Location Specific Advantages An Economist s Viewpoint

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1 Economic Consulting 6 March 2012 Location Specific Advantages An Economist s Viewpoint Sébastien Gonnet, Beijing Emmanuel Llinares, Paris/Geneva A presentation for TEI - EMEA Chapter

2 Objectives Provide an analytical framework for addressing location specific advantages (including market premium), and economic tools to identify, quantify and apportion them 1

3 Location Savings Arise When Relocating Manufacturing Functions From High Cost To Low Cost Countries Location savings emerge when companies transfer production or operation sites from a high cost environment to a low cost environment. Location savings = net savings from difference of input cost (e.g. labor cost) in a specific location, compared to an alternative location or locations 2

4 Court Cases Cases Fiscal Years Background Outcome Eli Lily & Co v US parent purchased pharmaceuticals from Location savings: US Puerto Rican subsidiary and resold them in the 100% to low cost US. Combined profits split as follows: returns manufacturer to routine functions (production -100% to Puerto Rico- and selling-100% to US), Location Savings (100% to Puerto Rico) and return on intangibles (55% Puerto Rico for IP 45% US for marketing intangibles). Sundstrand Corp. & Subs v. Comm Location Savings estimated with the costs of setting up/operating new hypothetical US factory. Manufacturing licence agreement gave to Singapore Sub. a monopolistic position : a third party would have kept all Loc. Sav. (after appropriate royalty for the technology license). Location savings: 100% to low cost manufacturer National Semiconductor Corp. v. Comm to 1981 Mutually dependent business relationship: NSC US needed the labour cost savings provided by NSC Asia to remain competitive and NSC Asia needed a high and steady volume of orders to justify heavy investments in equipment, etc. At arm's length, NSC Asia could not afford to risk losing NSC US's business by allowing NSC to suffer heavy losses. Mutually dependent business relationship implies that location savings should be shared b/w Parent and Sub. 3

5 Court Cases Cases Fiscal Years Background Outcome Bausch & Lomb 1980 Implicitly allocated Loc. Sav. to Sub. by Location savings: v. Comm. rejecting its characterisation as a mere 100% to low cost subcontractor given that neither volumes nor manufacturer prices were guaranteed. Compaq Computer Corp & Subs v. Comm Electronic circuits market is global and a world price should have been produced by competition within the market; moreover Compaq Asia had market power resulting from its ability to meet the product quality and flexibility requirements of its customer. Thus relevant market was the US and Court accepted CUPs paid by Compaq to unrelated subcontractors (mostly located in the US). Location savings: 100% to low cost manufacturer 4

6 The OECD Perspective Example Argument Outcome 1. Branded clothes manufacturer in a high cost Country owning all IP (brand, designs, etc.) decides to relocate basic contract manufacturing operations to a low cost Country [ ] Relocated activity is highly competitive, does not employ valuable intangibles, nor implies assumption of significant risks: the parent has the option realistically available to use either the affiliate or a third party. All or most of the location savings would be attributed to the Parent. 2. Provider of highly specialised engineering services in high cost Country A opens a subsidiary in low cost Country B; The clients of the parent in Country A ignore subcontracting and are charged country A hourly rates until competition forces parent to pass some of the savings to clients [ ] If the Subsidiary in Country B is the only one capable to provide the required quality standards (or has some locally developed intangibles) then a split of the profits is likely. Profit Split method to determine split of Location savings Source: OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, paragraphs , pages

7 The US Perspective If an uncontrolled taxpayer operates in a different geographic market than the controlled taxpayer, adjustments may be necessary to account for significant differences in costs attributable to the geographic markets. These adjustments must be based on the effect such differences would have on the consideration charged or paid in the controlled transaction given the relative competitive positions of buyers and sellers in each market. Thus, for example, the fact that the total costs of operating in a controlled manufacturer's geographic market are less than the total costs of operating in other markets ordinarily justifies higher profits to the manufacturer only if the cost differences would increase the profits of comparable uncontrolled manufacturers operating at arm's length, given the competitive positions of buyers and sellers in that market. 3 U.S. Section 482 regulations (d)(4)(ii)(C). 6

8 With Major Investments From MNEs In Low-cost Countries (e.g. BRIC), The Issue Of Location Savings Is A Hot Topic Number of responses Expected location of FDI by MNEs in Source: World investment prospects survey United Nations 7

9 In Addition To The Amounts, The Nature Of Investments In BRIC Is Also Leading To A Broader Concept Of Location Specific Advantages Produce in China, Sell outside China Produce in China (or outside), Sell in China Location savings at stake Location savings at stake and «market premium» 8

10 Chinese Transfer Pricing Agenda substantial market premium in the auto industry (SAT, July 2010) location savings, intangibles, and market premiums (SAT, April 2010) cost savings in the auto industry (SAT, July 2010) unique potential in the Chinese market (Ms. Wang Xiao Yue, Director of Anti-Avoidance Division, SAT, July 2009) how cost advantage impacts profitability (Ms. Wang Xiao Yue, July 2009) RMB0.5 billion was collected as additional tax revenue in BAPA cases in 2009 applying the concepts of location savings and market intangible (SAT) 9

11 The United Nations Transfer Pricing Draft Manual Another aspect of having different geographic markets is the concept of location savings which may come into play during transfer pricing analysis. The relocation of a business to a low cost jurisdiction may not only generate location savings, but also give some other location specific advantages in addition to location savings. This broader concept is known as location specific advantages (in short, LSAs). These advantages could be, depending on the circumstances of the case: highly specialized skilled manpower and knowledge access and proximity to growing local/regional market large customer base with increased spending capacity better information network powerful incentives. page 23, para , 6, 7 10

12 Location Specific Advantages : The Need For A Clear Definition Location specific advantages (LSAs) Location specific advantageous access to factors of production and distribution that can be exploited to produce a particular product or service cheaper, better or with less risk, or to increase the ability of a company to sell more product or achieve a larger market share Both supply and demand sides Broader than location savings Net location specific advantages and location rents Location rents Location rents exist if the following two conditions apply: - There is a quantifiable net location specific advantage - Certain market characteristics prevent the advantages / savings from being passed on to ultimate customers or unrelated suppliers 11

13 Location Specific Advantages : The Need For A Systematic Review Process Economic analysis is necessary to assess: 1. Whether or not an MNE benefits from LSAs in certain locations 2. In cases where LSAs are identified, whether they convert into location rents (super-profits) 3. Which entity (parent / principal / local subsidiary) is entitled to location rents (super-profits) 12

14 Step 1 - Whether Or Not An MNE Benefits From LSAs In Certain Locations The Before / After Comparison Other profit Normal profit Location Savings Savings due to difference in Input Costs Cost difference Production Cost Savings due to differences in Fixed Costs Production Costs After transfer Before transfer 13

15 Step 1 - Whether Or Not An MNE Benefits From LSAs In Certain Locations The Low Cost Country vs The Rest Of The Group Comparison Other profit Normal profit Location Savings Savings due to difference in Input Costs Cost difference Savings due to differences in Fixed Costs Production Cost Production Costs Low cost country Internal benchmark High cost countries only? Group average? Regional substitutes? 14

16 Step 2 Conversion Of LSAs Into Location Rents / Extra-profits Net Location-Specific Advantages Price level COGS COGS COGS Overheads Other Costs Actual Local Costs Operating Profit Overheads Other Costs Actual Local Costs Extra Profits ( ) Operating Profit Overheads Other Costs Actual Local Costs Operating Profit 1. Benchmark 2. Location Rents 3. No Location Rents 15

17 Step 3 Which Entity Is Entitled To Location Rents The LSA Matrix Generally Available CASE I SUPER PROFIT > 0 CASE IV SUPER PROFIT = 0 Availability of Location Advantages Rents accrue to the party that secures protection from competition in final markets (usually the parent?) CASE II SUPER PROFIT > 0 No rents competition forces prices down, benefits accrue to customers CASE III SUPER PROFIT > 0 Rents allocation depends on reasons for restricted competition & access to advantages Rents accrue to party that secures access to location advantages Exclusive Access (shared local company / parent?) Protection from Competition Degree of Competition in Product Market (local company?) Competition Note: this matrix is a revised version of a model introduced by Frisch in 1993 reflecting the conclusions from the US location savings case law 16

18 Step 3 Which Entity Is Entitled To Location Rents? In most cases, reliable CUPs / CUTs are not available Other methods should therefore be envisaged Allocation of location rents between parent (intellectual property owner) and local affiliate should be analyzed using their relative bargaining power Local affiliate is powerful if: It does not depend heavily on the IP owner for revenue There are high switching costs in changing local affiliate The local affiliate can easily have access to similar IP There are strong incumbency advantages Restrictive local government policy distorts competition IP Owner is powerful if: The IP is exclusive and cannot easily be replaced There are high switching costs for local affiliate to use IP from another source It relies on costly and specialized assets that cannot easily be used with other IP The IP is valuable and yields super-profits in the long run Investments in developing the IP are constantly renewed and controlled "IP" in this case embodies everything that 1. allows access and 2. safeguards competitive strength 17

19 Case Studies Open Discussion Case 1: Is TNMM appropriate to quantify and apportion LSAs? Experiment covering China, Europe and the USA aiming to compare the profitability of the players in each market for a certain player type (manufacturer, service company, distributor). For each panel the following systematic and consistent search process has been applied: Industry screening using appropriate NACE/SIC code Independence excluding shareholders, with ownership above 50 percent except individual and private person ownership Financial data availability at least three years financial data over the tested period Turnover a minimum turnover threshold has been used set at 10 million for the manufacturing and retail searches and 2 million for the service search (given the lack of comparables) Listed/Unlisted unlisted companies for EU-15 and listed companies for China and the USA A high qualitative review has then been performed, to remove companies obviously not connected to the industries in scope of the experiment. ORBIS has been used for the EU search, Compustat for the U.S. search and OSIRIS for the China search 18

20 Case Studies Open Discussion Manufacture EU USA China Min -8.3% -3.6% -6.0% Q1 1.1% 2.0% 2.5% Median 3.1% 6.0% 6.3% Q3 6.0% 9.8% 11.7% Max 37.8% 31.2% 19.7% No. of Companies Service EU USA China Min -36.6% -16.5% -2.0% Q1 1.0% 2.2% 13.2% Median 4.5% 9.1% 20.8% Q3 8.1% 14.9% 28.0% Max 91.9% 21.6% 44.9% No. of Companies Distribution EU USA China Min -6.7% -4.0% 1.4% Q1 1.8% 2.8% 3.5% Median 3.1% 5.5% 6.0% Q3 5.5% 8.5% 9.2% Max 30.2% 19.5% 20.1% No. of Companies

21 Case Studies Open Discussion Case 2: A global company Consistent global operations worldwide and highly centralized business model and IP Full-fledged operations (manufacturing and distribution) in 10 countries Question 1: can it be argued that in low cost countries, these companies benefit from a cost advantage? If so who shall be entitled to the corresponding profits if any? Question 2: in countries like China, where the demand is booming, can it be argued that the local company benefits from or secures a «market premium»? 20

22 Case Studies Open Discussion Case 3: A technology driven company Global R&D centralized in Canada with legal and economic (financing) ownership of IP (patents, etc.) IP centers in Germany, France, the US and India Gradual shift of R&D people and responsibilities to India Assuming R&D engineers and technicians in India cost 50% of the average cost of R&D staff in the other countries, what is the arm s length price for R&D services rendered by India to the group? 21

23 Concluding Remarks Location-specific advantages-related economic analyses can help multinational companies: Understand the reasons for deviations of profitability among various subsidiaries with similar functional profiles in different countries Set arm's length levels of prices or margins in the BRICS or emerging countries, notably in the absence of meaningful (local) comparable companies Justify and defend the level of IP royalties charged to subsidiaries in BRICS or emerging countries, notably in the absence of (local) comparable license agreements Solve conflicts or accelerate negotiations with tax authorities. In this respect, more or more disputes arise in Europe in relation to the BRICS, as European tax authorities tend to refuse any LSA to China and other BRICS and to require the repatriation of the quasi totality of BRICS-related profits to European Headquarters. 22

24 Contact us Sebastien Gonnet 龚 赛 安 Vice-President Beijing Office Emmanuel Llinares Vice-President Paris / Geneva Office

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