Understanding Transfer Pricing Risks for SMEs in Japan

Transfer Pricing Tax Risks for SMEs in Japan

How significant is the tax risk for so-called SMEs (with annual revenue of around 2 billion yen) under the transfer pricing system, and how much preparation is necessary?

In my experience, responses to this question vary depending on who you ask, and I've never received a convincing answer. However, I finally got a persuasive response this time, which I will share here. Please note, though, that the basis for the reasoning behind this answer is unverified and is merely my opinion.

Response from a Former Tax Inspector

The respondent is a man in his late 50s currently working at a private consulting firm (a medium-sized tax advisory firm). He has ten years of experience as a transfer pricing specialist with the National Tax Agency. His Response: If the SME has capital of 100 million yen or less, there is no taxation risk due to transfer pricing.

Reasons for No Transfer Pricing Tax Risk

Reason 1: Limitations of the Tax Office's Authority

The National Tax Agency supervises and directs local tax offices. However, it also directly conducts tax audits on large corporations with capital exceeding 100 million yen. Local tax offices handle tax audits for smaller businesses and individuals.

The local tax office conducts audits of SMEs with capital of 100 million yen or less, but it lacks the authority to impose taxes based on transfer pricing.

Reason 2: The National Tax Agency's Reluctance Toward Mutual Agreement Procedures

Even if a transfer pricing specialist from the National Tax Agency were involved in the audit, the agency would still prefer to avoid "mutual agreement" procedures betwen countries, would still want to avoid imposing additional tax based on trasfer prising.

Mutual agreement procedures occur when, for example, a company is taxed based on Japan's transfer pricing rules, leading to double taxation in Japan and the foreign country. To adjust to this, the two countries entered into negotiations. However, the number of National Tax Agency officials assigned to handle such cases is too few, so they are not in a position to process these cases efficiently.

Response to Taxation on Donations

SMEs seem to be almost never subject to taxes based on transfer pricing. However, the tax office may classify transactions with overseas affiliates as donations and impose taxes. In response, the former inspector advises that if the tax office claims that such transactions are donations, its reasoning is flawed. Companies should maintain that the issue is related to transfer pricing, not donations. If it becomes a transfer pricing matter, additional taxation would not be possible.

Distinguishing Between Donation Taxation and Transfer Pricing Taxation

So we should just argue that the issue relates to transfer pricing rather than donations. Because if it is an issue of transfer priceing, they would not impose tax.

You may think there wasn't much difference between donation taxation and transfer pricing taxation. But we now realize that the distinction is critically important.

What Steps Should SMEs Take?

Does this mean that SMEs don't need to prepare for transfer pricing regulations? According to the former tax inspector, while legal documentation like a local file is unnecessary, if the company establishes a transfer pricing policy and uses it to set prices for transactions with overseas affiliates, there should be no issues.

Conclusion

While SMEs with capital under 100 million yen face minimal tax risk from transfer pricing, it's essential to remain vigilant about potential tax challenges, particularly regarding donations. SMEs can safeguard themselves from future complications by establishing a clear transfer pricing policy and maintaining accurate pricing for transactions with overseas affiliates.

Though the tax landscape may seem complex, understanding these key distinctions helps ensure smoother operations and better compliance with Japan's tax regulations.