In brief

In 2022, Japan’s National Tax Agency (NTA) finalized amendments to the Commissioner’s Directive on the Operation of Transfer Pricing (Administrative Guidelines) regarding cost contribution arrangements (CCAs) and financial transactions. This article revisits the revisions, particularly as relevant for inbound taxpayers into Japan, in the context of potential future tax authority scrutiny.

It is relevant to note that the Administrative Guidelines do not have the force of law in Japan. However, Japanese tax authorities at all levels can be expected to act in accordance with the Administrative Guidelines in connection with transfer pricing matters.

The revisions are effective (and will be referred to by tax administrations in audits and advance pricing agreements) for years beginning on or after 1 July 2022.

1. Cost Contribution Arrangements

As Japanese transfer pricing law does not contain specific rules relating to CCAs, the Administrative Guidelines, together with the OECD Transfer Pricing Guidelines, represent authoritative guidance on how the arm’s length principle can be expected to be applied to CCAs in Japan.

The amendments revise the definition of a CCA. The revised definition expands the scope of a CCA and clarifies that “assumption of risk” is included in the contribution to the joint activity in a manner which is consistent with the OECD Transfer Pricing Guidelines. The clarification that the development of tangible assets as well as the provision of services can be subject to a CCA increases the potential applicability of CCAs. For example, under the revised definition, a CCA could cover capital expenditure for industries that require large capital investments or for services related to certain centralized group functions.

The amendments further clarify that a CCA is considered to be consistent with the arm’s length principle when the following requirements are met:

1. The proportion of the total amount of expected benefit (“Expected Proportion of Benefit”) is properly estimated;

2. The amount of each participant’s value contribution is consistent with the amount of consideration that would be paid if the transaction were conducted at arm’s length and in accordance with the terms and conditions of a transaction between independent parties; and

3. The proportion of the value of each participant’s contribution is consistent with the Expected Proportion of Benefit.

In addition, the revised guidelines clarify that, “if an adjustment payment is made to align the contribution value ratio with the Expected Proportion of Benefit, the amount after the payment shall be considered to be the value of the contribution of each participant.” They also state that, “if the amount of the expense borne by a participant under the CCA does not differ significantly from the value of the participant’s contribution, the expense amount may be treated as the value of the participant’s contribution.” These amendments can be expected to improve the predictability of the application of the arm’s length principle to CCAs in Japan.

Section 3-17 of the Administrative Guidelines sets out criteria to be considered by an examiner when analyzing a CCA during a transfer pricing audit. The amendments significantly revise and add to the criteria, which now instruct an examiner to analyze whether the details set forth in the contract are consistent with the work actually performed by the CCA participant and other facts relating to the CCA; 

• all participants obtain the expected benefits;

• the expected benefit ratio has been properly calculated;

• the contribution value ratio has been properly calculated;

• each participant’s respective value contribution percentage is consistent with its respective expected benefit percentage, and if not, whether an adjusted amount of payment was given or received; and

• appropriate compensation has been paid or received when a participant joins or withdraws from a CCA or when the CCA is terminated.

The revised guidelines further include a list of documents examiners should request and review when conducting an audit of a CCA. Although there is no stand-alone requirement for contemporaneous documentation and ordinary documentation thresholds apply to CCA-related transactions, taxpayers are expected to prepare these documents and deliver them to an examiner upon request.

2. Financial transactions

In addition to the revisions described above relating to CCAs, the Administrative Guidelines were also amended to update guidance on financial transactions. Based on explanatory material provided by the NTA, the changes are intended to align Japanese transfer pricing practice with the updated OECD Transfer Pricing Guidelines including guidance on financial transactions in Chapter X.

The revisions were primarily to Chapter 3 of the Administrative Guidelines, which provides instructions to auditors for use during tax examinations.

a) Loan pricing

Chapter 3-8 was revised to remove the priority of methods for intercompany loans. Previously, the Administrative Guidelines broadly provided that where no direct internal comparable uncontrolled price (CUP) applies, taxpayers (who are not principally engaged in moneylending) should test the appropriateness of the interest rate used in lending or borrowing based on the following approaches (in order of priority from 1 to 3):

1. Interest rate that would apply if the borrower borrowed from an unrelated bank on similar terms;

2. Interest rate that would apply if the lender borrowed from an unrelated bank under similar terms;

3. Interest rate that would be expected if the funds were invested in government securities.

Further guidance from the NTA clarified that these approaches would be based on market interest rate data. In practice, based on the previous guidance, taxpayers could use the lender borrowing rate and add a spread to support loans to Japanese subsidiaries. The updated Administrative Guidelines remove the priority of methods, including reference to the lender’s borrowing rate, and instead state that the loan should be priced using the most appropriate method. Further, while in the past it was common for companies to set the arm’s length interest rate for financial transactions based only on interest rates informally provided by a commercial bank, Chapter 3-8(5) of the updated Administrative Guidelines now clearly denies the arm’s length principle in such cases.

In addition, Chapter 3-7 was updated to emphasize the need to accurately delineate financial transactions, with a particular focus on comparability. In this connection, Chapter 3-8(2) now specifies that when analyzing comparability, the creditworthiness of the borrower must be considered. This may be, for example, based on a synthetic credit rating tool, or using a group credit rating methodology. The Administrative Guidelines also specify the need to consider implicit support when analyzing creditworthiness (consistent with OECD concepts).

As a practical matter, these changes taken together require the borrower’s characteristics (particularly its credit rating) to be considered in all cases, that a proper comparability analysis of the financial transaction is undertaken and that robust economic analysis (e.g., benchmarking) is performed to support the interest rate. Prior to the changes, it was common for Japanese taxpayers to exclude intercompany loans from analysis or inclusion in their transfer pricing documentation. Interest payments were also often considered immaterial due to a prolonged low interest rate environment. The changes to the Administrative Guidelines signal a potential focus by the tax authorities on intercompany loans involving Japanese companies — particularly relevant in the context of increasing interest rates.

b) Guarantees

Chapter 3-7 (2) was also updated to provide guidance on the need to collect consideration for debt guarantee transactions and to also provide examples of the method of calculating arm’s length prices. The revised guidance provides that when considering pricing of debt guarantees, the following three factors should be considered:

1) The nature of the obligation

2) The extent of the liabilities

3) The impact of the guarantee on the guarantor and borrower

In analyzing the impact of the guarantee, whether the guarantor is legally obligated under the guarantee (e.g., to assume specific obligations of the debtor in the event of default) and whether the guarantee actually increases the creditworthiness of the borrower must be considered.

Chapter 3-8(2) of the revised guidelines also state (in Notes 1 and 2) that passive association and implicit support must be analyzed when considering the increase in creditworthiness of the borrower. Consistent with the OECD guidelines, these concepts describe the credit enhancement of the borrower solely related to belonging to a corporate group. The accurate delineation of guarantee transactions (as clarified in Chapter 3-1 of the revised guidelines) in the context of whether consideration should be paid for such guarantees requires consideration of the economic benefit for the borrower, beyond the benefits derived from passive association.

Chapter 3-8(6) of the revised guidelines describe methods for calculating arm’s length prices for guarantees. The revised guidance sets out three methods as examples of calculating the arm’s length price.

1. Yield differential approach, which measures the difference in interest rate resulting from the guarantee, based on the borrower’s credit rating with and without the guarantee;

2. Cost (expected loss) approach, which is based on remuneration for risk of expected losses in the event of default;

3. Credit default swap approach, which is based on pricing of relevant credit default swap instruments in the market.

These pricing methods are broadly consistent with those described in D.2 of the OECD Guidelines (paragraph 10.170.-10.182). However, there are some differences. For example, the OECD Guidelines provide that the CUP method may be used to price guarantees, while the revised guidelines are silent on this point. Further, while the revised guidelines refer to a “credit default swap” approach, the OECD guidelines describe credit default swap data as an example of using the cost approach, rather than a separate pricing method.

However, these differences do not necessarily mean that the Administrative Guidelines are inconsistent with the OECD guidelines. As described above, the Administrative Guidelines are directives to Japanese tax examiners to apply when analyzing the pricing of financial guarantees. In this context, the guidelines are practical in nature, and the methods described above are provided as examples of practical approaches to pricing rather than an exhaustive list of available pricing methods. In addition, the omission of the CUP method may reflect the Japanese tax authority’s traditionally strict view of comparability. That is, while use of CUP may be theoretically possible, in practice, identifying such a comparable transaction for a guarantee with sufficiently similar terms (from a tax authority view) may be extremely difficult.

c) Cash pooling

Chapter 3-7(2) was also updated to provide comments on cash pooling arrangements. In considering the transfer pricing treatment of cash pooling, there are generally two important points to consider.

1. All participants in a cash pooling transaction share a common benefit from the interaction. In this connection, a note was added to Chapter 3-7(3) which states that the participants in a cash pool need to consider whether the cash pooling results in a decrease in interest to be paid, an increase in interest to be received or other benefits that are shared among all participants.

2. The treatment of the financial management function performed by the cash pool leader. In this connection, Chapter 3-7(3) was amended to state that financial management functions (e.g., negotiation with correspondent banks, account management of participants, bookkeeping, etc.) should be analyzed in accordance with Chapters 3-10 and 3-11 of the OECD guidelines. Based on the OECD guidelines, such financial management functions should be considered to be intragroup services (IGS) for which the leader should be remunerated (e.g., based on a markup on the cost of such IGS through the Transactional Net Margin method or Cost Plus method).

The NTA’s Reference Case Studies on the Application of Transfer Pricing Taxation (the “Reference Case Studies”) were also updated and provide an example of a cash pooling arrangement. Based on the Reference Case Studies, the consideration for the IGS performed by the leader would first be deducted from the amount attributed to the common benefits of the cash pooling. The Contribution Profit Split method or the Residual Profit Split method would then likely be the most appropriate transfer pricing method to allocate the remaining amount among the participants. This is described in assumption 4 of Case 7 of the Reference Case Studies, where the amount is allocated according to each participant’s account balance prior to cash transfer by cash pooling.

3. BM Comment

Although the Administrative Guidelines do not have the force of law in Japan, the Japanese tax authorities can be expected to act in accordance with the Guidelines. The fact that the NTA has updated the guidelines might be indicative of future audit scrutiny of these areas by the tax authorities. In this context, taxpayers impacted by the changes would be well advised to assess their current transfer pricing policies (considering not only the substance of the transaction and the terms of the contract, but also the context of their overall business) as well as their Japanese transfer pricing documentation strategy and respond accordingly.