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Significant changes to the dynamic of the financial services sector in recent years have shifted the paradigms in how we work. The increased digitisation of the workforce, changes in business models, globalisation, and remote working capabilities have led to a new approach to the delivery of services.
The Japanese transfer pricing (TP) legislation is in the Article 66-4 of Act of Special Measures Concerning Taxation, and is based on the arm’s length principle as per Article 9 of the OECD Model Tax Convention on Income and Capital, i.e. it follows the OECD Guidelines updated in July 2022.
The TP rules apply to Japanese taxpayers, including Japanese branches of overseas companies and PEs.
If the transfer pricing of the taxpayer does not meet the standard, taxpayer adjusts its tax return or settles a price adjustment. The tax return adjustment is a “one-way street”, i.e. upwards-only adjustments are permitted.
The preparation of transfer pricing documentation (i.e. Local file) is mandatory.
Japan has implemented CbCR (Country by Country Reporting) and Master file for the multinational enterprise groups with a consolidated total revenue for the Ultimate Parent Entity's preceding fiscal year of 100 billion yen or above.
Transfer pricing methods
The most appropriate pricing method should be selected on a transaction by transaction basis, providing the most reliable measure of an arm’s length result in each case. The current OECD methods, namely the comparable uncontrolled price method, resale price method, cost plus method, transactional net margin method, profit split method, and discounted cash flow method are all accepted but the method used must be in line with the functional and risk profile of the entity.
In the past, three-“traditional transaction methods” (comparable uncontrolled price method, resale price method, cost plus method) was prioritized over other method, however in the tax reform in 2013, revision was made to select the most appropriate transfer pricing method from all method
Transfer pricing documentation
Preparation of transfer pricing documentation
Japan follows the OECD transfer pricing documentation model based on the Master File and Local File (BEPS Action 13) approach.
Master file should be submitted to the competent District Director via electronic tax filing within one year of the day following the one when the Ultimate Parent Entity’s fiscal year ends.
Multinational enterprise groups with a consolidated total revenue for the Ultimate Parent Entity's preceding fiscal year of less than 100 billion yen are exempted from the submission of the Master File.
Penalty will be imposed for failure to submit a Master File to the District Director by the deadline without good reason.
The preparation of transfer pricing documentation, i.e. Local file is mandatory.
If National Tax Agency requests transfer pricing documentation, the taxpayer would have a deadline of 45 days in which to respond.
In the following cases, tax payers are exempted from the duty of transfer pricing documentation: A) If the amount of transactions (total of receipts and payments) with a foreign-related party during the previous business year (the current business year if there was not the previous one) was less than five billion yen, and B) If the amount of transactions of intangibles (total of receipts and payments) with a foreign-related party during the previous business year (the current business year if there was not the previous one) was less than 300 million yen. Having said that, if NTA requests transfer pricing documentation, the taxpayer would have a deadline of 60 days in which to respond
Master and Japanese local file
NTA follows OECD for the Master and Local file structure.
NTA stipulates that Local file should include the following information;
Details of intercompany transaction under analysis (such as assets and service relating to the intercompany transaction under analysis, function performed or risks assumed by the company, analysis of the market of the inventory assets regarding intercompany transaction, details of the business strategies of the companies, and profit and loss of the companies, etc.).
Documents used by the company for the determination of the arm's length price (such as selection process of comparable transactions adopted by the company, details of the comparable transactions, reasons for adoption of the TP methodologies to determine the arm's length price, and any other document prepared by the company for determining the arm's length price, etc.).
Japanese Local file must be preserved seven years from the day the follows the deadline for submission of final returns.
Some risk factors for challenge
High-risk business restructuring, such as transitioning from a buy-sell arrangement to a commissionaire arrangement, involves supply chain reform.
Limited risk distributor and contract services/ contract R&D arrangements could also potentially be challenged, especially where significant people functions are in Japan.
Where there is a failure to submitting Local File, the tax inspector is allowed to use inquiry and inspection rights and impose taxation by secret comparable and/or estimation. Taxation by estimation allows tax inspector to estimate transfer prices without reference to the taxpayer’s own transfer pricing method, theoretically, taxation with estimate would not be consistent with arm’s length nature as it may also be based on the transaction between affiliated parties.
Where there is a failure to submitting a CbCR and Master file, 300,000 Japanese Yen of penalty will be imposed.
Economic analysis and how to demonstrate an arm’s length result
In order to search for the comparable transaction, both internal comparable transaction (transaction related to comparable products between a member of the group and third-party) and external comparable transaction (transaction related to comparable products between the unrelated party and third-party) are to be examined.
NTA accepts the use of interquartile range calculated based on either an excel formula or the formula specified by the US Internal Revenue Service. While the average of the comparable transaction’s value would be considered by NTA to be the arm's length price, if the value of intercompany transaction under analysis is within the interquartile range, NTA does not ask to make an adjustment.
Transfer pricing for intragroup services are classified into A) services incidental to the core business, no mark-up on total cost: B) routine and support services with limited risk as a non-core business, a 5% mark-up on total cost as long as certain terms and conditions are met: and C) other services not categorized to A) and B), most appropriate TP method.
Advance Pricing Agreements (APAs), dispute avoidance and resolution
An Advance Pricing Arrangement (APA) is an arrangement based on an application from a taxpayer, NTA confirms in advance a set of criteria such as methods, comparables and associated adjustments, and critical assumptions regarding future events for the determination of the transfer pricing for intercompany transactions over a fixed period of time.
NTA recommends bilateral APAs over unilateral APAs.
There are around 121 cases agreed in 2020 and the average time taken to negotiate them is 29 months.
The company shall corrects taxable income on its final tax return or promptly file amended tax returns for upward profit adjustment and NTA does not apply secondary adjustment to this.
For downward adjustment, the company may correct taxable income on its final tax return or file a request for correction for the tax return.
CbCR and Master file: multinational enterprise groups with a consolidated total revenue for the ultimate parent entity's preceding fiscal year of 100 billion yen or above are exempted.
New rules regarding hard-to-value intangibles (HTVI) was implemented in Japanese 2019 tax reform. The rules allow tax authorities to make an adjustment to the pricing of certain transactions where there is a significant deviation of actual financial outcomes from the forecasts used to price the transaction.
Discounted cash flow method
Discount Cash Flow method (DCF method) was included in TP method in Japanese 2019 tax reform.
DCF method can be useful when
It is difficult to find a comparable transaction and;
It is difficult to apply profit split method due to the type of the intercompany transaction,
However, as DCF method relies on uncertain factors such as the projected amount at the time of purchase, if there are multiple candidates including the DCF method, select the most appropriate method other than DCF method.
NTA and taxpayer behaviour
In 2021, there were 154 cases of tax inspections on transfer pricing, which represented a 14.9% increase compared to the previous year. The total amount of corrections resulting from the transfer pricing inspections amounted to 33 billion Japanese yen, marking a 43% decrease from the previous year.
TP for Financial transactions
For fiscal years starting on or after July 1, 2022, the financial transaction transfer pricing part of the administrative guidelines for tax examiners in Japan was reformed. It highlights that arm's length charges are needed not only for intercompany loans but also for guarantee transactions. The pricing of intercompany financial transactions must be explicitly based on the creditworthiness of the intercompany borrower or the guaranteed party. The guidance that allowed it to be based on the creditworthiness of the intercompany lender no longer exists.
For further information on transfer pricing in Japan please contact: