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Transfer Pricing and location savings - An Indian perspective

By S. Sriram

Relocation of business from one country to another, where the labor and other costs are comparatively cheaper, results in cost saving to the Multi National Enterprise (‘MNE’) groups.  The net cost so saved is Location Savings (‘LS’) as explained by the Organization for Economic Co-operation and Development (‘OECD’) [see end note 1].The United Nations further expands the scope of LS to include certain advantages specific to a state, like huge customer base, advantage of infrastructure, etc, and terms LS as Location Specific Advantages (‘LSA’) [see end note 2].

LSAs have encouraged MNEs operating in high cost jurisdictions like USA and Europe to divert their capital to countries like India and China.  While a portion of the cost saved by the MNE group is retained in the low cost state, significant sums are usually pulled back by the holding companies. Indian tax authorities have recently taken recourse to local Transfer Pricing Regulations to tax such extracted profits.

Transfer Pricing on LSA – International practice: The OECD and UN have acknowledged LSA as a premium enjoyed by low cost jurisdictions.  OECD is of the view that where reliable local market comparables are available and can be used to identify arm’s length prices, specific comparability adjustments for location savings should not be required [see end note 3].  The UN, though vouching the practice, has added that, the first entrant in the low cost jurisdiction should be entitled to a premium [see end note 4]. The UN refers to the premium as ‘Arm’s Length Surplus’.

USA’s regulations and Courts  [see end note 5] seem to have acknowledged the view of UN that location saving if any, would exist only till comparable service providers emerge in the low cost market.  Enough guidelines are however not available on how to treat the LSA that accrued to a first entrant.  Recent amendment to the German Foreign Tax Act has created a rebuttable presumption that location saving must be allocated between the parent and the subsidiary [see end note 6]. The Finnish Administrative Court [see end note 7] has also acknowledged adjustment for LSA if the very same functions earlier performed in Finland were moved to a low cost jurisdiction. China, which also provides significant cost saving to manufacturing groups, more specifically automobiles, has put in place a specific rule to measure and allocate location saving [see end note 8].

Location Saving and India: India extends a variety of cost saving to MNEs operating in developed countries.  Such LSAs include human resource at discounted costs, huge customer base, easy physical access to whole of Asia etc.  India does not have a specific regulation to identify or allocate LSA.  In the Country Practice chapter of UN Practical Manual,the possibility of application of Profit Split Method (PSM) has been explored, as a means to allocate the location benefits derived by MNEs [see end note 9].In the context of Indian Research &Development Centers of MNEs, the Central Board of Direct Taxes (CBDT) expressed a view that an upward adjustment shall be made to the Transfer Price for LSA [see end note 10]. This Circular was however later withdrawn [see end note 11] due to significant protest from stakeholders.

Even in the absence of specific regulations and the Government still ‘exploring’ an appropriate method, the Revenue Authorities (‘RA’) during audit have been making upward adjustment for LSA derived by MNEs. Courts in India have so far been adopting a liberal approach towards it. The Income Tax Tribunal in the case of GAP International [see end note 12] observed that LSA would generally be passed on to end customer, and even if it is not, ALP determined based on appropriate comparables will ensure that LSA is adequately compensated. The Delhi High Court in Li and Fung India [see end note 13] rejected the claim for adjustment for LSA in the absence of specific finding on the existence and quantum of LSA.

What should be India’s revenue policy?:India has been showcasing its LSA to attract [see end note 14] foreign investment into India.  Eyeing investment by MNEs, India has also extended investment linked tax benefits to new investments in identified zones [see end note 15] and in specified sectors [see end note 16], carefully balancing its limitations on account of commitment under General Agreement on Trade and Tariff.  As a result of these measures, India is now amongst the top five investment destinations.  Having invited MNEs to invest in India by showcasing the LSAs it can offer, it would not be appropriate for India to impose a tax on the LSA itself. Secondly, LSA being enjoyed by India is no more unique. There is significant competition within India, and as a result, there will usually be enough comparables for ALP determination.  In this scenario, even as per the recommendations of UN, no adjustment on account of LSA is desirable.

[The author is a Principal Associate, Lakshmikumaran & Sridharan, New Delhi]

End Notes:

  1. OECD Revised Discussion Draft on Transfer Pricing Aspects of Intangibles, July 2013July 2010
  2. Para of United Nation Practical Manual on Transfer Pricing for Developing Countries, 2013
  3. Para 9.149 of OECD Transfer Pricing Guidelines for Multi National Enterprises and Tax Administrations, July 2010, further elaborated in Para D.6.1 on Revised Discussion Draft on Transfer Pricing Aspects of Intangibles, July 2013
  4. Para of United Nation Practical Manual on Transfer Pricing for Developing Countries, 2013
  5. Baush and Lomb Inc v Commissioner
  6. Transfer Pricing and Arm’s Length Principle in International Tax Law, Kluwer Law International BV, 2010.
  7. KHO 2013:36
  8. Paras – of United Nations Practical Manual on Transfer Pricing for Developing Countries, 2013.
  9. Para United Nations Practical Manual on Transfer Pricing for Developing Countries, 2013.
  10. Circular 2 of 2013 dated 26.03.2013
  11. Circular 5 of 2013 dated 29.06.2013
  12. GAP International Sourcing (India) (P.) Ltd. v ACIT [2012] 149 TTJ 437 (Delhi)
  13. Li and Fung India (P.) Ltd. v CIT [2014] 361 ITR 85 (Delhi)
  15. Income Tax, Customs and Excise exemption provided for new undertakings established in Free Trade Zones, Special Economic Zones etc
  16. Income Tax, Customs and Excise exemption provided for investment in developing infrastructure, generation of power, providing telecommunication services etc. 
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