Transfer Pricing Seminar for Medium-sized corporations in Japan

(This is the 9th article of this seminar series composed of 11 articles)

 (Part 9) Considerations When Preparing Local Files

1. “Functions to Be Performed” – the Significance of “Function Analysis”

The analysis of the functions performed by the transaction parties is an important factor in determining the arm’s-length price for the transactions.

Although the terms “functions” and “function analysis” may be uncommon in the general taxation system, they are widely used in transfer pricing. In this article, we will give a general explanation of these terms since they may not be familiar to medium-sized companies dealing with transfer pricing taxation for the first time. As you may already be aware, transfer pricing taxation is, broadly speaking, a system that tries to determine the allocation of the incomes earned by multinational group companies in transactions with unrelated companies through the application of objective criteria for allocating incomes among the group companies involved in the transactions.

In doing this, it is important to assess and evaluate the functions performed by each group company involved and the extent of each group company’s contribution to earning those incomes. In transfer pricing taxation, the functions performed by group companies in order to earn incomes are called the “functions performed,” and the “function analysis” refers to the process of assessing and evaluating those functions.

The “functions performed” may differ slightly from company to company, depending on the corporate structure and the nature of the products involved, but they generally include the following:

    1. Research and development
    2. Sales and marketing
    3. Manufacturing
    4. Procurement of raw and other materials
    5. Inventory
    6. Receivables management
    7. Customer support

Although the “risks borne” are analyzed alongside the functions performed, we believe that the connection between the risks and the incomes earned can be easily understood, and thus we have omitted the explanation here. “Risks borne” include the following:

    1. Research and development risk
    2. Market risk
    3. Manufacturing risk
    4. Inventory risk
    5. Credit risk
    6. Product warranty and liability risk
    7. Foreign exchange risk

2. Function Analysis

In transfer pricing taxation, it is necessary to conduct a function analysis of the parties engaged in the transactions, as it is thought that the parties should allocate incomes in proportion to the functions they perform, the risks they bear, and the distinctive intangible assets they own. The function analysis is also necessary in order to select the most appropriate transfer pricing method to determine the arm’s-length price. The best method depends on the details of the controlled transactions, the functions performed, and the risks borne by the parties.

1. Comparable Uncontrolled Price Method (CUP)

To apply this method, there must be similar inventory assets or services in the controlled and uncontrolled transactions before analyzing the functions performed by the parties. However, it is difficult to identify such assets and services using publicly available information alone, and thus this method is appropriate when there are internal comparable transactions available.

      2. Resale Price Method (RP) and Cost Plus Method (CP)

In selecting comparable transactions, the similarity of the functions performed by the parties in the controlled transactions is taken into consideration, as are the inventory assets and services. With these methods, adjustments must be made for any differences in the functions performed by the parties in the comparable and controlled transactions (“adjustment of differences”).

      3. Transactional Net Margin Method (TNMM)

With this method, more importance is placed on the similarity of the functions performed by the parties in the controlled transactions than on the similarity of inventory assets and services. TNMM does not basically require an adjustment for the differences, since the comparable transactions are selected based on the similarity of the functions performed by the parties. This makes the selection of comparable transactions easier compared to the traditional transaction methods.

3. Selection of the Tested Party

It is necessary to decide whether to use the Corporation or its foreign affiliate as the tested party before choosing the transfer pricing method to determine the arm’s-length price.

It is considered reasonable to select the party that performs the simpler functions in order to better identify the transactions with sufficient comparability. Therefore, the foreign subsidiary is frequently chosen as the tested party.

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

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