Transfer pricing and Japanese 2011 tax reform

February 28, 2011  |  Transfer Pricing

An artfully composed photograph of recently planted rice fields in rural Japan.

The outline of 2011 Japanese tax reform proposals (link in Japanese) issued on the 16th of December 2010 include a number of technical changes to the Japanese transfer pricing regulations that have important practical implications for transfer pricing practice in Japan. This article summarizes those proposed changes.

The transfer pricing section of the 2011 tax reform proposals starts by noting that proposed changes to the transfer pricing regulations are intended to reflect recent changes to the OECD Transfer Pricing Guidelines. Four areas of reform are outlined:

Abandonment of priority among TP Methodologies

Existing Japanese transfer pricing regulations include rules to determine the priority in which different defined methods of pricing treated as controlled for transfer pricing purposes (‘TP Methodologies’) are applied.

These rules are explained in more detail in this article which includes a flow chart explaining how such prioritization operates. However, in summary the impact of the pre-2011 reform regulations is to prioritize the three traditional transactional TP Methodologies – comparable uncontrolled price, resale price and cost plus methodologies – ahead of profit split methodologies, with transactional net margin methodologies given lowest priority.

Under the 2011 proposals such prioritization would be abandoned. The law would also be clarified to explicitly allow three different types of profit split TP Methodology – comparable profit split method, the contribution to profit split method and the residual profit split. These changes would be adopted from the 1st of October 2011 onwards.

Range of Arm’s Length Price

Current Japanese transfer pricing practice does not recognize the possibility that a range of arm’s length prices may exist for controlled transactions.

Under the 2011 proposals, the concept of a range of acceptable arm’s length prices would be adopted into the Japanese transfer pricing regulations.

If a controlled price fell within its arm’s length range, no transfer pricing adjustment would be made.

If a controlled transaction was priced outside the arm’s length range, adjustment could be made to bring it within range based on the average price of comparable uncontrolled transactions. Also, depending on the distribution of such prices, a logical price could be chosen as the third party comparable price for the purposes of any transfer pricing adjustment.

Secret comparables

Japanese transfer pricing practice is well known for allowing the use of “secret comparables” – being pricing information obtained from third parties by the Japanese tax authorities through transfer pricing examinations, questionnaires or similar that is not made known to the taxpayer undergoing transfer pricing audit. Taxpayers are clearly not in a good position to defend against a transfer pricing assessment based on a secret comparable.

Under the 2011 proposals the Japanese tax authorities are still be allowed to use secret comparables, but the authorities will be obliged to explain, to the extent possible while remaining within the limits of their obligations of confidentiality to other taxpayers, how they are applied to a taxpayer under transfer pricing audit.

Arbitration of Transfer Pricing Disputes

Japan’s recent tax treaties have seen the introduction of clauses allowing arbitration over tax disputes as an alternative to the traditional competent authority process. Under the 2011 proposals, regulations would be introduced to regularize the application by a taxpayer for such arbitration.


All of the above proposals are welcome changes from the point of view of fairness and practical application of transfer pricing practice in Japan.

Some of the changes may reflect bringing transfer pricing regulations more in line with actual practice. For example, the tax authorities themselves often seem to show great interest in applying a profit split TP Methodology regardless of the fact that it is not one of the three preferred TP Methodologies under existing regulations. The authorities also seem less inclined to vigorously pursue transfer pricing cases when it seems likely that a taxpayer’s transfer price falls within an arm’s length range.

While the use by the authorities of secret comparables is still regrettable, the proposed tax reform is at least consistent with allowing taxpayers the best opportunity to defend against their application where they think that their usage may not produce an arm’s length result.

Leave a Reply