Multinational corporations strategically relocate standardized production, development, support, or other service functions to locations that offer particular economic advantages. These include, for example, lower personnel and material costs, qualified specialists, efficient infrastructure, or favorable regulatory frameworks.
For transfer pricing purposes, the companies in question are often classified as Routine companies They are classified and compensated according to the cost-plus method. They receive their costs plus an arm's length profit margin. Any residual profit remaining above this amount typically stays with the principal company, which performs key functions, controls significant risks, and utilizes relevant intangible assets.
The crucial question: Who is entitled to the additional profit that arises precisely from the special advantages of the local location?
This is precisely where the discussion about location advantages begins (hereinafter also referred to as Location-Specific Advantages; “LSAs”) This can lead to a situation where a classic functional and risk analysis as well as a benchmark study alone are not sufficient to justify the distribution of results within the group.
The following we will show:
- what LSAs are and where the approach originates,
- how the more comprehensive LSA approach differs from the OECD understanding,
- what impact location advantages can have on the margins of foreign routine companies and
- how companies can pragmatically limit the resulting transfer pricing risks.
1. What are Location-Specific Advantages?
Local Special Areas (LSAs) are economic advantages or disadvantages that arise from conducting business in a specific geographic location. Unlike a patent, trademark, or similar right, they cannot generally be legally owned or controlled. Rather, they are based on the specific conditions of the local market.
Typical location advantages include, in particular:
- lower wage, land, rent or energy costs,
- Access to qualified workers or specialized suppliers,
- Government subsidies and favorable economic policy framework conditions,
- a high-performance infrastructure or proximity to customers and suppliers,
- Regulatory-restricted market access as well as
- above-average market growth or particularly high local demand.
1.1 Location Savings and other location advantages
The term LSAs is broader than the OECD's use of the term "location savings." Location savings primarily refer to net cost savings resulting from operating in a more favorable location. LSAs also encompass other local market characteristics, such as demand advantages, regulatory barriers to market access, or access to specific resources.
1.2 From location advantage to additional profit
A location advantage does not automatically lead to additional profit. Lower labor costs, for example, can be offset by lower productivity, higher quality control costs, additional logistics expenses, or political and regulatory risks. The net effect is therefore what matters.
Simplified logic: The advantage over a realistic alternative location, minus location-related additional costs, yields the potential net advantage.
The next step is to examine whether this advantage remains within the group. In highly competitive markets, cost advantages through lower prices can be passed on to customers in full. Only if a net advantage actually remains within the group does the question of its arm's length distribution arise.
1.3 Where does the discussion originate?
The LSA (Loss-Based Assistance) discussion is closely linked to the relocation of production, development, and service functions to lower-cost countries. Emerging and developing countries, in particular, sometimes argue that local resources and market conditions are not adequately reflected in traditional functional and risk analyses.
From this perspective, a location is not merely the place where routine, internally mandated services are performed. It can itself make a significant contribution to the group's bottom line. Therefore, the resulting location rent should not automatically remain entirely with a foreign principal company. Corresponding items can be found, in particular, in country-specific approaches presented in the UN Transfer Pricing Manual.
2. LSA approach and OECD approach: What is the difference?
2.1 Location advantages in the OECD approach
The LSA approach is not fundamentally at odds with the OECD Transfer Pricing Guidelines. The OECD also recognizes that geographical market conditions can influence comparability and thus arm's length prices.
According to the OECD approach, four questions need to be examined:
- Is there a location advantage?
- What is the resulting net benefit?
- Will the benefit be passed on to customers or suppliers?
- How would independent companies have distributed the remaining benefit?
Location advantages are therefore fundamentally comparability factors. They do not regularly represent an independent intangible value that could be attributed to a local company solely on the basis of its presence there.
2.2 Local benchmark companies as a key benchmark
If reliable local comparable companies are available, the OECD generally assumes that their results already reflect local market conditions. An additional premium for location advantages is then usually unnecessary.
This presupposes that the tested company and the comparison companies, in particular:
- operate in the same or a sufficiently comparable geographical market,
- provide comparable services and utilize local resources,
- are subject to comparable regulatory and competitive conditions as well as
- perform economically comparable functions and bear risks.
If these conditions are met, the location advantage is typically already included in the market prices or margins of comparable companies.
2.3 The further LSA approach
Further LSA positions sometimes attribute greater importance to local location factors for profit allocation. According to this view, a local company can make a significant value contribution even though it does not hold legally protected intangible assets and formally bears only limited risks.
Examples of value-creating factors include:
- a highly qualified and well-coordinated workforce,
- specific knowledge about the local market,
- Access to scarce resources or networks,
- Regulatory restricted market access,
- Government subsidies or significant economies of scale.
The difference, therefore, lies less in the question of whether location advantages are relevant, but rather in their treatment: The OECD primarily categorizes them within comparability analysis and the negotiating situation of independent companies. It considers more extensive local business advantages (LSAs) in some cases as an independent local value contribution that can justify participation in residual profits.
2.4 Who is entitled to the location advantage?
Merely being located in an advantageous location does not automatically entitle a company to the resulting additional profit. Conversely, being classified as a routine company does not automatically mean that the local company can be limited to any and all routine remuneration.
In comparison with other countries, the following questions in particular need to be asked:
- Who can actually take advantage of the location?
- Who made the location decision and the necessary investments?
- What realistic courses of action existed for both parties?
- Was the local service provider interchangeable?
- Who bears the additional costs and risks related to the location?
- What negotiating power would independent parties have had?
Practical relevance: The easier a local service provider is to replace, the less likely they are to retain any of the location's advantages. Therefore, simply considering location is no substitute for analyzing negotiating positions.
3. Impact on foreign margins
3.1 Why Cost Plus does not automatically distribute the location advantage
Under the cost-plus method, the local company receives its relevant costs plus an arm's length markup. If local costs decrease, its absolute compensation also decreases, assuming the markup remains unchanged. The cost advantage therefore generally remains with the commissioning company.
Simplified example:
- Costs at the alternative location: 10 million euros
- Costs at the local site: 6 million euros
- Profit margin: 5%
- Compensation for the local company: 6,3 million euros
The gross savings of €4 million thus remain largely with the commissioning company, before taking into account additional location-related costs. The crucial arm's length principle is whether an independent local provider would have accepted the same conditions or, due to limited capacity, specialized knowledge, or a lack of alternatives, would have been able to secure a portion of the advantage.
3.2 A routine profile and high margins are not necessarily contradictory.
A foreign company can achieve above-average margins despite a limited functional and risk profile. This can be due to factors such as specific local market conditions, subsidies, high capacity utilization, or operational efficiency. Conversely, a location advantage does not automatically justify higher local compensation. It can be passed on to customers, offset by disadvantages, or, due to the bargaining power of another company, attributed to that company at arm's length.
3.3 Impact on Benchmark Studies
Location advantages become particularly relevant when the benchmark study uses comparable companies from other geographic markets. Differences in costs, market size, growth, competition, subsidies, or market access can significantly affect comparability.
If reliable local benchmarks are lacking, appropriate adjustments for comparability or a supplementary quantitative analysis may be necessary. Both the advantages and disadvantages of the location must be considered. Focusing solely on low labor costs is generally insufficient.
Location advantages can also be reflected in the results of comparable companies used in a database study. If independent local companies can capture some of the location-related advantages themselves due to their market or negotiating position, their margins may be correspondingly higher than the margins of comparable companies without these location advantages. If local market conditions develop favorably for companies over time, for example, due to a shortage of skilled workers, market access restrictions, or increasing demand, this may also be reflected in an increase in observable comparable margins compared to previous analysis periods. However, such a development is neither necessarily nor automatically solely attributable to location advantages. It must be distinguished from other influencing factors such as economic conditions, capacity utilization, competition, functional profile, or operational efficiency. If reliable local comparable companies are used, location advantages may already be included in their margins. An additional location advantage premium would then create the risk of double counting.
3.4 Location advantages in German case law: Federal Fiscal Court ruling of August 9, 2023
The discussion surrounding location advantages is no longer purely theoretical or limited to the perspective of emerging and developing countries. In its ruling of August 9, 2023 (IR 54/19), the German Federal Fiscal Court (BFH) addressed the transfer pricing treatment of location advantages in detail and essentially confirmed the concept. This decision is of considerable practical importance: it demonstrates that a German tax audit or a German taxpayer can also take location advantages into account – and that a profit markup exceeding the usual range of routine remuneration can be justifiable.
Underlying facts
A German manufacturing company outsourced labor-intensive production steps to a foreign subsidiary in a low-wage location. The tax auditors classified the subsidiary as a contract manufacturer and compensated it using the cost-plus method. The point of contention was the amount of the profit margin – and, in this context, the question of to what extent the cost advantages achieved at the foreign location should be attributed to the local company or the domestic client.
Federal Fiscal Court ruling: Location advantages must be divided
The tax court had expressly recognized the location advantages of the foreign company and increased the profit margin applied by the tax office to reflect these advantages. The Federal Fiscal Court (BFH) did not fundamentally object to the concept of location advantages. However, it considered it a legal error that the tax court had merely estimated the amount of the location advantages and had not sufficiently quantified them.
Key statement of the Federal Fiscal Court: To take location advantages into account, their extent must first be determined; subsequently, a breakdown must be made based on the respective functions, risks, economic assets used and the realistically available alternative courses of action.
The Federal Fiscal Court (BFH) thus gave priority to a concrete, objective allocation based on the arm's length principle over a flat-rate distribution – such as an equal split. These criteria structurally correspond exactly to the standards that the OECD Transfer Pricing Guidelines (paragraphs 9.126 to 9.131) also provide for the treatment of location advantages. The UN Transfer Pricing Manual goes a step further and explicitly assigns location advantages – particularly in the country positions of China and India – to local value creation.
Justification for higher cost markups
Of particular practical relevance is the fact that, in the case at hand, the location advantages led to a profit markup that exceeded the range derived from database studies and industry information. While markups in the low single-digit percentage range – roughly between 3% and 10% – are often considered standard practice for routine manufacturers, a net advantage actually generated and retained at the location can justify a higher markup.
The ruling thus provides an important argument for taxpayers: If a foreign company achieves a margin above the classic benchmark range, this does not necessarily indicate an inappropriate profit shifting. Rather, the additional profit may be attributable to a quantifiable location advantage to which the local company – depending on its functional and risk profile as well as its negotiating position – is entitled, in whole or in part.
However, the Federal Fiscal Court (BFH) made it clear that a prerequisite is that the location advantage is reliably determined and its allocation is comprehensibly documented. A blanket approach or justification is insufficient to justify either an increased surcharge by the taxpayer or its reduction by the tax authorities.
4. Risks and solutions for companies
4.1 The risk of conflicting tax positions
Location advantages can lead to opposing adjustments. The state can demand a share of the location-related additional profit from the local company. Conversely, the state can argue that local benchmarks already reflect the advantage or that the local company lacks the necessary bargaining power.
Key risk: Both countries claim the same share of the profits. Without a sound analysis, transfer pricing adjustments, economic double taxation, and lengthy mutual agreement procedures are likely.
4.2 Typical Red Flags
Companies should review their transfer pricing model, especially if:
- Routine functions are performed at significantly more cost-effective or particularly high-growth locations,
- the cost-plus compensation has continued unchanged for years, even though the market and location have changed significantly,
- Local companies achieve unusually high or low margins without the reasons being documented.
- the benchmark study predominantly includes comparable companies from other geographic markets or
- Internal investment calculations cite location advantages as a key success factor, but the transfer pricing documentation remains silent on this point.
Comparison with internal documents is particularly important. If business cases justify a location with significant cost advantages, qualified specialists, or attractive market access, but these factors are not included in the transfer pricing analysis, a discrepancy arises that requires explanation.
4.3 A pragmatic five-step approach
- Identify location advantages
Determine the specific advantages and disadvantages of the location. General references to low costs or an attractive market are not sufficient.
- Quantify net benefit
Compare the advantages and additional burdens to a realistic alternative scenario. Factors to consider include productivity, quality costs, logistics, training requirements, regulatory burdens, and currency and political risks.
- Check for disclosure to third parties
Investigate whether the benefit is passed on to customers through lower selling prices or to suppliers through higher purchase prices. Only the net benefit remaining within the group is to be distributed.
- Analyze standard market rates
Assess the functions, risks, assets, realistic courses of action, interchangeability, and bargaining power of the parties.
- Coordinate implementation and documentation
The result should be consistently reflected in contracts, benchmark studies, calculation models, segment calculations, planning processes and transfer pricing documentation.
4.4 Possible courses of action
Depending on the outcome, the following measures in particular may be considered:
- Retention of the cost-plus method with more detailed justification,
- Use of local or regional comparable companies,
- targeted comparability adjustments,
- separate quantification and allocation of the net benefit,
- Adjustment of the profit margin or the remuneration structure,
- Application of a profit-sharing method in cases of mutually unique and valuable contributions,
- ongoing monitoring of local margins and relevant location factors as well as
- Protection through an Advance Pricing Agreement against material and long-term risks.
Neither a blanket LSA surcharge nor the complete disregard of location advantages is appropriate. A transaction-based analysis of the actual economic conditions remains decisive.
4.5 Alternative compensation models: the profit split
When location advantages lead to a local company making an independent, not merely routine, value contribution, the one-sided cost-plus method reaches its limits. This method assumes that one party is entitled to routine compensation and that the entire residual profit – including the location-related additional profit – remains with the principal company. This assumption is no longer readily tenable when there are significant local contributions.
In such cases, the transaction-based profit split method may be the more appropriate instrument. It allocates the relevant profit not according to a unilateral markup, but according to the respective value contributions of the participating companies. A profit split should be considered in particular when:
- Both companies make unique and valuable contributions.
- the business activities are so highly integrated that they cannot be evaluated in isolation,
- the parties bear significant risks jointly or in close cooperation, or
- No reliable comparative values are available for a one-sided method.
In practice, a residual profit split is frequently used: As a first step, all participating companies receive standard, arm's-length compensation for their non-unique functions. The remaining residual profit – which also includes the location-related additional profit – is then distributed to the companies that make unique contributions using appropriate allocation keys. This allows the location-related additional profit to be allocated in a targeted and justifiable manner.
Profit splitting, however, is not a straightforward solution: it is data-intensive, requires a robust value chain and functional analysis, and carries an increased risk of double taxation if the participating states apply it differently. It should therefore be used selectively and only where unilateral methods demonstrably no longer reflect economic reality.
5. Conclusion: Cost Plus remains, but not without location analysis.
Cost Plus is not obsolete. For standardized production and services, the method often remains appropriate. However, location advantages reveal the limitations of a purely schematic approach: The formula "routine company plus benchmark premium" does not always answer who is entitled to the location-related additional profit at arm's length. The fact that location advantages must be taken into account and – as the Federal Fiscal Court confirmed in its ruling of August 9, 2023 (IR 54/19) – specifically allocated, underscores the importance of a robust location analysis.
The overall economic picture is decisive:
- What are the actual net benefits?
- What contribution do the participating companies make?
- What realistic alternatives and what negotiating power exist?
- Are the site conditions already reflected in the comparison data?
If these questions are answered early and consistently documented, Cost Plus remains a robust transfer pricing model. However, if location advantages are ignored, a seemingly simple routine charge can become the starting point for cross-border transfer pricing adjustments.
