For efficiency, multinationals often relocate their production or service centers to jurisdictions with significantly lower operating costs. This phenomenon, known as Location Savings, is analyzed in detail in Chapter I of the OECD Guidelines (2022).
The tax dilemma is clear: When a company saves millions on labor or infrastructure by operating in a local market, should those savings increase the local subsidiary’s profit, or should they be transferred to the parent company through Transfer Pricing?
What Are Location Savings?
Location savings are the net profits a business group earns by operating in a low cost market. These include not only cheaper labor but also lower costs for land, utilities, transportation, or specific tax incentives. Conversely, the OECD notes that these savings do not always result in higher “extra” profits. In highly competitive markets, the savings may be passed directly on to the final customer through lower prices, enabling companies to gain market share.
OECD’s Analysis: Who Retains the Profit?
To determine how to allocate these savings among related parties, tax authorities evaluate two critical factors:
- Existence of local comparables: If there are independent companies in the market that perform similar functions and obtain standard profit margins, these “savings” could already be implicit in the market and do not need a special adjustment.
- Location-specific advantages: If the savings are extraordinary and stem from an advantage unique to the country (such as a free trade zone or exclusive access to resources), the OECD assesses whether that advantage belongs to the local entity or the parent company, which, through its strategy and assets, made it possible to capture that value.
Audit Risks for Subsidiaries
Tax authorities in developing countries often argue that Location Savings belong to the jurisdiction where the savings are generated. If a parent company takes all the profits, leaving the local subsidiary with minimal (“routine”) profitability, the local tax administration could adjust this, claiming that part of those savings should be taxed in its territory.
Only a robust functional analysis can demonstrate whether the subsidiary has sufficient economic substance to retain those savings or whether it merely acts as a low-risk service provider.
Conclusion
Location savings are a legitimate competitive advantage, but their treatment in Transfer Pricing requires absolute technical precision. Failure to properly document the allocation of these profits can lead to double taxation disputes, where two countries claim the right to tax the same profit derived from operational efficiency.
Does Your Transfer Pricing Policy Accurately Capture Location Advantages?
At TPC Group, we assist multinational groups in identifying and reporting the allocation of Location Savings in accordance with the most recent international standards. We establish operational structures and technical documentation that align with actual value creation, reducing potential audit risks and optimizing the group’s global tax position.
Source: OECD – Chapter I