The first question that comes to mind is that what is Location Savings? The answer to this is very simple; when a Multinational Enterprise (MNE) saves costs by relocating facilities from a high-cost jurisdiction to a low-cost one, it is considered location saving under transfer pricing terminology. From a business and strategic point of view a MNE is perfectly justified in its decision to relocate. One may ask why should there be an issue at all as the jurisdiction where the operations are located say for eg. India would stand to gain in terms of taxes?

The tax authorities in India claim that the Indian enterprise should additionally be compensated for the location savings that the MNE would have had by relocating their operations to India.

The Mumbai Tribunal in the case of Watson Pharma (P.) Ltd. v DCIT [2015] 54taxmann.com 88 recently had an occasion to adjudicate upon this controversial issue.

The facts of the case were that taxpayer was engaged in provision of contract manufacturing and contract Research and Development (R&D) services to its Associated Enterprises (AEs). The taxpayer adopted Transactional Net Margin Method (TNMM) and selected Indian comparable companies for benchmarking its international transactions with its AEs to substantiate the arm's length nature of these transactions.

The TPO while making addition on account of choice of comparables also contended that the taxpayer's AEs enjoyed locational advantage on account of lower costs in India by shifting contract manufacturing and contract R&D activities to the taxpayer in India vis-à-vis undertaking the same in the US. Further, relying on research paper / articles, the TPO held that there is approximately 40% and 50% cost reduction in India to the AEs on contract manufacturing and contract R&D activities respectively. Based on this analysis, the TPO computed the overall cost savings to AEs from these activities in India and attributed 50% of such savings to the taxpayer on the ground that such arrangement was mutually beneficial for the AEs and the taxpayer. The TPO accordingly proposed an adjustment for location savings which adjustment was confirmed by the DRP.

The Tribunal ruled in favour of the assessee. Amongst other reasons, the ITAT relied heavily on the ruling of the Delhi Tribunal in the case of GAP International Sourcing India Pvt. Ltd. vs. ACIT (2012) 149 TTJ 437 and held that when local Indian comparables which are operating in similar economic circumstances as that of the taxpayer are considered for benchmarking, any benefit (if at all) on account of location savings would have already got embedded in the operating margins of the comparable companies. Since the taxpayer's operating margin is higher than the arm's length margin based on such local comparables, specific adjustment for location savings is not required. While holding this position, the Tribunal also observed that G20 countries have given their consensus to the above view in OECD Guidance in Intangibles and India is part of G20 countries.

The Tribunal disregarded the contention of the TPO that in the absence of the various details regarding AEs (such as cost of manufacturing in the US and ultimate selling price by them to the distributors), it could be assumed that location savings arise to the AEs. The Tribunal held that the financial results of the AEs are not relevant for determining the arm's length margin of the taxpayer. The Tribunal also observed that the reliance placed by the TPO on research papers for computation of location savings is ad hoc, based on assumptions and cannot be accepted. The Tribunal observed that the research papers were only web based articles and were not accepted by any forum.

This ruling comes at a time when the Government is trying to promote a non-adversarial tax regime and would benefit pharmaceutical, auto, IT and IT-enabled companies, among others, that are engaged in similar disputes.

Originally published July 16, 2015

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