Due to the economic situation of automotive suppliers in Germany in 2006, “Cutting Tech GMBH” established a subsidiary (CB) in Bosnien-Herzegovina which going forward functioned as a contract manufacturer. CB did not develop the products itself, but manufactured them according to specifications provided by “Cutting Tech GMBH”. The majority of “Cutting Tech GMBH”‘s sales articles were subject to multi-stage production, which could include various combinations of production processes. In particular, “Cutting Tech GMBH” was no longer competitive in the labour-intensive manufacturing processes (cut-off grinding, turning, milling) due to the high wage level in Germany. Good contribution margins from the high-tech processes (adiabatic cutting, double face grinding) increasingly had to subsidise the losses of the labour-intensive processes. Individual production stages, however, could not be outsourced to external producers for reasons of certification and secrecy. In addition, if the production had been outsourced, there would have been a great danger that a third company would have siphoned off “Cutting Tech GMBH”‘s know-how and then taken over the business with “Cutting Tech GMBH”‘s customer. This could have led to large losses in turnover for “Cutting Tech GMBH”. Furthermore, some of the labour-intensive work also had to cover one or more finishing stages of the high-tech processes, so that this business was also at risk if it was outsourced. For these reasons, the decision was made to outsource the labour-intensive production processes to Bosnia-Herzegovina in order to become profitable again and to remain competitive in the future. There, there were German-speaking staff with the necessary expertise, low customs duties and a low exchange rate risk. CB functioned as a contract manufacturer with the processes of production, quality assurance and a small administrative unit. Cost advantages existed not only in personnel costs, but also in electricity costs. CB prevented the plaintiff’s good earnings from the high-tech processes in Germany from having to continue to be used to subsidise the low-tech processes. “Cutting Tech GMBH” supplied CB with the material needed for production. The deliveries were processed as sales of materials. “Cutting Tech GMBH” received as purchase prices its cost prices without offsetting profit mark-ups or handling fees/commissions. The material was purchased and supplied to CB by “Cutting Tech GMBH”, which was able to obtain more favourable purchase prices than CB due to the quantities it purchased. The work commissioned by “Cutting Tech GMBH” was carried out by CB with the purchased material and its personnel. CB then sold the products to “Cutting Tech GMBH”. In part, they were delivered directly by CB to the end customers, in part the products were further processed by “Cutting Tech GMBH” or by third-party companies. “Cutting Tech GMBH” determined the transfer prices for the products it purchased using a “contribution margin calculation”. Until 2012, “Cutting Tech GMBH” purchased all products manufactured by CB in Bosnia and Herzegovina. From 2013 onwards, CB generated its own sales with the external company P. This was a former customer of “Cutting Tech GMBH”. Since “Cutting Tech GMBH” could not offer competitive prices to the customer P in the case of production in Germany, CB took over the latter’s orders and supplied P with the products it manufactured in accordance with the contracts concluded. CB did not have its own distribution in the years in dispute. The tax audit of FY 2011 – 2013 The auditor assumed that the transfer of functions and risks to CB in 2007/2008 basically fulfilled the facts of a transfer of functions. However, since only a routine function had been transferred, “Cutting Tech GMBH” had rightly carried out the transfer of functions without paying any special remuneration. Due to CB’s limited exposure to risks, the auditor considered that the cost-plus method should be used for transfer pricing. In adjusting the transfer prices, the auditor assumed a mark-up rate of 12%. The material invoiced by “Cutting Tech GMBH” and the scrap proceeds was not included in the cost basis used in the assessment. For 2013, the auditor took into account that the customer P had agreed contracts exclusively with CB and reduced the costs by the costs of the products sold to P. Furthermore, the auditor took the legal view that the entire audit period should be considered uniformly. Therefore, it was appropriate to deduct an amount of €64,897 in 2011, which had been calculated in favour of “Cutting Tech GMBH” in 2010 and not taken into account in the tax assessment notices, in order to correct the error. The auditor did not consider it justified to determine the transfer prices for “Cutting Tech GMBH”‘s purchases of goods by means of a so-called contribution margin calculation. Based on the functional and risk analysis, the auditor concluded that CB was a contract manufacturer. On the grounds that this profit of CB was remuneration for a routine function, the auditor refrained from recognising a vGA because of the transfer of client P from the applicant to CB. However, he stated that according to arm’s length royalty rates, values between 1% and 3% could be recognised as royalty “according to general practical experience.” “Cutting Tech GMBH” filed an appeal against the assessment in 2015 and in November 2019 the Tax Court parcially allowed the appeal of “Cutting Tech GMBH” and adjusted the assessment issued by the tax authorities. An appeal and cross appeal against the decision of the Tax Court was then filed with the Federal Tax Court (BFH). Judgement of the BFH The Federal Tax Court overturned the decision of the Tax Court and referred the case back to the Tax Court for another hearing and decision. “The appeals of the plaintiff and the FA are well-founded. They lead to the previous decision being set aside and the matter being referred back to the Fiscal Court for a different hearing and decision (§ 126 Para. 3 Sentence 1 No. 2 FGO). The arm’s length comparison carried out by the lower court to determine the transfer prices for the acquisition of processed products from C by the Plaintiff is not free of legal ...

Couture, a U.S. apparel design corporation, contracts with Sewco, its wholly owned Country Y subsidiary, to manufacture its clothes. Costs of operating in Country Y are significantly lower than the operating costs in the United States. Although clothes with the Couture label sell for a premium price, the actual production of the clothes does not require significant specialized knowledge that could not be acquired by actual or potential competitors to Sewco at reasonable cost. Thus, Sewco’s functions could be performed by several actual or potential competitors to Sewco in geographic markets that are similar to Country Y. Thus, the fact that production is less costly in Country Y will not, in and of itself, justify additional profits derived from lower operating costs in Country Y inuring to Sewco, because the competitive positions of the other actual or potential producers in similar geographic markets capable of performing the same functions at the same low costs indicate that at arm’s length such profits would not be retained by Sewco ...

The following example illustrates the principles of this paragraph (d)(4)(ii)(C) ...

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 ...

As another example, assume now that an enterprise in Country X provides highly specialised and quality engineering services to independent clients. It charges a fee to its independent clients based on a fixed hourly rate that compares with the hourly rate charged by competitors for similar services in the same market. Suppose that the wages for qualified engineers in Country X are high. The enterprise subsequently subcontracts a large part of its engineering work to a new subsidiary in Country Y. The subsidiary in Country Y hires equally qualified engineers to those in Country X for substantially lower wages, thus deriving significant location savings for the group formed by the enterprise and its subsidiary Clients continue to deal directly with the enterprise in Country X and are not necessarily aware of the sub-contracting arrangement. For some period of time, the well-known enterprise in Country X can continue to charge its services at the original hourly rate despite the significantly reduced engineer costs. After a certain period of time, however, it is forced due to competitive pressures to decrease its hourly rate (at an amount that would not allow the company in Country X to cover the wages for qualified engineers in Country X, but that would still yield a benefit if those services are provided by qualified engineers in Country Y). Part of the location savings are passed on to its clients. In this case also, the question arises of which party(ies) within the MNE group should, at arm’s length, be attributed the part of the location savings not passed on to the clients: the subsidiary in Country Y, the enterprise in Country X, or both (and if so in what proportions) ...

In such an example, given that the relocated activity is a highly competitive one, it is likely that the enterprise in Country A has the option realistically available to it to use either the affiliate in Country B or a third party manufacturer. As a consequence, it should be possible to find comparables data to determine the conditions in which a third party would be willing at arm’s length to manufacture the clothes for the enterprise. In such a situation, a contract manufacturer at arm’s length would generally be attributed very little, if any, part of the location savings. Doing otherwise would put the associated manufacturer in a situation different from the situation of an independent manufacturer, and would be contrary to the arm’s length principle ...

Take the example of an enterprise that designs, manufactures and sells brand name clothes. Assume that the manufacturing process is basic and that the brand name is famous and represents a highly valuable intangible. Assume that the enterprise is established in Country A where the labour costs are high and that it decides to close down its manufacturing activities in Country A and to relocate them in an affiliate company in Country B where labour costs are significantly lower. The enterprise in Country A retains the rights on the brand name and continues designing the clothes. Further to this restructuring, the clothes will be manufactured by the affiliate in Country B under a contract manufacturing arrangement. The arrangement does not involve the use of any significant intangible owned by or licensed to the affiliate or the assumption of any significant risks by the affiliate in Country B. Once manufactured by the affiliate in Country B, the clothes will be sold to the enterprise in Country A which will on-sell them to third party customers. Assume that this restructuring makes it possible for the group formed by the enterprise in Country A and its affiliate in Country B to derive significant location savings. The question arises whether the location savings should be attributed to the enterprise in Country A, or its affiliate in Country B, or both (and if so in what proportions) ...

Where significant location savings are derived further to a business restructuring, the question arises of whether and if so how the location savings should be shared among the parties. In addressing this matter, the guidance in Section D.6 of Chapter I is relevant ...

Location savings can be derived by an MNE group that relocates some of its activities to a place where costs (such as labour costs, real estate costs, etc.) are lower than in the location where the activities were initially performed, account being taken of the possible costs involved in the relocation (such as termination costs for the existing operation, possibly higher infrastructure costs in the new location, possibly higher transportation costs if the new operation is more distant from the market, training costs of local employees, etc.). Where a business strategy aimed at deriving location savings is put forward as a business reason for restructuring, the discussion in Section D. 1.5 of Chapter I is relevant ...

An example is the case where a manufacturing activity that used to be performed by M1, one entity of the MNE group, is re-located to another entity, M2 (e.g. to benefit from location savings). Assume M1 transfers to M2 its machinery and equipment, inventories, patents, manufacturing processes and know-how, and key contracts with suppliers and clients. Assume that several employees of M1 are relocated to M2 in order to assist M2 in the start of the manufacturing activity so relocated. Assume such a transfer would be regarded as a transfer of an ongoing concern, should it take place between independent parties. In order to determine the arm’s length remuneration, if any, of such a transfer between associated enterprises, it should be compared with a transfer of an ongoing concern between independent parties rather than with a transfer of isolated assets ...

The need for comparability adjustments related to features of the local market in cases where reasonably reliable local market comparables cannot be identified may arise in several different contexts. In some circumstances, market advantages or disadvantages may affect arm’s length prices of goods transferred or services provided between associated enterprises ...

In situations where reasonably reliable local market comparables cannot be identified, the determination of appropriate comparability adjustments for features of the local market should consider all of the relevant facts and circumstances. As with location savings, in each case where reliable local market comparables cannot be identified, it is necessary to consider (i) whether a market advantage or disadvantage exists, (ii) the amount of any increase or decrease in revenues, costs or profits, vis-à-vis those of identified comparables from other markets, that are attributable to the local market advantage or disadvantage, (iii) the degree to which benefits or burdens of local market features are passed on to independent customers or suppliers, and (iv) where benefits or burdens attributable to local market features exist and are not fully passed on to independent customers or suppliers, the manner in which independent enterprises operating under similar circumstances would allocate such net benefits or burdens between them ...

In assessing whether comparability adjustments for such local market features are required, the most reliable approach will be to refer to data regarding comparable uncontrolled transactions in that geographic market between independent enterprises performing similar functions, assuming similar risks, and using similar assets. Such transactions are carried out under the same market conditions as the controlled transaction, and, accordingly, where comparable transactions in the local market can be identified, specific adjustments for features of the local market should not be required ...

When reliable local market comparables are not present, determinations regarding the existence and allocation of location savings among members of an MNE group, and any comparability adjustments required to take into account location savings, should be based on an analysis of all of the relevant facts and circumstances, including the functions performed, risks assumed, and assets used of the relevant associated enterprises, in the manner described in paragraphs 9.126 – 9.131 ...

Where the functional analysis shows that location savings exist that are not passed on to customers or suppliers, and where comparable entities and transactions in the local market can be identified, those local market comparables will provide the most reliable indication regarding how the net location savings should be allocated amongst two or more associated enterprises. Thus, 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 ...

Pursuant to the guidance in paragraphs 9.126 – 9.131, in determining how location savings are to be shared between two or more associated enterprises, it is necessary to consider (i) whether location savings exist; (ii) the amount of any location savings; (iii) the extent to which location savings are either retained by a member or members of the MNE group or are passed on to independent customers or suppliers; and (iv) where location savings are not fully passed on to independent customers or suppliers, the manner in which independent enterprises operating under similar circumstances would allocate any retained net location savings ...

Paragraphs 9.126 – 9.131 discuss the treatment of location savings in the context of a business restructuring. The principles described in those paragraphs apply generally to all situations where location savings are present, not just in the case of a business restructuring ...

Paragraphs 1.130, 1.132 and 6.120 indicate that features of the geographic market in which business operations occur can affect comparability and arm’s length prices. Difficult issues can arise in evaluating differences between geographic markets and in determining appropriate comparability adjustments. Such issues may arise in connection with the consideration of cost savings attributable to operating in a particular market. Such savings are sometimes referred to as location savings. In other situations comparability issues can arise in connection with the consideration of local market advantages or disadvantages that may not be directly related to location savings ...

Arm’s length prices may vary across different markets even for transactions involving the same property or services; therefore, to achieve comparability requires that the markets in which the independent and associated enterprises operate do not have differences that have a material effect on price or that appropriate adjustments can be made. As a first step, it is essential to identify the relevant market or markets taking account of available substitute goods or services. Economic circumstances that may be relevant to determining market comparability include the geographic location; the size of the markets; the extent of competition in the markets and the relative competitive positions of the buyers and sellers; the availability (risk thereof) of substitute goods and services; the levels of supply and demand in the market as a whole and in particular regions, if relevant; consumer purchasing power; the nature and extent of government regulation of the market; costs of production, including the costs of land, labour, and capital; transport costs; the level of the market (e.g. retail or wholesale); the date and time of transactions; and so forth. The facts and circumstances of the particular case will determine whether differences in economic circumstances have a material effect on price and whether reasonably accurate adjustments can be made to eliminate the effects of such differences. More detailed guidance on the importance in a comparability analysis of the features of local markets, especially local market features that give rise to location savings, is provided in Section D.6 of this chapter ...

Due to the economic situation of automotive suppliers in Germany in 2006, “Cutting Tech GMBH” established a subsidiary (CB) in Bosnien-Herzegovina which going forward functioned as a contract manufacturer. CB did not develop the products itself, but manufactured them according to specifications provided by “Cutting Tech GMBH”. The majority of “Cutting Tech GMBH”‘s sales articles were subject to multi-stage production, which could include various combinations of production processes. In particular, “Cutting Tech GMBH” was no longer competitive in the labour-intensive manufacturing processes (cut-off grinding, turning, milling) due to the high wage level in Germany. Good contribution margins from the high-tech processes (adiabatic cutting, double face grinding) increasingly had to subsidise the losses of the labour-intensive processes. Individual production stages, however, could not be outsourced to external producers for reasons of certification and secrecy. In addition, if the production had been outsourced, there would have been a great danger that a third company would have siphoned off “Cutting Tech GMBH”‘s know-how and then taken over the business with “Cutting Tech GMBH”‘s customer. This could have led to large losses in turnover for “Cutting Tech GMBH”. Furthermore, some of the labour-intensive work also had to cover one or more finishing stages of the high-tech processes, so that this business was also at risk if it was outsourced. For these reasons, the decision was made to outsource the labour-intensive production processes to Bosnia-Herzegovina in order to become profitable again and to remain competitive in the future. There, there were German-speaking staff with the necessary expertise, low customs duties and a low exchange rate risk. CB functioned as a contract manufacturer with the processes of production, quality assurance and a small administrative unit. Cost advantages existed not only in personnel costs, but also in electricity costs. CB prevented the plaintiff’s good earnings from the high-tech processes in Germany from having to continue to be used to subsidise the low-tech processes. “Cutting Tech GMBH” supplied CB with the material needed for production. The deliveries were processed as sales of materials. “Cutting Tech GMBH” received as purchase prices its cost prices without offsetting profit mark-ups or handling fees/commissions. The material was purchased and supplied to CB by “Cutting Tech GMBH”, which was able to obtain more favourable purchase prices than CB due to the quantities it purchased. The work commissioned by “Cutting Tech GMBH” was carried out by CB with the purchased material and its personnel. CB then sold the products to “Cutting Tech GMBH”. In part, they were delivered directly by CB to the end customers, in part the products were further processed by “Cutting Tech GMBH” or by third-party companies. “Cutting Tech GMBH” determined the transfer prices for the products it purchased using a “contribution margin calculation”. Until 2012, “Cutting Tech GMBH” purchased all products manufactured by CB in Bosnia and Herzegovina. From 2013 onwards, CB generated its own sales with the external company P. This was a former customer of “Cutting Tech GMBH”. Since “Cutting Tech GMBH” could not offer competitive prices to the customer P in the case of production in Germany, CB took over the latter’s orders and supplied P with the products it manufactured in accordance with the contracts concluded. CB did not have its own distribution in the years in dispute. The tax audit of FY 2011 – 2013 The auditor assumed that the transfer of functions and risks to the CB in 2007/2008 basically fulfilled the facts of a transfer of functions. However, since only a routine function had been transferred, “Cutting Tech GMBH” had rightly carried out the transfer of functions without paying any special remuneration. Due to CB’s limited exposure to risks, the auditor considered that the cost-plus method should be used for transfer pricing. In adjusting the transfer prices, the auditor assumed a mark-up rate of 12%. The material invoiced by “Cutting Tech GMBH” and the scrap proceeds was not included in the cost basis used in the assessment. For 2013, the auditor took into account that the customer P had agreed contracts exclusively with CB and reduced the costs by the costs of the products sold to P. Furthermore, the auditor took the legal view that the entire audit period should be considered uniformly. Therefore, it was appropriate to deduct an amount of €64,897 in 2011, which had been calculated in favour of “Cutting Tech GMBH” in 2010 and not taken into account in the tax assessment notices, in order to correct the error. The auditor did not consider it justified to determine the transfer prices for “Cutting Tech GMBH”‘s purchases of goods by means of a so-called contribution margin calculation. Based on the functional and risk analysis, the auditor concluded that CB was a contract manufacturer. On the grounds that this profit of CB was remuneration for a routine function, the auditor refrained from recognising a vGA because of the transfer of client P from the applicant to CB. However, he stated that according to arm’s length royalty rates, values between 1% and 3% could be recognised as royalty “according to general practical experience.” “Cutting Tech GMBH” filed an appeal against the assessment in 2015. Judgement of the Fiscal Court The Fiscal Court adjusted the assessment issued by the tax authorities and thus parcially allowed the appeal of “Cutting Tech GMBH”. Excerpts “In the case at issue, the decisive cause for the plaintiff losing the customer P is not to be seen in the transfer of business to CB. The applicant lost the customer because it could not offer him competitive prices. The takeover of the business with P by CB is thus not the cause of the loss of the customer. The plaintiff’s factual submission is undisputed in this respect and is confirmed by the small profit that CB made from the business according to the calculations of the foreign auditor.” “The FA was correct to add € … to the taxable income in the year 2013 due to the supply of materials to CB for the processing of its business with ...

As another example, assume now that an enterprise in Country X provides highly specialised and quality engineering services to independent clients. It charges a fee to its independent clients based on a fixed hourly rate that compares with the hourly rate charged by competitors for similar services in the same market. Suppose that the wages for qualified engineers in Country X are high. The enterprise subsequently subcontracts a large part of its engineering work to a new subsidiary in Country Y. The subsidiary in Country Y hires equally qualified engineers to those in Country X for substantially lower wages, thus deriving significant location savings for the group formed by the enterprise and its subsidiary Clients continue to deal directly with the enterprise in Country X and are not necessarily aware of the sub-contracting arrangement. For some period of time, the well-known enterprise in Country X can continue to charge its services at the original hourly rate despite the significantly reduced engineer costs. After a certain period of time, however, it is forced due to competitive pressures to decrease its hourly rate (at an amount that would not allow the company in Country X to cover the wages for qualified engineers in Country X, but that would still yield a benefit if those services are provided by qualified engineers in Country Y). Part of the location savings are passed on to its clients. In this case also, the question arises of which party(ies) within the MNE group should, at arm’s length, be attributed the part of the location savings not passed on to the clients: the subsidiary in Country Y, the enterprise in Country X, or both (and if so in what proportions) ...

In such an example, given that the relocated activity is a highly competitive one, it is likely that the enterprise in Country A has the option realistically available to it to use either the affiliate in Country B or a third party manufacturer. As a consequence, it should be possible to find comparables data to determine the conditions in which a third party would be willing at arm’s length to manufacture the clothes for the enterprise. In such a situation, a contract manufacturer at arm’s length would generally be attributed very little, if any, part of the location savings. Doing otherwise would put the associated manufacturer in a situation different from the situation of an independent manufacturer, and would be contrary to the arm’s length principle ...

Take the example of an enterprise that designs, manufactures and sells brand name clothes. Assume that the manufacturing process is basic and that the brand name is famous and represents a highly valuable intangible. Assume that the enterprise is established in Country A where the labour costs are high and that it decides to close down its manufacturing activities in Country A and to relocate them in an affiliate company in Country B where labour costs are significantly lower. The enterprise in Country A retains the rights on the brand name and continues designing the clothes. Further to this restructuring, the clothes will be manufactured by the affiliate in Country B under a contract manufacturing arrangement. The arrangement does not involve the use of any significant intangible owned by or licensed to the affiliate or the assumption of any significant risks by the affiliate in Country B. Once manufactured by the affiliate in Country B, the clothes will be sold to the enterprise in Country A which will on-sell them to third party customers. Assume that this restructuring makes it possible for the group formed by the enterprise in Country A and its affiliate in Country B to derive significant location savings. The question arises whether the location savings should be attributed to the enterprise in Country A, or its affiliate in Country B, or both (and if so in what proportions) ...

Where significant location savings are derived further to a business restructuring, the question arises of whether and if so how the location savings should be shared among the parties. In addressing this matter, the guidance in Section D.6 of Chapter I is relevant ...

Location savings can be derived by an MNE group that relocates some of its activities to a place where costs (such as labour costs, real estate costs, etc.) are lower than in the location where the activities were initially performed, account being taken of the possible costs involved in the relocation (such as termination costs for the existing operation, possibly higher infrastructure costs in the new location, possibly higher transportation costs if the new operation is more distant from the market, training costs of local employees, etc.). Where a business strategy aimed at deriving location savings is put forward as a business reason for restructuring, the discussion in Section D. 1.5 of Chapter I is relevant ...

An example is the case where a manufacturing activity that used to be performed by M1, one entity of the MNE group, is re-located to another entity, M2 (e.g. to benefit from location savings). Assume M1 transfers to M2 its machinery and equipment, inventories, patents, manufacturing processes and know-how, and key contracts with suppliers and clients. Assume that several employees of M1 are relocated to M2 in order to assist M2 in the start of the manufacturing activity so relocated. Assume such a transfer would be regarded as a transfer of an ongoing concern, should it take place between independent parties. In order to determine the arm’s length remuneration, if any, of such a transfer between associated enterprises, it should be compared with a transfer of an ongoing concern between independent parties rather than with a transfer of isolated assets ...

The need for comparability adjustments related to features of the local market in cases where reasonably reliable local market comparables cannot be identified may arise in several different contexts. In some circumstances, market advantages or disadvantages may affect arm’s length prices of goods transferred or services provided between associated enterprises ...

In situations where reasonably reliable local market comparables cannot be identified, the determination of appropriate comparability adjustments for features of the local market should consider all of the relevant facts and circumstances. As with location savings, in each case where reliable local market comparables cannot be identified, it is necessary to consider (i) whether a market advantage or disadvantage exists, (ii) the amount of any increase or decrease in revenues, costs or profits, vis-à-vis those of identified comparables from other markets, that are attributable to the local market advantage or disadvantage, (iii) the degree to which benefits or burdens of local market features are passed on to independent customers or suppliers, and (iv) where benefits or burdens attributable to local market features exist and are not fully passed on to independent customers or suppliers, the manner in which independent enterprises operating under similar circumstances would allocate such net benefits or burdens between them ...

In assessing whether comparability adjustments for such local market features are required, the most reliable approach will be to refer to data regarding comparable uncontrolled transactions in that geographic market between independent enterprises performing similar functions, assuming similar risks, and using similar assets. Such transactions are carried out under the same market conditions as the controlled transaction, and, accordingly, where comparable transactions in the local market can be identified, specific adjustments for features of the local market should not be required ...

When reliable local market comparables are not present, determinations regarding the existence and allocation of location savings among members of an MNE group, and any comparability adjustments required to take into account location savings, should be based on an analysis of all of the relevant facts and circumstances, including the functions performed, risks assumed, and assets used of the relevant associated enterprises, in the manner described in paragraphs 9.126 – 9.131 ...

Where the functional analysis shows that location savings exist that are not passed on to customers or suppliers, and where comparable entities and transactions in the local market can be identified, those local market comparables will provide the most reliable indication regarding how the net location savings should be allocated amongst two or more associated enterprises. Thus, 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 ...

Pursuant to the guidance in paragraphs 9.126 – 9.131, in determining how location savings are to be shared between two or more associated enterprises, it is necessary to consider (i) whether location savings exist; (ii) the amount of any location savings; (iii) the extent to which location savings are either retained by a member or members of the MNE group or are passed on to independent customers or suppliers; and (iv) where location savings are not fully passed on to independent customers or suppliers, the manner in which independent enterprises operating under similar circumstances would allocate any retained net location savings ...

Paragraphs 9.126 – 9.131 discuss the treatment of location savings in the context of a business restructuring. The principles described in those paragraphs apply generally to all situations where location savings are present, not just in the case of a business restructuring ...

Paragraphs 1.110, 1.112 and 6.120 indicate that features of the geographic market in which business operations occur can affect comparability and arm’s length prices. Difficult issues can arise in evaluating differences between geographic markets and in determining appropriate comparability adjustments. Such issues may arise in connection with the consideration of cost savings attributable to operating in a particular market. Such savings are sometimes referred to as location savings. In other situations comparability issues can arise in connection with the consideration of local market advantages or disadvantages that may not be directly related to location savings ...

Arm’s length prices may vary across different markets even for transactions involving the same property or services; therefore, to achieve comparability requires that the markets in which the independent and associated enterprises operate do not have differences that have a material effect on price or that appropriate adjustments can be made. As a first step, it is essential to identify the relevant market or markets taking account of available substitute goods or services. Economic circumstances that may be relevant to determining market comparability include the geographic location; the size of the markets; the extent of competition in the markets and the relative competitive positions of the buyers and sellers; the availability (risk thereof) of substitute goods and services; the levels of supply and demand in the market as a whole and in particular regions, if relevant; consumer purchasing power; the nature and extent of government regulation of the market; costs of production, including the costs of land, labour, and capital; transport costs; the level of the market (e.g. retail or wholesale); the date and time of transactions; and so forth. The facts and circumstances of the particular case will determine whether differences in economic circumstances have a material effect on price and whether reasonably accurate adjustments can be made to eliminate the effects of such differences. More detailed guidance on the importance in a comparability analysis of the features of local markets, especially local market features that give rise to location savings, is provided in Section D.6 of this chapter ...

A AB purchased manufacturing services of its subsidiary B AS, which had its headquarters in Estonia. The internal pricing of services had since July 2004 been under the net margin method. The price data beside B AS’s realized expenses also included half of the so-called location-savings. On taxation of A AB approved as deductible expenditure only B AS’s actual expenses plus a calculated profit margin. The Supreme Administrative Court stated that A AB in Finland did not have such manufacturing as B AS was conducted in Estonia during the tax year. B AS’s production of the products differed substantially from A ABs former manufacturing in Finland, where A AB had manufactured the products by hand. Most of the new working methods and stages developed in Estonia had never been used in Finland. Hence the situation was not comparable to the location savings by moving the activities as described in the OECD report, and the pricing of would not be judged on the basis of the principles according to the OECD report in such situations. The base price was not included, the calculated benefits for A AB of the subsidiary’s manufacturing costs being lower than the estimated costs that the company would have had if it had manufactured products in Finland. The market-based internal price for contract manufacturing could be determined by using the net margin method so that it was based on comparable companies’ profit margins. In assessing which companies were comparable, in addition to other factors would be taken into account that B AS had its business in a country where costs were low and therefore had the opportunity for a larger margin than companies in countries where costs were higher. In determining the profit margin had to take account of A ABs and B AS’s supposed negotiating power in the event that they had been independent company. B AS was not the holders of intellectual property rights or particularly high-class know-how or technology that would have formed the basis for a high profit margin. Within the company, however, were developed manufacturing processes so that it was suitable for large scale production, and B AS had acquired significant expertise in the production. It was therefore reasonable to expect a higher profit margin for the B AS than comparable companies in the A AB’s documentation. Click here for translation ...

Finally, there might be some cases where the costs savings (or costs) generated by the centralisation of the purchasing function would be shared amongst the central purchasing entity and the manufacturing plants through a form of profit split ...

It may happen that what would be prima facie regarded as an arm’s length mark-up on costs or commission fee from the perspective of the central purchasing entity in effect leads to determining purchase prices for the manufacturing entities that are higher than the prices they could obtain by themselves. If the incremental costs that are created for the manufacturers are material (e.g. they materially affect, on a recurrent basis, the basket of products channelled through the central purchasing entity), the question arises whether independent manufacturers would have agreed to pay such higher prices and what the economic rationale would be, or whether at arm’s length the central purchasing entity should bear part or all of the inefficiencies through a reduction of its sales prices to the manufacturers. The response will depend on the facts and circumstances of the case. Key to the analysis will be the determination of the benefits that could reasonably be expected by the parties (manufacturing entities and central purchasing entity) from the implementation of the central purchasing function, and of the options realistically available to them, including in appropriate cases the option not to participate in the central purchasing in case the expected benefits were not as attractive as under other options. Where benefits could reasonably have been expected by the parties, it will be key to analyse the reasons for the central purchasing entity’s apparent inefficiency, the contractual terms under which the central purchasing entity operates and the functional analysis of the manufacturers and of the central purchasing entity, in particular their respective roles and responsibilities in the decisions that led to the inefficiencies. This analysis should make it possible to determine what party(ies) should be allocated the inefficiency costs and to what extent. Where this analysis indicates that inefficiencies should be allocated to the central purchasing entity, one way of doing so would be to price the sale transactions to the manufacturing entities by reference to CUP i.e. based on prices that the manufacturing entities could obtain on the free market for comparable supplies in comparable circumstances. No inference should be drawn however that any inefficiencies should be allocated by default to the central purchasing function, or that the positive effects of synergies should always be shared amongst the members of the group ...

In some cases, the central purchasing entity acts as an agent either for the suppliers or for the purchasers (or both) and is remunerated by a commission fee paid either by the suppliers or by the purchasers (or both). This might be the case where the central purchasing entity negotiates with the third party suppliers but does not take title to the inventories, i.e. the manufacturing plants continue to acquire the raw materials directly from the suppliers but at a discounted price obtained thanks to the activity of the central purchasing entity and to the participation of the group of manufacturing plants in the arrangement. The commission fee might be proportional to the supplies (especially if paid by the supplier) or to the discounts obtained (especially if paid by the manufacturing plants). It should be comparable to the commission fee that would be charged by independent parties for comparable agency functions in similar circumstances ...

Where the CUP method cannot be used, e.g. because the price of the raw materials fluctuates and the price paid by the manufacturing entities before the setting up of the central purchasing entity cannot serve as a reference, the cost plus method might be considered. For instance, the central purchasing entity might purchase the raw materials from third party suppliers and re-sell them to the manufacturing plants at cost plus, i.e. the new purchase price of the raw material by the central purchasing entity plus an arm’s length mark-up. In such a case, the mark-up rate attributed to the central purchasing entity should be comparable to the mark-up rate earned in comparable uncontrolled trading activities ...

First, there will be cases where the CUP method will be applicable. Assume the central purchasing entity purchases the raw materials from third party suppliers and sells them to the manufacturing plants. The CUP method might be applicable if the raw materials are traded on a commodity market (see paragraph 2.18). It may also be the case that the price that was paid by the manufacturing plants before the interposition of the central purchasing entity or the price paid by independent parties for comparable raw materials may, subject to a review of the facts and circumstances and of the effects of the controlled and uncontrolled transactions taking place at different times, be used as a comparable uncontrolled price to determine the price at which the manufacturing plants should acquire the raw materials from the central purchasing entity. However, such a CUP, if unadjusted, may well mean that all the costs savings would be attributed to the central purchasing entity. As noted at paragraph 9.154, a determination of whether or not this would be an arm’s length condition has to be made on a case by case basis. Should it be determined that in the circumstances of the case, a portion of the cost savings should be attributed to the manufacturing entities, then the question would arise whether the CUP should and could be adjusted accordingly ...

Assume an MNE group puts in place a central purchasing entity that will negotiate with third party suppliers the purchases of raw materials used by all the manufacturing plants of the group in their manufacturing processes. Depending in particular on the respective functional analyses of the manufacturing plants and of the central purchasing entity and on the contractual terms they have agreed upon, a variety of remuneration schemes and transfer pricing methods could be considered ...

This section illustrates the application of the arm’s length principle in the case of the implementation of a central purchasing function. It reflects the central importance of comparability analyses and in particular of the functional analysis in order to understand the role played by each of the parties in the creation of synergies, costs savings, or other integration effects. The list below is not intended to cover all the possible situations but only the most frequent ones. Which transfer pricing method is the most appropriate will depend on the facts and circumstances of the case. In particular, a determination of which party(ies) should be allocated the cost savings or inefficiencies created by the centralisation of the purchasing function will depend on the particular circumstances of each case ...

In this example, it might be that there is a high demand for the type of engineering services in question and the subsidiary in Country Y is the only one able to provide them with the required quality standard, so that the enterprise in Country X does not have many other options available to it than to use this service provider. It might be that the subsidiary in Country Y has developed a valuable intangible corresponding to its technical know- how. Such an intangible would need to be taken into account in the determination of the arm’s length remuneration for the sub-contracted services. In appropriate circumstances (e.g. if there are significant unique contributions such as intangibles used by both the enterprise in Country X and its subsidiary in Country Y), the use of a transactional profit split method may be considered ...

As another example, assume now that an enterprise in Country X provides highly specialised engineering services to independent clients. The enterprise is very well known for its high quality standard. It charges a fee to its independent clients based on a fixed hourly rate that compares with the hourly rate charged by competitors for similar services in the same market. Suppose that the wages for qualified engineers in Country X are high. The enterprise subsequently opens a subsidiary in Country Y where it hires equally qualified engineers for substantially lower wages, and subcontracts a large part of its engineering work to its subsidiary in Country Y, thus deriving significant location savings for the group formed by the enterprise and its subsidiary. Clients continue to deal directly with the enterprise in Country X and are not necessarily aware of the sub-contracting arrangement. For some period of time, the well known enterprise in Country X can continue to charge its services at the original hourly rate despite the significantly reduced engineer costs. After a certain period of time, however, it is forced due to competitive pressures to decrease its hourly rate and pass on part of the location savings to its clients. In this case also, the question arises of which party(ies) within the MNE group should be attributed the location savings at arm’s length: the subsidiary in Country Y, the enterprise in Country X, or both (and if so in what proportions) ...

In such an example, given that the relocated activity is a highly competitive one, it is likely that the enterprise in Country A has the option realistically available to it to use either the affiliate in Country B or a third party manufacturer. As a consequence, it should be possible to find comparables data to determine the conditions in which a third party would be willing at arm’s length to manufacture the clothes for the enterprise. In such a situation, a contract manufacturer at arm’s length would generally be attributed very little, if any, part of the location savings. Doing otherwise would put the associated manufacturer in a situation different from the situation of an independent manufacturer, and would be contrary to the arm’s length principle ...

Take the example of an enterprise that designs, manufactures and sells brand name clothes. Assume that the manufacturing process is basic and that the brand name is famous and represents a highly valuable intangible. Assume that the enterprise is established in Country A where the labour costs are high and that it decides to close down its manufacturing activities in Country A and to relocate them in an affiliate company in Country B where labour costs are significantly lower. The enterprise in Country A retains the rights on the brand name and continues designing the clothes. Further to this restructuring, the clothes will be manufactured by the affiliate in Country B under a contract manufacturing arrangement. The arrangement does not involve the use of any significant intangible owned by or licensed to the affiliate or the assumption of any significant risks by the affiliate in Country B. Once manufactured by the affiliate in Country B, the clothes will be sold to the enterprise in Country A which will on-sell them to third party customers. Assume that this restructuring makes it possible for the group formed by the enterprise in Country A and its affiliate in Country B to derive significant location savings. The question arises whether the location savings should be attributed to the enterprise in Country A, or its affiliate in Country B, or both (and if so in what proportions) ...

Where significant location savings are derived further to a business restructuring, the question arises of whether and if so how the location savings should be shared among the parties. The response should obviously depend on what independent parties would have agreed in similar circumstances. The conditions that would be agreed between independent parties would normally depend on the functions, assets and risks of each party and on their respective bargaining powers ...

Location savings can be derived by an MNE group that relocates some of its activities to a place where costs (such as labour costs, real estate costs, etc.) are lower than in the location where the activities were initially performed, account being taken of the possible costs involved in the relocation (such as termination costs for the existing operation, possibly higher infrastructure costs in the new location, possibly higher transportation costs if the new operation is more distant from the market, training costs of local employees, etc.). Where a business strategy aimed at deriving location savings is put forward as a business reason for restructuring, the discussion at paragraphs 1.59-1.63 is relevant ...