Companies have to navigate through an unprecedented global economic and financial crisis. Now, in addition to their economic survival, companies need to be concerned with tax authorities’ efforts to protect their share of diminishing tax revenues. Companies operating in Japan especially should pay close attention as the Japanese government relies heavily on the collection of corporate income taxes and has one of the world’s most stringent and aggressive tax and transfer pricing regimes.
On transfer pricing, recent years have seen a surge in enforcement activity as measured by the number and size of adjustment cases. In the 2008 tax year, 133 transfer pricing-related assessments were issued, an increase of 32% over the previous tax year, with total adjustments reaching JP\ 170 billion ($1.8 billion), an increase of 61%. In the future, such audit activity is expected to increase.
Permanent establishment
In addition to this audit activity, Japan’s tax authorities continue their reviews of taxpayers’ arrangements from a permanent establishment (PE) perspective in assessing whether a taxable presence exists for foreign companies in Japan. Such reviews mainly target direct sales models using a related-party service provider in Japan, such as a commissionaire or other limited risk entity. A PE is typically defined as a fixed place of business through which the business of an enterprise is wholly or partly carried on. Profits of a foreign company shall be taxable in Japan only to the extent that they are attributable to a PE.
The most recent PE case involves a major US-based online retailer. The company noted in its 10-K securities filing for the fiscal year ended January 30 2009 that “...in 2007, Japanese tax authorities assessed income tax, including penalties and interest, of approximately $119 million against one of our US subsidiaries for the years 2003 through 2005. ...Further proceedings on the assessment will be stayed during negotiations between the US and Japanese authorities over the double taxation issues the assessment raises, and we have provided bank guarantees to suspend enforcement of the assessment. We also may be subject to income tax examination by Japanese tax authorities for 2006 through 2008.”
Additional information was revealed in newspapers, stating that the company’s US affiliate had commissioned its related parties to manage sales and logistics operations in Japan, while recording all sales from its Japan business in the US. The Japanese tax authorities are taking the view that the distribution center in Japan, where books and other merchandise are stored before delivery, has sufficient ties to its US affiliate to constitute a PE in Japan for which the company has failed to report related income in Japan. Such ties include the use of computers and other equipment supplied by the US affiliate, the need for permission from the US affiliate before plant design changes can be made and receipt of email instructions from the US affiliate (The Asahi Shimbun, July 6 2009).
Similar cases arose toward the end of the 1990s when various institutions in the financial and insurance sector faced the first wave of PE assessments.
Another type of potential challenge to a direct sales model (using commissionaire or other type of limited risk entity) is a challenge to the underlying transfer pricing. Aggressive transfer pricing enforcement is, of course, not limited only to such structures but occurs with all types of cross-border related-party transactions. For example, software company Adobe Systems’ affiliate in Japan, Adobe Systems Company. (Adobe Japan) received a transfer pricing assessment for fiscal years 2000 to 2002. The Japanese tax authorities claimed that Adobe’s transfer pricing was incorrect, and in their calculations came to the conclusion that Adobe had underreported over JP\ 1 billion of income in Japan. In this case, Adobe Japan provided sales and marketing support services to its foreign related parties and received cost-based compensation plus commissions.
The Japanese tax authorities identified a buy-sell distributor whom they claimed was comparable (and whose identity was undisclosed, in other words, a secret comparable) and argued that this company’s gross margin should be applied in computing the appropriate remuneration for Adobe Japan. In response to the assessment, Adobe Japan first lodged an appeal with the National Tax Tribunal, and, when this was unsuccessful, filed a lawsuit. Litigation over tax cases is rare in Japan, and it is especially uncommon for taxpayers to take a transfer pricing case to court. This is hardly surprising, since up until 2008, no taxpayer had ever won a court challenge in a transfer pricing case. In October 2008, for the first time ever, the Tokyo High Court ruled against the National Tax Agency in a transfer pricing matter and rejected the assessment, ruling that the comparable used by the authority was inappropriate. Unfortunately, the court did not comment on the use of secret comparables which remain a threat to taxpayers operating in Japan.
Despite the setback for the Japanese tax authorities in the Adobe case, taxpayers can expect increasing scrutiny of arrangements that limit profit potential in Japan, especially commissionaire or limited risk structures. Japan’s tax authorities typically pay close attention to the actual transaction undertaken. If the transaction does not have sufficient substance and business rationale, the authorities could adopt a substance over form approach and, in cases of an undue decrease in Japanese income tax, disregard or re-characterise certain transaction structures or otherwise make adjustments for transfer pricing. The Japanese tax authorities could also perform detailed analyses and examine the contributions of all parties involved in the transaction which may be used as the basis for a profit split analysis. These developments underpin the need for a comprehensive approach to designing, implementing and documenting a tax strategy in the Japanese context that ensures compliance with local requirements while meeting business objectives.