The upper house of Japan's legislature recently passed tax law amendments that contain significant changes to Japanese transfer pricing rules. Subsequent to the amendments to the law, interpretative circulars and National Tax Administration (NTA) Transfer Pricing Directives were updated. These changes are effective for fiscal years beginning on or after April 1, 2020. This article provides an overview of the changes and related practical considerations.
Prior to the amendments, the term "intangible asset" was not clearly defined in Japanese transfer pricing law. The amendments insert the following definition for intangible assets:
"Patent rights, utility model rights and other assets (other than the [excluded] assets listed below), where under a transfer or license of the assets (including the establishment of rights pertaining to the assets and any other acts that cause other persons to use the assets) or similar transaction, consideration would be paid between unrelated parties according to ordinary business terms."
The definition contains a list of excluded assets, which are primarily financial assets such as securities, cash and derivatives. The amendment also includes examples of intangible assets, which includes copyrights, trade and brand names, trade secrets, know-how and technology rights as well as rights established through the licensing of such assets.
The new definition of intangible assets is broadly in line with the definition in the 2017 OECD Transfer Pricing Guidelines. While the Japanese definition does not include the language that requires the asset to be "capable of being owned or controlled" (which is included in the OECD's definition), the requirement that consideration would be paid between unrelated parties according to ordinary business terms may have a similar effect (e.g. in excluding market characteristics such as location-specific advantages from the definition).
A DCF method of calculating an arm's-length price was inserted in the transfer pricing law. The method allows the DCF to be used when pricing transactions in cases where comparable transactions cannot be identified. Based on the NTA Transfer Pricing Directives, the DCF method should only be used where no other pricing method is appropriate (i.e. as a method of last resort).
The NTA Transfer Pricing Directives also provide guidance on the use of financial projections when applying the DCF, such as determining the reliability of data as support for such projections, and contain case studies that emphasize the importance of using an appropriate discount rate that can be verified by the tax authorities.
While Japanese taxpayers may already use the DCF in pricing, we expect that the formal inclusion of a DCF method in the transfer pricing law will result in the Japanese tax authorities seeking to rely on DCF calculations on a more regular basis.
The amendments introduce the OECD's HTVI approach for making after the fact (ex-post) adjustments to the pricing of transactions relating to certain intangible assets, making Japan among the first countries to introduce such rules in domestic law. The rules allow the Japanese tax authorities to make an adjustment to the pricing of certain transactions where there is a significant deviation of actual financial outcomes from the forecasts used to price the transaction. The new rules apply to transactions relating to "specified intangible assets", defined to be an "intangible asset" (based on the new definition), that satisfies the following criteria:
The rules contain exceptions, including a 20% threshold for the deviation from the financial forecasts. An exception may also be available where the deviation from the forecast was a result of a "disaster or similar event" that was difficult to predict, or that the probability of the occurrence of this event was appropriately considered when pricing the transaction. The term 'disaster or similar event' refers to events that were clearly difficult to predict at the time the transaction took place such as financial crises, changes to laws or government regulations, or significant changes to the market.
Each of the exceptions require the taxpayer to furnish supporting documentation and evidence (e.g. details of valuation calculations, risk weighting, etc.) and as such creating and maintaining an appropriate level of documentation at the time of the transaction would be important.
The amendments introduce a "quartile method" that allows the interquartile range to be used as a method of accounting for comparability differences. The quartile method may be used where such differences in comparability are found to be minor and that adjustments cannot be made to account for the differences. While the median value in the interquartile range would be considered by the Japanese tax authorities to be the arm's length price, if the consideration for the transaction is within the interquartile range, the authorities should not seek to make an adjustment, provided that certain conditions are met. The NTA Transfer Pricing Directives clarify the criteria that should be met in order to apply the quartile method.
Interpretative material issued with the amendments clarify that the interquartile range may be calculated based on either an excel formula (which uses interpolation) or the formula specified by the US Internal Revenue Service (which does not use interpolation).
After the formal introduction of the interquartile range, taxpayers may expect additional scrutiny when using the full range in an analysis and taxpayers should therefore ensure that appropriate supporting arguments are contained in their transfer pricing documentation.
The statute of limitations sets a limit on how many fiscal years are open for audit by the tax authorities. Following the amendments, the period for transfer pricing is extended from six years to seven years. From a practical perspective, taxpayers should now maintain transfer pricing documentation covering seven fiscal years.
The recent changes to Japanese transfer pricing law are significant. The changes to the law that primarily impact the pricing of transfers of intangible assets, however, also have broader applications. The changes provide the Japanese tax authorities with the tools to make after-the-fact (or ex-post) pricing adjustments, and the extension of the statute of limitations increases the period for which an adjustment may be made. Taxpayers undertaking transactions involving intangible assets, or who are considering undertaking such a transaction, should evaluate the application of the new rules and consider implementing risk mitigation strategies. Such strategies may involve entering into an advance pricing arrangement (or APA) covering the transaction, or ensuring robust documentation and support is in place at the time of the transaction.