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Recent transfer pricing developments in Japan

With the globalization of many industries approaching near ubiquity, and Japan's often-cited shrinking population, many Japanese companies today find themselves in an increasingly outward-looking position. To remain competitive, Japanese companies have progressively moved operations such as manufacturing offshore, and to offset the shrinking Japanese population, there has been a heightened focus on foreign markets for the sale of Japanese goods and services. Further, the strength of the yen in recent years has spurred outbound M&A activity by Japanese multinationals. This complex mix of factors has resulted in a somewhat natural growth trend for Japanese companies to establish an overseas presence, but not all Japanese companies have planned their outbound expansion comprehensively. From a transfer pricing perspective, many Japanese companies are now in a position where they have significant cross-border transactions with related parties and may not have fully considered (or even be aware of) their transfer pricing obligations.

Increasing focus on transfer pricing compliance and internal governance

The Japanese tax authorities seem to have recognised this and have introduced several initiatives aimed at both gauging taxpayers' awareness of transfer pricing issues and internal controls for tax and accounting more generally, as well as directing Japanese companies to consider such issues.

To these ends, Japan's National Tax Agency (NTA) has issued questionnaires on general internal risk policies to large corporate taxpayers. The NTA generally issues the questionnaire when visiting relevant companies (so far, these have been large multinational corporations). The questionnaire contains questions on internal tax and accounting risk management policies, covering the following areas:

  • the involvement of top-level management in corporate governance matters;
  • the current status of the accounting/audit department;
  • internal control systems for tax and accounting procedures;
  • the company's efforts to raise awareness of tax-related matters; and
  • internal disciplinary measures for employees engaging in tax or accounting fraud.

It is broadly believed that the NTA will use the questionnaires to assess whether further investigation of the company is necessary, and to raise awareness of the relevant issues in an effort to improve compliance.

As a follow-up to this general questionnaire, the NTA has also begun issuing a transfer-pricing-specific checklist to relevant companies, which assesses the company's knowledge of and compliance with the Japanese transfer pricing rules. The survey covers issues such as

  • the company's understanding of Japan's transfer pricing rules;
  • the involvement of top-level management in transfer pricing matters;
  • knowledge of issues relating to foreign related-party transactions;
  • the existence of a global transfer pricing policy;
  • the arm's length nature of relevant transactions;
  • the parent company's involvement in transfer pricing issues of relevant subsidiaries;
  • and the level of communication with the tax authorities.

The questionnaires represent a two-pronged approach by the Japanese authorities to transfer pricing and general corporate governance issues. That is, the approach gives the authorities the flexibility to allow a company the chance to get its internal affairs in order, and establish a transfer pricing policy with good tax compliance procedures, as well as arming the authorities with data on the risk level of the relevant companies, which could be used for future investigations or audits.

Changes in tax audit procedure

As is the case in many countries, Japanese companies have undergone a growing number of tax audits in recent years, and these audits have increasingly covered transfer pricing. Within the past decade, the number of transfer pricing audits in Japan has multiplied approximately fourfold, and this trend appears likely to continue. Traditionally, a corporate tax audit and a transfer pricing audit would be conducted separately by the Japanese authorities, with the corporate tax audit being concluded relatively quickly, whereas transfer pricing audits could stretch on for several years. However, as of January 1 2013, corporate tax and transfer pricing audits are being handled together by default (the taxpayer may still request that the two audits be conducted separately). There are also additional reporting and notice requirements on the Japanese authorities in relation to investigations and audits, and a new requirement that every audit commenced must ultimately be closed.

Whilst combining corporate tax and transfer pricing audits may appear to have little impact on the way audits are conducted, the package as a whole signals increased focus by the Japanese tax authorities on audit activity in general. Further, given that transfer pricing audits generally take much longer to complete than corporate tax audits, this could lead to the corporate tax portion of the audit remaining in a pending stage for an extended period. This possibility, combined with the requirement that every audit must now be closed, may provide additional incentive for the Japanese authorities to speed up the transfer pricing portion of the audit, which could result in greater turnover of audits and additional capacity for new audits to commence.

Recent changes to Japanese transfer pricing rules

Parallel to the increased focus on compliance and procedure, several important changes have been made to the Japanese transfer pricing rules to bring them more in line with the OECD transfer pricing guidelines and current best practices. Specifically, a package of reforms introduced in 2011 removed the existing hierarchy when selecting the transfer pricing method, and replaced this with a most appropriate method rule. The changes also provided guidance and clarification in various areas, such as the use of profit-based methods and the acceptability of using a range of prices, rather than a specific price point.

While the changes introduced in 2011 were significant, arguably they have not had as great an impact on the way Japanese companies undertake their transfer pricing as might be expected, because the changes were largely seen as closing the discrepancy between theory and practice. In this respect, the main practical impact of the changes seems to have been that less explanation is required from taxpayers, for example, as to why a certain transfer pricing method was chosen.

2013 has seen another move by the Japanese tax authorities to bring Japan's transfer pricing regime closer to the OECD approach with the introduction of the Berry ratio as an acceptable profit level indicator. The Berry ratio, a ratio of gross profit to operating costs, was approved by the OECD in 2010 (other countries, including the United States, have used the Berry ratio for some time); however, it was not until April 2013 that the Japanese government officially allowed its use. The absence of the Berry ratio may have led to complications for companies with limited functions and risks whose profits were closely linked to operating costs, such as simple routine distributors. For example, a US company with a simple distribution operation in Japan that used the Berry ratio as the basis for its transfer pricing in the region may have been challenged by the Japanese authorities if the resulting operating margin of the Japanese distributor was low. Without the ability to support the pricing using the Berry ratio, the Japanese distributor may have been subject to an increase in profits in Japan, even though the pricing policy was acceptable from a US perspective.

Addition of mandatory arbitration in US treaty

An amending protocol to the Japan-US treaty has recently been signed and approved by the Japanese parliament. The protocol includes a provision for binding, mandatory arbitration in cases when a mutual agreement procedure (including bilateral Advance Pricing Agreements (APAs)) does not lead to an outcome within two years. In those circumstances, a third-party panel will be appointed to select the resolution proposed by one government or the other. Japan's treaties with Hong Kong and the Netherlands already include mandatory arbitration procedures, and the government is keen to include such procedures in its treaties with other countries.

Bilateral APAs are common in Japan, and over half the bilateral APAs the United States concludes are with Japan. Thus, this is an important development, as it ensures that an outcome will be reached in bilateral APAs between the countries, and is likely to provide additional incentive for the competent authorities to reach an agreement in a timely manner, before the arbitration procedure is initiated.

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In an environment of increasing focus on compliance and audit from the Japanese tax authorities, specifically covering transfer pricing, and given the recent changes to the Japanese transfer pricing rules, it would be prudent for Japanese multinationals and foreign companies with a Japanese presence to revisit their pricing policies, to ensure that they are compliant and would stand up to scrutiny by the Japanese tax authorities.