Tax controversy update vol. 12 - Revision of adjustment method for differences

The tax reform of FY2019 stated that "when calculating the transfer price in reference to the profitability of comparable transactions where adjustments cannot be made due to the differences being difficult to quantify, adjustments can be made using an inter-quartile range (the quartile method)."

1 Background of the revision

The World Family Case (Tokyo District Court Case, 11 April 2015) is case in which the adjustment method of differences was a topic. Below is an overview of the case:

① Relevant adjustments for differences need not be made if it is not objectively clear that the differences will affect the calculation of the normal profit margin.

② Relevant adjustments for differences must be made if it is objectively clear that the differences will affect the calculation of the normal profit margin.

i. If the extent of the variance in gross profit margin arising from the differences is clear and appropriate adjustments can be made, the arm's length price can be calculated using the ratio after making the necessary adjustments to the variance in gross profit margin.

ii. If the extent of the variance in gross profit margin arising from the differences is unclear, and appropriate adjustments cannot be made, the arm's length price cannot be determined based on those comparable transactions.

With regard to ②ii above, the tax reform of FY2019 made it possible to calculate the arm's length price if the adjustment for differences can be covered through the use of the quartile method, even when the difference cannot be quantified. This change could be seen as the tax authorities giving themselves a new right to taxation.

2 Questions concerning the revision

(1) Section 4-5 (1) of the Commissioner’s Directive on the Operation of Transfer Pricing stipulates that "adjustment to the median value can be made when there is a difference that is difficult to understand quantitatively even after making adjustments as described in Sections 4-4 (1) to (4), and when the impact of the difference on the adjusted ratio is deemed to be minor." (underlining by EY for emphasis). However, it would seem difficult to determine whether or not the impact is minor for differences that are difficult to identify quantitatively.

(2) Paragraph 3.57 of the OECD Transfer Pricing Guidelines cited in the explanation of the FY2019 revisions states: “It may also be the case that, while every effort has been made to exclude points that have a lesser degree of comparability, what is arrived at is a range of figures for which it is considered, given the process used for selecting comparables and limitations in information available on comparables, that some comparability defects remain that cannot be identified and/or quantified, and are therefore not adjusted. In such cases, if the range includes a sizeable number of observations, statistical tools that take account of central tendency to narrow the range (e.g. the interquartile range or other percentiles) might help to enhance the reliability of the analysis.” This section of the OECD Guidelines was likely the basis for the revisions at hand. However, according to Section 4-6 of the Commissioner’s Directive on the Operation of Transfer Pricing, methods based on a quartile method are to be applied to the adjusted ratios of four or more comparable transactions. This seems to overlook the above underlined portion regarding the assumptions for the use of statistical tools.

(3) The application of the quartile method may improve the reliability of the range by eliminating outliers. On the other hand, while the impact on the profit margin of the comparable transactions may be positive or negative when adjusting for differences, the median value is used when making adjustments with the quartile method. In the absence of meeting criteria to apply statistical methods (e.g, a sufficient sample size), and from simply an intuitive standpoint, the quartile method does not seem well-suited for making adjustments to differences in an arm's length price calculation.

(4) According to Section 4-6 of the Commissioner’s Directive on the Operation of Transfer Pricing, calculations using a method based on the quartile method employ data points rather than form a range, but transfer pricing taxation will not be assessed if an actual value falls within the range.
This in effect permits the treatment in the following citation from the Act on Special Measures Concerning Taxation also applies for the interquartile range. However, while the values that make up the range in the treatment described in Section 66-4(3)-4 below are considered to be comparable transactions, only median values can be comparable transactions in the treatment described in Section 4-6 of the Commissioner’s Directive on the Operation of Transfer Pricing. Therefore, it may be a leap of faith to say that transfer pricing taxation does not apply when an actual value exists within the interquartile range.

Section 66-4(3)-4 of the Act on Special Measures Concerning Taxation When there are multiple comparable transactions to the foreign related transaction and the arm’s length price is established within a fixed range, and if the amount of compensation for that foreign related transaction falls within that range, care should still be taken whether the provisions of Article 66-4(1) of the Act on Special Measures Concerning Taxation do not apply.

* Please note the opinions expressed in this article are solely those of the author and do not represent the opinions or views of EY Tax Co.