With BEPS-related transfer pricing documentation rules in full force in Japan, 2018 has seen foreign-headquartered companies operating in the country experiencing significant tax authority audit activity. Based on the information requests received by taxpayers, it appears that the Japanese tax authorities are now requesting transfer pricing documentation (i.e. local files) as a matter of policy at the commencement of an audit. Initial information requests may also include copies of intercompany contracts and supporting data such as detailed benchmark worksheets, calculations of year-end pricing adjustments and explanations of pricing policies. It is expected that corporate tax examiners would review this information (together with master files and Country-by-Country Reports (CbCRs) already received by the tax authorities, as applicable) and, if potential transfer pricing issues are identified, involve specialised audit staff of transfer pricing examination divisions. While taxpayers may have up to 45 or 60 days to provide such information (depending on the size of the related party transaction in question), in practice, taxpayers are often requested to provide information on a shorter timeframe.

From a broader picture, it is understood that local files requested through audits (as well as through non-audit consultations) will be assessed by the tax authorities in order to form a view on the sufficiency of information currently being provided by taxpayers. This assessment may be used to monitor the need for any future changes or clarifications to Japanese transfer pricing documentation rules.

For taxpayers operating through branches in Japan (or otherwise with a Japanese permanent establishment), Japan’s domestic adoption of the Authorized OECD Approach (AOA) to attribution of profit to permanent establishments is now in full force (Japan’s domestic AOA rules apply for income years commencing on or after April 1, 2016). New documentary requirements were also introduced, such that taxpayers must be able to evidence their application of the domestic AOA rules (e.g. following the steps set out in the law), and support the profit attribution outcomes reached. Further, for years beginning on or after April 1, 2017, local file rules also specifically apply to permanent establishments. In this context, taxpayers operating through a permanent establishment in Japan can expect requests for supporting information and increased tax authority attention to their Japanese permanent establishments.

In terms of trends, we observe small-to-mid-sized multinationals, or large multinationals with a more limited Japanese footprint, being examined at an apparent higher rate than in previous years. Such examinations are generally carried out at the district taxation office level. Broadly, district taxation offices have primary responsibility to examine Japanese corporations with stated capital of less than ¥100 million (with some exceptions) while regional taxation bureaus, such as the TRTB, have primary responsibility to examine Japanese corporations with stated capital of ¥100 million or greater and foreign corporations with permanent establishments in Japan (with some exceptions) – transfer pricing issues are generally assigned to specialised audit staff of transfer pricing examination divisions within the regional taxation bureaus. Examinations may cover a broad range of issues including general corporate income tax, consumption tax, employment taxes, and withholding taxes. Taxpayers also note that audits appear to be undertaken on an accelerated timeline, with the total amount of time from the initial contact to closing an audit being shorter than their past experience, and opportunities to settle examinations (where relevant) arising at an early stage in the process.

We are not aware of any formal shift in the tax authority audit procedures. However, increased audit activity at this level of the market may have several explanations. For example, tax examiners may consider larger multinationals (or multinationals with a large presence in Japan), to have more sophisticated and defensible transfer pricing policies for their Japanese business, and to have been at the forefront of preparing BEPS-compliant documentation and pricing policies. While pursuing examinations for such taxpayers may result in larger potential adjustments, examinations may also be longer and more involved, requiring a larger investment of resources by the tax office. Such audits would also generally require involvement of the regional tax bureaus.

On the other hand, the value of potential transfer pricing adjustments for small-to-mid-sized multinationals (or large multinationals with a smaller Japanese presence) may be more limited – though authorities may expect such taxpayers to be less likely to be fully compliant with BEPS-related documentation requirements, or that their pricing policies are less defensible. Taxpayers in this group may also be seen as less willing to invest significant resources to defend audits and more likely to settle early in the audit process. In these circumstances, audit adjustments may be seen as being more easily made, which could free up capacity within tax authorities to examine other taxpayers (i.e. a higher volume of smaller adjustments).

Taxpayers have raised concerns whether these examinations may be considered as a first phase, information gathering and risk assessment exercise, with more detailed examinations being undertaken in future years. Given the compressed timeline of the audit, taxpayers have also voiced concerns over having sufficient time to produce the information requested. We are not aware of any tax authority policy changes underlying these concerns. However, we continue to recommend to clients to ensure they are compliant with local transfer pricing rules, both from a defensibility of pricing perspective and documentary evidence perspective, and are in a position to provide information to tax authorities when requested.