Would LSAs affect technology companies in China?

Technology companies operating in China must consider how location-specific advantages may impact their global transfer pricing. Although not a new risk, recent developments have put renewed focus on this controversial topic – one that technology companies should address.

The renewed focus was clear in October 2012 when China released its contribution to the UN Transfer Pricing practice manual, in which location-specific advantages (LSAs) took a prominent place. That same month, China and the United States concluded a bilateral advanced pricing arrangement (BAPA) for a U.S. technology company. Under that agreement, the Chinese subsidiary was remunerated for location-specific advantages, and the agreement recognised local enhancements to the group's intellectual property (IP).

Now the tax authorities in China are increasingly claiming that Chinese subsidiaries should earn excess profits, or at least share part of the group's residual profit because of the group's operating profits from low-cost labor, tax incentives, financial subsidies, market price premiums, and low cost related factors linked to the Chinese economy. For technology companies, the stakes can be high.

LSAs have been briefly addressed in the OECD transfer pricing guidelines for many years. Location savings were the focus of the business restructurings section (Chapter IX), which stated:

"Location savings can be derived by an MNE group that relocates some of its activities to a place where costs (such as labor 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."

References to LSAs have also appeared repeatedly in China's tax rulings and practices. Despite this, a precise definition had not been issued until the release of Chapter 10.2 of the UN Transfer Pricing Manual in October 2012, which stated:

"The globalization of trade and economies has given rise to concepts such as "location savings," "market premium," and more generally, location-specific advantages. The LSAs are advantages for production arising from assets, resource endowments, government industry policies and incentives, etc., which exist in specific localities."

The Chinese tax authorities are now keen to put the LSA concept into practice. Practitioners have already seen this concept being raised in current advanced pricing agreement (APA) and transfer pricing audit cases. The LSA arguments are raised for both market premiums and location savings.

Market premium is a term used for surplus profits attributed to higher local prices or high demand leading to increased prices, caused by differences in market conditions. China's State Administration of Taxation (SAT) claims a premium exists in the Chinese market for some products because of:

• Consumer preferences for foreign brands and imported products, such as luxury goods; or

• China's large population with growing wealth.

The market premium concept is sometimes linked with China market intangibles created by successful local marketing efforts. Based on these concepts, the Chinese tax authorities may discount the contributions of foreign intangibles and conclude that domestic Chinese marketing IP exists.

The SAT approaches location savings by considering the cost savings of companies that relocate operations to China on a net basis. This approach considers inputs such as raw materials, labor, rent, transportation, and infrastructure, and additional expenses such as increased training costs, relocation costs or tariffs. However, it is unclear how the SAT will deal with other aspects of location savings, such as when all or part of the cost savings effect has been passed to customers.

In the past, the SAT has dealt with under-remunerated Chinese affiliates by demanding the application of higher transfer pricing mark-ups to low-margin or contract providers that benefit from location savings. This position is now evolving to adopt a more robust approach of calculating and attributing the location savings.

The Chinese tax authorities have consistently stated that Chinese taxpayers have to be remunerated for their LSAs, however the calculation of the benefit has been traditionally controversial.

The SAT has suggested a four-step approach to quantify the LSAs described above in the UN Transfer Pricing Manual, although there is no specific regulation on how to identify and quantify LSAs in China. The four steps are explained as follows:

The first step is to identify whether an LSA exists by evaluating incentives or market characteristics that could have an effect on profitability – industry analyses and company's profitability analyses can be critical at this stage. Each characteristic should be individually reviewed. If no LSAs are identified, no further analysis is required.

The next step is to perform a cost base/price comparison between China and the appropriate benchmark jurisdiction. This stage may require some professional judgment, as the factors to consider are not defined, for example, should you consider whether the cost savings effect is passed to end customers?

Multiple factors could contribute to additional profits in China. The taxpayer should identify costs that materially offset any additional profits, such as relocation costs and other dis-savings. The net value after the offset would be the additional profits that resulted from the LSA.

According to the OECD transfer pricing guidelines, location savings should be allocated in the same way that independent parties would split them. This would depend on the functions, assets and risks of each party and on their respective bargaining powers. Unfortunately, splitting the profit could not possibly be this simple in practice – each tax authority will likely surely have a different view.

Certain technology companies have benefitted from the globalising economy by establishing operations in China to take advantage of lower manufacturing costs, well-educated staff in research and development (R&D) centres, and a rapidly emerging consumer class. These operations are typically limited-function operations (contract or toll manufacturers, contract R&D providers, or limited-risk distributors). These companies retain relatively small profits in China, while sometimes contributing significantly to group profits. Technology companies need to consider how LSAs could impact their own China subsidiaries before the SAT.

In today's highly competitive market, some technology groups are establishing R&D centres in China to help target Chinese consumers, and benefit from highly educated Chinese employees. These types of R&D services are used by the SAT as an example to demonstrate how to identify LSAs and allocate the excess profit to Chinese entities – a position challenged by taxpayers and advisors.

Technology groups often set up R&D centres in China that perform work at the direction of the global technology centre – the global technology centre will own any results. The contract R&D centre in China is paid for services based on its costs plus an arm's-length mark-up for R&D service providers.

To quantify the location savings effect, the following two methods of calculating the LSA are explored used:

A direct approach simply compares the direct costs of doing business in one country, with those of another country – easy in principle, hard in practice. There should always be an argument about whether the developed country's cost should be used directly as the benchmark for comparing costs. Rather, there is a better view that the next best jurisdiction's cost would be a better benchmark to use.

Steps	Description
Step 1	Compare each cost item for the benchmark country and the China company and then identify all the factors contributing to LSAs
Step 2	Quantify the net savings for each factor (savings and dis-savings)

This approach has a major drawback as many factors cannot be specifically identified or directly quantified. For example, although salary differences may be obvious, the difference in education and skill levels between groups of employees cannot be practically quantified accurately. Furthermore, lower costs may impact the scale of the R&D and the selling price to customers.

The indirect approach depends on a comparable uncontrolled price/transaction, or otherwise suitable benchmark to determine the routine profits of the Chinese R&D centre and a way to attribute the residual profit of the group to the Chinese R&D centre. If any crucial IP would be generated in the covered transactions, the reasonable economic return on the IP will be excluded prior to attributing the residual profit to LSA's contributor.

This table outlines the possible way to allocate LSAs to China using the indirect method.

Steps	Description
Step 1	Calculate routine profits of the Chinese R&D center and related party
Step 2	Identify allocation key to residual profit
Step 3	Allocate part of residual profit to China based on identified allocation key
Step 4	Determine the adjusted arm's length return for China

If there is no internal comparable, Chinese or regional comparable service providers may have to be used. However, comparable companies with their main operations in developed countries (such as Japan) may be challenged as not comparable. While comparable profit methods (CPM or TNMM) would be extensively used, the residual profit split method may be preferred by the SAT for contract R&D services.

Either approach raises many issues. It is debatable whether all the location savings would be retained by the group. In fact, local R&D centres are not usually set up for location savings, but for company strategy and other business reasons, such as proximity to production sites to lower production costs and market, etcetera. Therefore, an analysis showing the product's price trends or the profitability of the group may be important to demonstrate that other factors (other than location savings) exist. Decrease in product prices or the group's overall sales or profitability could demonstrate that location savings have been passed onto consumers.

Furthermore, the argument for location savings asserted by the tax authority may not be sustainable in the long run. As more competitors enter into China, the savings from the location will decline as the savings are passed to customers through competition. However, this doesn't mean the SAT will not continue to raise the issues.

As with contract R&D activities, many technology companies have shifted their factories or manufacturing operations to developing countries. The savings from manufacturing activities are often much larger than those for services, and are much more complicated to deal with as cost savings may be passed onto consumers.

Taking the electronic manufacturing services (EMS) sector as an example – Chinese affiliates comprise the bulk of manufacturing and assembly activities. These activities usually require large workforces, vast plants, and high expenditure on capital equipment in China. The cost savings from these inputs could be very significant. As these manufacturing operations are generally contract or toll manufacturers with low risk profiles, they are prime candidates for a review. If LSAs are identified and quantified, the allocation would require analysis of the functions, assets and risks of each party; their respective bargaining powers; the beneficial ownership of intangibles; and contractual rights to distribute products directly to third party customers.

However, these Chinese affiliates usually purchase key components from and can only sell the products to overseas related parties, and should never have R&D responsibilities. Therefore, it could be difficult to conclude that the Chinese manufacturers have any bargaining power – although clearly they are considered important to the group, complicating any allocation of the benefits.

Most Chinese consumers have a strong preference for foreign brands and imported products. This is a general preference, unlike loyalty to a specific brand. The SAT concludes that this preference creates opportunities for brand-centric technology companies to charge higher prices and earn additional profits on products sold in China. Although China market premiums are more commonly expected in the luxury goods sector, the concept is being applied broadly. An analysis of market premiums will need to take account of differences in indirect taxes (such as tariffs, value added tax, and anti-dumping duties) and other China market factors. There is also a danger that a review of market premiums may raise questions about the marketing contribution made by the Chinese distributor or retailer. Adding marketing intangible claims to market premiums would certainly complicate the calculation of sales side LSAs.

Location-specific advantages are still a highly controversial topic in emerging markets. Given their actions so far, it appears that the Chinese tax authorities will apply the concept in tax controversy cases. Affected technology companies should review their policies, consider responses to questions about location-specific advantages, and be ready to reasonably justify their current models. Strong transfer pricing policies and documentation are a good start, but more will need to be done. This is an evolving issue in China and it seems likely that it won't be long before more APAs and disputes refer to location-specific advantages.

Biography
		Nick Chen Manager Shanghai Deloitte Tax Ltd. Tel: + 86 21 6141 1291 Email: nickchen@deloitte.com.cn Nick Chen is a Manager in the transfer pricing service line of Deloitte China. Experience Nick has 8 years' experience in providing professional service. Before entering Deloitte China, he served in the audit department of Deloitte Taiwan and engaged in financial statement audit, examination of income tax return and review of transfer pricing report for subsidiaries of multi-national enterprise; Nick renders transfer pricing services, such as preparation of transfer pricing reports, planning for cross-border transfer pricing risks on the association between enterprises, assisting enterprises to negotiate transfer pricing agreements and tax adjustments; Nick Chen has been serving many multi-national companies of technology, media and telecommunications sector for many years in the aspects of cross-border tax issues and transfer pricing matters. Professional Accreditation and Certifications Nick is a Master of Accountancy and Finance of University of Glasgow.

Biography
		Eunice Kuo Partner Deloitte China Tel: + 86 21 6141 1308 Email: eunicekuo@deloitte.com.cn Eunice Kuo, a tax partner of Deloitte China, is the national leader for China/Hong Kong transfer pricing service in charge of transfer pricing, business model optimisation, and tax-structuring services. Experience Ms. Kuo has 27 years of experience in providing cross-border tax service. Before joining Deloitte China in 2010, she was the tax practice leader and led transfer pricing and international tax services of Deloitte Taiwan. Ms. Kuo has many years of providing transfer pricing services. She started up Deloitte Taiwan's transfer pricing practice. She has worked with the preparation of transfer pricing reports, planning for cross-border transactions including supply chain issues, performing transfer pricing due diligence at mergers and acquisition projects and helping mitigate transfer pricing risk, assisting in settling tax audit cases, helping with conclusion of advance pricing agreements and mutual agreement procedures, and advising on tax issues from business restructure. Ms. Kuo is experienced in serving multinational companies' inbound activities as well as China- and Taiwan-based multinational companies' outbound transactions. She has led the global transfer pricing projects, including but not limited to pricing policy formulation, implementation of transaction models and pricing policy, intangibles planning, as well as pricing adjustments in various ways. Ms. Kuo has been serving technology, media and telecommunications service companies for years in the area of cross-border tax issues and transfer pricing matters. Professional Accreditation and Certifications Ms. Kuo is a Taiwanese certified public accountant (CPA), as well as a Chinese CPA. Since Taiwan was listed by Euromoney as one of the jurisdictions of transfer pricing service providers survey since the introduction of Taiwan TP rules in 2004, Ms. Kuo had been named the leading TP advisor consecutively every year. After her move to Deloitte China in 2010, she has been named the China leading TP advisor by Euromoney since 2011. She was also named the best female TP advisor in Asia Pacific by the Legal Media Group. Ms. Kuo is a frequent speaker at public seminars and also trainings of tax authorities. She has also been active in associations in Shanghai and has been invited to speak for foreign enterprises and local companies in China.