Practical Guide to Location Savings Analysis in Transfer Pricing
Some jurisdictions, like the Chinese State Administration of Taxes (CSAT), include location savings as a key topic in a transfer pricing analysis. CSAT is particularly clear on its expectations on this front. It will only consider an APA when the enterprise has provided a thorough value chain/supply chain analysis that takes into account China’s location-specific advantages such as cost savings and market premiums in choosing and applying an appropriate transfer pricing methodology.
Location savings were added to the OECD Transfer Pricing Guidelines (TPG) in 2017 as part of the international response to BEPS (base erosion and profit shifting) Actions 8-10. Taxpayers in all jurisdictions that apply the OECD TPG will need to consider location savings.
Location Savings: Analysis and Application
The OECD Secretariat described location savings generally in its July 2010 “Location Savings” paper supplementing the brief discussion of location savings in OECD TPG 2010 ¶ 9.148-9.153,:
Location savings are generally understood as the net savings in costs that may be derived by an MNE group that relocates some of its activities to a place where labour or real estate expenditures, to cite only a couple of examples, are lower than in the location where the activities were initially performed.
The OECD TPG 2017 introduce Location Savings in ¶ 1.139:
Difficult issues can arise in evaluating differences between geographic markets and in determining appropriate comparability adjustments. Such issues may arise in connection with the consideration of cost savings attributable to operating in a particular market. Such savings are sometimes referred to as location savings.
In analyzing these savings, the OECD TPG requires that identifying and sharing the savings is done as it would be between independent parties. That is, a reliable analysis needs to show precisely how such savings arise and then provide a reliable calculation of their quantum. Following that, the analyst needs to carefully consider the context of the comparables, their behavior in transacting with independents and any other evidence of third-party behavior to allocate the same or similar savings between the parties. A broad-based functional analysis of the parties and the comparable transactions – and the necessary financial analysis – is an essential starting point (OECD TPG 2017, ¶ 1.143).
As a work process, the OECD TPG suggest analyzing the following:
- Whether such savings or market advantages or disadvantages exist.
- The amount of the savings, increase or decrease in costs, revenues or profits that are attributable to a local market advantage or disadvantage.
- The extent to which those savings are retained by the entity or passed on to independent suppliers or customers.
- Where the savings are retained by the taxpayer’s group, the manner in which independent enterprises under similar circumstances would allocate any retained net locations savings between its members (OECD TPG 2017, ¶ 1.141 and 1.146).
- Apply location savings adjustments to arm’s length prices.
Location Savings: Analysis and Application
Location savings refer to advantages (or disadvantages) specifically attributable to a market or location. In analyzing location savings, it is important to distinguish between such advantages and other advantages that may be connected to the market or location, but are attributable to other factors.
The OECD TPG provide insights for determining whether such market advantages exist:
Location savings can arise from the different economic circumstances of the parties to a transaction, compared to comparables. Different markets may have different prices for the same or similar property, goods or services. That outcome could be driven by different supply and demand conditions in the market affecting costs of production including land, labour, capital, transport costs and so on, as well as other market advantages or disadvantages (OECD TPG 2017, ¶ 1.110).
Some local market features that may lead to location savings, include:
- Low market prices of supplies or manufacturing costs.
- The purchasing power and product preferences of households.
- An expanding or contracting market.
- Degree of competition (or lack there-of) that effect prices or margins.
- Availability of infrastructure or access to a skilled workforce, and so on.
For example, if a distributor pursues a market penetration strategy but costs are paid by another party, where the strategy is strongly connected to the location, then this may lead to location savings (OECD TPG 2017, ¶ 1.117).
Where savings from relocating business activities is a key driver of the decision to restructure a business, the location savings are important for the parties to realize and must be considered when determining arm’s length renumeration (OECD TPG 2017, ¶ 9.127).
However, the OECD TPG also stress that in location savings analysis, market advantages should be distinguished from intangibles or other advantages. For instance, it may be necessary to consider contracts, licenses, the know-how or other intangibles of an enterprise, but they are not location advantages per se. This can arise as a government license may limit competition in the market, but such licensing may have been gained with the assistance of the parent or other group members. The license may then allow the licensee to extract a greater share of benefits from customers, but those benefits may be attributable to others in the group and would need to be allocated amongst them consistent with the contributions made by third parties. (OECD TPG 2017 ¶ 1.149)
Another example may be the enterprise’s assembled skilled workforce that leads to lower labor costs, which could be a feature unique to the enterprise (say, group synergies) or related to their intangibles rather than a location (OECD TPG 2017 ¶ 1.156). An assembled workforce may be a common feature of comparable enterprises and factored into their pricing and margins. More generally, a cost savings strategy used by independents (e.g., regular price reductions from standard costs which passes some benefits of cost reductions to customers) should be differentiated from retained location savings or a local market advantage and treated accordingly. (OECD TPG 2017, ¶ 2.101)
Location Savings Adjustments
After performing a location savings analysis, the analyst must also determine adjustments to the arm’s length pricing, or whether any adjustment is necessary at all.
The OECD TPG reiterate several times that if comparable entities and transactions in the local market can be identified, then those local market comparables will provide the most reliable indication of how those advantages should be allocated amongst group members. This would mean that no specific comparability adjustments for location savings would be required if reliable local comparables are available (OECD TPG 2017, ¶ 1.141).
However, if no reliable comparables can be found, then appropriate comparability adjustments may be required to take location savings into account (OECD TPG 2017, ¶ 1.143).
Depending on the relative contributions of each party, the analyst may also determine that the transactional (residual) profit split method is the most reliable method to determine an arm’s length price.
Important Considerations in Location Savings Analysis
Location savings are often an economic driver of business restructures. Operating cost savings on wages or other inputs can support decisions to relocate activities from one location to another. For example, say a principal changed its source of IT and e-commerce infrastructure services from a high wage country to a low wage country and then compensated the new low-cost provider at a rate of similar services from that country. Where the principal can still retain its charge out rates to third parties despite a reduced labor cost, or even slightly reduce its rates, the principal would be attributed that part of the location savings not passed onto clients (OECD TPG 2017, ¶ 9.130).
But other parties may have a different operating context and different options and thus achieve a different outcome. For instance, a company with an assembled skilled workforce and unique know-how that acts as a barrier to competition may be able to charge higher rates than its peers where the buyer has limited options other than to use the provider — such as overly high wage costs in the home country (OECD TPG 2017, ¶ 9.131).
As we can see, location savings should be specific and identifiable and considered for their impact on the related party price or margin arising from the transactions. They should be based on a sound functional and financial analysis and evaluated with the insights available from relevant comparables. Then, location savings can be allocated between related parties.
OECD Secretariat, “Location Savings,” July 2010, OECD.org.