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Location Savings: Does It Call For A TP Adjustment?

Published on Wed, Feb 04,2015 | 18:47, Updated at Tue, Feb 10 at 17:23Source : 

By: Shuchi Ray- Director & Nimisha Parikh- Manager, Deloitte India

The last couple of years have seen India take some serious and well calculated positive steps towards improving the general perception the globe has about the Transfer Pricing (‘TP’) environment in India. Notable amongst them being the fact that in a very short time, India has concluded five unilateral advance pricing arrangements (‘APAs’) for a variety of transactions and followed up with the conclusion of a bilateral APA with Japan. To further add to this, off late, different appellate authorities in India have pronounced quite a few favourable and near conclusive judgments on complex and pertinent topics such as applicability of TP on issuance of shares, alignment of pricing and functionality in captive buying / sourcing services and royalty payment by corporates. Hence, overall, the Indian TP environment looks pretty encouraging and progressively driven in line with the new government’s initiative of ‘make in India’.   

Moving from a macro perspective to a more micro analysis, one of the common TP adjustments various Indian taxpayers have experienced in recent TP audits is the one on account of location savings. The same is a well-deliberated and immensely discussed topic not only in India, but also in the international TP circuit. In most such cases, the Indian tax authorities have gone ahead to make adjustments on the basis that the Indian enterprise ought to be compensated (over and above its routine compensation) a fair share of the so called ‘cost savings’ that accrues to the multinational group by relocating the activities under consideration to India (viz., say 50% of the cost savings due to relocation of operations to a low cost jurisdiction in the value chain should be attributed to the entity operating in that low cost location – herein, it being India).

The said issue was recently dealt with in substantive detail by the Mumbai Income-tax Appellate Tribunal (‘Tribunal’) in the case of Watson Pharma Pvt. Ltd . The Tribunal held that where the operating margin earned by a taxpayer is at arm’s length based on local market comparables operating in similar economic circumstances as the taxpayer; and the taxpayer as well as its Associated Enterprises (‘AEs’) operate in a perfectly competitive business environment, any further return (i.e. cost saving attribution) on account of location savings is not admissible. This article discusses the said ruling in detail and other relevant aspects centric there around.

Facts Of The Case

Watson Pharma (the tax payer) was engaged in rendition of contract manufacturing and contract Research and Development (‘R&D’) services to its AEs. The taxpayer used the transactional net margin method (‘TNMM’) to benchmark the said transactions.

While the Indian tax authorities accepted the use of TNMM, they purported that the tax payer should additionally receive extra compensation on account of the location savings that have arisen pursuant to the AE transferring the manufacturing activity from UK and other European countries to a low cost jurisdiction (i.e., India).

Tribunal Ruling: Observations & Analysis

•    The Tribunal, while observing the overall bargaining power, options realistically available and the general market competition, noted that the tax payer and the AE, both, operated in a perfectly competitive market. Further, the taxpayer did not have exclusive access to any such factor that could result in location specific advantages. As a result, there was no unique advantage to the taxpayer over competitors. The AE had various alternatives available, and this conferred due bargaining power in its hands. There was no super profit that arose as such in the entire supply chain. Further, if there would have existed any location savings; it would have been passed on to the customers of the AE (and not to the AE).
•    The Tribunal, following the ruling in the case of GAP International Sourcing (India) Pvt. Ltd. , held that location savings( if any) would be reflected in the profitability earned by the local comparables (operating in similar economic circumstances as the taxpayer) which are used for benchmarking the international transactions. Hence, no separate compensation is called for on account of such location savings.

•    In this ruling, it is remarkable to note that an Indian Tribunal has, for the first time, specifically talked about India’s participation as a part of G20 . Further, it has also categorically stated the position which G20 countries have concurred upon on the pertinent matter - “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”. As regards India’s views in the UN TP Manual, the Tribunal has specifically observed that the claimed position is that of the Indian tax administration and not the view of Indian Government.

Accordingly, keeping in perspective the perfectly competitive market, options realistically available, absence of super profit in the value chain, and while concurring with the position of the G20 countries, the Tribunal has held that where the operating margin earned by a taxpayer is at arm’s length based on local market comparables (operating in similar economic circumstances as the taxpayer), an extra return for location savings is not called for.

It is worth noting that the above decision of the Tribunal is exactly in line with the Rangachary Committee report furnished in relation to Safe Habour rules. Para 3.17.4 of the said report states that “An alternate view within the Committee is that market premium or location savings need not be factored in. The comparables chosen for the purposes of evaluation of whether the pricing is at arm’s length operate in the same location and enjoy the same market premium or location savings as are enjoyed by the Indian captive service providers. As such, once an arm’s length price is worked out and is factored in, evolving a safe harbour, there is no question of incremental factoring in of market premium or location savings.”

Further, on the issue of separate compensation on account of location savings, the Finnish Supreme Administrative Court (March 2013) has held that locations savings cannot be determined by comparing the actual costs in the low-cost country with notional costs in the high-cost country. The margins of companies operating in low-cost jurisdictions may be much higher than that of companies operating in high-cost jurisdictions. Accordingly, location savings would be accepted through application of higher (arm’s length) mark-up.

The above finding of the highest appellate authority in Finland squarely applies in the Indian context as well - where local comparables earn higher margins than those of companies engaged in similar activity in higher cost jurisdictions. From the benchmarking result of local databases (which are used in searches for US comparables, European comparables and Indian comparables), one would find out that companies engaged in similar activity in India earn a higher percentage of mark-up when compared with those in the US or European regions. Accordingly, once the taxpayer operates in an economic environment which is similar to that of the local comparables, anything extra cannot and ought not to be attributed towards location savings. Such benefits (including other benefits that may arise on account of working in similar circumstances) anyways get embedded in the net profitability of the comparables.


The said ruling, as on date, is definitely a ‘one of its kind’ from the India judiciary. While it may not have the teeth to single handedly settle this issue conclusively for good (more so, since it will be heard by the higher appellate courts as well), it certainly has done a world of good in terms of providing directional guidance to tax payers embroiled in the same controversy. Tax payers finally have some judicial support to rely upon, when it comes to this otherwise extensively debated and deliberated topic.

Summarily, some of the critical principles emerging out of the ruling are as follows:

a)    Locations savings depend on the functions, assets and risks of each party and their respective bargaining powers. Generally, the factors determining the bargaining power are (1) beneficial ownership of the intangible property; (2) the relative competitive position of buyer and seller; (3) functions, assets and risk analysis; and (4) alternative options realistically available to each party to the transaction.
b)    Comparability should be determined after taking into account the geographical location, conditions prevailing in the market, the level of competition, etc.
c)    Location savings should be taken into account while determining the comparability analysis. Further, once the comparable set has been identified, no additional adjustment ought to be made on account of location savings.

The aforesaid ruling clearly hints towards a mature evolvement of the Indian TP position on this matter in line with international standards and the position adopted by G20 countries on the same. While it would be really interesting to see how the higher appellate authorities in India adjudicate on this matter at a later date, rulings such as this one definitely go ahead to create a positive and fair perception about the Indian judiciary in the eyes of international on lookers, and this for sure, is the call of the hour. The ruling also seamlessly coincides with all the other positive efforts being actively taken up by the new government in India to create an open, unambiguous, well laid and hassle free environment for foreign investors coming into India. The ‘feel good’ factor exists for sure currently, and it is hoped that the momentum would continue to exist in the future as well - as and when this issue is adjudicated upon by the higher appellate authorities.


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