(This is the 8th article of this seminar series composed of 11 articles)
(Part 8) Considerations to prepare the Local File
1. Items to Be Listed in Local Files
In the previous seven articles, we looked at the concepts behind transfer pricing taxation, discussed the various ways of determining the arm’s-length price, and saw a few examples of usage. However, companies are required to have additional know-how when attempting to determine the arm’s-length price in controlled transactions. Next, we will turn our attention to the local files, which were introduced as part of the contemporaneous documentation responsibility mandated at the time of the fiscal 2016 revision of the Japanese tax system.
Although the preparation of local files is a preparatory step for companies in determining the arm’s-length price, the local files cannot be completed with only the information and documents that the companies have.
In this article, we will explain the points to consider when preparing the eight major items listed in Sample 1 in “Guide for Contemporaneous Documentation,” found on the website of the National Tax Agency. (“Corporation” refers to a Japanese corporation, and “Corporation A” refers to its foreign affiliate.) This example assumes the Corporation has a “corporate brochure,” but not a “securities report.” Corporation A prepares an “annual report.”
1. Overview of the corporation and group companies
2. Overview of foreign affiliates
3. Details of controlled transactions
4. Functions and risks of the Corporation and Corporation A in controlled transactions
5. Business policies of the Corporation and Corporation A
6. Industry analysis
7. Transfer pricing methods to determine the arm’s-length price
8. Other transactions closely related to the controlled transactions with Corporation A
2. Overview of the corporation and group companies
The overview of the corporation and the entire group is described in this section.
The description starts with a business overview of the entire group, such as one provided in the “Corporate Brochure,” and then is narrowed down to focus on the controlled transactions. Here, each foreign affiliate’s business, its performance during the specified time frame, number of employees, etc., are described. If there are many affiliates, such as divisions in North America, Asia, and Europe, then a division-by-division description is required.
A bare minimum would be to prepare a chart that describes the shareholding relationship between the Corporation and the affiliates in the group.
3. Overview of foreign affiliates
In this section, the foreign affiliates involved in controlled transactions are described in detail: the basic information should include such things as the date of incorporation and the shareholding relationship, as well as the details of the controlled transactions, internal operations related to the transactions, and transactions with third parties.
4. Details of controlled transactions
This section should include the following:
(1) A transaction chart (confirmation of the controlled transactions)
The company first needs to prepare a transaction chart representing the controlled transactions (see the figure below).
The chart may look similar to the ones in Parts 5, 6, and 7 of this seminar series. This chart is used to support the choice of a transfer pricing method for the arm’s-length price, and it will contain information such as the amount involved in the controlled transactions (also the selling price to an unrelated third party) as well as the roles of the Corporation and Corporation A in the transactions. Please refer to pp. 97 and 116 of the NTA’s “Guide for Contemporaneous Documentation” (hereafter referred to as “NTA Samples of Local Files,”) and “Examples for Preparing Documents Required for Determining Arm’s-Length Prices,” dated June 2016 (hereafter referred to as “NTA Examples of Local Files”).
(2) Information on the controlled transactions
Based on internally available information, describe the details of the controlled transactions, such as contractual relationships, price-setting methods, and transaction details.
(3) A description of profit and loss in the controlled transactions
Although the profit and loss for both the Corporation and Corporation A are intended, in practice, the profit and loss of only Corporation A is often deemed as that of the controlled transactions because middle-sized companies tend not to conduct any transactions other than the controlled transactions already stated. If Corporation A is engaged in any additional transactions, the profit and loss generated in those transactions are excluded. With regard to the Corporation (the tested party), not only the profit and loss of the controlled transactions is calculated (called the “segmentation of profit and loss” or “segmented profit and loss”), but also the operating profit, in consideration of the application of the Transactional Net Margin Method (TNMM). Here, common costs, such as selling expenses and general administration expenses, need to be reasonably allocated.
Please refer to “NTA Examples of Local Files” (pp. 17-18) for the transfer pricing methods of segmented profit and loss.
[Example: Transaction Flow]
[Source: Guide for Contemporaneous Documentation (p. 97)]
5. Functions and risks of the Corporation and Corporation A (foreign affiliate) in controlled transactions
This is an important section that will be explained in the next article, “Part 9.”
6. Business policies of the Corporation and Corporation A
The business policies of the Corporation and Corporation A can be prepared based on corporate brochures and annual reports. This section is referred to when screening for qualitative criteria, for example, “similarity in business policy.” This will be explained in the next article, “Part 9.”
7. Industry analysis
In this section, distinctive features of the product market are described, especially government policies, such as preferential taxation or remittance restrictions.
If the market has any distinctive features, they may be referred to during an audit to see whether or not they have any impact on transaction prices or operating profits. If they do, adjustments may be required.
Please refer to “NTA Examples of Local Files” (pp. 19-20) for more details.
8. Transfer pricing methods to determine the arm’s-length price
This section is divided into two parts:
(1) The selected transfer pricing method for the arm’s-length price
Give the name of the selected tested party, and describe the transfer pricing method selected to determine the arm’s-length price and the profit-level indicator (PLI) used in the calculation. Also, explain why the selected transfer pricing method is the most appropriate.
(2) The selected comparable transactions
This will be explained in an upcoming article, “Part 10.”
9. Other transactions closely related to the controlled transactions with Corporation A
For example, suppose the Corporation assigns licenses of manufacturing technologies or provides technical guidance on a product to Corporation A when exporting key components of the product to Corporation A; Corporation A then manufactures the product and sells it to third parties. These transactions are recognized as transactions closely related to the controlled transactions of the key components.
This section is referred to when calculating the arm’s-length price by taking multiple, related controlled transactions as one transaction.
Please refer to “NTA Examples of Local Files” (pp. 22-23) for more details.
(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