(This is the first in a series of 11 articles.)
(Part 1) Working Seminar for Medium-sized Corporations Unfamiliar with Transfer Pricing
Transfer pricing is usually regarded as a concern only for large corporations with foreign affiliates but not for medium-sized companies whose transaction volumes with their foreign affiliates are only a few million dollars.
However, transfer pricing documentation was made mandatory in Japan during the tax reform enacted in FY2018, following an international discussion of BEPS and the global trend of its introduction. In this reform, all corporations engaged in transactions of inventory assets totaling 5 billion yen or more or engaged in transactions of intangible assets totaling 300 million yen or more became subject to the documentation requirement. In addition, even companies whose transaction volumes with foreign affiliates are below these limits are obliged to prepare transfer pricing documents and submit documents similar to transfer pricing documents within 60 days if an examiner requests them during the tax audit. In addition, many of the countries in which foreign affiliates reside (especially Southeast Asian countries) have started introducing transfer pricing documentation requirements regardless of the size of the controlled transactions. Consequently, transfer pricing documentation has become unavoidable for many medium-sized companies with overseas subsidiaries and affiliates.
In the selection of the calculation method of arm’s-length prices for typical controlled transactions, the Transactional Net Margin Method (TNMM), which emphasizes comparability based on the similarities of the parties’ functions and publicly available information, is now being employed more often than traditional transaction methods, such as Comparable Uncontrolled Pricing (CUP), the Resale Price Method (RP), or the Cost Plus Method (CP). These three traditional transaction methods require products to be identical or highly similar. This seems due to the fact that the practice existed first and the taxation requirements came later. This will be explained in detail in the following sections. In preparing the documents, the sections explaining the ‘similarities of the parties’ functions’ and sections dealing with the ‘selection of comparable companies through analysis of publicly available information’ are the most difficult parts to compile for medium-sized companies as these require many years of transfer pricing experience and know-how.
2. Overview of Enforcement of Transfer Pricing Taxation from the Introduction Phase to the Present
(1) Taxation Practices at the Introduction Phase (Traditional Transaction Methods)
For a while after its introduction in Japan in 1986, transfer pricing taxation was mainly concerned with foreign companies. Traditional transaction methods, with their emphasis on the comparability of products, was stipulated, and the authorities wanted to see internally available information demonstrating that products were identical or highly similar. The arm’s-length price was calculated using traditional transaction methods. The Transactional Net Margin Method (TNMM), which is the most common calculation method today, was not widely employed in Japan at the time.
(2) Mutual Agreement on Taxation and the Problem of Secret Comparables
In contrast to the Japanese tax authorities, the U.S. tax authorities had longer experience in transfer pricing taxation, and had already started adopting the Comparable Profits Method (CPM), which emphasized comparability calculated from publicly available information. It was difficult for both countries to settle on a common method to calculate arm’s-length pricing. It was pointed out that the traditional transaction methods employed by the Japanese tax authorities created the problem of secret comparables since the selection was based on the internally available information to the authorities, and corporations could not verify those comparables.
(3) The Shift to Advance Pricing Arrangements (APAs) and the Introduction of TNMM
Large corporations having transactions between Japan and the U.S. started requesting APAs in order to avoid the risk of significant taxation arising from transfer pricing. This automatically led them to employ the CPM to calculate arm’s-length prices, which the U.S. tax authorities had been employing, simply because they had no other option but selecting comparable transactions based on publicly available information when requesting an APA. Subsequently, the OECD, which was initially critical of CPM, came to accept the TNMM*, which was similar to CPM, and in 2004 Japan followed by also introducing TNMM.
* CPM is a method that compares and tests the operating margin of one of the two parties engaged in the controlled transactions to that of the selected comparables (one of the two parties is called the ‘tested party’). The TNMM is a method that segregates the profit and loss of the controlled transactions and compares and tests the operating margins earned by the transaction units. However, in practice, it is often the case that the TNMM takes the transactions of the tested party in their entirety as one transaction unit. This consequently becomes the same calculation method as the CPM.
(4) Introduction of the Best Method Rule
Japan’s tax authorities continued to explain why the traditional transaction methods were no longer applicable in transfer pricing taxation or in APAs, even though traditional transaction methods were still on the books after the introduction of TNMM. Then, in 2011, the traditional transaction methods were repealed, and the application of the best method rule was introduced to calculate the arm’s-length price for controlled transactions. In fact, there actually were many cases in which it had been difficult to apply the traditional transaction methods using only publicly available information.
In this 11-part transfer pricing seminar, HLS Japan will discuss the general practice of transfer pricing taxation for medium-sized companies that may be unfamiliar with the topic. The discussions here are, of necessity, general; consultation is available for individual cases and specific situations.
(The next article in this ‘Transfer Pricing Seminar Series for Medium-sized Corporations in Japan’ will be published next month.)
For further inquiries, please contact us at Japan@HLS-Global.jp