The principal Japanese transfer pricing legislation is Article 66-4 of the Special Taxation Measures Law (the Law) and Article 39-12 of the Enforcement Order thereof (the Order). For a taxpayer who files a consolidated tax return, Article 68-88 of the Law and Article 39-112 of the Order are applicable. While they are not legislation, the National Tax Agency of Japan (NTA) published detailed interpretations in respect of these statutory provisions in Chapter 12 of the Basic Circular of the Law (the Circular) and in the Commissioner’s Directive on the Operation of Transfer Pricing (the Directive), under which the transfer pricing legislation is enforced.
The Japanese transfer pricing rules only cover income tax on corporations (under the Corporation Tax Law), and do not cover individuals or trusts (with certain limited exceptions).2 The rules are applicable to transactions between a Japanese corporation (or a foreign corporation subject to the Japanese corporation income tax) and its ‘foreign related corporation’ (as defined by the Law). A foreign related corporation is defined, in essence, as a foreign corporation, controlling, controlled by or under common control of a Japanese corporation (i.e., a parent–subsidiary or brother–sister relationship), as measured by 50 per cent or more direct or indirect ownership, or by effective control through officers, business dependency or finance.
ii Conformity with OECD Guidelines
The Law and the Order spell out a set of transfer pricing methodologies that effectively follow the Organisation for Economic Co-operation and Development Transfer Pricing Guidelines (the OECD Guidelines). Specifically, the Japanese transfer pricing rules were overhauled in 2011 in response to the amendments to the OECD Guidelines in 2010, confirming the prevalence of the transactional net margin method (TNMM) as well as introducing the ‘most appropriate method’ rule and the ‘range’ concept. The 2013 amendment to the Order adopted the Berry ratio as another net profit indicator, in line with the OECD Guidelines. In 2016, in line with Action 13 of the OECD Base Erosion and Profit Shifting (BEPS) project, the Japanese government introduced new legislation adopting the three-tiered documentation approach, consisting of a master file, a country-by-country report (CbCR) and a local file. In 2019, in line with the OECD Guidelines as revised in 2017, the Japanese government introduced new legislation adopting the discounted cash flow method as another transfer pricing method, and price adjustment measures for hard-to-value intangible assets (see Section III.i below). The 2017 edition of the OECD Guidelines is used in practice, and the Japanese tax authority and courts can refer to paragraphs in that edition to help them determine whether transactions predating such Guidelines were at arm’s length, as long as a specific paragraph in that edition is understood to clarify the rules and principles that were adopted in prior editions, rather than creating a new rule in the 2017 edition.
iii Covered transactions
The Japanese transfer pricing rules cover ‘foreign related transactions’ conducted between a Japanese corporation and its foreign related corporation; the rules cover any types of transactions that include, among others, purchases or sales of inventory or other property, leases, provision of services, sales or licensing of intangible assets, and borrowing or lending of money.
While the Japanese transfer pricing rules cover any income transactions, they are unlikely to be applied to capital contributions, even if it is theoretically possible. For example, when a Japanese parent company was deemed to have received shares in its Thai subsidiary in excess of the value of the new capital money that the Japanese parent contributed, the NTA invoked the rules for ‘gift’, not resorting to the Japanese transfer pricing rules, which was affirmed by the Tokyo High Court judgment, dated 24 March 2016.
Broader taxation issues
i Diverted profits tax, digital sales taxes and other supplementary measures
There are no diverted profits taxes or similar taxes under Japanese law and no immediate proposals have been made for such taxes. Furthermore, the Japanese government has not made any immediate proposals for digital sales taxes. There is no multinational anti-avoidance law or anything similar to the US BEAT/GILTI regime.
ii Tax challenges arising from digitalisation
The Japanese government has been proactively participating in and leading discussions regarding the Inclusive Framework Pillar One and Global Anti-Base Erosion (GloBE) proposals. Nevertheless, considering the potential impacts on Japanese companies operating internationally, the Japanese government argues that companies that allocate profits appropriately in market countries should not be materially affected by the reforms, representing the voices of Japanese multinational companies.
For Pillar Two, the Japanese government appears to support the global minimum tax regime currently proposed by the OECD, although Japanese multinational companies are particularly nervous about the minimum taxes being applicable to subsidiaries operating in emerging markets that have manufacturing or distribution functions. While such subsidiaries in emerging countries are exempt from the Japanese controlled foreign corporation (CFC) regime due to their substantive activities in the emerging countries, they may not be exempt due to their engagement in active businesses and would be subject to the new minimum taxes under Pillar Two because it is expected not to exclude low-taxed subsidiaries owing to their substance.
iii Transfer pricing implications of covid-19
After the World Health Organization recognised covid-19 as a potential pandemic on 11 March 2020, governments around the world, including the Japanese government, took emergency action. Lockdowns and other preventive measures worldwide have restricted economic activity with an enormous impact on global and Japanese economies. Companies will certainly suffer tremendous losses, raising the question of which parties will assume such losses, or, if both parties are to assume such losses, how the losses will be allocated between the parties for transfer pricing purposes. It is likely that parties will have to deal with possible disagreements with the respective governments in relation to transfer pricing calculations determined after the crisis impacted the economy. In accordance with the transactional net margin method (TNMM), which is the prevailing transfer pricing method in Japan, a party that performs simple or routine functions is deemed to be a contractor that does not assume any business risks and could supposedly be compensated based on fixed fees regardless of any economic losses from an overall transaction. If some governments take such a position, the taxpayer will be required to pay corporate income tax despite its financial losses. Even if a taxpayer tries to defend itself by benchmarking based on comparable companies, identifying comparable transactions may not be easy given the extraordinary nature of the crisis. Taxpayers are encouraged to delineate specifically how covid-19 caused their sales to drop and to identify justifiable reasons as to why the taxpayer, as opposed to the other party, is suffering losses.
The OECD published the ‘Guidance on the Transfer Pricing Implications of the COVID-19 Pandemic’ on 18 December 2020, which was approved by the 137 members of the Inclusive Framework. Because Japan has joined the Inclusive Framework, the Japanese government is expected to follow the Guidance and taxpayers are advised to adopt the appropriate strategies suggested in the Guidance to cope with the irregular incidences of 2020 and 2021.
iv Double taxation
Japan has an APA programme, which may be effective depending upon the counter-party countries (see Section VI above). Bilateral as well as unilateral APAs are available; in practice, multilateral APAs are rare.
In general, any transaction types or issues with foreign related corporations can be covered by APAs. A taxpayer must submit to the relevant regional tax bureau of the NTA a proposed method to calculate the arm’s-length price and the relevant materials to support the proposed method, for review by the relevant section of the regional tax bureau. The taxpayer needs to pay no user fees for an APA application.
Roughly speaking, it often takes approximately two to three years to obtain a bilateral APA. According to the NTA, it took 30.3 months on average for a bilateral APA or MAP in 2020. In practice, APAs often cover five years. Rollback is also available. The key advantage of obtaining an APA with the tax authority is the avoidance of transfer pricing disputes in the future; the key disadvantages are that it is time-consuming and costly.
v Consequential impact for other taxes
In practice, transfer pricing assessments do not affect value added tax (‘consumption tax’ under Japanese tax law), or import or customs duties.
Outlook and conclusions
In 2019, there were 212 enforcements, assessments or amendments in respect of transfer pricing imposed or suggested by the Japanese tax authority, amounting to ¥53.4 billion, which represented a significant increase in number but a decline in monetary amount compared to 2005, in which there were 178 enforcements, assessments or amendments, amounting to ¥43.5 billion. This shows that investigations are now being directed at a wider range of companies, encompassing not only large companies, but also small to medium-sized companies.
The BEPS initiative could significantly change transfer pricing in Japan. Before the introduction of CbCRs, the Japanese tax authority had no effective measures to obtain information regarding the taxpayer’s global tax position, which is necessary to assess the profit share per jurisdiction in respect of Japanese taxpayers. However, as the first CbCRs were due on or after 31 March 2018, depending on the taxpayer’s fiscal year, the Japanese tax authority is expected to be keen to examine the CbCRs to find potential imbalances of taxable income per jurisdiction and identify revenue losses due to inappropriate transfer pricing so that it can pursue transfer pricing audits more effectively.