For example, a transaction in which a U.S. subsidiary purchases a product developed and manufactured by a Japanese parent company and sells it in the U.S. market occurs between related parties. Because of this, the price for this transaction can be arbitrarily determined. In this case, if the sales price from the Japanese parent company to the U.S. subsidiary is too low, the income attributable to this transaction will be transferred from the Japanese parent company to the U.S. subsidiary, resulting in an understatement of taxable income reported in Japan and, conversely, an overstatement of taxable income reported in the United States. Since the income reported in Japan will be understated, if this problem is pointed out during a tax audit, the Japanese Tax Authority will reassess the income based on the correct price and impose additional tax payments, resulting in double taxation.
Thus, transfer pricing taxation is established to prevent the imbalance of declared taxable income in each country in cross-border transactions between foreign related parties. The foundation of transfer pricing taxation is the “arm’s-length principle,” which means that transactions between foreign related parties should be priced and conducted on the same terms as those between unrelated parties. Today, transfer pricing taxation has been introduced in almost all countries and is strictly enforced by tax authorities. It is one of the areas of international taxation that companies expanding overseas should be aware of.
There are two points in transfer pricing taxation that we would like companies to pay special attention to:
- Transactions subject to transfer pricing taxation are diverse and may be overlooked by companies.
- Methods for determining arm’s-length prices are stipulated in the transfer pricing regulations of each country, and foreign affiliated transactions must be priced based on these methods.
First, there is a wide range of transactions that are subject to transfer pricing taxation. Almost all activities between foreign related parties that have commercial and economic benefits are subject to transfer pricing taxation and can be categorized as follows:
- Purchase and sales transactions of tangible assets (inventories, manufacturing equipment, etc.)
- Intangible asset licensing transactions (technology licensing, brand licensing agreements, etc.)
- Service transactions (sales support, technical support, business management support, etc.)
- Financial transactions (loans, guarantees, etc.)
As mentioned above, transactions subject to transfer pricing taxation are not limited to transactions that can be traced by forms and other means, such as the purchase and sale of inventory, but also include the provision of services and intangible asset transactions, which cannot be easily traced within a company and may not even be recognized as having occurred. For example, if a U.S. subsidiary develops and sells its own product in the U.S. and uses the Japanese parent company’s trademark to sell the product, the U.S. subsidiary is in fact using an intangible asset owned by the Japanese parent company and must pay consideration for it, and a transfer pricing issue arises as to how much this consideration should be paid. This is just one example. Again, there are a wide variety of transactions subject to transfer pricing taxation, so it is important to periodically check within the corporate group to see if any transactions subject to transfer pricing taxation have occurred between foreign related parties.
The second point is that the method of determining transfer pricing is stipulated in the transfer pricing regulation of each country, and the pricing must be determined based on this transfer pricing method. Note that even if a company’s own pricing is reasonable and fair, it may be subject to adjustment if the price is inconsistent with the price calculated according to the method stipulated in the transfer pricing regulations. For example, in inventory sales transactions between a parent and its subsidiaries, we often see pricing that allows the gross profit to be split 50-50 between the parent and its subsidiaries. For the company, this may be seen as a fair method, since the profits are split 50-50. However, in the case of inventory sales transactions, when there are no comparable internal transactions, we are often required to use a method called the Transactional Net Margin Method and set the price so that the operating margin of the tested party (generally, a foreign subsidiary) is reasonable compared to the operating margin of comparable third-party companies. In this case, even if the foreign subsidiary earns half the gross profit, if it does not achieve a certain level of operating margin, the price may not be considered arm’s length. For details, please refer to the transfer pricing regulations of each country. Please note that the transfer pricing method stipulated by the transfer pricing regulations must be used for the pricing of foreign-related transactions.