Location Savings - Basic Concepts and Guidance

1. Location Savings – Basic
concepts and Global guidance
August 2014
Presented by:
Rakesh Mishra

2. 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

3. Price Waterhouse & Co. LLP
Concepts and Definitions on location
savings
Slide 3
August 2014Location savings – Basic concepts and Global guidance

4. Price Waterhouse & Co. LLP
Concepts and Definitions on location savings
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
August 2014Location savings – Basic concepts and Global guidance

5. Price Waterhouse & Co. LLP
Concepts and Definitions (Contd…)
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
August 2014Location savings – Basic concepts and Global guidance

6. Price Waterhouse & Co. LLP
Concepts and Definitions (Contd..)
Location rent
• Incremental / super profits (if any) derived from the existence and exploitation of
the 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 available
to the parties given their respective bargaining power
Slide 6
August 2014Location savings – Basic concepts and Global guidance

7. Price Waterhouse & Co. LLP
Global guidance available on location
savings
Slide 7
August 2014Location savings – Basic concepts and Global guidance

8. Price Waterhouse & Co. LLP
Global guidance available on location savings
UN Manual
Para 5.3.2.39 states that “an example of a potential issue relating to geographic locations 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 realises as a result of relocation of
operations from a high cost jurisdiction to a low-cost jurisdiction. Typically, the possibility to
derive location savings may vary from one jurisdiction to another, depending for example on
the 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” on
account of the poor quality and reliability of the power supply, higher costs for
transportation, quality control etc. Accordingly, only the net location savings may give rise to
an extra profit arising to an MNE due to the relocation of its business from a high cost to a low
cost jurisdiction.
Slide 8
August 2014Location savings – Basic concepts and Global guidance

9. Price Waterhouse & Co. LLP
Global guidance (Contd..)
UN Manual
Para 10.3.3.2 states that “Location savings are the net cost savings derived by a
multinational company when it sets up its operations in a low-cost jurisdictions. Net cost
savings 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 for
hiring less skilled labour.”
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 1.63 states that “….it is recognised that a business strategy such as market
penetration may fail, and the failure does not of itself allow the strategy to be ignored for
transfer pricing purposes. However, if such an expected outcome was implausible at the time
of the transaction, or if the business strategy is unsuccessful but nonetheless is continued
beyond what an independent enterprise would accept, the arm’s length nature of the business
strategy may be doubtful..”
Slide 9
August 2014Location savings – Basic concepts and Global guidance

10. Price Waterhouse & Co. LLP
Global guidance (Contd..)
OECD View
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.”
OECD’s Revised discussion draft on intangibles (“RDD”) issued on
July 30, 2013
RDD highlights that where reliable local market comparables are available and
can be used to identify ALP, specific comparability adjustments for location
savings should not be required. However, when not available, allocation of location
savings 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
August 2014Location savings – Basic concepts and Global guidance

11. Price Waterhouse & Co. LLP
Existing Regulations available on
location savings
Slide 11
August 2014Location savings – Basic concepts and Global guidance

12. Price Waterhouse & Co. LLP
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 “location
savings”, “market premium” and more generally Location Specific Advantages (“LSAs”). The
LSAs are advantages for production arising from assets, resource endowments, government
industry policies and incentives, etc. which exists in specific localities. For example, household
electronics manufacturers invest in China to take advantage of a large pool of well educated
low cost labour and a well developed network of suppliers…..; it has been seen that
certain issues such as location savings and market premium arise more
frequently in China and other developing economies rather than in established
and developed economies..”
“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 material, labour, rent, transportation and
infrastruture 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.”
“10.2.3.3. In dealing with Chinese taxpayers, the Chinese tax administration has
adopted a four step approach on the issue of LSAs:
Slide 12
August 2014Location savings – Basic concepts and Global guidance

13. Price Waterhouse & Co. LLP
Chinese Regulation (Contd..)
Four-step approach for determining LSAs:
Slide 13
August 2014Location savings – Basic concepts and Global guidance
• 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

14. Price Waterhouse & Co. LLP
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
August 2014Location savings – Basic concepts and Global guidance

15. Price Waterhouse & Co. LLP
Illustration
Slide 15
August 2014Location savings – Basic concepts and Global guidance

16. Price Waterhouse & Co. LLP
Illustration
Chinese taxpayer’s cost base = 100
Average cost base in developed countries = 150
Median 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
August 2014Location savings – Basic concepts and Global guidance

17. Price Waterhouse & Co. LLP
Case laws
Slide 17
August 2014Location savings – Basic concepts and Global guidance

18. Price Waterhouse & Co. LLP
Case laws – Indian ruling - GAP Ruling
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; 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 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; and
• 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 18
August 2014Location savings – Basic concepts and Global guidance

19. Price Waterhouse & Co. LLP
GAP Ruling (Contd..)
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; and
• No separate/additional allocation is called for location savings
August 2014Location savings – Basic concepts and Global guidance
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)

20. Price Waterhouse & Co. LLP
Case Laws – International Rulings
Slide 20
August 2014
Cases Background Outcome
Eli Lily & Co v.
US (1971-72)
US parent purchased pharmaceuticals from Puerto
Rican subsidiary and resold them in the US.
Combined profits split as follows: returns to routine
functions (production -100% to Puerto Rico- and
selling-100% to US), Location savings (100% to
Puerto Rico) and return on intangibles (55% Puerto
Rico for IP– 45% US for marketing intangibles).
Location savings: 100% to
low cost Manufacturer
Sundstrand
Corp. & Subs v.
Comm.
(1977-78)
Location savings estimated with the costs of setting
up/operating new hypothetical US factory.
Manufacturing licence agreement gave to Singapore
subsidiary a “monopolistic position”: a third party
would have kept all location savings (after paying
appropriate royalty for the technology license).
Location savings: 100% to
low cost Manufacturer
National
Semiconductor
Corp. v. Comm.
(1976-81)
Mutually dependent business relationship:
NSC US needed the labour cost savings provided by
NSC Asia to remain competitive and NSC Asia
needed a high and steady volume of orders to justify
heavy investments in equipment, etc. At arm's
length, NSC Asia could not afford to risk losing NSC
US's business by allowing NSC to suffer heavy
losses.
Mutually dependent
business relationship
implies that location
savings should be
shared between parent and
subsidiary
Location savings – Basic concepts and Global guidance

21. Price Waterhouse & Co. LLP
Case Laws – International Rulings
Slide 21
August 2014
Cases Background Outcome
Bausch & Lomb
v. Comm.
(1980)
Implicitly allocated location savings to
subsidiary by rejecting its characterisation as a
mere subcontractor given that neither volumes
nor prices were guaranteed.
Location savings:
100% to low cost Manufacturer
Compaq
Computer Corp
& Subs v.
Comm.
(1986-92)
Electronic circuits market is global and a world
price should have been produced by competition
within the market; moreover Compaq Asia had
market power resulting from its ability to meet
the product quality and flexibility requirements
of its customer. Thus, relevant market was the
US and Court accepted CUPs paid by Compaq to
unrelated subcontractors (mostly located in the
US).
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 from
income. SCA found that the functions
performed by Estonian subsidiary (Low cost
jurisdiction entity) were not very same as earlier
performed by Finnish Parent. Hence, no actual
transfer of functions.
The claimed location savings
cannot be determined by
comparing the manufacturing
expenses at the parent and
subsidiary company level.
Implicitly making clear that if the
functions are very same then the
claim of location savings stands
good.
Location savings – Basic concepts and Global guidance

22. Price Waterhouse & Co. LLP
Case Study
Slide 22
August 2014Location savings – Basic concepts and Global guidance

23. Price Waterhouse & Co. LLP
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
August 2014Location savings – Basic concepts and Global guidance

24. Price Waterhouse & Co. LLP
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
August 2014Location savings – Basic concepts and Global guidance

25. Price Waterhouse & Co. LLP
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
August 2014Location savings – Basic concepts and Global guidance
X

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Conclusion
Slide 26
August 2014Location savings – Basic concepts and Global guidance

27. Price Waterhouse & Co. LLP
Conclusion
Slide 27
August 2014Location savings – Basic concepts and Global guidance
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…

28. Thank You
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