The FY 2011 Amendment of the Japanese Tax Legislation ("Legislation Amendment") includes following changes to the Japanese transfer pricing legislation, and is effect for the fiscal years starting on or after October 1, 2011:
- Introduction of the most appropriate method
Legislation was amended from the traditional transactional methods approach, which was preferred over the transactional net margin method ("TNMM"), to the most appropriate method rule; and
- Inclusion of specific profit split method in the statute
Legislation specified the various forms of the profit split method, including the residual profit split method ("RPSM"), contribution profit split method ("Contribution PSM") and comparable profit split method ("Comparable PSM").
As a result of the Legislation Amendment, the following amendments have also been made to the the Commissioner's Directive on the Operation of Transfer Pricing in Japan ("Administrative Guidelines") and Special Taxation Measures Law Circulars ("STMLC") for clarification.
- Clarification of the use of secret comparables (possibility of presumptive taxation and use of comparable information obtained from interviews of third parties in similar industries);
- Instruction on selecting the most appropriate method;
- Instruction on selecting the comparable search criteria when applying the TNMM; and,
- Clarification of the use of arm's-length range.
These amendments in the Administrative Guidelines and the STMLC are intended to provide guidance for the introduction of the most appropriate method rule and also to respond to requests from taxpayers for specific clarification for the existing Japanese transfer pricing legislation.
The following summarizes the overview of the most appropriate method rule and the profit split method stipulated in the amended Japanese Tax Legislation,
During 2010, the Organization of Economic Cooperation and Development ("OECD") guidelines were amended to incorporate the most appropriate method rule. Prior to the amendment, the OECD guidelines maintained a degree of hierarchy, with a preference for the traditional transactional methods. More specifically, the comparable uncontrolled price method, the resale price method, and the cost plus method were preferred over the TNMM or the profit split method. The amended OECD guidelines eliminated the hierarchy; and as a result, the OECD guidelines adopted the most appropriate method rule, in which the taxpayer can select any transfer pricing method considering the comparability and quality of data.
The Japanese Legislation was amended in order to: (1) align Japanese Transfer Pricing Legislation with the international standards, such as OECD guidelines; and (2) to allow the Legislation to provide more realistic alternatives for testing. Specifically, taxpayers faced difficulty in applying the traditional transactional methods (Kihon Sanpo as commonly known) due to their strict comparability requirements. Although the traditional transactional methods were preferred under the Legislation, many taxpayers resorted to applying the TNMM.
In order to apply the most appropriate method rule, a taxpayer must consider the following criteria:
- The pros and cons of the each transfer pricing method for analysing intercompany transactions;
- The application of an appropriate transfer pricing method based on the characteristics of intercompany transactions and the functions and risks of the related parties in the transaction under analysis;
- The availability of data necessary for applying the transfer pricing methods;
- The comparability of the intercompany transactions and the comparable transactions.
In selecting the most appropriate method, a taxpayer may bear more burdens of proof to the tax authorities that its transfer pricing method is most reliable. Further, it is anticipated that TP assessments by the Japanese tax authorities using the TNMM will increase in the future. Below is an example of how this amendment may affect the approach of an assessment by the Japanese tax authority.
A Japanese company has a manufacturing subsidiary located in Asia, and the manufacturing subsidiary is earning a high profit. The subsidiary is also paying a royalty fee to the parent company. In such a case, the Japanese tax authority may challenge the taxpayer's transfer price policies by applying the TNMM with the subsidiary as the tested party. Before the FY 2011 Japanese Tax amendment, the taxpayer would have been able to counter-argue by claiming that the TNMM can be used only if the traditional methods to test the royalty fee payment itself are proven unreasonable. However, the introduction of the most appropriate method rule may allow the tax authority to make an assessment solely by explaining that the method it used, i.e. in this case, TNMM, is most appropriate without having to state reasons for not applying the traditional transactional methods.
As a result of the above changes, time taken for each transfer pricing audit may be shortened, allowing the auditors to increase the number of transfer pricing audit cases. Accordingly, a taxpayer may need to prepare transfer pricing documentation with robust arguments for applying a certain transfer pricing method over others. Further, in the event of a Japanese tax audit, a taxpayer may be required additional steps to defend their rationale for the selection of the best method.
The changes to the Japanese transfer pricing legislation will have significant impact on many taxpayers conducting intercompany transactions. Therefore, further clarification by the tax authorities for the application of the most appropriate method rule is expected to follow the Administrative Guidelines.
With the introduction of the most appropriate method rule, it was necessary for the Legislation to encompass all possible transfer pricing methods when analysing transfer prices. As a result, the definition of the profit split method was categorized into three types in the statute.
The three types of the profit split methods are:
- Contribution PSM;
- Comparable PSM; and
With these three methods, the Japanese Transfer Pricing Legislations will be aligned with the international standard, i.e. the OECD guidelines.
Previously, the RPSM and the Comparable PSM were included in the STMLC, but not in the Special Taxation Measures Law. Because the tax authorities interpreted that the Legislation also allowed the use of the profit split methods, the tax authorities made assessments under the RPSM. However, the taxpayers frequently argued with the tax authorities that the application of the RPSM was not allowed under the "principle of no taxation without law", and that other methods such as traditional transactional methods were more appropriate. Thus, with this Legislation Amendment, such disputes between the taxpayers and the Japanese tax authorities are expected to decrease.
Nevertheless, in comparison with other transfer pricing methodologies, the profit split method relies on various assumptions, such as allocable channel profit/loss and allocation key factors. As such, the arm's-length pricing analysis will heavily depend on these assumptions. Although the profit split method has been officially introduced into the Legislation this time, details on the application of the method have not been established yet. Therefore, further clarification on the application of this method is expected in the future.
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