(This is the 2nd article of this seminar series composed of 11 articles)
(Part 2) Overview of Transfer Pricing Taxation
1. Basic Provisions of Transfer Pricing Taxation
The Japanese Ministry of Finance explains transfer pricing taxation on its website as follows: “A corporation is able to transfer profits to a foreign affiliate if the corporation sets its transaction prices with the foreign affiliate differently from the prices it sets with third-parties,” and “Transfer pricing taxation is a system to calculate the taxable profits and impose tax with the assumption that the transactions between a corporation and its foreign affiliate are conducted at the third-party price (the arm’s-length price) in order to prevent abusive overseas transfers of profits through the transactions between the corporation and its foreign affiliate.”
Let us look at the composition of Article 66-4-1 of ‘Act on Special Measures Concerning Taxation,’ which provides for transfer pricing taxation:
- In the case where a corporation
- …sells and buys assets, provides services, or has any other transactions with its foreign affiliate (…),
- and the payment the corporation receives from its foreign affiliate as a consideration for those transactions (‘controlled transactions’) is below the arm’s-length price, or the payment the corporation pays to its foreign affiliate as a consideration for the controlled transactions is above the arm’s-length price,
- … the controlled transactions will be deemed to have been conducted at the arm’s-length price.
2. Keywords in the Basic Provisions
There are several keywords in the Basic Provisions of Transfer Pricing Taxation: “corporation,” “foreign affiliate,” “controlled transactions,” and “arm’s-length price.” The first three keywords are explained below in Section (1). They are notions either well-established or clearly defined in the tax law. On the other hand, the last keyword, “arm’s-length price,” is described below in Section (2). The transaction price can be calculated using one of multiple methods stipulated in the tax laws. These are different from the actual transaction price, and it requires practical experience to calculate the arm’s-length price, as it can be difficult to determine which method should be applied and how to calculate the price.
(1) “Corporation”, “Foreign Affiliate”, and “Controlled Transactions”
“Corporation” refers to a corporate body (domestic or foreign) subject to the corporate tax. Sole proprietorships are not subject to transfer pricing taxation.
B. “Foreign Affiliate”
“Foreign affiliate” refers to a foreign corporation that is related to another corporation through a shareholding relationship, a substantially controlled relationship, or a “special relationship,” in which the first two relationships are linked.
- “Shareholding relationship” refers to either 1) the so-called “parent-subsidiary relationship,” in which one of the two parties directly or indirectly holds 50% or more of the outstanding shares issued by the other party, or 2) the so-called “fellow subsidiary relationship,” in which one and the same person directly or indirectly holds 50% or more of the outstanding shares issued by each of the two parties.
- “Substantially controlled relationship” refers to a relationship in which one of the parties has substantial control over the other party’s business policy, for example, one party controls half or more of the board members, or an employee who holds the right of representation at one party doubles as a board member or an employee at the other party.
- “Special relationship” here refers to a linkage of shareholding and substantially controlled, in which a corporation and its foreign affiliate are related either by a shareholding relationship, a substantially controlled relationship, or both.
C. “Controlled Transactions”
“Controlled transactions” refers to the sale or purchase of assets, including intangible assets, the provision of services, or any other transactions conducted between a corporation and its foreign affiliate.
(2) “Arm’s-Length Price”
“Arm’s-length price” refers to the price determined based on the assumption that the transactions between a corporation and its affiliate are conducted at the same price as the transactions between that corporation and a non-affiliated corporation.
The first three keywords in (1) above can be clarified when the facts are confirmed. However, in most cases, the “arm’s-length price,” cannot be calculated using only the documentation available to or prepared by the corporation and its foreign affiliate. However, it must be calculated to conform to the “arms-length price calculation methods,” as provided by the law.
The “arms-length price calculation methods” will be explained in Part 4 of this seminar series and later.
3. Laws, Directives, Administrative Guidelines, and Other References
In the practice of transfer pricing taxation, laws, directives, and administrative guidelines play significant roles. The National Tax Agency in Japan has additionally released the references listed below:
- “Act on Special Measures Concerning Taxation,” Article 66-4-1 ~ 5
- “The Enforcement Order of Special Taxation Measures Law,” Article 39-12-1~ 4
- “Commissioner’s Directive on Interpretation of the Act on Special Measures Concerning Taxation,” Article 66-4(1)-1 ~ 66-4(10)-1
- “Commissioner’s Directive on the Operation of Transfer Pricing (Administrative Guidelines)”
‣ 1-1 ~ 5-3 (Taxation)
‣ 6-1 ~ 6-24 (APA)
‣ “Reference Case Studies on Application of Transfer Pricing Taxation” (“NTA Reference Case Studies of Transfer Pricing”)
✓ Case 1 ~ 26 (Taxation)
✓ Case 27 ~ 28 (APA)
- “NTA Transfer Pricing Guidebook – For Autonomous Preservation and Improvement of Voluntary Tax Compliance (June 2017)” *
- “Transfer Pricing Administration Policy of the National Tax Agency – Future Policy and Initiatives Based on the Development of Contemporaneous Documentation” *
- “Points to Consider and Check for When Applying Transfer Pricing Rules – Items Considered in the Practice of Transfer Pricing Taxation” *
- “Guide for Contemporaneous Documentation – Samples of Preparing Local Files (“NTA Samples of Local Files”)” *
- “Documentation on Transfer Pricing Taxation (FAQ) (August 2018)” *
- “Examples for Preparing Documents (Local Files) Required for Calculating Arm’s-Length Prices (June 2016)” (“NTA Examples for Local Files”) *
(Note 1) “Controlled transactions” refers to the sale or purchase of assets, the provision of services, or other transactions conducted by corporations with foreign-related parties.
(Note 2) * The references marked with an asterisk are available only in Japanese.
(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.
Transfer Pricing Seminar Series Articles:
- (Part 1) Working Seminar for Medium-sized Corporations Unfamiliar with Transfer Pricing
- (Part 2) Overview of Transfer Pricing Taxation
- (Part 3) Transfer Pricing Examinations, Advance Pricing Agreements, and Documentation
- (Part 4) Transfer Pricing Methods to determine the Arm’s Length Price
- (Part 5) Traditional Transaction Methods
- (Part 6) Transactional Net Margin Method: TNMM
- (Part 7) Profit Split Method
- (Part 8) Considerations to prepare the Local File
- (Part 9) Considerations When Preparing Local Files
- (Part 10) Selection of the comparable companies and calculation of the profitability range
- (Part 11) Transfer Pricing Policy and Transfer Pricing Documentations