concepts and guidance

Case Study

AB US:

• Engaged in manufacturing and sale of

power transmission, spare parts, etc;

• 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.

• 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 13


Summarise

Four-step approach for determining LSAs:

Slide 14


• Identifying whether the LSAs exists Step 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

Global guidance


Global Guidance

Pratices Location savings LSAs

OECD Guidelines √

UN TP Guidelines

US Practices √ √

India View in UN TP Guidelines

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Slide 16


Base Erosion and Profit Sharing – Action Plan 8


Base Erosion and Profit Shifting (‘BEPS’) Location Savings

● The BEPS relies on Location Savings guidance provided in OECD guidelines – Ch. IX

● Action plan 8 on ‘Transfer Pricing Aspects of Intangibles’ discusses in determination of location savings that are to be shared between two or more AEs.

● Where reliable local market comparables are available which can be used to identify allocation of location savings among AEs, specific comparability adjustment for location savings should not require.

● When reliable local markets comparables are not available, determination of existence and allocation of location savings among members of MNE group shall be based on the functions performed, risks assumed and assets used as well as other relevant facts of the relevant associated enterprises in the manner prescribed in OECD guidelines.


Slide 18

Location Savings

Existence Amount Retained/ passed on

Manner of allocation

Base Erosion and Profit Shifting (‘BEPS’)

Local market features

● The access to location specific market features may / may not lead to LSA which enables an MNE group to increase financial outcomes. The BEPS throws light on the local market features that affect comparability

● Such factors may include availability of skilled manpower, proximity to profitable market, etc. These factors may be advantageous or disadvantageous

● In assessing whether comparability adjustment for such factors are required, the most appropriate / reliable approach is to find local comparable data.

● In case the local comparable data is not available, appropriate comparability adjustment needs to be considered. In this regard, it is necessary to consider: (a) whether market is advantageous or disadvantageous; (b) Quantification of increase or decrease; (c) degree of benefit / burden passed on to customer; and (d) in case not passed, the manner in which independent parties would have allocated such burden / benefit


Slide 19

Case Study

Group HQ

9 subsidiaries (without any significant cost advantage)

1 regional subsidiary

(significant cost advantage)

• Global operations worldwide and highly centralsed business model and IP

• Full-fledged operations (manufacturing and distribution) in 10 countries

• 1 out of 10 subsidiaries (say in India) enjoys lower labour costs

Facts of the case:

1. Whether India should benefit from the cost advantage? 2. Where the demand is booming, can it be argued that India should benefit

from or secure a market premium?

Slide 20

Indian Tribunal Rulings on Location Savings


GAP Ruling – Indian tribunal Background

• 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 of apparel, inspection and quality control, and ensure timely delivery

• All technical and intellectual input provided by overseas entity

• 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% on sales

• Revenue contended that location savings should be attributable to GAP India since GAP US saved huge 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

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

Slide 22


GAP Ruling

Tribunal Ruling

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

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

• No separate/additional allocation is called for location savings


Slide 23

Watson Pharma Ruling – Indian tribunal Background

• Watson Pharma Private Limited was engaged in contract manufacturing for its associated enterprises and provided contract research and development services to its AEs.

• For these transactions, the taxpayer was compensated by its AEs on a total operating cost plus arms length mark-up basis.

Revenue’s contentions

• The TPO made an adjustment on account of locations savings owing to the transfer of activities from USA to India

• The TPO computed location savings based on the articles available in public domain.

• In doing so, the TPO relied on certain international judicial precedents, and on the Indian tax administration’s position articulated in the UN TP Manual

• The revenue authorities asked for certain information from the Assessee relating to AE which the taxpayer partly submitted. Revenue authorities alleged lack of details submitted by taxpayer, and assumed that the impact of savings was not passed on to the ultimate consumers/ distributors.

Tax Payer’s contentions

• There was no super-profit which arouse in the entire supply chain as the tax payer does not have exclusive access to the factors resulting in location specific advantages.

Slide 24


Watson Pharma Ruling – Indian tribunal Tax Payer’s contentions

• The comparables selected by the Tax payer are local Indian comparables, operating in similar economic circumstances. Thus, if any benefit arises due to location savings is embedded in operating margins of comparables.

• The Tax payer operated in perfectly competitive market and does not have monopoly in the market thus, if location saving exists it would have been passed to final customer.

• The AE has operations across the world and can procure finished goods/services from the Tax payer or any other group member or third party. Various alternatives are available to AE which could provide higher bargaining power.

Tribunal Ruling

• The taxpayer as well as AEs operated in a perfectly competitive market, and the taxpayer did not have exclusive access to factors leading to location-specific advantages. Therefore, the taxpayer did not have any unique advantage, and there was no super profit arising in the entire supply chain.

• Where local market comparables were available and used, specific adjustment for location savings was not required. Any benefit/ advantage to the AE was irrelevant if the profit level indicator (PLI) of the taxpayer was within the range of comparables.

• Indian chapter of the United Nations Transfer Pricing (UN TP) manual (which amongst other issues also discusses location savings) represents a view of Indian tax administration and is not binding on Appellate authorities.


Slide 25

Key takeaways


Key takeaways

● Robust documentation in case of outsourcing of operations. This would include:

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

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

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

o AE had the product and process intangibles

o Relative bargaining powers of the two entities

o Whether benefit was passed to the end customer, etc.

● Commercial rationale of outsourcing operations

● Analyse whether there arise any incremental profits in the system

● In case location rent arises, undertake appropriate allocation of the same

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

Thank You

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….. Where a business strategy aimed at deriving location savings is put forward as a business reason for restructuring, the discussion at paragraphs 1.59-1.63 is relevant.”

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.”

Slide 29


Back

Global guidance…

OECD – Intangibles discussion draft

24. Specific characteristics of a given market may affect the arm’s length conditions of transactions in that market. For example, the high purchasing power of households in a particular market may affect the prices paid for certain luxury consumer goods. Similarly, low prevailing labor costs, proximity to markets, favourable weather conditions and the like may affect the prices paid for specific goods and services in a particular market. Such market specific characteristics may not, however, be owned, controlled and transferred by an individual enterprise. Such items are not intangibles within the meaning of section A.1., and should be taken into account in a transfer pricing analysis through the required comparability analysis.

Slide 30


Back

…Global guidance…

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 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.”

“…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.”

Back

An example of a potential issue relating to geographic location is that of “location savings”, which may come into play during a transfer pricing analysis. Location savings are the net cost savings that an MNE realizes as a result of relocation of operations from a high-cost jurisdiction to a low-cost jurisdiction.

The relocation of a business may also (in addition to location savings) or alternatively give some other location‐specific advantages (in short LSAs). Location savings and location specific advantages are one type of benefit related to geographical location. These LSAs could be, depending on the circumstances of the case:

• highly specialized skilled manpower and knowledge;

• proximity to growing local/regional market;

• large customer base with increased spending capacity;

• advanced infrastructure (e.g. information/ communication networks, distribution system); or

• market premium.

UN TP manual

Slide 32

Back

Indian TP regulations (The Income-tax Act, 1961) • The concept of location savings is not directly explained in the Indian TP regulations UN TP Manual • The India Chapter in the UN TP Guidelines represents the views of the Indian tax administration

• It states that 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. Further, it also talks about LSAs in addition to location savings.

UN TP Manual – India Chapter • It recognizes that the allocation of location savings and location rent should be made by reference

to what independent parties would have agreed in comparable circumstances - Tax administration believes it is possible to use the profit split method to determine arm’s length allocation of location savings in cases where CUPs are not available

• Local comparables will determine the price of a transaction with a related party in a low-cost jurisdiction, however, it will not take into account the benefit of location savings

View of Indian tax authorities

Slide 33

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location savings - basic concepts and guidance · · 2017-09-08location savings – basic...

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