Location-specific advantages, including location savings are a crucial concept in the field of transfer pricing. They refer to the cost savings and other (beneficial) local market features that multinational enterprises (MNEs) can achieve by relocating their operations to another jurisdiction.
What are location-specific advantages?
Location savings are the net cost savings MNEs gain by moving their operations to locations where the costs of production or service provision are lower than in their original location. These savings can for example include reduced labor costs, lower raw material costs, subsidies, tax incentives and lower rental costs.
The concept of location savings is essential in transfer pricing as it impacts how profits are allocated among different entities within an MNE group. The term location-specific advantages is broader than merely the location savings, and also takes into account advantages arising from assets, government industry policies and workforce-in-place.
OECD guidelines on location-specific advantages
The OECD guidelines provide a framework for understanding and applying location savings in transfer pricing. The guidelines emphasize that:
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Location savings should be identified, quantified, and allocated based on the functions, assets, and risks of each party involved.
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The OECD guidelines also highlight the importance of considering both the benefits and costs associated with local market features, ensuring that only net savings are relevant for transfer pricing analyses.
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The guidelines state that the allocation of net location savings should correspond to the relative bargaining power of the entities, indicating that the entity with more bargaining power and contribution to the savings should receive a larger portion of the savings.
According to the OECD guidelines, local market features are not considered an intangible asset for transfer pricing purposes as they cannot be owned or controlled (merely used). Where comparable transactions in the local market van be identified, specific adjustments for local market features should not be performed.
UN Model on Location Savings
The UN model, representing the perspective of developing countries, emphasizes the need to consider local economic factors in determining transfer pricing methods and comparability when selecting comparable companies. It also highlights the importance of quantifying and measuring the additional profits arising from location-specific advantages and determining the appropriate transfer pricing method to allocate these profits.
The chapters on India and China in the UN Transfer Pricing Manual shed light on how these two major economies approach the concept of location-specific advantages. For example, China outlines a structured approach to assess and allocate extra profits from local advantages, mainly in manufacturing and sourcing.
Key Differences Between OECD Guidelines and UN Model
While both the OECD guidelines and the UN model recognize the importance of location savings, there are some key differences in their approaches:
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Definition and Scope: The OECD guidelines focus on cost savings due to lower operational expenses, while the UN model includes a broader range, such as government policies and incentives.
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Allocation of Savings: The OECD guidelines emphasize the allocation of location savings based on functions, assets, and risks, and recognize bargaining power as an important factor in determining how such savings are shared. In contrast, the UN model gives more weight to local economic factors rather than the bargaining power.
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Comparability Adjustments: The OECD guidelines recommend suitable comparability adjustments to account for location-specific advantages, while the UN model highlights the need to consider local market features and their impact on transfer pricing.
Notable Cases Involving Location Savings
Several court cases have addressed the issue of location savings, providing valuable insights into how these savings are recognized and allocated in the jurisdictions involved.
A Oyj vs. Finnish Tax Authorities
In this case, A Oyj, a Finnish MNE, transferred its manufacturing activities to a subsidiary in Estonia. The Finnish Supreme Administrative Court ruled that location savings could not be recognized due to significant differences in the manufacturing processes between Finland and Estonia. The court emphasized the importance of comparability and the need to consider the bargaining power of the entities involved. Hence, it should be thoroughly analyzed if a decrease in costs is caused by a relocation of operations or by a development in manufacturing resources.
Watson Pharma Pvt. Ltd.
In this landmark ruling by the Mumbai Income Tax Appellate Tribunal, the court held that no separate compensation for location savings is required if there are local comparables. The court emphasized that the operating margin earned by the taxpayer should be based on local market comparables operating in similar economic circumstances.
The GAP case
The GAP International Sourcing ruling is pivotal in understanding location savings. GAP India facilitated apparel sourcing for the GAP group, initially remunerated on a cost-plus fifteen percent basis. The administration argued for a commission adjustment to five percent, citing the Arm’s Length Principle.
The tax authorities contended that GAP India created procurement intangibles and should benefit from location savings due to low-cost services in India. Under the FAR analysis, the claim that GAP India provided a low-risk procurement service was rejected. It was retained that GAP India should be the enterprise entitled to location savings, as it realized a super profit for the benefit of GAP US. The Indian Tribunal ruled these savings relevant to the entire industry, emphasizing fair apportionment and competitive sales strategy advantages passed to end-customers.
Conclusion
Location savings play a significant role in transfer pricing, impacting how profits are allocated among different entities within an MNE group. Both the OECD guidelines and the UN model provide important frameworks for identifying, quantifying, and allocating these savings, although their approaches differ in scope and emphasis. Understanding these nuances, and applying them correctly in practice, is critical to achieving compliance and managing transfer pricing risks.
If you need support with analyzing location savings or any other transfer pricing matters, feel free to contact us. Our team of experts is ready to help you navigate the complexities of transfer pricing and ensure your strategies are aligned with the latest international guidelines and local practices.
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