Transfer pricing rules
The Japanese transfer pricing (TP) legislation is in Article 66-4 of the Act of Special Measures Concerning Taxation and is based on the arm’s length principle as per Article 9 of the OECD Model Tax Convention on Income and Capital, i.e. it follows the OECD Guidelines updated in July 2022.
The TP rules apply to Japanese taxpayers, including Japanese branches of overseas companies and PEs.
If the transfer pricing of the taxpayer does not meet the standard, the taxpayer adjusts its tax return or settles a price adjustment. The tax return adjustment is a “one-way street”, i.e. upwards-only adjustments are permitted.
The preparation of transfer pricing documentation (i.e. Local file) is mandatory.
Japan has implemented CbCR (Country by Country Reporting) and Master file for the multinational enterprise groups with a consolidated total revenue for the Ultimate Parent Entity’s preceding fiscal year of 100 billion yen or above.
Transfer pricing methods
The most appropriate pricing method should be selected on a transaction-by-transaction basis, providing the most reliable measure of an arm’s length result in each case. The current OECD methods, namely the comparable uncontrolled price method, resale price method, cost plus method, transactional net margin method, profit split method, and discounted cash flow method are all accepted but the method used must be in line with the functional and risk profile of the entity.
In the past, three-“traditional transaction methods” (comparable uncontrolled price method, resale price method, cost plus method) were prioritized over other methods, however in the tax reform in 2013, revision was made to select the most appropriate transfer pricing method from all method
Transfer pricing documentation
Preparation of transfer pricing documentation
Japan follows the OECD transfer pricing documentation model based on the Master File and Local File (BEPS Action 13) approach.
- The master file should be submitted to the competent District Director via electronic tax filing within one year of the day following the one when the Ultimate Parent Entity’s fiscal year ends.
- Multinational enterprise groups with a consolidated total revenue for the Ultimate Parent Entity’s preceding fiscal year of less than 100 billion yen are exempted from the submission of the Master File.
- Penalty will be imposed for failure to submit a Master File to the District Director by the deadline without good reason.
The preparation of transfer pricing documentation, i.e. Local file is mandatory.
If the National Tax Agency requests transfer pricing documentation, the taxpayer would have a deadline of 45 days in which to respond.
In the following cases, taxpayers are exempted from the duty of transfer pricing documentation: A) If the number of transactions (total of receipts and payments) with a foreign-related party during the previous business year (the current business year if there was not the previous one) was less than five billion yen, and B) If the number of transactions of intangibles (total of receipts and payments) with a foreign-related party during the previous business year (the current business year if there was not the previous one) was less than 300 million yen. Having said that, if NTA requests transfer pricing documentation, the taxpayer would have a deadline of 60 days in which to respond
Master and Japanese local file
NTA follows OECD for the Master and Local file structure.
NTA stipulates that the Local file should include the following information;
- Details of intercompany transaction under analysis (such as assets and services relating to the intercompany transaction under analysis, function performed or risks assumed by the company, analysis of the market of the inventory assets regarding intercompany transaction, details of the business strategies of the companies, and profit and loss of the companies, etc.).
- Documents used by the company for the determination of the arm’s length price (such as the selection process of comparable transactions adopted by the company, details of the comparable transactions, reasons for adoption of the TP methodologies to determine the arm’s length price, and any other document prepared by the company for determining the arm’s length price, etc.).
Japanese Local files must be preserved seven years from the day the follows the deadline for submission of final returns.
Some risk factors for the challenge
High-risk business models such as commissionaire.
Limited risk distributor and contract services/ contract R&D arrangements could also potentially be challenged, especially where significant people functions are in Japan.
Penalties
Where there is a failure to submit a Local File, the tax inspector is allowed to use inquiry and inspection rights and impose taxation by secret comparable and/or estimation. Taxation by estimation allows tax inspectors to estimate transfer prices without reference to the taxpayer’s transfer pricing method, theoretically, taxation with estimate would not be consistent with arm’s length nature as it may also be based on the transaction between affiliated parties.
Where there is a failure to submit a CbCR and Master file, a 300,000 Japanese Yen penalty will be imposed.
Economic analysis and how to demonstrate an arm’s length result
To search for the comparable transaction, both internal comparable transactions (transactions related to comparable products between a member of the group and third party) and external comparable transactions (transactions related to comparable products between the unrelated party and third party) are to be examined.
NTA accepts the use of interquartile range calculated based on either an Excel formula or the formula specified by the US Internal Revenue Service. While the average of the comparable transaction’s value would be considered by NTA to be the arm’s length price, if the value of the intercompany transaction under analysis is within the interquartile range, NTA does not ask to adjust.
Transfer pricing for intragroup services are classified into A) services incidental to the core business, no mark-up on total cost: B) routine and support services with limited risk as a non-core business, a 5% mark-up on total cost as long as certain terms and conditions are met: and C) other services not categorized to A) and B), most appropriate TP method.
Advance Pricing Agreements (APAs), dispute avoidance and resolution
An Advance Pricing Arrangement (APA) is an arrangement based on an application from a taxpayer, NTA confirms in advance a set of criteria such as methods, comparables, and associated adjustments, and critical assumptions regarding future events for the determination of the transfer pricing for intercompany transactions over a fixed period.
NTA recommends bilateral APAs over unilateral APAs.
There are around 121 cases agreed in 2020 and the average time taken to negotiate them is 29 months.
The company shall correct taxable income on its final tax return or promptly file amended tax returns for upward profit adjustment and NTA does not apply a secondary adjustment to this.
For downward adjustment, the company may correct taxable income on its final tax return or file a request for correction for the tax return.
Exemptions
CbCR and Master file: multinational enterprise groups with a consolidated total revenue for the ultimate parent entity’s preceding fiscal year of 100 billion yen or above are exempted.
Related developments
Hard-to-value intangibles
New rules regarding hard-to-value intangibles (HTVI) were implemented in the Japanese 2019 tax reform. The rules allow tax authorities to adjust the pricing of certain transactions where there is a significant deviation of actual financial outcomes from the forecasts used to price the transaction.
Discounted cash flow method
The Discount Cash Flow method (DCF method) was included in the TP method in the Japanese 2019 tax reform.
DCF method can be useful when
- It is difficult to find a comparable transaction and;
- It is difficult to apply the profit split method due to the type of intercompany transaction,
However, as the DCF method relies on uncertain factors such as the projected amount at the time of purchase, if there are multiple candidates including the DCF method, select the most appropriate method other than the DCF method.
NTA and taxpayer behavior
In 2020, there were 134 cases of tax inspection on transfer pricing, and this was 63.2% of the previous year.
Undeclared income as a result of the tax inspection amounted to 50 billion Japanese yen, and this was a 6% decrease from the previous year.