An excerpt from The Transfer Pricing Law Review, 5th Edition
The main Japanese transfer pricing legislation is Article 66-4 of the Special Tax Measures Act (the Act) and Article 39-12 of its enforcement order (the Order). For a taxpayer filing a consolidated tax return, Articles 68-88 of the Law and Articles 39-112 of the Regulation apply. Although not laws, the National Tax Agency of Japan (NTA) has detailed interpretations of these legal provisions in Chapter 12 of the Act’s basic circular (the Circular) and in the Commissioner’s Directive on the Operation of Transfer Pricing (the Directive), according to which the transfer pricing legislation is enforced.
The Japanese transfer pricing rules apply only to corporate income tax (under the Corporate Income Tax Act) and not to individuals or trusts (with certain limited exceptions) .2 The rules apply to transactions between a Japanese corporation (or a foreign corporation subject to Japanese corporation tax) and theirs “Foreign Affiliate” (as defined by law). A foreign corporation is essentially defined as a foreign corporation that controls, controls, or is jointly controlled by a Japanese corporation (ie, a parent-subsidiary or brother-sister relationship), measured at 50 percent or more directly or indirect ownership or effective control by officers, business dependency, or finance.
ii Compliance with the OECD Guidelines
The law and regulation establish a number of transfer pricing methods that effectively follow the Transfer Pricing Guidelines of the Organization for Economic Co-operation and Development (the OECD Guidelines). In particular, the Japanese transfer pricing rules were revised in 2011 in response to the changes to the OECD Guidelines in 2010, confirming the prevalence of the transactional net margin method (TNMM) and introducing the ‘best method’ and ‘range’ concept. With the amendment of the regulation of 2013, the berry ratio was introduced as a further net profit indicator in accordance with the OECD guidelines. In 2016, in line with Action 13 of the OECD’s Base Erosion and Profit Shifting (BEPS) project, the Japanese government introduced new legislation that uses the three-tier documentation approach, consisting of a master file, a country-by-country report (CbCR) and a local file . In 2019, in line with the OECD Guidelines, revised in 2017, the Japanese government introduced new legislation introducing the discounted cash flow method as an additional transfer pricing method and price adjustment measure for intangible assets that are difficult to value (see Section III.i below). The 2017 edition of the OECD Guidelines is used in practice and the Japanese tax authorities and courts may refer to paragraphs in this edition to determine whether transactions prior to these guidelines were made on market terms, provided a specific paragraph in this edition reads: understood to clarify the rules and principles adopted in previous editions rather than creating a new rule in the 2017 edition.
iii Covered Transactions
Japanese transfer pricing rules apply to “overseas related transactions” conducted between a Japanese company and its overseas affiliate; the rules apply to all types of transactions that include, but are not limited to, buying or selling inventory or other property, leasing, providing services, selling or licensing intangible assets, and borrowing or borrowing.
While Japanese transfer pricing rules cover all income transactions, it is unlikely to apply to capital contributions, even if theoretically possible. For example, if a Japanese parent company was believed to have received shares in its Thai subsidiary in excess of the value of the new capital brought in by the Japanese parent company, the NTA relied on the “gift” rules and did not resort to the Japanese transfer back Price rules upheld by the Tokyo Supreme Court ruling on March 24, 2016.
Broader tax issues
i Inferred income tax, digital sales tax and other complementary measures
There are no diverted income taxes or similar taxes under Japanese law, and no immediate proposals have been made for such taxes. In addition, the Japanese government has not made any immediate proposals for digital sales taxes. There is no multinational anti-circumvention law or anything like the US BEAT / GILTI regime.
ii Tax challenges from digitization
The Japanese government participated proactively in the discussions on the proposals of the Inclusive Framework Pillar One and Global Anti-Base Erosion (GloBE) and led them. However, given the potential impact on Japanese international companies, the Japanese government argues that companies that distribute their profits appropriately in market countries should not be materially affected by the reforms, as they represent the voices of Japanese multinationals.
For the second pillar, the Japanese government appears to support the global minimum tax system currently proposed by the OECD, although Japanese multinational corporations are particularly nervous when the minimum taxes apply to subsidiaries operating in emerging markets that have manufacturing or sales functions. While such emerging market subsidiaries are exempt from the Japanese controlled foreign corporation (CFC) regime due to their substantial activities in the emerging markets, they may not be exempted due to their involvement in active businesses and would be subject to the new minimum Pillar two taxes because of it is that low-taxed subsidiaries are not excluded because of their substance.
iii Effects of Covid-19 on Transfer Pricing
After the World Health Organization recognized Covid-19 as a potential pandemic on March 11, 2020, governments around the world, including the Japanese government, took immediate action. Lockdowns and other preventive measures around the world have constrained economic activity with a huge impact on the global and Japanese economies. Corporations are sure to suffer enormous losses, which begs the question of which parties will bear those losses or, if both parties are to bear such losses, how the losses will be shared between the parties for transfer pricing purposes. It is likely that the parties will have to grapple with potential disagreements with their respective governments over the transfer pricing calculations made after the economic impact of the crisis. According to the predominant Transactional Net Margin Method (TNMM) in Japan, a party performing simple or routine tasks is considered a contractor who does not assume any business risk and could allegedly be compensated on the basis of fixed fees regardless of economic losses from an overall transaction . If some governments take such a position, the taxpayer will have to pay corporation tax despite his financial losses. Even if a taxpayer tries to defend itself by benchmarking against comparable companies, the unusual nature of the crisis may make it difficult to identify comparable transactions. Taxpayers are encouraged to explain exactly how Covid-19 caused their sales to decline and identify valid reasons as to why the taxpayer is making losses as opposed to the other party.
On December 18, 2020, the OECD published the “Guidance on the Transfer Pricing Implications of the COVID-19 Pandemic”, which was approved by the 137 members of the Inclusive Framework. As Japan has joined the inclusive framework, the Japanese government is expected to follow the guidelines and taxpayers are advised to take the appropriate strategies suggested in the guidelines to deal with the irregular incidents in 2020.
iv double taxation
Japan has an APA program that may be effective depending on the countries of the counterparty (see Section VI above). Both bilateral and unilateral APAs are available; in practice, multilateral APAs are rare.
In general, any type of transaction or issue with foreign affiliates can be covered by APAs. A taxpayer must submit a proposed methodology for calculating the arm’s length price to the competent regional tax office of the NTA and the relevant documentation to support the proposed method for review by the competent department of the regional tax office. The taxpayer does not have to pay any usage fees for an APA application.
Broadly speaking, it often takes around two to three years to get a bilateral APA. According to the NTA, it took an average of 34.1 months for a bilateral APA or MAP in 2018. In practice, APAs often span five years. Rollback is also available. The key benefit of obtaining an APA with the tax authority is avoiding transfer pricing disputes in the future; the main drawbacks are that it is time consuming and costly.
v Impact on other taxes
In practice, transfer pricing evaluations have no effect on value added tax (“consumption tax” under Japanese tax law) or import or customs duties.
Outlook and conclusions
In 2018, there were 257 executions, assessments or changes in transfer pricing imposed or proposed by the Japanese tax authorities for 36.5 billion and 178 executions, assessments or changes for 43.5 billion. This shows that the investigations are now aimed at a broader group of companies, including not only large companies, but also small to medium-sized companies, although the respective amount has decreased, possibly due to the more cautious approach of the tax authorities.
The BEPS initiative could significantly change transfer pricing in Japan. Prior to the introduction of CbCRs, the Japanese tax authorities did not have effective measures to obtain information on the global tax position of the taxpayer, which is necessary for the determination of the profit share per country in relation to Japanese taxpayers. However, since the initial CbCRs were due on or after March 31, 2018, depending on the taxpayer’s fiscal year, the Japanese tax authority is expected to investigate the CbCRs to identify potential taxable income imbalances per country and loss of revenue due to inappropriate transfer pricing in order to make transfer pricing reviews more effective to be able to perform.