Transfer Pricing in Japan: How are Intercompany Transactions Priced and What are the Documentation Requirements?

For multinational enterprises (MNEs) operating in Japan, or Japanese companies with overseas affiliates, transfer pricing (移転価格税制 - iten kakaku zeisei) stands as one of inadequacy or non-compliance can lead to significant tax adjustments, penalties, and potential double taxation. This article provides an overview of Japan's transfer pricing regulations, focusing on the arm's length principle, methods for determining arm's length prices, documentation requirements, and dispute resolution mechanisms.

1. Introduction to Transfer Pricing and its Importance

Transfer pricing refers to the setting of prices for transactions of goods, services, intangible property, and financial instruments between related entities within an MNE group. Because these prices are set internally and not by open market forces, they can be manipulated to shift profits from high-tax jurisdictions to low-tax jurisdictions, thereby eroding the tax base of the former.

Recognizing this risk, Japan introduced formal transfer pricing legislation in 1986, primarily codified in Article 66-4 of the Act on Special Measures Concerning Taxation (ASMT). The core objective of these rules is to ensure that transactions between related parties are conducted at "arm's length," as if they were between unrelated independent enterprises, thereby ensuring that Japan receives its fair share of tax on the economic activity conducted within its borders. The rules have evolved over time, significantly influenced by international developments, particularly the OECD Transfer Pricing Guidelines.

2. The Arm's Length Principle: The Cornerstone of Japanese Transfer Pricing

Japan's transfer pricing rules are firmly based on the arm's length principle (独立企業間原則 - dokuritsu kigyōkan gensoku). This internationally accepted standard dictates that the conditions (e.g., price, profit margin) of a transaction between related parties should not differ from those that would have been made between independent enterprises in comparable transactions under comparable circumstances.

If a transaction between a Japanese entity and its foreign related party is found not to be at arm's length, and this results in lower taxable income for the Japanese entity, the Japanese tax authorities can re-calculate the income as if the transaction had been conducted at an arm's length price. This adjustment ensures that profits are taxed where the economic activities generating them occur and where value is created. The OECD Transfer Pricing Guidelines are highly influential in the interpretation and application of the arm's length principle in Japan, a point even noted in diplomatic exchanges like the notes accompanying the Japan-U.S. tax treaty.

3. Scope of Application: Who and What is Covered?

Japan's transfer pricing rules under ASMT Article 66-4 apply to:

• Taxpayers: Japanese corporations and foreign corporations with a Permanent Establishment (PE) in Japan.
• Counterparties: Transactions with a "foreign related person" (国外関連者 - kokugai kanrensha). A foreign related person is generally defined as a foreign corporation with which the Japanese taxpayer has a "special relationship." This special relationship primarily includes:
  • Direct or indirect ownership of 50% or more of the shares or capital contribution by either party in the other.
  • The ability of one party to substantially determine all or a part of the business policies of the other (effective control).
• Transactions Covered (国外関連取引 - kokugai kanren torihiki): A wide range of cross-border dealings, including:
  • Sale or purchase of tangible goods (inventory, fixed assets).
  • Provision of services (management services, technical assistance, R&D, etc.).
  • Financial transactions (loans, guarantees, cash pooling).
  • Licensing or transfer of intangible property (patents, trademarks, know-how, trade secrets).
  • Cost sharing arrangements.

It's important to note that transactions between a foreign related person and the PE of another foreign corporation in Japan are generally excluded if those transactions relate to the PE's attributable income, to prevent overlap with PE profit attribution rules. Additionally, certain transactions conducted through an unrelated intermediary may be deemed as direct transactions with a foreign related person if specific conditions are met.

4. Determining the Arm's Length Price: Approved Methodologies

ASMT Article 66-4, paragraph 2, outlines the methods for calculating an arm's length price. Since a 2011 reform, aligning with OECD guidance, the rules stipulate the use of the "most appropriate method" based on the nature of the transaction, the functions performed by the parties, and other relevant circumstances. The traditional hierarchy of methods was abolished. The primary methods are:

A. Traditional Transaction Methods:

1. Comparable Uncontrolled Price (CUP) Method (独立価格比準法 - dokuritsu kakaku hijunhō): This method compares the price charged in a controlled transaction (between related parties) to the price charged for property or services transferred in a comparable uncontrolled transaction (between unrelated parties) in comparable circumstances. If a directly comparable uncontrolled transaction exists, the CUP method is often considered the most direct and reliable way to apply the arm's length principle.
2. Resale Price Method (RPM) (再販売価格基準法 - saihanbai kakaku kijunhō): This method is typically used for the resale of goods purchased from a related party to an independent customer. It starts with the resale price to the independent customer and subtracts an appropriate gross margin (the "resale price margin") representing the amount out of which the reseller would seek to cover its selling and operating expenses and make an appropriate profit. The remainder is regarded as an arm's length price for the original purchase from the related party.
3. Cost Plus Method (CPM) (原価基準法 - genka kijunhō): This method is often used for the transfer of goods or services to a related party where the provider is the tested party. It begins with the costs incurred by the supplier in the controlled transaction for property transferred or services provided to a related purchaser. An appropriate cost plus mark-up, representing a profit margin for the functions performed, assets used, and risks assumed by the supplier, is then added to this cost. The result is the arm's length price.

For these traditional methods, especially CUP, finding highly comparable transactions can be challenging. Adjustments are often needed to account for differences between the controlled and uncontrolled transactions or between the enterprises undertaking them.

B. Transactional Profit Methods:

When traditional transaction methods cannot be reliably applied (or cannot be applied at all), transactional profit methods may be used. These methods examine the net profits from particular controlled transactions. The two main transactional profit methods prescribed by Cabinet Order under "other methods" are:

1. Profit Split Method (PSM) (利益分割法 - rieki bunkatsuhō): This method identifies the combined profit (or loss) arising from a controlled transaction (or a series of closely related transactions) and then splits that profit between the associated enterprises on an economically valid basis that approximates the division of profits that would have been anticipated and reflected in an agreement made at arm's length. There are different approaches to profit splitting, such as comparable profit split, contribution profit split (based on relative contributions to value creation), and residual profit split (which first allocates routine profits to each party and then splits the residual non-routine profit).
2. Transactional Net Margin Method (TNMM) (取引単位営業利益法 - torihiki tan'i eigyō riekihō): This method examines the net profit margin relative to an appropriate base (e.g., costs, sales, assets) that a taxpayer realizes from a controlled transaction (or a series of transactions that are appropriate to aggregate). This net profit margin is then compared to the net profit margins realized by comparable independent enterprises in comparable uncontrolled transactions. Various profit level indicators (PLIs) can be used, such as operating profit to sales, operating profit to total costs (full cost mark-up), or the Berry ratio (gross profit to operating expenses). TNMM was formally introduced in Japan by the 2004 tax reforms.

C. The Arm's Length Range (独立企業間価格の幅（レンジ）):
Transfer pricing is not an exact science. Applying any method can result in a range of figures, all of which may be arm's length. If the taxpayer's pricing falls within this arm's length range, Japanese tax authorities generally will not make an adjustment. If the pricing falls outside the range, an adjustment is typically made to a point within the range that best reflects the arm's length condition (often the median or average of the comparable data, depending on the distribution and reliability of the data points). The use of interquartile ranges is a common statistical tool to refine the arm's length range.

Japanese courts have seen an increasing number of transfer pricing disputes, often focusing on the selection of the most appropriate method, the choice of comparables, and the treatment of intangibles or business restructurings (e.g., cases involving companies like Adobe, Honda, and Pacific Fruit Ltd. have dealt with these complex issues, with some challenging the application of contribution or residual profit split methods for intangibles).

5. Documentation Requirements: The Key to Defense

To demonstrate compliance with the arm's length principle, Japanese taxpayers engaging in foreign related transactions are required to prepare and maintain contemporaneous transfer pricing documentation. The specific requirements have been significantly influenced by the OECD's BEPS (Base Erosion and Profit Shifting) Project, particularly Action 13.

Japan has adopted the three-tiered documentation approach recommended by BEPS Action 13:

1. Master File: Provides a high-level overview of the MNE group's global business operations, its transfer pricing policies, and its global allocation of income and economic activity.
2. Local File: Provides detailed information specific to the Japanese taxpayer's transactions with its foreign related parties, including a detailed comparability analysis and justification for the transfer pricing methods used.
3. Country-by-Country (CbC) Report: For MNE groups exceeding a certain consolidated revenue threshold (currently EUR 750 million), the CbC Report provides aggregate tax jurisdiction-level information relating to the global allocation of the MNE's income and taxes paid, along with indicators of the location of economic activity within the MNE group.

Failure to prepare or submit required documentation in a timely manner upon request by the tax authorities can lead to disadvantages, including the potential for the tax authorities to use presumptive taxation (推定課税 - suitei kazei). Under presumptive taxation (ASMT Art. 66-4, para. 6), if the taxpayer fails to provide necessary documents without delay, the tax authorities can determine the arm's length price based on the gross profit ratios of comparable businesses of similar size and type. Tax authorities also have the power to examine such comparable third-party businesses to obtain this information. While "secret comparables" (where the tax authority uses data not disclosed to the taxpayer) have been a concern, operational guidelines aim for greater transparency within the bounds of confidentiality for third-party data.

6. Tax Authority Adjustments and Relief from Double Taxation

If the Japanese tax authorities conclude that a taxpayer's transfer prices are not at arm's length, they can make an adjustment, increasing the taxpayer's taxable income in Japan. Such an adjustment by one country without a corresponding adjustment in the other country (where the foreign related party is located) leads to economic double taxation – the same profit is taxed in two different jurisdictions in the hands of different legal entities within the same MNE group.

To resolve this, tax treaties typically provide for a Mutual Agreement Procedure (MAP). The Japanese taxpayer can request its competent authority (the National Tax Agency) to enter into discussions with the competent authority of the treaty partner country to reach an agreement on the arm's length price and make corresponding adjustments (対応的調整 - taiōteki chōsei) to relieve the double taxation. Japan's domestic law (Act on Special Provisions for Tax Treaties, etc., Art. 7) allows for such downward adjustments to income based on a MAP agreement.

Following a primary transfer pricing adjustment, secondary adjustments (第二次調整 - dainiji chōsei) may also arise. These address the cash flow implications of the difference between the actual transaction price and the arm's length price. For instance, if a Japanese subsidiary overpaid its foreign parent for goods, the excess payment, after the primary income adjustment, might be treated as a deemed dividend to the parent or a loan, potentially triggering further tax consequences (e.g., withholding tax).

7. Dispute Prevention and Resolution Mechanisms

Given the complexity and potential for disputes in transfer pricing, mechanisms for prevention and resolution are crucial:

• Advance Pricing Arrangements (APAs) (事前確認制度 - jizen kakunin seido): Taxpayers can proactively request an APA from the Japanese tax authorities. An APA is an agreement between the taxpayer and one or more tax authorities (unilateral, bilateral, or multilateral) concerning the prospective application of transfer pricing methodology to specified future transactions. APAs provide certainty and reduce the risk of future transfer pricing disputes. The number of bilateral APAs concluded by Japan has been increasing.
• Mutual Agreement Procedure (MAP): As noted, MAP is the primary mechanism for resolving disputes arising from transfer pricing adjustments under tax treaties. Japan has provisions for suspending tax payment related to a transfer pricing adjustment while a MAP is in process (ASMT Art. 66-4-2) and for waiving interest for the period of MAP discussions if an agreement is reached (ASMT Art. 66-4, para. 21).

The statute of limitations for transfer pricing adjustments in Japan is generally 6 years.

8. The Influence of the BEPS Project

The OECD/G20 BEPS Project has had a profound global impact on transfer pricing. Japan has been an active participant. Key BEPS actions relevant to transfer pricing include:

• Actions 8-10: Addressing transfer pricing for intangibles, risk and capital, and other high-risk transactions, with a strong emphasis on aligning transfer pricing outcomes with value creation.
• Action 13: Standardizing transfer pricing documentation (Master File, Local File, CbC Report), which Japan has implemented.

These developments have led to increased scrutiny of MNEs' transfer pricing policies worldwide, including in Japan, and a greater focus on economic substance and the actual conduct of the parties. Japan has also extended transfer pricing-like principles (based on AOA) to internal dealings of PEs of foreign corporations (ASMT Art. 66-4-3) and foreign PEs of Japanese corporations.

Conclusion

Japan's transfer pricing regime, centered on the arm's length principle and heavily influenced by OECD guidelines and the BEPS Project, is a complex and dynamic area of tax law. For MNEs with operations in Japan, establishing and defending arm's length transfer prices for their intercompany transactions is paramount. This requires robust economic analysis, contemporaneous documentation consistent with the three-tiered approach, and a proactive strategy for managing transfer pricing risks, including the potential use of APAs. Given the significant financial implications and the evolving international landscape, specialized professional advice is indispensable for navigating these rules effectively.