Tax Controversy – disallowance of related company recharges

News, information

The Asahi Newspaper reported on 11 August 2010 that Hewlett Packard’s Japanese subsidiary (‘Japan HP’) had received an assessment in respect of JPY47Bn (USD550m) unreported income.

According to the Asahi article, Japan HP was subject to an audit for the two years to the end of October 2006, also the period for which the assessment was raised.  Japan HP had paid in excess of JPY20B to its parent as management and business expenses. T he tax authorities however alleged that, from a tax point of view, the consideration received by HP Japan for such payment was lacking.  Treating these expenses as tax deductible gave rise to the under reporting of taxable income.  It would appear that HP disagrees with the position of the authorities and has commenced an appeal.

The Asahi article commented further that in recent years many multinational companies have not been placing management functions in the subsidiaries of the foreign countries in which they are expanding, but rather these functions have been borne by the parent company in order to reduce costs.  It would seem that the Japanese tax authorities are strengthening their review of expenses charged between parent and subsidiary companies in order to make sure that, while the globalization of activities of enterprises continues, such growth is not used in excess as a tax planning device.

According to representatives of HP Japan, from 2005 onwards the people, activities and similar making up the management of functions common to different countries, such as manufacturing and sales for each country, were concentrated in the US parent company.  The parent company, acting through as subsidiary established in Switzerland, requested the payment of a total of JPY47Bn from HP Japan.  HP Japan recognized these charges as “Expenses for general management, group support and management of assets”.

In response to the above the Japanese tax authorities who carried out the audit of  HP determined that the “the expenses that were paid to the parent company were different from those made to other overseas related parties.  The nature of the services for which the payments were made was not clear and hence payment lacked logic”.  Given that the payments were treated as expenses, income was reduced and hence this has given rise to under-reporting of income.  Including penalties, the additional taxes seem to be approximately JPY23Bn.  Following the payment of the amount HP will be appealing the assessment.

Japan Hewlett Packard corporate communications noted “We have reported taxes appropriately, in accordance with Japanese tax law.  We cannot comment in detail further”.

Comment

Generally in a Japanese tax audit of parent company fees or an allocation of head office costs, the Japanese tax authorities will want to establish an audit trail from the local ledgers of the company under audit back to the original underlying records.  In addition to identifying expenses charged directly from the head office to its Japan subsidiary, this will also include examining costs that are apportioned to different overseas subsidiaries on a headcount or other logical basis.  To the extent that this information is not already attached to the Japanese tax return of the company as required under Japanese tax law, the authorities may ask for further sample evidence that the parent company incurred the costs concerned – such as copies of invoices.

The auditors will also generally seek evidence regarding the underlying nature of the services which it has analyzed under the above process.  Such evidence could include e-mail correspondence, organizations charts of the head office groups whose expenses are charged to the local entity and similar information.  Based on this evidence the authorities will then assess the appropriateness of the charges and whether or not they are at arms’ length.  As a very general statement the authorities will apply OECD principles in these considerations and hence will, for example, expect the Japanese company under audit to be able to distinguish between shareholder costs and costs that directly benefit the subsidiary.  The auditors may also consider the appropriateness of other matters, such as allocation basis, whether or not a mark up is appropriate or similar matters.

One practical problem that multinational companies experience is that the complexity of their operations often make it is difficult for them to respond in a timely basis to requests for audit information unless the organisation  is very well prepared.  Tactically during a Japanese tax audit it responses should be made as quickly as possible so both parties involved can focus on substantive issues.  Delayed responses often imply that the tax payer lacks confidence in their position or, at a worst case, is not taking the process seriously. We can speculate that in HPs case establishing a subsidiary in Switzerland to help administer the charges from its parent company complicated the process of responding to audit queries.

The Asahi article does not report whether they have assessed Japan HP as a transfer pricing issue or as a “donation” issue”. This article discusses the difference between taxation of a transaction as a Donation rather than a transfer pricing matter, which may well be an issue in this case.



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