When a financial group moves trades between its entities, the price of those trades splits income between Japanese and foreign companies. In some situations, that price is checked against an arm's length level.

What transfer pricing decides

Companies in the same group can set the price of their dealings internally. That price changes each country's company income, so how it is set shifts how much income is taxed in which country. This price is the transfer price, and tax authorities check it against the price that unrelated parties would have set.

The standard for that comparison is the arm's length principle. The OECD Transfer Pricing Guidelines (the guidelines) base the principle on the article of the Model Tax Convention that deals with transactions between associated enterprises. The principle treats the members of a group as separate entities, not as inseparable parts of a single business. It looks at whether the terms of the transactions between them differ from the terms of comparable transactions between unrelated parties1.

For the general taxation of gains and losses, see Taxation of Derivative Gains and Losses.

Where Japan's transfer pricing rules adjust income

Article 66-4 of Japan's Act on Special Measures Concerning Taxation applies when a company transacts with a foreign related party. A foreign related party is a foreign corporation in a special relationship specified by cabinet order, such as one where one side holds 50% or more of the other's issued shares directly or indirectly2.

Suppose the consideration a company receives from a foreign related party falls short of the arm's length price, or the consideration it pays to one exceeds that price. In that case, the transaction is deemed to have been made at the arm's length price when corporation tax income is computed2. The difference between the consideration and the arm's length price is not deductible, except for the part that counts as a donation3. Only prices that push the Japanese company's income below the arm's length level fall under this rule.

The arm's length price is the amount calculated by the most appropriate method, taking into account the content of the transaction and the functions the parties perform. That method finds the consideration that would have been set on ordinary terms between independent businesses. For sales and purchases of inventory, the statute lists the comparable uncontrolled price method, the resale price method, the cost plus method, and methods similar to these. For other transactions, it lists equivalent methods4.

A foreign corporation that is a foreign related party may have a permanent establishment (PE) in Japan. Among the transactions related to the foreign corporation's Japan-source income attributable to the PE, those specified by cabinet order are excluded from the foreign related-party transactions covered by Article 66-42.

Under the Corporation Tax Act, a PE is a place of business such as a branch or factory that a foreign corporation has in Japan, a place of construction or installation work, or a person with authority to conclude contracts for the foreign corporation. Where a tax treaty provides otherwise, the treaty's provision takes precedence5.

When a foreign corporation does business in Japan through a PE, the income attributable to the PE is determined by asking how the PE would be treated if it were a business operating independently of the foreign corporation. The functions the PE performs, the assets it uses, and its internal transactions with the head office are taken into account6. An internal transaction is a fact, such as a transfer of assets or a provision of services between the PE and the head office, that would be recognized as a sale, purchase, provision of services, or similar transaction if the same fact occurred between independent businesses7.

This provision concerns the income of a foreign corporation that has a PE in Japan. For a PE such as a branch and its head office, the rule that considers internal transactions applies instead of Article 66-4.

Financial transactions and intragroup hedging

The National Tax Agency's directive covers financial transactions. The directive is the operating guideline that tax offices and regional taxation bureaus follow when they carry out transfer pricing examinations and advance confirmations. In an examination of a financial transaction such as a loan, the examiner checks details such as the currency, timing, and term. The group's financial activities, such as managing foreign exchange risk and raising and investing funds, are also examined8.

When it is hard to find a comparable transaction among actual transactions, a transaction in the same situation can be assumed and used for comparison, based on an objective indicator drawn from actual transactions, such as a financial market interest rate. A rate quoted by a bank on inquiry does not count as such an indicator9.

Chapter X of the guidelines also covers intragroup hedging. When a group centralizes hedging in a treasury function and the treasury arranges a hedging contract for an operating entity, the treasury can be seen as providing a service to that entity. The treasury should receive compensation on arm's length terms10.

When the treasury or another group entity enters into the hedging contract and the payments do not offset within the same entity, the guidelines say it would be inappropriate to match hedges across entities as if they were within one entity without analysis. The same applies to natural hedges, where no contract exists. An analysis of the accurate delineation of the actual transactions and of their commercial rationality is needed first11.

Pricing back-to-back trades

The following example differs from the hedging arrangement the guidelines describe. A Japanese company transfers a trade it made with a client to a booking entity in the group on the same terms. The mechanism is explained in Intragroup Back-to-Back Trades. This section looks only at how the fixed rate set on the intragroup trade splits income between the two companies.

Consider a hypothetical example in which W Co., a Japanese company, enters into a three-year interest rate swap with a corporate client, with a notional amount of 10 billion yen. The client pays a fixed rate of 1.10% and receives a floating rate. W Co. enters into an offsetting swap with its wholly owned foreign subsidiary (the booking entity), with the same notional amount and term, paying a fixed rate and receiving a floating rate. The floating-rate payments are the same on both trades, so they cancel out at W Co. What remains with W Co. is only the difference between the fixed rate it receives from the client and the fixed rate it pays to the booking entity. This page calls that difference the amount that remains with W Co. In this example, the booking entity takes on the market risk of the swap, and part of the net payment is compensation for that. The example does not split out that amount.

ClientCompanyW Co.In JapanBooking entityForeign subsidiaryFixed 1.10%FloatingFixed 1.05%Floating
Figure 1Interest rate swap payments among the client, W Co., and the booking entity (when the fixed rate paid to the booking entity is 1.05%)
Figure description

The client pays W Co. a fixed rate of 1.10% and receives the floating rate from W Co. W Co. pays the booking entity a fixed rate of 1.05% and receives the floating rate from the booking entity. W Co. passes the floating rate it receives straight on to the client. What remains with W Co. is the 0.05% difference between the fixed rates, which on a notional amount of 10 billion yen is 5 million yen a year. The booking entity receives the fixed rate of 1.05% and pays the floating rate.

In this example, the amount that should remain with W Co. at the arm's length level is set at 0.05% of the notional amount. This value is set for the example. It was not calculated by a method under Article 66-4, and the example skips the step of deriving it from comparables. The fixed rate that corresponds to the arm's length price is 1.05%, which is the 1.10% received from the client minus 0.05%. The table below shows the yearly amounts for three fixed rates that W Co. could pay the booking entity. It treats the fixed rate itself as the level of consideration that W Co. pays to the foreign related party.

Case Fixed rate W Co. pays the booking entity Amount remaining with W Co. per year Difference from the arm's length price (1.05%) Treatment under Article 66-4, paragraph 1
A 1.05% (105 million yen) 5 million yen None No adjustment
B 1.08% (108 million yen) 2 million yen W Co.'s income is 3 million yen lower The consideration paid exceeds the arm's length price, so the transaction is deemed to have been made at the arm's length price
C 1.02% (102 million yen) 8 million yen W Co.'s income is 3 million yen higher Not covered by the rule

In Case B, W Co. pays the booking entity 3 million yen more, and the amount remaining with W Co. is 3 million yen below the arm's length level. In Japan, the transaction is deemed to have been made at 1.05%, and the 3 million yen difference is not deductible. If the foreign country also taxes the 3 million yen it received, the same income is taxed twice across borders. A shared understanding among the tax authorities of the countries involved is important for resolving this double taxation12. In Case C, the consideration W Co. receives does not fall short and the consideration it pays does not exceed the arm's length price, so the Japanese rule does not apply. From the booking entity's country, the fixed rate the booking entity receives is 3 million yen lower. How that country treats it is outside the scope of this article.

Assumptions and limits of the example

The back-to-back example is simplified to show the idea. It treats the fixed rate as the level of consideration W Co. pays to the foreign related party, and it first sets the amount that should remain with W Co. and works backward from it to the arm's length price. An actual calculation uses the most appropriate method, taking into account the content of the transaction and the functions performed. The example does not split out how much of the net payment is compensation for the risk the booking entity takes on, and it does not derive that amount from comparables.

This simplification holds only if certain conditions are met. For example, if the floating-rate terms of the two trades drift apart, the payments no longer cancel out at W Co., and what remains is no longer only the difference between the fixed rates. If the risk the booking entity takes on differs from what the example assumes, the compensation for that risk changes too, so the fixed rate that corresponds to the arm's length price could be a level other than 1.05%.

Allocating profit in global trading

The guidelines say that in some cases the parties perform functions jointly, use assets jointly, or share the assumption of risks. Their contributions can then be impossible to evaluate in isolation. Global trading of financial instruments by associated enterprises is given as an example, and the transactional profit split method can be applied to it13.

An example of a profit splitting factor is the compensation of employees involved in the key functions that create value for the transaction, and the guidelines use global trading as the example. The list is not exhaustive. Other factors are acceptable if they produce arm's length outcomes for all relevant parties14.

What is described here is one approach the guidelines present. Which approach is appropriate depends on the facts about functions, assets, and risks. When choosing a method, the strengths and weaknesses of each method, the availability of reliable information, and the degree of comparability are also considered, in addition to the functional analysis15.

Documentation and advance confirmation

A company that has carried out a foreign related-party transaction must prepare or obtain, and keep, the documents recognized as necessary for calculating the arm's length price. It must do so by the filing deadline of the final tax return for that business year. The documents are set by Ministry of Finance ordinance. The company has no duty to prepare them if both of the following held in the previous business year. First, the total of payments and receipts of consideration for foreign related-party transactions with a single foreign related party was under 5 billion yen. Second, the total for transactions that are transfers or leases of intangible assets was under 300 million yen. Cases such as when there was no previous business year are set by cabinet order16.

Japan also has reporting at the level of the whole group. A multinational group whose total revenue in the most recent ultimate parent fiscal year was 100 billion yen or more is called a specified multinational enterprise group. Among domestic corporations that are constituent companies of such a group, the one that is the ultimate parent entity or a surrogate parent entity provides the country-by-country report items to the director of the tax office. It does so within one year from the day after the end of that fiscal year17. A domestic corporation that is a constituent company provides the master file items (the business overview report items) within the same one year. This is not limited to the ultimate parent entity or surrogate parent entity18.

As a standard for documentation in each country, the guidelines name three tiers. A master file carries information on the whole group. A local file carries the material transactions of the local company. A country-by-country report carries income and tax paid by country20.

Advance confirmation is when the director of a tax office or a regional taxation bureau confirms in advance the method for calculating the arm's length price of a foreign related-party transaction and the specific content of that method21. Its purpose is to secure predictability for companies and to make the enforcement of the transfer pricing rules smoother12.

A company applies for advance confirmation by submitting an application to the competent director of the tax office or similar authority, by the first day of the first business year covered. The application states the transactions to be confirmed, the foreign related party, the method for calculating the arm's length price, and so on. A company that has not held a preliminary consultation is guided to hold one first22. The application is accompanied by documents such as the flow of the transaction, the functions each company performs, the risks borne, the assets used, and an explanation of the calculation method and why it is the most appropriate method23.

In the guidelines, an APA (advance pricing arrangement) is an arrangement that determines, in advance of controlled transactions, a set of criteria for setting the transfer pricing of those transactions over a fixed period. The criteria are the method, comparables and adjustments, and critical assumptions as to future events. It is initiated by a taxpayer and negotiated among the taxpayer, one or more associated enterprises, and one or more tax administrations24.

What this article does not cover

The following are not covered on this page.

  • Whether derivative transactions fall under inventory transactions or other transactions in Article 66-4, paragraph 2, and which method calculates their arm's length price
  • How far the directive's statements on financial transactions can be used to compare derivative transactions
  • When the profit split method and other methods can be used, and which transactions can use advance confirmation
  • The treatment of the income of a branch (PE) that a Japanese company keeps abroad
  • The details of the cabinet order that defines foreign related parties, and the procedure for corresponding adjustments
  • Profit allocation in global trading other than where the contributions are so joint that they cannot be valued separately, and the ranking of the approaches
  • The transfer pricing rules of countries other than Japan, and the mutual agreement procedure under tax treaties
  • Application to any individual transaction

Notes

  1. OECD, "OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022", Chapter I, paragraph 1.6 (PDF page 33). The wording of Article 9, paragraph 1 of the Model Tax Convention and the separate entity approach. ↩

  2. Act on Special Measures Concerning Taxation (租税特別措置法), Article 66-4, paragraph 1 (the version in force from October 1, 2026; in Japanese). The definition of a foreign related party, the comparison of consideration with the arm's length price, and the deeming rule. It also covers the transactions excluded from foreign related-party transactions (those specified by cabinet order among the transactions related to income under Article 141, item 1 (a) of the Corporation Tax Act). "Foreign related party" is a translation of 国外関連者. ↩ ↩2 ↩3

  3. Act on Special Measures Concerning Taxation, Article 66-4, paragraph 4. Amounts that count as donations are treated separately under paragraph 3 of the same Article. ↩

  4. Act on Special Measures Concerning Taxation, Article 66-4, paragraph 2, item 1 (sales or purchases of inventory: (a) comparable uncontrolled price method, (b) resale price method, (c) cost plus method, (d) methods similar to these and other methods specified by cabinet order) and item 2 (other transactions: methods equivalent to those in item 1 (a) to (d)). ↩

  5. Corporation Tax Act (法人税法), Article 2, item 12-19 (permanent establishment), (a), (b), (c), and the proviso (in Japanese). ↩

  6. Corporation Tax Act, Article 138, paragraph 1, item 1. ↩

  7. Corporation Tax Act, Article 138, paragraph 2. ↩

  8. National Tax Agency, "移転価格事務運営要領" (in Japanese. An attachment to the directive of June 1, 2001, including the amendment of June 10, 2022; the version retrieved on October 5, 2026), Chapter 3, 3-7, the main text and (3). ↩

  9. National Tax Agency, "移転価格事務運営要領" (in Japanese), Chapter 3, 3-8 (1) and (5). ↩

  10. OECD, "OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022", Chapter X, paragraphs 10.149 to 10.152 (printed pages 432–433, PDF pages 434–435). ↩

  11. OECD, the same guidelines, Chapter X, paragraph 10.153 (printed page 433, PDF page 435). Section D.1 of Chapter I covers the accurate delineation of the actual transaction, and Section D.2 the commercial rationality of the transaction. ↩

  12. National Tax Agency, "移転価格事務運営要領" (in Japanese), Chapter 1, 1-2 (2) and (3). ↩ ↩2

  13. OECD, "OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022", Chapter II, paragraph 2.134 (PDF page 135). For the global trading example, the paragraph refers to Part III, Section C of the 2010 "Report on the Attribution of Profits to Permanent Establishments". ↩

  14. OECD, the same guidelines, Chapter II, paragraph 2.172 (printed page 143, PDF page 145). ↩

  15. OECD, the same guidelines, Chapter II, paragraph 2.2 (printed page 93, PDF page 95). As matters to consider in choosing a method, it lists the strengths and weaknesses of each method, the nature of the transaction as seen in the functional analysis, the availability of reliable information, and the degree of comparability. ↩

  16. Act on Special Measures Concerning Taxation, Article 66-4, paragraph 6 (preparing or obtaining, and keeping, documents) and paragraph 7 (exemption when the previous business year's total payments and receipts of consideration for foreign related-party transactions were under 5 billion yen, and for intangible asset transactions under 300 million yen; cabinet order for cases such as no previous business year). ↩

  17. Act on Special Measures Concerning Taxation, Article 66-4-4, paragraph 1 (the deadline for providing the country-by-country report items) and paragraph 4, item 3 (specified multinational enterprise group; total revenue of 100 billion yen or more, as an amount set by Ministry of Finance ordinance). "Country-by-country report items," "specified multinational enterprise group," "ultimate parent entity," and "surrogate parent entity" are translations of the Act's Japanese terms. ↩

  18. Act on Special Measures Concerning Taxation, Article 66-4-5, paragraph 1 (the deadline for providing the master file items, called business overview report items in the Act). "Master file items" is a translation. ↩

  19. Act on Special Measures Concerning Taxation, Article 66-4, paragraph 12 (designated dates of 45 days and 60 days; the methods of presumption are in items 1 and 2). "Contemporaneous documentation" is a translation of 同時文書化. ↩

  20. OECD, "OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022", Chapter V, paragraph 5.16 (printed page 231, PDF page 233). ↩

  21. National Tax Agency, "移転価格事務運営要領" (in Japanese), Chapter 1, 1-1 (40) (advance confirmation). "Advance confirmation" is a translation of 事前確認. ↩

  22. National Tax Agency, "移転価格事務運営要領" (in Japanese), Chapter 6, 6-2 (1) and (2). ↩

  23. National Tax Agency, "移転価格事務運営要領" (in Japanese), Chapter 6, 6-3 (1) (a) to (d). ↩

  24. OECD, "OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022", Chapter IV, paragraph 4.134 (printed page 213, PDF page 215). ↩