The objective of any corporate enterprise is to maximise profits. The options available are to either reduce costs or to generate additional revenue by capturing a higher market share. Aided by today’s globalized economic atmosphere, advances in telecommunications and science, at times Multi National Enterprises (“MNE”) pursue the route of cost reduction, as it results in higher profits despite a stagnant market share.
Many MNEs have set up their operations in low cost jurisdiction to reap the inherent benefits of acquiring the talent at lower costs. India and China are two of the economies well known for providing low cost benefits, as evident from their presence in the list of top outsourcing destinations in the world. It is no surprise that the tax authorities in such countries demonstrate a very aggressive and rigid approach towards the issue of location savings and have expressed an intention of bringing back the maximum of the benefits of location savings accruing from operating in these geographies to their respective economies.
In common parlance, location savings can be understood as savings in cost that accrue to an organisation on account of operating in a low-cost jurisdiction vis-a-vis a high cost jurisdiction. According to OECD guidelines, location savings are the net savings that accrue to the MNE on account of relocation of its business to a location where the costs are lower than what would have been incurred in the former jurisdiction.
The United Nations (UN) manual defines location savings as “the cost savings or benefits such as cheaper production or service costs resulting from locating a manufacturing or other operation in a low cost jurisdiction”. The UN guidelines also state that there may be certain location specific handicaps, which could lead to an increase in certain cost items for the MNE. If the operations are relocated to a low cost jurisdiction, such incremental costs have been termed as ‘dis-savings’. Examples of such dis-savings are – irregularity of power supply, poor quality of raw materials, training cost of labour etc. Hence in order to determine the “net” locations savings (in terms of reduced costs) which has accrued to the MNE, it is important to consider the location specific dis-savings as well.
Location Savings and Transfer Pricing
The interconnection between location savings and attraction of transfer pricing laws on it is the crux here. The transfer pricing issue around location savings is that whether a portion of benefit derived by an MNE on account of operating in a low cost jurisdiction vis-a-vis in another high cost jurisdiction, should be allocated to and consequently taxed in low cost jurisdiction. Indian Transfer Pricing authorities are of the opinion that MNEs continuously search for alternatives to lower their costs in order to increase their profits and India provides operational advantages to the MNEs such as reduced labour costs, raw material costs, infrastructure costs, tax incentives etc. Thus India should also get a share in such profits.
Location Specific Advantages and Location Rent
The concept of Location Savings cannot be analysed on a standalone basis. There is a need to consider Location Specific Advantages (‘LSA’) and Location Rent. To identify benefits of operating in one jurisdiction vis-a-vis another, Location Savings, Location Specific Advantages and Location Rent needs to be considered. These three concepts are interlinked and have a direct bearing on each other.
LSAs are specific characteristics of a particular location that make it possible for companies operating there to take advantages of those specific characteristics to earn higher profits. It may not necessarily lead to a reduction in cost, but still be advantageous to the operations of MNE. Examples of LSAs are specialized and skilled manpower, large customer base, proximity to growing markets, distribution channels etc.
It is not necessary that entire location savings get reflected in terms of incremental profits. In these competitive times, it is quite possible that a portion of the location savings would be passed on to the customers in the form of reduced prices and only a portion is retained with the MNE as incremental profit. This incremental profit is known as Location Rent.
Apportionment of Location Savings
Where significant location savings are derived, the question arises whether it should be shared among the parties and in particular whether part of the location savings should be allocated to the entity in the low cost jurisdiction, i.e. whether an entity operating in a low cost jurisdiction should receive additional compensation on account of location savings. Secondly, the issue is in what manner the benefit derived by operating in a low-cost jurisdiction should be computed and then allocated to the associate enterprise. Under arm’s length pricing, allocation of location savings between associated enterprises should be made by reference to what independent parties would have agreed in comparable circumstances.
The general principle stated across guidelines is to apportion the benefit amongst parties on the basis of functions performed, risks assumed and assets employed (“FAR”) by each of the enterprises.
Li and Fung’s Case
In Li and Fung’s case, the taxpayer was engaged in providing sourcing services to clients worldwide, including its AE in Hong Kong and was remunerated on a cost-plus mark-up of 5 percent by its AE. On the allegation that the taxpayer was performing all critical functions, was assuming significant risk and had created valuable intangibles over a period of time, the TPO rejected FAR profile submitted by the taxpayer. Considering that the AE was being remunerated on a commission-on-FOB value basis, the TPO proceeded to compute the transfer pricing addition by considering a 5 percent commission on FOB value of goods sourced by the taxpayer for its AE. TPO alleged that taxpayer should be entitled to the location savings enjoyed by AE due to the taxpayer.
Ruling against the taxpayer, the Appellate Tribunal concluded that the taxpayer was not a low-risk service provider, it performed critical functions, had incurred time and expense in creating valuable intangibles which were beneficial to the group. It was further noted that the AE did not perform any critical functions. The Appellate Tribunal noted that the taxpayer’s conduct and operations in India did create Location Savings for the AE, the benefit of which the taxpayer is entitled to. Given the facts, the Appellate Tribunal ruled that the commission received by the AE (5 percent of FOB value of goods sourced) was to be shared in the ratio of 80:20 to India. Although the case discusses Location Savings, it has not provided a definitive ruling on the aspect. The core issue was the FAR profile and remuneration model.
The issue of location savings is in a very nascent stage in India and would be a bone of stress for the MNE groups operating in India. The tax authorities have clearly stated their rigid views and are sure to approach this issue in a much stricter manner. Location savings and its apportionment will be unique in every case and it seems difficult that industry specific methodology can be formulated for it. It can be said that in coming times location savings would be an interesting issue to track, especially the statements of Indian Tax Authorities in this regard.