Economic liberalisation has enabled multinational corporations to redesign their global supply chain by moving key functions from a high-cost jurisdiction to low-cost countries such as India, China, Indonesia, or Philippines. Thus they are able to minimise costs, maximise profits, or simply thwart competition to remain profitable.

Location saving (LoS) — realised from relocating to a low-cost jurisdiction — results from lower input costs in the form of raw material, labour and rent, and incentives such as tax exemption, leading to key operational advantages.

The LoS in developing economies is offset to some extent by economic hurdles such as poor utilities and infrastructure. LoS coupled with other geographical economic benefits such as burgeoning customer base, market vicinity and specialised labour force, leads to location-specific advantages (LSA). The incremental profit, if any, derived from LSAs is known as “location rent” in the transfer pricing arena.

While India has been a low-cost destination for some time now, and will be for the foreseeable future, its revenue department’s mindset has been to try and capture some of the location savings through high-pitched mark-ups on costs (especially for information technology, IT-enabled services).

The concept of LoS and attribution of incremental profit in the arm’s length scenario are discussed in Chapter 10 of the UN Transfer Pricing Manual. Further, the Rangachary Committee, in its first report on the taxation of the development centre and IT sector, recommended that India should seek a higher mark-up under the Transactional Net Margin Method, possibly also factoring in the LoS and LSA. In an arm’s length scenario, profit sharing would have been similar to an independent third-party dealing with an interplay of demand and supply.

The moot transfer pricing issue is in measuring LoS and identifying the entity entitled to it — be it an entrepreneur whose decision led to LoS, or the captive units operating in India.

The attribution of LoS should benefit both entities, based on the relative contribution of each. Relocation of operations should not automatically lead to a taxing right in the low-cost country on the cost saved. In an independent third-party dealing, an entity’s negotiation depends on the relative bargaining power, which might be determined by relative contribution, criticality of the intangible, market structure (monopoly, oligopoly, or perfect competition), and so on. For instance, the state of perfect competition in a low-cost country may reduce the bargaining power of the captive unit. In contrast, a principal company in a perfect competition market may be compelled to pass the benefit to the customer through reduced price.

At a practical level, the Indian company to which functions are outsourced by an MNC is most likely to be benchmarked against independent comparable companies in India. The cost structures are bound to be similar. Therefore, so long as the tested Indian company earns an operating profit margin commensurate with the comparable companies, no additional LoS-related adjustment should be attributed to India.

In 2011, the Delhi Income-Tax Appellate Tribunal referred to the concept of location savings in its ruling in the case of Li & Fung (India) Pvt Ltd. The company was engaged in buying/ sourcing services for supply of consumer goods such as garments, handicrafts, and leather products in India for its affiliate in Hong Kong. The company was paid service charges computed on the basis of cost plus 5 per cent mark-up. Based on factual analysis, it was established before the court that the Indian company was performing all critical functions, assuming significant risks, and used both tangibles and unique intangibles developed by it over a period of time. Moreover, the assessee had developed several unique intangibles providing advantage in the form of low cost and quality of product, and enhanced profitability for the overseas affiliate.

The Indian company had developed the supply chain management, which gave the customer a strategic and pricing advantage. It had also developed a human capital intangible at its cost. The transfer pricing officer held that the cost of development and maintenance of these intangibles, borne by the Indian company, was not taken into consideration for the computation of the routine mark-up. It was held that the presence of the company in India offered cost and operational advantages, including lower salaries, and low-cost material and manufacturing. The overseas affiliate had neither quantified the locational savings nor attributed any part of the additional profit to the assessee in India. The court held that the mark-up on the ‘free on board’ value of the goods sourced through the Indian company shall be the most appropriate method to work out the arm’s length compensation for the Indian company.

As with most transfer pricing controversies, a robust transfer pricing documentation, appropriately characterising each transacting entity based on a factual analysis of the functions, assets and risks is necessary to demonstrate the right owner of the LoS. The risk of further disagreements with Revenue can also be mitigated by an appropriate benchmarking analysis, backed by an economic rationale for allocation/ non-allocation of LoS or location rents on the LSA to the Indian company servicing the MNC group.

The author is Partner, Transfer Pricing Services, Grant Thornton India LLP

Vishwa R. Sharan, Manager, Transfer Pricing Services, contributed to the article.

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