Transfer Pricing Seminar for Medium-sized Corporations in Japan

(This is the 4th article of this seminar series composed of 11 articles)

(Part 4) Transfer Pricing Methods to determine the Arm’s Length Price

1.      Transfer Pricing Methods Based on OECD Transfer Pricing Guidelines

When a parent corporation is taxed on its controlled transactions with foreign subsidiaries, transfer pricing principles govern that the profit increased at the parent should be decreased at the subsidiary. However, unless the country where the subsidiary resides adopts transfer pricing taxation similar to that of the country of the parent, the subsidiary’s profit will not be decreased, and the result will be double taxation. In order to avoid this situation, it is desirable for countries to share common rules on transfer pricing taxation; in fact, the OECD’s Transfer Pricing Guidelines function as the common rules.
Transfer pricing taxation in Japan is based on the OECD Transfer Pricing Guidelines, and Japan’s calculation methods, which will be explained in later sections of this series, are also internationally recognized under the OECD Guidelines.
Prior to the fiscal 2011 revision of the tax system, priority was given to Japan’s traditional transaction methods over other methods; those other methods were applied only in situations where the traditional transaction methods could not be applied. However, in the 2011 reform, it was decided to apply only the most appropriate methods, and the traditional transaction methods were abandoned.

2.       Traditional Transaction Methods

Traditional transaction methods in Japan refer to the Comparable Uncontrolled Price Method (CUP), the Resale Price Method (RP), and the Cost Plus Method (CP). In the Comparable Uncontrolled Price Method (to be explained in the next article), if there are uncontrolled transactions identical to the controlled transactions, the uncontrolled transactions will be recognized as comparable, and that transaction price will be adopted as the arm’s-length price for the controlled transactions. In this situation, uncontrolled prices are those between unrelated parties or between a company and an unrelated party.

The Resale Price Method is employed when there are no identical transactions, but there are transactions similar to those in the controlled transactions. Again, the transactions might be between unrelated parties or between a company and an unrelated party. In this case, the similar transactions are recognized as comparable. In this method, the arm’s-length price on purchases is calculated by deducting the profit on comparable transactions from the selling price to an unrelated party.

The Cost Plus Method calculates the arm’s-length price on sales by adding the profit on the comparable transactions to the purchase price from an unrelated party.

It is thought that the Comparable Uncontrolled Price Method best reflects the concept of transfer pricing taxation, followed by the Resale Price Method and the Cost Plus Method. Traditional transaction methods require strict comparability in transactions, but that makes it difficult for both the tax authorities and the companies to specify comparable transactions using only the required verifiable publicly available information.

3.       Other Methods

(1)     Transactional Net Margin Method (TNMM)

The Transactional Net Margin Method is the arm’s-length price calculation method most used nowadays. The TNMM (to be explained in Part 6) emphasizes the level of operating profit in the controlled transactions at one of the related parties. In this method, for the operating margin of the controlled transactions to be deemed at arm’s-length, it must fall within the range of the operating margins of comparable transactions conducted by multiple comparable corporations selected through publicly available information. There are three calculation methods available under TNMM, each adopting a different profit level indicator (PLI): the ratio of operating margin to net sales; the ratio of operating margin to full cost, meaning the cost of goods plus the selling, general, and administrative expenses (full cost); or the Berry ratio (the ratio of net sales to operating expenses).

(2)     Profit Split Method (PS)

The Profit Split Method (to be explained in Part 7) calculates the arm’s-length price by splitting the combined profits in the controlled transactions between the related parties by applying one of the following specific methods: the Comparable Profit Split Method, the Contribution Profit Split Method, or the Residual Profit Split Method.

The Profit Split Method is considered applicable when there can be no comparable transactions, such as when each party owns distinctive functions, for example, intangible assets.

To our knowledge, the Comparable Profit Split Method, which divides the profit of the controlled transactions in proportion to the division of profits at the comparable corporations, has never been used in practice.

The Contribution Profit Split Method and the Residual Profit Split Method calculate the arm’s-length price by splitting the combined profits gained in the controlled transactions and allocating them between the related parties according to factors sufficient to estimate the extent of the parties’ contributions to the generation of the profits (splitting factor). The former splits the total amount of the combined profits, whereas the latter splits the residual profits between the related parties after allocating the estimated profits if both parties did not own the unique functions, such as intangible assets.

(The next article in this “Transfer Pricing Seminar Series for Medium-sized Corporations in Japan” will be published next month.)

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