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Japanese companies fear the rise of the profit split method

As Japan moves towards a new transfer pricing (TP) regime, companies fear the increasing use of the profit split method could erode the arm’s-length principle (ALP).

The Japan Business Federation, widely known as Keidanren, has been analysing the Shinzo Abe government’s ambitious plans to reform TP rules. The federation may not be known worldwide, but many of its members are household names, including Hitachi, Mitsubishi and Toyota.

With almost every major Japanese business being a member, Keidanren is the voice of industry. So when this association talks, the Japanese government listens closely.

“We are concerned by the proliferation of the profit split method, which involves the notion of allowing the prices of foreign controlled transactions to be determined without using comparables,” Hiroshi Makuuchi, who oversees tax policy at Keidanren, told TP Week.

Although the Japanese government has opted for the discounted cash flow (DCF) method as a fail-safe approach for transactions with few or even no comparables, Keidanren is concerned that the Asian trend towards the profit split method or formulary apportionment could influence policy in Japan.

“It appears that Japan’s neighbouring countries, many of which are emerging economies, are eager to use the profit split method more frequently,” Makuuchi said. “This is a very slippery slope.”

“This [profit split] notion, which is close to so-called formulary apportionment, could make TP rules based on the [ALP] very ambiguous,” he added, explaining that this is why businesses fear the ALP’s days may be numbered.

The profit split method is also gaining popularity as a means of dealing with taxation of the digital economy. However, the method risks double taxation as it could strengthen the taxing rights of countries where the value is created.

Nevertheless, the profit split method may soon be the norm in China, where it has been the tax authority’s preferred TP option for several years.

“This is being driven by globalisation and the booming digital economy,” said Wei Zhuang, former TP manager at Chevron China. “Taxing the value at its source is one way to approach cross-border transactions, especially digital transactions,” she explained.

Method in the madness

Going against the profit split method trend in East Asia, the Abe government has opted for the discounted cash flow (DCF) method as a fail-safe approach in transactions with few or even no comparables, but this approach doesn’t help companies used to more internationally harmonised methodologies or with intangibles.

Although Japan’s chosen DCF method might be a better option for some taxpayers than profit split, it has problems. For example, there are few real life examples of Japanese companies using this option as the best method to set a price. The preferred option is the transactional net margin method (TNMM), which focuses the comparison on profit margins.

The TNMM is used across sectors such as car manufacturing, pharmaceuticals and the IT industry.

This is especially true in cross-border, inter-group transactions involving intangible assets, which are a crucial point in the reform package – the rules on intangibles and methodology are now being defined.

“Japanese companies prefer to hold their important intangibles within their reach and rarely transfer them to foreign related parties,” Makuuchi explained. “Instead, they often conclude licence agreements with foreign affiliates and receive royalties deriving from the intangibles.”

This may be why much of the tax reform package focuses on how to define intangible assets, particularly hard-to-value intangibles (HTVIs). Tax policymakers have tried to pin down the category of HTVIs and force a new approach to pricing on taxpayers.

The new approach will take into account actual results (ex-post) as the basis for forecasting (ex-ante) transactions involving such intangible assets. But this could mean taxpayers will take a hit on past transactions.

Keidanren is concerned that the ex-post outcome will lead to retroactive taxation. Fortunately, the Abe government is taking this seriously and the application of the new approach will likely be limited once the proposals are finalised.

However, a tax manager at an IT company warned that the rules have been designed to make it much harder for Japanese multinationals to transfer their functions overseas as this is unlikely to change.

“Japanese companies are becoming more international than ever before,” he said. “Historically Japanese businesses ran everything domestically, including IP assets, but they are increasingly studying what functions they can move abroad.”

Although Japanese businesses are making sure their voices are heard, what the government does next will determine TP practices for decades to come.

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