2010 Tax Reform Proposals
On December 22, 2009, the Government Tax Commission issued its “Outline of 2010 Tax Reforms” (“2010 Outline”). One of the proposals concerns potential transfer pricing documentation requirements.
Japan presently does not impose such documentation requirements or assess penalties for a failure to provide prescribed documentation. The National Tax Agency (NTA) has issued a directive to its examiners indicating what information they should obtain and review during a transfer pricing audit. The only sanction for a taxpayer’s failure to provide documentation is the application of the so-called “presumptive taxation” rules, which would raise several serious concerns for taxpayers, as described further below and, consequently, constitute a kind of penalty.
In early December, the Ministry of Finance (MOF) had proposed to the Commission the need to clarify the documentation requirements under the existing presumptive taxation rules. Under these rules, the tax authorities can “presume” certain prices to be arm’s length prices when a taxpayer does not present documentation which is considered to be “necessary to determine arm’s length prices.” However, at present, there is no clear guidance in the law or related orders as to what documentation is “necessary” in order to avoid presumptive taxation.
The 2010 Outline explains that the “necessary” documentation will be clarified, based upon (a) “documents stating the contents of the foreign related transactions” and (b) “documents pertaining to the arm’s length prices determined by the taxpayer with regard to those transactions.” It is not clear how this will be done, but observers suggest that this may be accomplished through an amendment to the relevant ministerial order or possibly through a change in the NTA’s transfer pricing directive.
Potential Documentation Requirements
The 2010 Outline itself does not provide any further details as to the documentation which may be required. However, the NTA’s directive sets forth a list of documents to be reviewed by examiners, including “documents stating the contents of the foreign related transactions” and “documents pertaining to the arm’s length prices determined by the taxpayer with regard to those transactions.” The OECD Transfer Pricing Guidelines may be taken into account. It is also possible that reference may be made to the criteria set forth in the Bilateral Advance Pricing Arrangement (BAPA) Operational Guidance for Member Countries of the Pacific Association of Tax Administrators (PATA).
Of particular concern to foreign-based taxpayers is the possibility that the necessary documentation will include segmented profit-and-loss information of all foreign related parties involved (directly or indirectly) in the foreign related transactions with the Japanese taxpayer. At present, the statute requires that taxpayers only “endeavor” to obtain documentation held by foreign related parties but it imposes no obligation to obtain such information.
Implications for Taxpayers
If documentation requirements are imposed, taxpayers who have not prepared documentation should do so in accordance with the applicable Japanese requirements. This may require modifying or supplementing standard documentation prepared for use around the world. Furthermore, in any event, it is always prudent to consider whether such standard documentation is appropriate for use “as is” in a Japanese transfer pricing audit.
In addition, if the proposed 2010 changes do result in the requirement to disclose foreign segment profit-and-loss information, taxpayers will have to weigh the burdens and risks of preparing and disclosing such information against the risk of application of the presumptive taxation method.
The burden of preparing such information will likely depend upon whether the taxpayer has accounting systems in place to create the required segment data up through the chain of transactions which ultimately ends in Japan. The risk of providing such information lies in the possible use of certain profit split methods by the Japanese tax authorities to allocate excessive profits to Japan, based upon, for example, their positions concerning the economic ownership in Japan of intangibles and use of allocation factors which ignore the value of intangibles created, owned and controlled by foreign related parties.
The presumptive taxation risks, on the other hand, include (i) shifting of the burden of proof to the taxpayer, (ii) the application of transfer pricing methodologies which are significantly relaxed in favor of the tax examiners and (iii) in the opinion of the tax authorities, both the potential use of related party transactions as comparable transactions and the lack of any requirement to make adjustments for differences.
Burden of Proof
If the presumptive taxation rules are applied, then, in the event of a subsequent appeal or litigation, the arm’s length price determined by the tax examiners is “presumed” to be correct. The taxpayer can rebut this presumption only by affirmatively proving that its prices are arm’s length pursuant to a normal transfer pricing method. If the taxpayer cannot do so, then the prices determined by the tax authorities are to be accepted.
The shifting of the burden of proof to the taxpayer may become a more critical objective of the Japanese tax authorities in audits going forward. In the Adobe Case in late 2008, the Tokyo High Court concluded that the NTA had not met its burden of proof in connection with the method used as the basis for an assessment. Consequently, there is now an increased concern that NTA examiners will aggressively exploit the presumptive taxation rules, which would dramatically lower the burden upon them to establish an arm’s length price for an assessment.
“Relaxed” Transfer Pricing Methodologies
Under the presumptive taxation rules, the examiner is permitted to make an assessment by presuming that the arm’s length price is an amount which is computed in accordance with certain specified methods that are based upon (but not identical to) the resale price method, the cost plus method, profit split methods or transactional net margin methods. A review of the detailed requirements in the statute and related orders suggests that these specified methods are considerably relaxed as compared with the normal transfer pricing methods.
Use of Related Party Transactions
The provisions in the law and orders setting forth the various comparative methods under the presumptive taxation rules refer only to the requirement for the tax examiners to identify a “similar business activity” conducted on a similar scale and whose other circumstances are similar to those of the corporation subject to presumptive taxation. These provisions do not explicitly require that this business activity be conducted with unrelated parties. Consequently, the NTA believes that related party transactions may be used.
Adjustments for Differences
Unlike the normal resale price method, cost-plus method or transactional net margin method, the provisions describing the methodologies to be used under the presumption taxation rules contain no explicit language requiring that the margins applied as comparable margins have been adjusted for differences. Japanese tax examiners have indicated that only the minimal tests (“similar business,” “similar scale” and “other similar details”) explicitly prescribed in the presumptive taxation rules need be applied.
The next steps in the legislative process should be the release of a tax reform bill in late January or early February, deliberations and passage in the National Diet in February or March, and then the publication of the amended law and the related cabinet and ministerial orders by April. It is not yet clear what effective date may be applied for new documentation requirements.