Multinational corporations (MNCs) have been relocating portions of their global supply chain to developing countries, including India and China, to generate efficiencies and remain competitive in the marketplace. Moreover, the vast consumer base in India and China, and the lowering of trade barriers have allowed MNCs to sell their products in these countries, sometimes at premium prices. As a result, the tax authorities in these countries have argued that their unique market features deserve separate recognition and compensation through appropriate transfer prices. The issue gets complicated because the option of relocating portions of a global supply chain in different countries is often available only to global MNCs and not to local, independent companies. Hence, there is a lack of available third-party data that may provide a basis for separately determining how LSAs are treated in arm's-length conditions. This issue is at the heart of the current debate on LSAs.
The BRICS block of countries has assumed significant relevance in the current global business environment because they house 40% of the global population, hold an estimated $4.4 trillion of foreign exchange reserves, and contribute 20% to global GDP. Transfer pricing developments in these economies have the potential to affect the operations and profitability of MNCs in significant ways. Hence, it is important to understand the LSA concepts being discussed and work toward consensus on how to identify, quantify, and allocate income arising from such LSAs.
LSAs are those location-specific market features and/or factors of production that enable a firm to achieve an improved financial outcome from the provision of the same product or service compared to alternative locations. They may include access to skilled labour, incentives, market premiums, access to growing markets, superior infrastructure, and cost savings.
OECD, UN, and US views of LSAs
The OECD first acknowledged and addressed the issue of location savings in the new Chapter IX on transfer pricing issues associated with business restructurings that was incorporated into the OECD's transfer pricing guidelines in 2010 by stating:
"The [allocation of significant location savings] 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." [Chapter IX, Business Restructurings, paragraph 9.149]
In the same section, the OECD transfer pricing guidelines provide examples that essentially argue that of the two entities engaged in trade, the entity that has the bargaining power, which in itself is driven by ownership of intangibles, will be able to claim the location savings. Subsequently, the OECD added a new section in its July 2013 draft of the chapter on intangibles dealing with the transfer pricing treatment of local market features, location savings, assembled workforce, and group synergies. The OECD has proposed a position acknowledging the presence of LSAs in MNC operations, but has emphasised that quantifying and allocating such benefits must be done in accordance with the arm's-length principle. It goes on to state that LSAs are comparability factors that should be considered in transfer pricing analyses, but are not in themselves intangible assets (but can involve intangible assets in certain situations). Moreover, sharing LSAs between group companies is best done through a comparability analysis, if the savings are not passed on to third-party customers.
The tax authorities of India and China formally laid out their position on LSAs in a separate chapter of the UN Transfer Pricing Manual that was released October 2012, departing from the quasi-consensus position on this issue the UN presented in the other chapters in the manual. India's and China's positions are discussed later in this article, but the UN's view is that LSAs may play an important role in increasing an MNC's profitability, and concludes that the allocation of benefits to the respective entities will depend on competitive factors relating to the nature of access to the LSAs and on the alternatives available to the parties given their relative bargaining power.
The US recognises the concept of location savings (as opposed to other types of LSAs) in Treas. Reg. §1.482-1(d)(4)(ii) of the transfer pricing regulations, which states that if the comparable company operates in a different geography, adjustments may be required for differences in the cost of resources, while considering the competitive position of the buyer and seller.
In summary, the OECD, the UN, and the US all recognise LSAs (or location savings) as an important factor in transfer pricing analysis, but reiterate their reliance on the arm's-length standard explicitly, stating that such factors are not separately compensable but should be dealt with as a part of the comparability analysis.
Economics of LSAs
The starting point of any transfer pricing analysis involving LSAs should be their identification. The perception that LSAs are available to an MNC can often be unfounded, particularly because an MNC's decision to locate its manufacturing or service operations in India and/or China may be driven more by competitive pressure from the markets that require them to lower costs simply to remain in business than by the prospect of benefiting from LSAs. Clearly, in such instances, location savings are passed on to the companies' end customers, and do not warrant any further changes to the prevailing transfer pricing arrangements. It is only in certain instances that LSAs give rise to location rents that are actually retained within an MNC.
Assuming that LSAs give rise to location rents, the process of quantifying the rent should take into account the net benefit to the MNC by recognising benefits and dissavings that can be inherent to operations in a developing country. Benefits may manifest themselves through low input costs, specialised skilled manpower, government subsidies, scale economies, and lower environmental standards. On the end-product market side, benefits may take the form of higher demand for branded products resulting in price premiums, entry barriers limiting competition, or unique features of the consumers in a market that make it easier for companies to sell products into those markets.
These benefits may be offset by economic costs such as higher transportation costs, higher warranty costs, higher cost of capital, economic costs of managing an operation in a remote location, and higher indirect costs of doing business. The quantification of location rents should be based on a careful consideration of both advantages and disadvantages of operating in these markets. Incidentally, both India and China have acknowledged the presence of dissavings when quantifying LSAs.
Once the location rent is quantified, the next step in the analysis is to allocate this rent to the parties involved in generating such rents. Relative bargaining power is recognised as the key factor for that allocation. In the absence of third-party comparables that provide guidance on how such bargaining powers are manifested in market transactions, concepts of bargaining theory in economics provide useful guidance to determine how third parties would split such profits.
Several important factors affect the outcome of a bargaining situation:
- Time value of money: one party's bargaining power is greater the more patient it is, relative to the other negotiator. All other things remaining constant, if all the entities on the bargaining table value the cost of waiting in the same manner (that is, the present value of the future is discounted at the same rate for all parties), the outcome will likely be one where each entity will split the location rent equally.
- Risk of breakdown: While bargaining, the parties may perceive that the negotiations might break down into disagreement because of some exogenous and uncontrollable factors. For example, while two firms bargain over how to divide the returns from a new technology, an outside firm may discover a superior technology that makes their technology obsolete. The exact partition of the net surplus between the entities will depend on their relative degrees of impatience (as described above) and on their relative degrees of aversion to risk.
- Outside options: A key principle is that an entity's outside option will increase its bargaining power if and only if the outside option is sufficiently attractive; if it is not attractive enough, then it will have no effect on the bargaining outcome. This is the so-called outside option principle (OOPS).
- Role of commitment: In many bargaining situations, the parties often take actions before and/or during the negotiation process that partially commit them to some strategically chosen bargaining positions (or "demands"). Those commitments are partial in that they are revocable, but revoking a partial commitment (backing down from one's demands) can be costly. The presence of such commitments (such as a long-term supply contract with another member of the MNC) can have an impact on how location rents are split.
- Asymmetric information: There may be instances in which one entity has access to relevant information important to the business that the other does not; such informational asymmetries will also have an impact on the bargaining outcome.
For a helpful overview of some of these concepts, see "A Non-Technical Introduction to Bargaining Theory," by Abhinay Muthoo, WORLD ECONOMICS, Vol. 1, No. 2, April–June 2000.
Often, it is difficult to argue that the location savings should accrue to the MNC entity located in the low-cost country because the intangible-owning entrepreneur entity often has more options than the entity located in the low-cost country, thus reducing its bargaining power to retain any location savings that might exist.
India's position on LSAs
Over the last few years, the Indian tax authorities have been stressing that a portion of any LSAs should accrue to the Indian entity and be subject to tax in India. However, they have yet to announce or apply a systematic approach for identifying and quantifying LSAs.
The Indian tax authorities' aggressive view on this topic is clear from their submission to the UN Transfer Pricing Manual. India's submission begins by asserting that India not only provides location savings but other LSAs such as access to highly specialised skilled manpower and knowledge; access and proximity to a growing local/regional market; a large customer base with increased spending capacity; a superior information network; a superior distribution network; incentives; and market premiums.
The Indian chapter of the manual goes on to state, without much basis: "The Indian transfer pricing administration believes it is possible to use the profit split method to determine arm's-length allocation of location savings and rents in cases where comparable uncontrolled transactions are not available." This is a fairly aggressive stance, without much regard to how such an approach may be applied. India's submission also states that transfer prices defended using local comparable companies do not capture the benefit of location savings. India's tax department has already lost on this last position in the Income Tax Appellate Tribunal, the first judicial level at which income tax cases are argued in India.
The desire to include location savings in Indian profits has been raised multiple times by Indian government representatives in seminars, forums, tax assessments, and APA discussions. However, the authors have not come across any instance where the Indian government has been successful in quantifying the location savings and arguing that they should accrue to the Indian entity.
China's position on LSAs
China's State Administration of Taxation (SAT) first officially expressed its views on location savings in Guo Shui Han  No. 106, and on market premiums in Guo Shui Han  No. 84. In the SAT's view, many foreign corporations should have higher profit margins due to location savings and/or market premiums because of the lower cost and higher selling prices found in China. In recent years, the SAT has paid special attention to the automotive, pharmaceutical, and luxury industries because of the importance of LSAs in those industries.
The SAT has recently used LSAs (and other arguments) in transfer pricing audits. For instance, a foreign company's Chinese subsidiary was determined to adjust its income tax for more than RMB100 million for 10 years. LSAs also have been used in self-adjustments, which are similar to transfer pricing audits although not legally official and conducted by state tax bureaus. The SAT has also used LSAs in bilateral APA cases, especially in negotiations with Japan's National Tax Authority.
Chinese courts have adjudicated very few transfer pricing cases, and none of them involve LSAs.
In the SAT's view, Chinese companies should get most, if not all, of LSAs. But up to this point, the SAT has not come up with an acceptable approach to allocate LSAs benefits.
Suggestions and anticipated future development
According to the OECD transfer pricing guidelines, location savings should be allocated based on relative bargaining powers, but the guidelines are vague on the allocation of benefits. Even though the OECD guidelines do not mention market premiums, it is an important issue – at least in China – and should be taken into account as well.
The important issue is how to estimate and allocate LSAs. The calculation of LSAs may not be too difficult, as long as all location dissavings and factors such as custom duties are taken into account. Also, indirect approaches, especially for location savings, must be used because of the difficulties in using direct approaches and the need to repeat the procedure every year. The difficulty, rather, is how to appropriately allocate relevant savings/premiums.
There are several approaches for allocating location savings. One of them is using domestic or regional comparable companies. But in some countries, such as China, there are few domestic public companies. Another potential issue is that in the tax authorities' view, selected comparable companies are not comparable enough based on functions, risks, and products. But one thing for sure is that location savings cannot be estimated based on cost savings only, because some savings are passed on to customers.
It is comparatively easier to estimate and allocate market premiums. As long as taxpayers take the difference in selling prices in China/India and developed countries, and other relevant factors (such as custom duties) into account, the market premium can be reasonably estimated. The difficulty here is still about comparable companies, especially in China, because there are very few publicly traded distributors. For manufacturing parts, for the same reason, would it be reasonable to allocate market premium based on two companies' relevant cost, say the Chinese/Indian entity's own manufacturing cost and the foreign entity's value of important parts? The result may not be absolutely accurate, but at least it's reasonable.
The key in the near future is to engage with the tax authorities to share with them these positions and come up with reasonable ways to estimate and allocate LSAs.
Senior director and principal economist
Mr Ghosh is a transfer pricing partner in Deloitte India. He has recently relocated to the US and is located in Boston. Shanto has more than 13 years of transfer pricing experience, six of those years working in the US.
Mr Ghosh has advised clients in the life sciences, technology (including media and telecoms), and automobile sectors. He has been actively involved in assisting clients with their global transfer pricing policy and documentation, and has implemented a number of large-scale global planning and supply chain restructuring projects. He also established and successfully set up Deloitte's Global Transfer Pricing Center in India, which supports the global Deloitte network in performing global documentation studies for multinational companies.
Mr Ghosh has been recognised in Euromoney Legal Media Group's World's Leading Transfer Pricing Advisers. He has also been a a visiting lecturer at the IBFD and a member of International Taxation magazine's editorial board. He is a frequent speaker at international conferences across the globe and has published a number of high-profile articles.
In addition to his consulting experience, Mr Ghosh has been a teaching fellow at the Harvard Institute of International Development and a lecturer of Financial and Development Economics at the University of California, Berkeley.
Wei Shu is the lead economist of Deloitte China's transfer pricing practice. With more than 15 years of professional transfer pricing experience, he had worked in Washington DC, Los Angeles, and the Silicon Valley for seven years before he joined the firm's Shanghai office in June 2002.
Shu has assisted numerous multinational companies in various industries in both the US and China with transfer pricing contemporaneous documentation, tax authority transfer pricing audits, advance pricing agreements, and both compliance- and efficiency-driven transfer pricing/tax planning. His clients include large banks and companies in high-tech, textile & clothing, automobile, electronics, chemicals, pharmaceuticals, luxury goods, business services, sports goods, food & beverages in addition to a number of very large contract manufacturers. He was the China team's chief economist on China's first bilateral advance pricing agreement.
As one of the leading and most experienced Chinese speaking transfer pricing economists in the world, Shu is a frequent speaker on the Chinese transfer pricing issues and has published many articles in the BNA Transfer Pricing Report and other transfer pricing/international tax journals.
Shu holds a B.A. in economics from Fudan University in China and a Ph.D. in economics (finance minor) from the University of Maryland at College Park.
Rahul is currently a senior director of transfer pricing in Deloitte's Delhi office. He led the Philadelphia transfer pricing group of Deloitte US before moving to India in October 2012.
He has more than 11 years of experience in transfer pricing, mostly in the US, and for another four years he has been involved in valuation, pricing analysis, and negotiation work.
Rahul has managed and led transfer pricing engagements involving planning, documentation, and controversy work, across more than a dozen industries, including healthcare, industrial products, technology and telecom. His specialisation is in assisting clients with transfer pricing planning, often covering complex transfer pricing structures involving intellectual property analysis, restructuring, and entity conversions. Rahul has also led global documentation projects coordinating with Deloitte colleagues in over a dozen countries.
He has co-authored a number of transfer pricing related articles published in international trade journals such as the Transfer Pricing Report and the International Transfer Pricing Journal, and has spoken in a number of seminars and forums.
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