The Critical Importance of Foreign Related Party Concepts in Transfer Pricing Regulations
One of the most crucial concepts in transfer pricing regulations is the determination of “foreign related parties.” This determination is a vital element directly connected to corporate tax compliance and requires precise understanding. Whether an entity qualifies as a foreign related party determines which transactions fall under transfer pricing regulations, significantly impacting companies’ international transaction strategies.
This article provides detailed explanations of foreign related party determination criteria from both formal and substantive perspectives, introducing practical points of attention with specific case examples.
Basic Definition and Importance of Foreign Related Parties
A foreign related party refers to a foreign corporation that has a special relationship with a Japanese corporation, such as shareholding relationships of 50% or more or substantial control relationships. This definition serves as the criterion for determining the scope of transfer pricing regulation application and becomes the starting point for judging whether transaction prices between companies are appropriate.
The importance of foreign related party determination lies in the fact that the purpose of transfer pricing regulations is to prevent tax burden reduction through arbitrary pricing in transactions between entities with such relationships (foreign related party transactions). Between companies with parent-subsidiary or sister relationships, transactions may occur at prices that would not be established between independent third parties, making tax authorities particularly vigilant.
During determination, fact verification is conducted through documents such as annual reports, securities reports, capital structure diagrams, officer lists, secondment orders, loan agreements, and approval documents. These documents serve as important evidence during tax audits, requiring appropriate management and maintenance.
Foreign Related Party Determination Based on Formal Criteria
Formal criteria provide clear and objective determination standards based on shareholding relationships. Under these criteria, entities are determined as foreign related parties when shareholding relationships of 50% or more exist. Specifically, the following three patterns apply.
Parent-Subsidiary Relationship: When a Japanese corporation directly holds 50% or more of shares in an overseas corporation. This is the most typical case, arising when Japanese parent companies establish or acquire overseas subsidiaries.
Grandparent-Grandchild Relationship: When a Japanese corporation holds 50% or more shares in overseas corporation A, and overseas corporation A holds 50% or more shares in another overseas corporation B, overseas corporation B also becomes a foreign related party of the Japanese corporation. This concept of indirect ownership is an important notion reflecting substantial control relationships.
Sister Relationship: When there is no direct shareholding relationship between a Japanese corporation and an overseas corporation, but both companies are 50% or more owned by the same corporation or individual. In this case, being under common control is judged as having a substantial related relationship.
In calculating ownership percentages, direct and indirect ownership are combined for judgment. For example, if a Japanese corporation directly holds 40% of foreign corporation B’s shares while simultaneously owning 10% through foreign corporation A (which the Japanese corporation owns 50% of), the total becomes 50% (40% + 10%), making foreign corporation B a foreign related party.
Control Relationship Determination Based on Substantive Criteria
Substantive criteria are standards that determine foreign related parties based on substantial control relationships even when shareholding percentages are less than 50%. These criteria are established to capture substantial control relationships that cannot be grasped through formal shareholding relationships alone.
Officer Dependency Relationship: When half or more of the foreign corporation’s officers or its representative are dispatched from the Japanese corporation. Even with a 49% shareholding percentage, if management is dispatched from Japan, it is judged as being substantially under Japanese corporation control. This criterion recognizes substantial control relationships through personnel control.
Business Dependency Relationship: When the foreign corporation depends on the Japanese corporation for a substantial portion of its business activities. Specific examples include cases where manufacturing is impossible without technical licensing from the Japanese corporation, or products cannot be completed without parts supplied by the Japanese corporation.
Financial Dependency Relationship: When the foreign corporation depends on the Japanese corporation for a substantial portion of its financing. This applies when there is a relationship where business continuity would become difficult if funding provision from the Japanese corporation were to stop.
Intangible Asset Dependency Relationship: When the foreign corporation conducts business activities depending on intangible assets such as copyrights, industrial property rights, and know-how provided by the Japanese corporation. These intangible assets often become sources of competitive advantage in modern business, and their dependency relationships serve as important indicators of substantial control relationships.
Understanding Deemed Foreign Related Party Transactions and Practical Response
Deemed foreign related party transactions are transactions that appear to be with third parties but substantially have the same economic reality as transactions with foreign related parties, making them subject to transfer pricing regulations. This system requires appropriate pricing even for transactions that formally go through third parties.
A typical case involves apparel product import transactions. This occurs when a Japanese subsidiary purchases apparel products from a foreign parent company through an import general agent (third party) due to customs and clearance convenience. In this case, the import general agent is a third party without shareholding relationships, but if the following conditions are met, it constitutes a deemed foreign related party transaction.
First, in the contract between the foreign parent company and the import general agent, it must be predetermined that apparel products will be sold from the import general agent to the Japanese subsidiary. Second, regarding apparel product pricing, the import general agent must not be involved, with prices substantially determined between the foreign parent company and Japanese subsidiary.
In such transaction structures, even though an import general agent as a formal third party is involved, the price determination process and product flow are substantially the same as direct transactions between parent and subsidiary companies, making them subject to transfer pricing regulations. Companies must not neglect transfer pricing considerations when adopting such transaction structures.
Special Considerations for Joint Ventures
Joint venture treatment becomes a particularly complex issue in foreign related party determination. For example, in the case of a joint venture with 50% investment by a Japanese corporation and 50% by a local corporation, it formally qualifies as a foreign related party of the Japanese corporation, but in actual operations, price negotiations with the joint venture partner local corporation are often necessary, possessing characteristics close to transactions with independent third parties.
To address this issue, the Transfer Pricing Administrative Guidelines stipulate that “when a foreign related party is established through joint investment by multiple parties, transfer pricing investigations should be conducted considering that negotiations regarding transaction conditions for foreign related party transactions and negotiations considering the arm’s length principle in such negotiations may occur.”
However, facts such as merely “conducting strict price negotiations to determine transaction prices” or “parties other than the concerned parties becoming negotiating parties for transaction conditions” alone do not serve as grounds for not qualifying as foreign related parties, with considerably high hurdles established in actual operation.
Important Practical Considerations
There are several important points requiring attention in foreign related party determination practice. First, regarding determination timing, judgment based on circumstances at the time each transaction occurs is the basic principle. Since corporate shareholder composition and officer composition change over time, accurately grasping relationships at each transaction point is important.
International differences also require attention. While Japan determines foreign related parties based on 50% or more shareholding, some countries adopt 25%, and some have no clear standards. Therefore, even if an entity does not qualify as a foreign related party from Japan’s perspective, the Japanese corporation may qualify as a foreign related party from the counterpart country’s perspective, requiring understanding of treatment differences between countries.
Differences in calculation methods from the controlled foreign company (CFC) rules are also important points. Transfer pricing regulations calculate indirect ownership relationships through simple addition, while CFC rules adopt a multiplication method. Furthermore, transfer pricing regulations judge based on 50% or more (inclusive), while CFC rules judge based on over 50% (exclusive), requiring attention to avoid confusion.
Conclusion
Foreign related party determination is the most fundamental and important element in transfer pricing regulation application. Accurate understanding of shareholding relationship determination through formal criteria and control relationship determination through substantive criteria is required, along with comprehensive judgment including the concept of deemed foreign related party transactions.
For companies, careful examination of foreign related party applicability before beginning international transactions is essential, and when applicable, appropriate pricing and documentation based on transfer pricing regulations are indispensable. Additionally, when relationships change due to organizational restructuring or investment ratio changes, reviewing determinations each time is also important. Through appropriate determination and response, companies can achieve both tax risk minimization and efficient international business operations.
