Japanese Taxation of a PE under the AOA Approach

Background

The “Authorized OECD Approach” (“AOA”) rule for taxation of permanent establishments (“PE”) was introduced in Japan's 2014 tax reform and will be applied to fiscal year commencing April 1, 2016. The new rule includes changes to source rules, the introduction of transfer pricing to intra-company transactions, and the introduction of the documentation rule on income attributable to a PE.

Source rule

Under the current source rule, Article 138 of the Corporation Tax Law (“CTL”), domestic source income for business income is different from income attributable to a PE. Therefore, foreign source income attributable to a PE is out of scope for corporate income tax. Under the new rule, domestic source income for business income is income attributable to a PE. A foreign corporation is subject to corporate income tax as long as it has income defined in Article 138(1)(i) of the CTL.

According to Article 138(i), domestic source income for business income is defined as follows: “Where a foreign corporation conducts business through a PE, income attributable to the PE with reference to functions performed by the PE, assets owned by the PE, and intra-company transactions etc. assuming that the PE is a separate enterprise conducting business independently of the foreign corporation.”

When calculating income attributable to a PE, new rules will be introduced.

Disallowance of interest expenses corresponding to equity attributable to the PE

Where the equity (net assets) of the PE are lower than the equity of the foreign corporation attributable to the PE, interest expenses on debt of the PE corresponding to the deficiency of equity is disallowed1.

Disallowance of head office expenses allocation

Where the PE takes a tax deduction for head office expenses allocation and documentation of head office expenses allocation is not maintained, that allocation is disallowed.

Foreign tax credit

Where the PE pays foreign taxes on foreign source income, the PE is allowed to take a foreign tax credit within the limit of the corporation tax amount corresponding to the foreign source income2.

Intra-company transactions

Under the current rule, certain intra-company transactions such as intra-company licenses, intra-company loans etc, are not recognized3. Under the new rule, intra- company transactions are recognized. Intra-company transactions are transactions with head office or other offices in the same entity, which would be made between independent enterprises such as transfer of assets, providing services etc.4

Transfer Pricing rule

The Japanese transfer pricing rule has been applicable to transactions between separate legal entities which are related in terms of ownership and other substantive control5. Although the arm's length principle is applicable to intra-company transactions, Article 66-4 of the Special Taxation Measures Law (“STML”) does not apply. There are differences between intercompany transactions and intra-company transactions for the statute of limitation, presumptive assessment and documentation requirements for transfer pricing purposes. In light of the tax reform, the transfer pricing rule will become applicable to intra-company transactions in the same way as intercompany transactions. Article 66-4-3 of the STML was introduced as a set of transfer pricing rules applied to intra-company transactions, is identical to Article 66-4 and the same rules for the statute of limitation, presumptive assessment and documentation requirement are applied to intra-company transactions.

Transfer pricing documentation must be submitted without delay when requested. Failure to comply may result in the tax authorities assessing tax by presumptive assessment. Transfer pricing documentation includes documents describing intra- company transactions and documents describing arm's length pricing for intra-company transactions.

Documents describing intra-company transactions may include:

• documents describing details of assets and services in intra-company transactions;

• documents describing functions performed and risks assumed by head office etc. and the PE;

• documents describing intangible assets and tangible assets utilized by head office etc. and PE;

• contracts or equivalent documents describing transfer of assets, provision of services or other facts;

• documents describing the method for determining intra-company transactions pricing and negotiations for this;

• documents describing market analysis of intra-company transactions;

• documents describing the business policy of a foreign corporation, businesses of head office etc. and the PE; and

• documents describing other transactions (including other intra-company transactions) closely connected with the intra-company transaction and that transaction's contents.

PE transactions documentation

The PE is required to prepare and maintain documentation about transactions with third parties and intra-company transactions7.

Third party transactions documentation8

The PE is required to prepare the following documents describing:

• contents of transactions attributable to the PE (“PE attributable intercompany transactions”);

• details of assets and liabilities the PE and head offices etc utilize for PE attributable intercompany transactions;

• people's roles on functions (risks) performed and controlled by the PE and head office etc. in PE attributable intercompany transactions, people's roles and other functions in assets attribution and risks related to these; and

• departments and business of departments engaged in functions performed in PE attributable intercompany transactions.

Intra-company transactions9 documentation

The PE is required to prepare the following:

• orders, contracts, shipping documention, receipts, price estimates, equivalent documents or copies of these describing intra-company transactions such as transfer of assets, provision of services etc. and other information;

• documents describing the details of assets and liabilities the PE and head offices etc utilize for intra company transaction;

•  documents describing people's roles on functions (risks) performed and controlled by the PE and head office etc. in intra-company transactions, people's roles and other functions in asset attribution and risks related to these;

•  documents describing departments and business of departments engaged in intra-company transactions; and

• documents evidencing facts related to intra-company transactions (facts relating to transfer of assets, provision of services or other intra-company transactions).

Actions Required

Under the new AOA rules, compliance requirements for the PE of a foreign corporation have significantly increased. Affected companies are recommended to review the current status of changes and prepare timelines to satisfy requirements in time.

Yoichi Ishizuka,
Head of Tax Grant Thornton, Japan 
Email: yoichi.ishizuka@jp.gt.com 

NOTES

1 Article 142-4 CTL

2 Article 144 CTL

3 Article 176(3)(ii) of the Corporation Tax Law Enforcement Ordinance (“CTLEO”) 

4 Article 138(2) CTLEO

5 Article 66-4 of the Special Taxation Measures Law (“STML”)

6 Article 22-10-3(1) of Special Taxation Measures Law Enforcement Regulation (“STMLER”)

7 Article 146-2 of CTL

8 Article 62-2 of Corporation Tax Law Enforcement Regulation (“CTLER”)

9 Article 62-3 of CTLER