Transfer pricing is a taxation to set appropriate prices for cross-border transactions with foreign related parties based on the “arm’s-length principle” and to require appropriate tax payment in each country. For example, a transaction in which a U.S. subsidiary purchases a product developed and manufactured by a Japanese parent company and sells it in the U.S. market occurs between related parties. Because of this, the price for this transaction can be arbitrarily determined. In this case, if the sales price from the Japanese parent company to the U.S. subsidiary is too low, the income attributable to this transaction will be transferred from the Japanese parent company to the U.S. subsidiary, resulting in an understatement of taxable income reported in Japan and, conversely, an overstatement of taxable income reported in the United States. Since the income reported in Japan will be understated, if this problem is pointed out during a tax audit, the Japanese Tax Authority will reassess the income based on the correct price and impose additional tax payments, resulting in a double taxation.
Transfer pricing is a fascinating area of international taxation and accounting that is concerned with determining the conditions and price for transactions within a Multinational Enterprise Group (MNE Group), which results in the allocation of profits to related companies across different tax jurisdictions.
Under internationally compliant transfer pricing methods, goods are priced based on the arm’s length principle and valued at the current market price — without manipulation or distortion from either the buyer or the seller.
While the transfer pricing mechanism is a way that companies can legally shift tax liabilities to low-cost tax jurisdictions and allocate earnings among their various subsidiaries and affiliate companies, there are a number of serious issues that organizations need to be aware of when engaging in these activities.
We explore what these are and offer an overview of the rules surrounding transfer pricing in Japan, which can have far-reaching implications for any company doing business here.
Transfer pricing rules exist to prevent entities from distorting taxable income in a way that would not happen between completely independent entities.
BEPS refers to tax planning strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations. This is considered unjust and has the effect of eroding tax bases through deductible payments, such as interest or royalties.
Working together within the OECD, Japan and other jurisdictions coordinate on the implementation of 15 measures to tackle tax avoidance, including specific transfer pricing guidelines to improve consistency and transparency in the international tax environment.
Member countries of the OECD include the US, Canada, Mexico, Japan, South Korea, Australia, and most European nations. All multinationals within these countries are required to adhere to appropriate transfer pricing methods and process accurate reports on their activities.
Rules regarding transfer pricing in Japan and the enforcement of these rules by the government are largely in line with OECD standards. This means that it adopts the “arm’s length principle” and looks to enforce the key measures set out in the OECD/G20 Inclusive Framework on BEPS.
The arm’s length method relies on the fact that the different parties of a transaction are independent and on an equal footing. It is an important part of international tax law and allows an adequate allocation of profit taxation rights among different jurisdictions.
In this regard, transactions between associated enterprises have to be priced as if these enterprises were independent and operating at arm’s length — engaging in transactions under equally applied conditions and economic circumstances.
This includes when a corporation sells property to, or buys property from, a foreign-related person, or provides services or conducts other transactions with them.
A foreign-related person is an entity that has a special relationship with another corporation, whether this is under the umbrella of a parent-subsidiary or substantial control relationship.
Arm’s Length Methods
The arm’s length price for the transaction of assets may be determined using a number of approved methods. The most suitable approach should be determined based on the individual situation. Some examples of these include:
Profit split method
Transactional net margin method
Comparable uncontrolled price method
Resale price method
Cost plus method
Berry Ratio method
Advance Pricing Agreements
An advance pricing agreement (APA) system is available to approve the arm’s length pricing procedure set forward by a tax paying organization undertaking transfer pricing in Japan. This is a complex process that requires a significant body of documentation, but once completed, can secure an agreement between your business and Japan’s tax authorities.
If a specific subsidiary or division of a parent company exists in a higher tax country (company A), they can save on taxes if they allocate more of their income to another subsidiary or division (company B), which exists in a lower tax jurisdiction.
Through this process, company A charges lower prices to company B and therefore boost profits through income generation in this lower tax jurisdiction. The result is that less tax is applied to company A, resulting in greater profits for the parent company.
This ultimately allows the parent organization to negotiate how much tax is paid in a way that would not happen if company A charged market prices to company B.
Tax authorities have strict rules influenced by the arm’s length method to prevent companies using transfer pricing as a way to avoid taxes and increase overall company profits, which negatively impacts the tax generating potential of a tax authority.
If a subsidiary exists in a higher tax country, they can save on taxes if they allocate more of their income to a subsidiary in a lower tax jurisdiction.
Penalties for Improper Transfer Pricing
Determining the appropriate cost of transactions between related entities within a company can be a complicated process for large multinationals entering the Japanese market. Errors in accounting can lead to breaches of the tax regulations and result in penalties.
This will apply if transfer values are not priced accordingly or documentation such as financial statements are not sufficient evidence for tax auditors or regulators, resulting in a fee, or penalty.
Also, if it is deemed that a corporate group has partaken in artificial profit shifting and tax avoidance through inappropriate transfer pricing methods, they may be issued with tax penalties by the Japanese government.
Disputes with the tax authorities over issues regarding transfer pricing in Japan can be costly and complicated. They may be brought to an administrative quasi-judicial body (National Tax Tribunal) and subsequently to the courts.
Transactions between a Japanese corporation and its affiliated overseas company are always potentially subject to transfer pricing taxation, so careful preparation is always necessary.
Transfer pricing is not an exact science and requires an in-depth understanding of tax regulations, market conditions, and accounting processes. Therefore, companies will be prudent to ensure they stay on top of intra-group transactions with the help of advisors or dedicated tax accountants who are familiar with the Japanese landscape.
At HLS, we have helped several international companies, including many European and US organizations entering the Japanese market, overcome such hurdles by helping them to achieve efficient transfer pricing and international tax accounting.
Corporations operating across multiple jurisdictions must adhere to the different laws and regulations required for each location. However, there are still advantages that arise from having access to assets across multiple geographies, including resources, goods, and labor.
To make the most of these opportunities, it is important to understand how principles of transfer pricing and international trade can help you to build an efficient and strategic tax system.
If you would like to know more about the international business strategies and tax procedures used by some of the most successful MNE Groups operating in Japan, or want to learn more about how your organization can operate smoothly across multiple tax jurisdictions, get in touch with one of our experts at HLS who will happily advise you on how to navigate cross-jurisdictional tax landscapes.
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