CFO Insights 2020 May

COVID-19’s impact on transfer pricing in Japan

CFO Insights is a monthly publication to deliver an easily digestible and regular stream of perspectives on the challenges confronting CFOs. In this article, we focus on COVID-19’s potential implications on Japan transfer pricing.

The COVID-19 (novel coronavirus) pandemic continues to cause serious disruption globally, impacting vital components of the economy, such as production, the supply chain, consumption, and financial markets.

Many industries and business sectors are experiencing serious impact, and global markets are volatile. It is in this context that global multinationals are considering how a downturn may affect their tax and transfer pricing positions.

In Japan, the government has taken tax relief measures in response to the outbreak. For example, companies satisfying certain conditions will be granted an interest-free tax payment deferral for one year (without the need for collateral).

At the date of writing, no public announcement has been made with respect to measures specifically relating to transfer pricing.

Impact on taxpayers

While the reach of the pandemic is global in nature, certain industries and businesses are likely to be more sensitive to an economic downturn.

For example, businesses that typically involve a higher ratio of fixed costs may be expected to be more affected than those with a greater proportion of variable costs. Industries with large fixed costs, such as manufacturing, are likely to experience significant implications. Distributors also are likely to be impacted, to the extent that they need to sell a certain volume to cover fixed costs.

In Japan, given the extremely robust labor laws leading to a less flexible workforce scale, employees’ labor costs may be considered akin to a long-term fixed cost for a business. Depending on the length of the outbreak, businesses with large permanent employee workforces, and businesses with large capital or labor costs may be substantially affected.

Impact on “limited risk” transfer pricing models

Many foreign multinationals operating in Japan use “limited-risk” models based on the transactional net margin method (TNMM) of pricing. Limited-risk pricing models are often considered to give taxpayers a “guaranteed return” for their activities, benchmarked against the profit margins of comparable companies in the Japanese market. However, foreign tax authorities and taxpayers may question the outcome of such pricing models in the event of a significant market downturn resulting from COVID-19.

At a high level, the impact of such a market downturn may likely depend on the risk profile of the Japanese subsidiary. For example, a typical limited-risk distributor may be exposed to certain market risks that may result in a loss of revenue streams. If the Japanese distributor is responsible for managing and controlling its fixed costs, it may be exposed to such risk to the extent of those fixed costs.

In order to form a view on the impact of the coronavirus outbreak on a particular Japanese subsidiary, the taxpayer would need to consider its analysis of the risk profile of the subsidiary. Any analysis of risk should start with the terms of the intercompany contract. Taxpayers should review their intercompany contracts as part of their analysis of the risk profile of the Japanese subsidiary. For companies that do not have intercompany contracts, taxpayers may wish to look at their course of dealings over the past few years.

Impact on funding

The pandemic is also likely to cause significant impact on near term liquidity. Depending on the financing structure of the taxpayer, this could raise several questions from a tax and transfer pricing perspective.

For example:

  • Taxpayers using intercompany funding for liquidity may see an increase in intercompany debt levels. This could cause a taxpayer to breach thin capitalization limits or earnings stripping rules, and could also result in an increase in uncertainty with respect to the arm’s length nature of the amount of debt.
  • Setting of prices of debt during the pandemic would need to take into consideration market price volatility, liquidity and interest rate risk. Pricing decisions made during the pandemic should be strongly supported with benchmarking analyses and documenting why and how decisions are made.

Subsidiaries facing liquidity shortage may seek to defer interest payments or restructure loans. The tax and transfer pricing consequences should be considered in advance of any restructuring or deferral of interest payments. In addition, documenting why and how decisions are made during the crisis period would be essential to future audit defense files.

Practical considerations

Japanese taxpayers typically approach compliance and risk management through the use of an advance pricing agreement (APA) or a “document-and-defend” strategy (that is, preparing annual transfer pricing documentation to use as a basis for defense in the event of a potential future audit). The practical considerations of the above issues for both strategies are described below. 

Transfer pricing documentation

For taxpayers following a document-and-defend strategy, the documentation should be consistent with the outcomes of the risk analysis described above. To the extent that the local entity experiences a significant reduction in profit margin or is in a loss position, an additional explanation and support for this outcome should be provided. Further, the industry analysis typically included in transfer pricing documentation may become a more central aspect of the analysis and documentation strategy in the coming years.

In terms of economic analysis, taxpayers may need to consider the need for adjustments to support the results of their subsidiaries, or interest rates on intercompany funding. Taxpayers may wish to review the robustness of their existing Japanese benchmarking studies and consider refining their benchmarking strategy if needed.

Finally, depending on the taxpayer’s transfer pricing policy, significant year-end adjustments may be necessary during a major market downturn. It is important that the mechanism for such adjustments are contained in an intercompany contract and supported in the transfer pricing documentation.

Taxpayers with APAs

In principle, taxpayers that have APAs should continue to follow the agreed upon outcome under the APA and generally would be expected to be shielded from the impact of the issues described above.

However, APAs generally include a set of “critical assumptions,” the conditions on which the agreement is based. Critical assumptions often contain items such as significant changes to economic conditions and fundamental changes in the conditions of a particular industry. When a critical assumption is not met, the taxpayer and the revenue authority may agree to continue to honor the APA, revise the APA, or cancel the APA.

In this context, taxpayers that have an APA should review the terms included as critical assumptions and assess whether the current pandemic could trigger a discussion with the revenue authority to revise or cancel the APA. In the event that a critical assumption has been triggered, taxpayers should consider working with their advisors to initiate contact with the relevant revenue authorities.

If you would like more information, please speak to our Deloitte subject matter specialists Sam Gordon ( and Luke Tanner (

Additional resources

Deloitte Global CFO Insights:

Exploring the questions and options CFOs can consider as they seek to boost their function’s resiliency by mastering the virtual financial close

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