In June 2022, the National Tax Administration Agency (NTA) announced amendments to the Transfer Pricing Administration Guidelines. The amendments are thought to reflect the January 2022 update to the OECD Transfer Pricing Guidelines on financial transactions, and they revise Japan’s legislation on the treatment of financial transactions and cost contribution agreements (CCA). It should be noted that this may affect Japanese companies operating outside of Japan, including those operating in the United States.
In this first part of a two-part series, we will focus on the amendments related to financial transactions, explaining key changes and points regarding the treatment of US-Japan transfer pricing taxation. In the second part, we will explore best practices and typical issues Japanese multinationals encounter in related-party financial transactions.
- Loan Transactions under Japan’s Transfer Pricing Legislation
Prior to these amendments, taxpayers were allowed to determine arm’s-length interest rates by referring to the following three-tiered approach. Note that priority was given in ascending order, given data availability.
- The interest rate that would have been charged if the borrower had borrowed from a third-party bank or other entity under similar terms and conditions, such as currency, timing, and duration.
- The interest rate that would have been charged if the lender had borrowed from a third-party bank or other entity under similar terms and conditions, such as currency, timing, and duration.
- The interest rate that would have been obtained by investing in government bonds with similar terms and conditions, such as currency, timing, and duration.
Under the recent amendments, the above method was abolished, and instead, the new guidelines require the taxpayer to determine the best method to calculate the arm’s-length interest rate. Specifically, the taxpayer is required to appropriately evaluate its own creditworthiness and determine an appropriate intercompany interest rate based on publicly available interest rate data.
- Borrower’s Creditworthiness
In reality, it would be difficult for a taxpayer to accurately evaluate its own creditworthiness. However, if the parent company has a credit rating, a method called the Group Rating Method, published by the credit rating agency, could potentially be applied to determine the subsidiary’s credit rating.
If the parent company does not have a credit rating, ideally, it should ask an agency or an outside expert to have one issued. However, the cost of such service will likely be a big burden on the taxpayer. Alternatively, a taxpayer could seek help from a transfer pricing professional with access to a database containing publicly available financial and credit data to find comparable companies and to come up with a credit rating for the parent company.
- Market Interest Rates
If the currency, timing, institution, creditworthiness, and other factors that could potentially affect the comparability of an interest rate are similar, publicly available interest rates, such as bank borrowing rates, swap rates, and government bonds, could be used as comparable interest rates. However, since these market interest rates do not reflect the creditworthiness of the borrower, the arm’s-length interest rate (base rate + spread) should be calculated by adding to the base rate a spread reflecting the creditworthiness of the subsidiary based on the parent company’s credit rating, as mentioned above. In addition to this method, it would also be possible to calculate an arm’s-length interest rate by referring to the yield on corporate bonds issued by companies comparable to the borrower or the lender in terms of industry, size, and credit rating.
Estimates of interest rates and credit spreads obtained through inquiries to banks and other financial institutions are considered unjustifiable since they are not based on actual transactions and therefore cannot be used to evaluate market interest rates or the creditworthiness of the borrower.
- Financial Guarantees
As for financial guarantees under these amendments, taxpayers must consider the economic benefit derived from the financial guarantee by evaluating 1) whether the guarantor has the legal obligation to pay off the loan in case of a default, and 2) whether the guaranteed party’s creditworthiness increased as a result of the provision of the guarantee. If it is determined that the guarantee does in fact provide an economic benefit to the guaranteed party, then the taxpayers must refer to the following methods to determine an arm’s-length interest rate:
- Yield Approach: This method calculates the spread between the interest rates that would have been payable with and without the guarantee.
- Cost Approach: This method calculates the additional risk borne by the guarantor by estimating the expected loss that the guarantor incurs by providing the guarantee.
The guaranteed party’s creditworthiness is again required to properly evaluable a financial guarantee transaction. This can be done following the methods described earlier in the Borrower’s Creditworthiness.
Whether to use the yield approach, the cost approach, or a hybrid method by taking the average of the two approaches depend on which approach can be considered the best method. In doing so, taxpayers must have a clear understanding of the nature of the guarantee transaction and select the best method to determine the arm’s-length transaction. That means evaluating the credit risk borne by the guarantor and the economic benefit received by the guaranteed party.
- Loan Transactions under U.S. Transfer Pricing Regulations
Under U.S. transfer pricing regulations, an arm’s-length interest rate must be determined by considering factors such as the principal amount, the duration of the loan, the security involved, and the credit standing of the borrower. This approach is similar to the revised Japanese transfer pricing legislation. However, presumably, because the government recognizes that it is difficult for non-financial institution taxpayers to calculate interest rates according to a borrower’s credit rating, the United States has a safe harbor rule. Specifically, if the related-party interest rate is set between 100% and 130% of the Applicable Federal Rate (“AFR”) published by the IRS, the related-party interest rate is deemed to be arm’s-length. However, if a Japanese lender makes a loan to a related-party U.S. borrower at an interest rate based on this safe harbor rule, the Japanese lender may end up with additional tax in a tax audit, since the AFR may be lower than the arm’s-length interest rate from a Japanese tax perspective. Especially since dollar interest rates have been rising rapidly since 2022, dollar-denominated loan transactions are becoming increasingly risky. Therefore, when renewing related-party loan transactions in the future, taxpayers must calculate the intercompany interest rate based on the borrower’s credit rating in accordance with both U.S. and Japanese transfer pricing regulations.
Because financial transactions are not core businesses for most taxpayers, many believe it is acceptable not to follow proper transfer pricing methods or to take action after it has been addressed in a tax audit. The recent amendment to Japan’s transfer pricing legislation on financial transactions requires taxpayers to determine the arm’s-length interest rate based on the creditworthiness of either the borrower or the guaranteed party.
With the recent interest rate increases for major currencies, including dollars and euros, it would not be a surprise for the Japanese tax authorities to take note of this and shift their focus to related-party financial transactions during a tax exam. We encourage our readers to take this opportunity to analyze the underlying risk of your existing related-party transactions, including financial transactions, to prepare for the next tax audit.
Note that these amendments apply to tax audits and advance pricing agreements for fiscal years beginning on or after July 1, 2022. For companies with March year ends, the amendment applies from the fiscal year ending March 31, 2024. For companies with December year ends, the amendments apply from the fiscal year ending December 31, 2023.
Hotta Liesenberg Saito LLP provides transfer pricing advice tailored to your specific needs and situation. If you have any questions regarding transfer pricing, please feel free to contact us.
Hotta Liesenberg Saito LLP
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