The Japanese transfer pricing regulations address a number of diverse issues as part of the case examples. These examples address:
The schematic of the business relations specifies:
Japanese Corporation P provides these services to the S group:
The taxpayer can determine whether each of the preceding services that Japanese Corporation P provides to foreign-related person S has commercial value. The taxpayer is to make the commercial value determination by considering the commercial value criteria specified in Administrative Guideline 2-10. Administrative Guideline 2-10 provides for:
The fact pattern in this example does not provide sufficient facts to determine whether each service has commercial value. In practice, the taxpayer would need to undertake a more detailed investigation. Nevertheless, the Reference Case Studies on the Application of Transfer Pricing Taxation (hereafter Reference Case Studies) suggest that the services falling into categories (d), (e), and (g) do not have commercial value. Those services arise from Japanese Corporation P’s position as shareholder. In contrast, the Reference Case Studies suggest that the other enumerated services would often be judged to have commercial value. The taxpayer should provide proper consideration to Administrative Guideline 2-10. This consideration includes determining whether such activities correspond to the activities that the provider of services performed in its capacity as a shareholder:
All of the transactions between Japanese Corporation P and the foreign-related corporation S that have commercial value correspond to foreign-related transactions. The taxpayer is to treat transactions as having commercial value if the subsidiary is a foreign-related person that:
A corporation might routinely maintain personnel resources, facilities, and similar resources that are capable of providing services. The corporation might retain these resources to provide services, as and when necessary, in response to requests by foreign-related persons. The maintenance of such resources is equivalent to the providing of services.
A subsidiary might receive services from an unrelated person, or the subsidiary might engage in such services for itself, even if the parent company provides the same services to the subsidiary. Those services are duplicate services. The term “duplicate services” excludes instances where such duplication is considered to be temporary or where the duplicated services are deemed to be procedural double-checks to reduce the risks associated with errors in business judgment. Such duplicate services have no commercial value, and these duplicate services are not treated as foreign-related transactions.
The same situation for duplicate services also applies to shareholder activities. Services that the shareholder undertakes as a parent company in its capacity as a shareholder of the subsidiary provide no commercial value, and these shareholder services are not treated as foreign-related transactions. This treatment applies to activities undertaken by the parent company for its general meeting of shareholders, or to prepare its financial reports in accordance with the Securities and Exchange law.
As a general matter, the decision is to be made as to whether services have commercial value by making that determination according to the respective circumstances pursuant to Administrative Guideline 2-10. The decision can then be made as to whether the activities of the parent company correspond to the shareholder activities—for instance, an oversight of a subsidiary deemed to be providing services.
A taxpayer calculates arm’s length services provisions pursuant to Administrative Guideline 2-10, the Treatment of Intra-Group Services. The taxpayer is to examine transfer pricing methods that are “equivalent to” the comparable uncontrolled price method and to examine methods that are “equivalent to” the cost plus method (i.e., methods that are “equivalent to” the traditional transaction methods pursuant to Act on Special Measures Concerning Taxation [ASMT] Directive 66-4(6)-5). The taxpayer is to mark up the services expenses as required. However, the services that the taxpayer provides may be incidental to the core operations of the corporation of the related person. In that event, it might be possible for the taxpayer to use the final cost of services as the arm’s length price pursuant to Administrative Guideline 2-9. The reader should see Case 5.
A company that provides services with commercial value to the subsidiary might employ the parent company’s intangibles. If that situation applies, it is necessary to the taxpayer to consider whether it includes the portion of the intangibles in the consideration for such services pursuant to Administrative Guideline 2-8. If the taxpayer excludes these intangibles, it is necessary for the taxpayer to access the business activities of the subsidiary to which the intangible assets are used. After the taxpayer contributes activities, it might not be possible to shift the intangible from the taxpayer to the contributors.
The taxpayer is to contribute these intangible activities for the purpose of calculating the consideration each party makes to these activities. The taxpayer is to take the parent’s core business into account and to ensure the parent’s business has appropriately allocated this income.
Case 24 illustrates the calculation of the arm’s length price in a multiyear situation that reflects changes in market conditions. The schematic reflecting this situation is shown next for Japanese Corporation P and foreign-related person S in Country X.
Japanese Corporation P undertakes these activities:
Foreign-related person S undertakes these activities:
Over a 10 year interval, Japanese Corporation P and foreign-related person S undertook these activities:
Product A is part of a broader industrial category, termed “Product A industry.” The Product A industry to which the Japanese Corporation P’s group belongs is known for its large global swings in demand. Company profits follow a cyclical pattern, subject to fluctuations in demand. Foreign-related corporations’ actual operating margins and the operating margins of corporations in Product A industry have exhibited a regular cycle over the past ten years according to a database of Country X corporate data.
A comparison has taken place between foreign-related person S’s operating margin and the average operating margin of the corporations in the Product A industry. This operating margin comparison indicates that, on a single-year basis, foreign-related person S’s operating margin is generally higher than the industry average in each year. Foreign-related person S’s operating margin is similarly higher than the industry average for the past ten years.
Country X requires corporations to provide financial data disclosure, but this financial data disclosure system does not require corporations to reflect cost data. Japan does require the corporations to disclose these costs as part of operating income in these reports.
Foreign-related person S’s operating margin generally exceeds the operating margin level in the industry as a whole in individual years, and the average for multiple years over the past ten years, despite being affected by cyclical fluctuations in market demand.
These fluctuations present problems for the taxpayer from the point of view of the transfer pricing taxation of foreign-related taxation of foreign-related transactions between Japanese Corporation P and foreign-related person S, pursuant to Administrative Guideline 2-2(2).
The taxpayer sought to ascertain the applicability of traditional transaction methods and sought to ascertain the applicability of methods that are “equivalent to” these traditional transaction methods. The taxpayer had sought a method of calculation of the arm’s length price as to these transactions. The taxpayer, however, was unable to find these applicable data for comparable transactions.
The reader should see Case 1 as to the applicability of the traditional transaction methods, including methods that are “equivalent to” the traditional transaction methods. The taxpayer considered applying transfer pricing methods that are “consistent with” the traditional transaction methods, considered applying transfer pricing methods that are “equivalent to” these methods, considered applying other transfer pricing methods prescribed in the ASMT Cabinet Order, and considered applying other transfer pricing methods that are “equivalent to” these methods. The taxpayer obtained these transfer pricing results:
The taxpayer is to consider these possible problems from the transfer pricing taxation point of view. The taxpayer is to consider the existence of this analysis or otherwise from multiple perspectives according to the specific circumstances of individual transactions. At the same time, the taxpayer should be mindful of the items listed in Administrative Guideline 2-1, the State of Allocation of Profits between the Corporation and the Foreign-Related Person. The taxpayer should undertake this process in such a manner as not to impede an efficient tax audit pursuant to Administrative Guideline 2-2.
For an example of such an approach, take the case where the taxpayer finds it inappropriate to examine foreign-related transactions by considering information on individual taxable years standing alone. For a second example, take the case where the taxpayer finds it inappropriate to examine foreign-related transactions for taxable years owing to considerable fluctuations in prices of inventory assets, such as commonly occurring changes in demand or changes in the product life cycle. In such cases, the taxpayer is to treat the average consideration as being acceptable for the foreign-related transaction or transactions deemed comparable with the foreign-related transaction. Alternatively, the taxpayer is to treat the average consideration as being acceptable as to the foreign-related transaction or transactions deemed comparable with the foreign-related transaction.
The taxpayer is to take the preceding analysis into account for transactions that take place during a “reasonable period” before and after the taxable year or the consolidated taxable year. The taxpayer is to treat such an amount as a base, and take this amount when considering whether there are any transfer pricing taxation problems pursuant to Administrative Guideline 2-2(2). This same treatment applies to the provisions of Administrative Guideline 2-2(1).
There might be situations in which there are considerable price fluctuations in a foreign-related transaction context but prices of transactions are deemed comparable with the foreign-related transactions remaining at a constant level. Alternatively, there might be fluctuations of these prices in a different manner compared with the foreign-related transaction. In those situations, it is necessary for the taxpayer to consider whether it has any transfer pricing taxation problems. The taxpayer can use a variable, such as average consideration or profit margin for the foreign-related transaction and for transactions the taxpayer would deem comparable with foreign-related transactions in multiple years.
In the present case, multiple transactions that are deemed comparable with the foreign-related transaction exhibit largely the same price fluctuations as a foreign-related transaction. The taxpayer need undertake no special consideration in this instance, given the market cycle for the foreign-related transaction. The taxpayer is to consider the life cycle of the product involved in a foreign-related transaction and in the life cycle of products involved in the transactions if the taxpayer can identify that data from publicly available information.
The taxpayer might make use of average consideration or profit margin in multiple years. The taxpayer, in helping to determine whether there are transfer pricing problems, must calculate the arm’s length price, on a tax-assessed basis, only for such taxable years found to be problematic in light of transfer pricing taxation, as prescribed in ASMT Article 66-4 if these problems exist.
The facts in Case 25 reflect the setting of a profit range for an advance pricing agreement (APA) applicant.
The schematic of the business relations is:
Japanese Corporation P and foreign-related person S filed advance pricing agreement (APA) applications with mutual agreement to the tax authorities in both countries.
Both Japanese Corporation P and foreign-related person S considered the selection of transfer pricing methods for purposes of the APA. The parties determined that Japanese Corporation P manufactured Product A using Japanese Corporation P’s original technologies that result from Japanese Corporation P’s R&D activities. The parties were unable to find comparable transactions in applying the traditional transaction methods to Japanese Corporation P, and the parties did not apply the traditional transaction methods.
Foreign-related person S has no intangible properties that could serve as a source of income in foreign-related transactions. Nevertheless, it was not possible for foreign-related person S to acquire the information that it would need from information publicly available in corporate databases to select comparable transactions in applying the traditional transaction methods. As a result, foreign-related person S could not apply the traditional transaction methods. See Case 1 as to the applicability of the traditional transfer pricing transaction methods, including transfer pricing methods that are “equivalent to” the traditional transaction methods. Therefore, Japanese Corporation P and foreign-related person S considered applying transfer pricing methods that are “consistent with” the traditional transaction methods and considered applying other methods prescribed in the ASMT Cabinet Order. Japanese Corporation P and foreign-related person S had these results:
The taxpayer could find comparable transactions for the purpose of applying the transactional net margin method to foreign-related person S. Foreign-related person S’s use of the transactional net margin method is appropriate due to its having relatively simple functions. Japanese Corporation P’s selection of comparable transactions is appropriate for APA purposes.
It is appropriate in this case to incorporate the effects of the business cycle in the target profit margin range because there is a large cycle of profit fluctuations among companies in the Product A industry to which Japanese Corporation’s business group belongs. The taxpayer must attach critical assumptions in the APA application in cases of extreme changes in conditions, such as those conditions that exceed normal fluctuations in the Product A industry. Case 26 addresses the setting of critical assumptions.
Here is how the Japanese tax authorities apply the APA program:
Case 26 addresses the appropriateness of attaching material commercial or economic conditions to the APA. The schematic of the business relations is:
Product A and similar products are susceptible to sharp fluctuations in market prices worldwide. The profits for Product A and for similar products fluctuate considerably, depending on fluctuations in market prices. Further, the specifications of the best-selling products change rapidly in this industry. The accounting system in Country X is currently undergoing major revision. Taxpayers expect future extensive amendments to the Country X accounting system.
Japanese Corporation P and foreign-related person S apply to the tax authorities of the two countries for an APA. Both Japanese Corporation P and foreign-related person S seek to apply mutual agreement procedures. Both Japanese Corporation P and foreign-related person S would apply the transactional net margin method to foreign-related person S as the means of calculating the arm’s length price. These APA applications were appropriate in content in terms of the selection of the transfer pricing method to calculate the arm’s length price, the choice of comparable transactions, and so forth.
In this case, there is a possibility that foreign-related person S’s actual profit margin in the future might substantially fluctuate in the event of large fluctuations in market prices or changes in the specifications of the products traded. If these substantial fluctuations occur, it is considered inappropriate for the taxpayer to use the arm’s length price, in unmodified form, that the taxpayer has confirmed with the government based on the current situation.
Moreover, the method that foreign-related person S applies to calculate its profit margin might undergo change as a result of changes to its accounting system. Foreign-related person S’s actual profit margin might diverge from the results calculated based on the details foreign-related person S submitted for the APA request. As a result of this divergence, there is risk that Japanese Corporation P and foreign-related person S could no longer determine whether the actual value conforms to the content of the APA.
In this case, Japanese Corporation P and foreign-related person S need to attach the business or economic conditions for the APA and for confirmation with the tax authorities to guard against such a situation occurring in taxable year. Such conditions might include:
A taxpayer concludes the APA process when the taxpayer finds that the transfer pricing methodologies are reasonable, based on the method of calculating the arm’s length price in future years, in light of the business situation concerning past and present foreign-related transactions.
Unforeseeable changes in material circumstances can arise in the taxable year the government is to confirm. Such unforeseeable changes could include substantial changes in market prices. In the event that such changes in circumstances could occur, the taxpayer must change the conditions on which the taxpayer relies. In such circumstances, it is no longer appropriate to continue the APA in unmodified form. For this reason, the taxpayer should set up its critical assumptions (i.e., the material and business conditions essential to the APA). The taxpayer should attach documents describing these conditions with the APA document request pursuant to Administrative Guideline 5-3(c).
It is difficult for the taxpayer to exhaustively predetermine the factors that might affect the continuation of an APA. For that reason, it is common for the taxpayer to attach generic conditions to the APA request. Such a general condition could include, for example, the requirement that there should be “no material changes in business conditions or in economic conditions.” Similarly, the general condition could include, for example, “the requirement that they have made no specific fundamental changes in the functions performed by the related parties or the assets they have utilized.” However, the parties may need to attach more specific conditions in some cases, such as to preclude a change beyond a certain range in exchange rates. The taxpayer might provide such a proviso in order to make clear whether a situation corresponds to the conditions established as critical assumptions.
Changes might occur in the changes the critical assumptions prescribe. In the event that such changes occur, it is necessary for the taxpayer to consider its calculation of the arm’s length price as to the situation in question. As a rule, the confirmed corporation will have to apply for an amendment of the APA pursuant to Administrative Guideline 2-10. This amendment process is mandatory. The failure to apply for an application invalidates the APA from the taxable years in which the situation arose pursuant to Administrative Guideline 5-21(1)(a).
In the case of an APA that has a mutual agreement, the tax authorities must initiate the mutual agreement procedure and take into account an agreement the tax authorities reached on a method of calculating the arm’s length price that differs from the initial method.
The confirmed corporation is to enter and submit a report for each taxable year. That report is to provide a “statement of changes” to changes to business conditions or to economic conditions, based on whether the government provides the taxpayer with the APA pursuant to Administrative Guideline 5-17.
3.136.22.50