Geographic benefits derived from operating in a particular market provide a competitive edge that can lead to higher than average profits for a local enterprise. These advantages include lower labor costs, proximity to a large consumer base, specialized infrastructure and government subsidies that are unique to a specific region. The concept of location specific advantage governs how these extra profits are allocated between a Chinese subsidiary and its foreign parent company for tax purposes.
It applies to multinational groups that choose to locate their manufacturing or service hubs in the Chinese mainland to take advantage of the local economic environment. The boundary of this concept is set by the ability of the tax authorities to quantify the specific value of these benefits and adjust the transfer prices accordingly. The state taxation administration argues that the profits resulting from these local factors should be taxed in China rather than being shifted overseas through high royalty payments or service fees.
Economic factors such as a high population density and an efficient supply chain contribute to what is known as market premium and location savings. A location specific advantage is often found in the manufacturing sector where the presence of a vast network of suppliers reduces the cost of raw materials and logistics. Similarly, the rapid growth of the Chinese middle class provides a market premium for foreign brands that can charge higher prices than in their home countries.
Tax authorities analyze these factors to determine if the local entity is earning a profit that is significantly higher than that of comparable companies in other countries. If the profit is higher, they will attribute the difference to these local advantages and demand that a larger portion of the income remains within the Chinese tax jurisdiction. This approach challenges the traditional transfer pricing models that use global or regional benchmarks without adjusting for the specific conditions of the local market.
Calculation of the value added by these local factors requires a detailed comparison between the costs and prices in China and those in a reference market. This process for identifying a location specific advantage involves calculating the total savings achieved through lower rent, wages and utility costs in the local province. These savings are then adjusted for any additional costs, such as higher management fees or the need for more intensive training for the local workforce.
The net result represents the location savings that the tax bureau expects to see reflected in the company’s local profit margin. For market premiums, the analysis looks at the price difference for identical products sold in different global regions. The difficulty of this method lies in separating the value of the local market from the value of the global brand and technology owned by the parent company.
Auditors and taxpayers often disagree on the percentage of the profit that should be attributed to each factor.
Investigations by the provincial tax bureaus often target companies that report low or average profits while benefiting from clear local advantages and high sales volumes. During an audit, the authorities will request a specific study on the location specific advantage of the entity to justify its transfer pricing policy. They look for evidence that the company is using its local presence to gain a profit that is not being captured in its tax filings.
If the company cannot prove that it has shared these benefits with the Chinese entity through lower intercompany charges, the tax bureau will impose an adjustment. This focus has led many multinational firms to include a separate section on local advantages in their annual contemporaneous documentation. This proactive approach helps to manage the risk of a formal investigation and provides a basis for negotiations with the tax officials.
The final settlement often involves a compromise on how much of the local savings should be retained by the Chinese subsidiary. This quantitative focus ensures that the tax system keeps pace with the changing economic landscape of the country.
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