Transfer Pricing in Japan: Arm’s Length Prices and Local File Basics

Transfer pricing rules (移転価格税制) apply where the price of a transaction between a Japanese company and an overseas affiliate (a foreign related party, 国外関連者) differs from the price that would be agreed between unrelated parties (the arm’s length price, 独立企業間価格) and, as a result, income in Japan is reduced. In that case, corporation tax is assessed as if the transaction had taken place at the arm’s length price. Typical targets are payments to an overseas parent for goods, royalties and service fees. Above a certain transaction volume, the company must prepare documentation supporting its prices (a Local File) by the filing deadline.

What transfer pricing covers: counterparties and transactions

A foreign related party is a foreign corporation that has a certain capital relationship or substantive control relationship with the Japanese company. Typical examples are an overseas parent company, sister companies and overseas subsidiaries.

Any type of transaction with a foreign related party is covered. Transactions commonly seen in Japanese subsidiaries include the following.

• Purchases and sales of goods or raw materials
• Royalties for the use of intangibles such as trademarks and technology
• Consideration for services, such as management fees, system usage fees and outsourcing fees
• Interest on intra-group loans and borrowings
• Bearing the personnel costs of seconded staff

If a Japanese company overpays a foreign related party or sells to it too cheaply, the income it reports in Japan falls. Transfer pricing rules recalculate that portion at the arm’s length price and tax it. Conversely, where the price increases income in Japan, no tax is assessed under these rules.

Situations that commonly raise issues for Japanese subsidiaries

• Losses or low margins continue even several years after incorporation
• Large payments to the parent (royalties or management charges) squeeze profits
• Margins on goods bought from the parent are lower than those of companies performing similar functions
• There is no contract, and the basis for calculating fees cannot be explained

Meeting any one of these does not in itself lead to an assessment. However, these are situations in which a tax audit is likely to ask for an explanation.

The arm’s length principle and pricing methods

The arm’s length price is the price recognised as one that would be agreed if a transaction with a foreign related party had taken place between third parties with no capital relationship. It is determined by comparison with identical or similar transactions carried out between unrelated parties under similar circumstances (comparable transactions).

The 2011 tax reform (Heisei 23) abolished the order of priority among pricing methods. Today, the most appropriate method is selected taking into account factors such as the nature of the transaction and the functions performed by each party. The change was made to align Japan’s rules with the OECD Transfer Pricing Guidelines.

For example, for a subsidiary that sells in Japan goods purchased from its parent, you check whether its margin is too low compared with independent companies performing similar sales functions.

Which method is appropriate depends on the functions the Japanese subsidiary performs (sales, manufacturing, research and development, etc.), the risks it assumes and the intangibles it uses. Rather than simply applying the parent group’s policy, check that it fits the reality of the Japanese company.

The obligation to prepare a Local File (contemporaneous documentation)

The FY2016 tax reform (Heisei 28) put in place transfer pricing documentation rules in response to the recommendations of the BEPS project. Today, for foreign related-party transactions above a certain size, a Local File must be prepared and retained by the filing deadline for the final tax return (the contemporaneous documentation requirement). The start date and detailed requirements can be checked in the National Tax Agency’s FAQ on the documentation rules.

Transactions below both thresholds are exempt from the contemporaneous documentation requirement. However, documents that are important for calculating the arm’s length price must still be presented if requested in an audit. What is exempted is the preparation deadline, not the responsibility to explain your prices.

Main contents of a Local File

• The capital relationship with the foreign related party and the business of each party
• Details of the transactions (contracts, pricing method, terms)
• The functions each party performs, the risks it assumes and the intangibles it uses
• The pricing method selected and the reasons for selecting it
• The selection of comparable transactions and the adjustments made for differences

The National Tax Agency publishes a contemporaneous documentation guide with sample entries. It is a useful reference for structure when preparing a Local File for the first time.

Documents required of large groups

Large multinational groups whose total consolidated revenue exceeds a certain size must, in addition to the Local File, provide a Master File (事業概況報告事項) describing the group’s overall business and a Country-by-Country Report (国別報告事項) showing revenue, tax paid and other data by jurisdiction. As the Japanese subsidiary may itself have a filing obligation, agree the division of responsibilities with the relevant department at the parent.

Points to watch for intra-group services such as management fees

When paying for management services or systems provided by the parent, be ready to explain that the Japanese company actually receives a benefit. Other points to check are whether the services duplicate work the Japanese company performs itself and whether the basis for allocating charges is reasonable. Keeping records of the services provided (reports, meeting materials, etc.) in addition to contracts and invoices makes them easier to explain in an audit.

What happens if documentation is not prepared

If the Local File or other documents are not presented by the specified date, the tax office can estimate the arm’s length price using, for example, the margins of companies in the same industry, and assess tax on that basis (presumptive taxation). The calculation may rest on assumptions unfavourable to the company.

A transfer pricing assessment means paying additional corporation tax and other taxes in Japan. If the same income is also taxed in the parent’s country, it is double taxed. With countries that have a tax treaty with Japan, the company can request a mutual agreement procedure to seek relief from double taxation.

Practical steps for Japanese subsidiaries

1. List all transactions with foreign related parties and check the amounts and whether contracts exist
2. Document how each transaction is priced and put contracts in order
3. Check every year whether prior-year transaction amounts exceed the JPY 5 billion and JPY 300 million thresholds
4. Check that the parent group’s transfer pricing policy is consistent with the reality of the Japanese company
5. For significant transactions, consider using an advance pricing arrangement

Common oversights

• Using group documentation prepared by the parent as is, without enough explanation of the functions and risks of the Japanese company
• The fee calculation method in the contract does not match how invoices are actually issued
• In years when transactions fall below the thresholds, no materials supporting the prices are kept
• Salary costs of seconded staff and the settlement of advances are not managed as foreign related-party transactions

Each of these tends to work against the company when a tax audit asks for an explanation. Reconciling the list of transactions with contracts and invoices before each year-end close gives you peace of mind.

What is an advance pricing arrangement (APA)?

An advance pricing arrangement (事前確認) is a procedure for obtaining the tax authority’s confirmation in advance of matters such as the method for calculating the arm’s length price. Its stated aims are to give companies predictability and to ensure the proper and smooth administration of transfer pricing rules. Where confirmation is also sought from the other country’s authority, a mutual agreement procedure is involved. Because it takes time and money, decide in light of the size of the transactions and the tax risk.

For an overview of taxes including corporation tax and consumption tax, see an overview of taxes on Japanese companies; for differences by form of entry, see Japan branch vs Japanese subsidiary. For the consumption tax treatment of services received from overseas, the Qualified Invoice System and foreign companies is also useful.

How TIMOA can help

Transfer pricing compliance starts with organising your transactions so that you can explain how prices are set. Deciding on contracts with the parent and fee calculation methods at the incorporation stage reduces the burden of dealing with audits later.

Working with partner certified tax accountants, TIMOA helps you organise intra-group transactions, put contracts in place and confirm whether a Local File is required. For details, see our Accounting, Tax & HR services.