Donations to foreign related parties

August 15, 2010  |  Domestic, Transfer Pricing

Shishi odoshi, often seen in Japanese temples or traditional gardens

This article examines an issue that often arises during the course of a corporate tax audit of the Japanese subsidiary of a foreign multinational.  During such an audit the auditors may assert that a Japanese company’s transaction with its Foreign Related Party (‘FRP’) is a “Donation” for Japanese tax purposes (as defined below) and that the amount of the Donation is not deductible for Japanese tax purposes.  An assessment for additional Japanese tax and penalties will normally follow.

The foreign parent in the above situation is often confused as to why the Japanese tax authorities are assessing taxes on corporate Donations rather than dealing with the transaction as a transfer pricing issue.  Japanese tax guidelines provide some clarity on this question. However foreign investors may still feel that the system lacks some transparency in this area, given that transactions that are identical in their economic impact are dealt with under different headings in the tax law.


In October 2008 the Japanese tax authorities issued revisions to the Japanese TP Guidelines which provided some clarification as to how Donations to FRPs are treated for Japanese tax purposes.  Some light on whether a transaction with an FRP is treated as a Donation or as transfer pricing issue also comes from a close reading of the sections of the Japanese Special Taxation Measures Law (STML) that introduces both treatments.

Taxation as Donation

Under STML article 66 no 4-3 when a company makes a Donation to a Foreign Related Party (‘FRP’) then the amount of the Donation cannot be treated as deductible for Japanese tax purposes.  Donation is defined in CTL Article 37, and the wording in paragraph 7 refers to transactions that are “…donations, contributions…regardless of the term referred to, where a Domestic Company makes a gift of monetary or other assets or of economic gains or provides them for no compensation…”.  Article 37 goes on to explain that the value of a Donation is measured by reference to market values.  The article also defines “In Substance Donations”, which arise when assets are transferred or services provided at less than market value and are equal in amount to the difference between their market value and the market value of the consideration received.  Gift is also defined in the Japanese Civil Code (article 549) as being the intention by a person to transfer their own assets for no consideration to another person where such transfer is made effective by its acceptance by the other person.

Taxation under the transfer pricing regulations

STML article 66 no 4 also governs the taxation of transactions for transfer pricing purposes but the wording used to define a tax adjustment for transfer pricing purposes is different from the wording defining Donation for Japanese tax purposes in article 37.  Such difference is one area to try distinguish between Donations and transfer pricing issues.

Under 66 no 4-1 where a company transacts with a FRP in the sale or purchase of assets or the provision of services and where either the consideration received from the FRP is less than the amount that would be received from an independent enterprise or the consideration paid is more than would be paid to independent enterprise, then the difference between the amount of consideration paid or received and the amount that would be paid or received from an independent enterprise is treated as increasing the amount of taxable income of the Japanese company transacting with the FRP.

Donation? or Transfer Pricing issue?

Given the above, when considering whether a transaction is a Donation one must address whether the transaction included elements of gift or transfer for zero consideration or consideration less than market value.  In contrast, for a transfer pricing issue one has to consider how a transaction compares with an arms length transaction with an unrelated enterprise.  Clearly in a case where services are provided or assets are transferred for zero consideration the distinction is relatively easy to make; such a transaction would seem to be a Donation.   It is however difficult for a foreign investor to understand the difference between an In Substance Donation and a transfer pricing adjustment.  One basis for such a distinction may be intent.  Documentation itself may also indicate one treatment applies rather than another, although documentation itself would arguably ultimately be evidence of intent in any case.  The TP Guidelines do however discuss the distinction in more detail, as outlined further below.

TP Guidelines and the Provision of Group Services

The TP Guidelines at 2-9(5) discuss when the provision of group services is treated as a Donation.  When Japanese company receives from an FRP managerial, financial, business, clerical or other services and pays consideration for them then, when considering whether the consideration paid is appropriate, if it is not possible for the taxpayer to present documents that record the content of the services concerned then it is necessary to consider whether the transactions are Donations.

In practice the above guidance would likely mean that the tax authorities would expect to be able to confirm the contents of the contract underlying the provision of group services, the means by which the amount of consideration was set, the process by which the price or the services was negotiated, the persons involved at the FRP who provided the services (roles, departments, numbers and similar), assets used and the original cost (TP Guidelines example 23).  This documentation would be expected to show that the intent was not to provide some gratuitous benefit to the FRP.  A typical transfer pricing study would probably meet much of this requirement.  If a taxpayer cannot provide this documentation then the risk of Donation treatment is correspondingly higher.

TP Guidelines 2-19 also notes that where a company sells assets, lends money or provides services (below, participates in  ‘FRP Transactions’) and does not account for any income and when the FRP Transactions are the gift of monetary or other assets or the provision of economic benefits or provision of services for no compensation then such transactions are Donations.  However 2-19 also goes on to make it clear that other transactions where consideration is received and accounted for (though less than market value) and transactions where consideration paid is in excess of market value can also be treated as Donations.  Regrettably this does not help much to distinguish between Donations and transfer pricing adjustments.

The TP Guidelines do note that in certain circumstances, for example where for the purposes of government financial support for the FRP and where prices are set to avoid the bankruptcy of a subsidiary or similar unavoidable situation arises, then the transactions concerned may not be treated as Donations.  This exception should clearly not be relied on other than in exceptional cases.   Finally the TP Guidelines also make it clear that the existence or otherwise of a contract for an agreed price for the provision of services does not determine treatment as Donation or as a transfer pricing issue.

Practical points

A couple of practical points arising out of the above are as follows:

  • Foreign investors may find that Donation issues arise when audited in their routine scheduled corporate tax audits.  In general handling transfer pricing issues is under the jurisdiction of the Japanese tax authorities specialist transfer pricing teams, hence the non specialist corporate tax auditors will tend to raise Donation as an issue given it is clearly in their jurisdiction.
  • When prices charged for services or similar provided from or to FRPs are changed, care should be taken to document the reasons for the change including why it is at arms’ length. This should help mitigate the risk of such change being treated as a Donation rather than a revision of an arms’ length price further to transfer pricing analysis.
  • There may be some risk that foreign investors may find it more difficult to appeal a Donation assessment or bring it within the remit of competent authority and transfer pricing regulations under the domestic law or treaty.  This is a good reason to make sure that all transactions with FRPs are documented further to appropriate transfer pricing studies.

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