Japan's TP proposals to hit IP assets

The Japanese government has rolled out ambitious plans to reform the country’s TP regime to introduce a stricter policy, re-align its standards with global norms and raise incentives for high-tech innovation. Business leaders are optimistic that the proposals could help transform the economy and its infrastructure, but it also brings a higher tax burden.

The proposals have major implications for how companies structure their intangible assets and the best way to apply the arm’s-length principle (ALP). The results may mean greater compliance and a higher threat of audits and disputes.

“The high [corporate] tax rate is one reason why this [reform] is happening,” said one tax manager at an IT company. “These new rules have been designed to make it much harder for Japanese multinationals to transfer their functions overseas.”

The biggest change in the tax reform package is the introduction of the ex-post outcome price adjustment to bring Japanese standards in line with the OECD’s TP guidelines.

“The new rules will lead to very different results for how businesses manage their transfer pricing arrangements and the tax authority will be more likely to challenge companies,” one tax director at a multinational company told TP Week.

The price adjustment takes into account actual results (ex-post) as the basis for forecasting (ex-ante) transactions involving intangible assets. This is one way to address the asymmetry of information between taxpayers and the tax administration, but it could also leave taxpayers with less room to manoeuvre .

At the same time, the rise of intangibles has created a new focus for the tax authority. Much of the reform package focuses on how to define intangible assets, particularly hard-to-value-intangibles (HTVIs).

“Historically, Japanese companies were focused on producing goods, whereas today services are more important and data is a lot more important,” the tax director said. “Things were much simpler when it came to the manufacturing sector.”

“It’s very difficult to find the comparables you need as part of some of these transactions,” the director added. “So it’s getting more difficult to carry out a quantitative comparison and this makes it harder to apply the arm’s-length principle.”

Many companies believe Japan’s tough TP documentation requirements are unnecessary. “We’ve always strongly argued that Japanese corporations have not taken an aggressive approach to tax planning, so the strict approach to TP is not necessary in Japan,” the tax director said.

“That’s a consistent message coming from the Japanese tax community, but the government has decided to persist,” they added. “This is just going to increase the workload for businesses and tax professionals.”

The days of simplicity are over in the world’s biggest economies, and Japan finds itself caught between the US on one side and China on the other. The Japanese government has embarked on tax reform to catch up with its two great trading partners.

Yet, US multinationals operating in Japan are likely to be less affected by the TP reforms than their Japanese subsidiaries and Japanese companies with IP assets in the country. The reform package might hold far more surprises for traditional companies that have modernised to keep up with a changing world.

The reform package includes an expansion of the R&D tax credits available to businesses, which would primarily benefit Japanese manufacturers.

However, any Japanese R&D paid for by foreign entity of the same group will not qualify for the benefits, warned one tax head for the Japanese subsidiary of a large multinational company.

Separately, the legal definition of a ‘large company’ will be expanded to close a loophole through which companies indirectly controlled by large corporations are able to receive tax reliefs designed for small or medium-sized enterprises.

“Right now, larger companies can divide their activities into smaller pieces with a lot of layers – and if they called one subsidiary a ‘small company’, and get tax relief, that’s not fair, right?” said the tax head.

However, the source indicated that their corporate colleagues were unhappy about Japan’s embrace of the OECD’s advice on earnings-stripping rules, which fall under BEPS Action 4. The proposed change will expand the scope of interest payments subject to earnings-stripping rules, so that all net interest payments, and not just those to related persons, would be in scope.

Additionally, the proposal would reduce the maximum deductible interest payments from half to a fifth of adjusted taxable income.

The rules, which closely follow the OECD’s suggestions, aim to reduce tax avoidance that uses deductible interest payments to reduce a company’s tax liability. But they may also harm businesses that use debt financing with no intention of minimising their tax bills.

“I hear a lot of complaints from my colleagues, from Japanese multinationals, complaining about this earnings-stripping rule even becoming stricter,” said the tax head. “They say that the Japanese government is too eager to comply with the international recommendations.”