Intercompany management fees and recharges
October 23, 2020 18:08PM by Chris Bowd, 5426 views
Most foreign companies with balanced financial strategies charge intercompany management fees and recharge various expenses to their Japanese subsidiary company or office; some to such an extent the Japanese subsidiary company or office consistently makes a losses or minimal profits. Although it’s understandable that foreign company CFOs want to minimize taxable income in a relatively high tax jurisdiction such as Japan, and justified intercompany management fees and recharges to their Japanese subsidiary company or office are one way to achieve such an outcome, the National Tax Agency’s transfer pricing auditors are constantly looking for companies exploiting intercompany management fees and recharges to to their Japanese subsidiary company or office in this way. If your company’s Japanese subsidiary company or office made unexpectedly high profits, and your CFO instructed you to create some intercompany management fees or recharges to eliminate the profit, there are some basic rules you must follow if you want to avoid the National Tax Agency auditors, a potentially very expensive multi-month audit, and tax penalties.
Rule 1. Issue monthly intercompany invoices (not a single yearend aggregated one-liner). The National Tax Agency is very unlikely to accept without question a “last day of the financial year” intercompany invoice in a Japanese subsidiary company or office’s financial statements with a one-line “intercompany management fees and recharges” fee. This is especially a problem if the invoice almost cancels (minimal profit), exactly cancels (breakeven), or more than cancels (loss) the Japanese company’s taxable income. There are some Japanese accountants (会計士) and tax accountants (税理士) who seem to take an “I’m not the client’s representative director, so I’ll just let them dig themselves into an audit hole” view, and allow such an invoice in the final financial statements and tax-returns. Problems can then arise, because part of a standard Japanese corporate tax-return is a simple one-line summary of monthly expenses, in which a spike in expenses in month 12 can cause the National Tax Agency’s automated system to flag the tax-return for a manual review. Three months later, when the National Tax Agency calls to start an audit, the same tax accountant will happily tell you his or her fee for attending tax audits is JPY120,000 a day (or much more) plus consumption tax. To avoid an unnecessary audit, intercompany management fees and recharges should be calculated and invoiced to to the Japanese subsidiary company or office on a monthly basis. This is not a tax avoidance tip, because if your company invoices excessive intercompany management fees and recharges to its Japanese subsidiary company or office, regardless of spreading the fees over the full financial year the National Tax Agency’s sophisticated algorithms will still detect a potential issue and trigger a manual review. Of course, if such a “last day of the financial year” intercompany fees invoice is supported with justifiable arm’s length fee calculations, the National Tax Agency will accept it, although an auditor might still call to validate the charges.
Rule 2. Issue detailed intercompany invoices with exhibits describing the fees (not one-liners with no explanation). When a Japanese tax accountant files a Japanese subsidiary company or office’s corporate tax-return and financial statements, he or she must attach to it (and certainly must have reviewed) invoices, and supporting detail of such invoices, for all intercompany management fees and recharges. This is because one of the first tests the National Tax Agency’s algorithms applies to a Japanese subsidiary company’s tax-returns in its search for possible tax evasion, is to subtract the value of intercompany management fees and intercompany recharges from the Japanese subsidiary company or office’s net income to determine if it would have been profitable (or more profitable) without them. This is especially true if the Japanese company has high sales income. A simple one-line invoice stating “Total intercompany management fees and recharges for October 2020, JPY1,920,000” is not sufficient supporting detail; in fact it might again trigger a National Tax Agency manual review. An invoice for intercompany management fees should state what the management services were, who provided them, and at what hourly rate. An invoice for intercompany recharges should state what expenses were recharged, with receipts for each expense (just as is expected for expenses the Japanese subsidiary company or office incurs directly), and what markup or administrative charge is associated with such recharged expense. Why must such detailed information be attached to filed financial statements and tax-returns? Because in the National Tax Agency’s opinion, intercompany management fees and recharges for management services which were never provided, or for expenses which were never incurred, is one of the most common ways foreign companies try to manipulate their Japanese subsidiary company or office’s tax liability.
Rule 3. Issue “arm’s length” intercompany invoices. When a National Tax Agency auditor manually examines intercompany invoices for management fees, he or she will compare the amounts the Japanese subsidiary company or office is paying with amounts it would pay for similar services if purchased from an independent service provider (arm’s length comparison). Similarly, when examining intercompany recharges, he or she will compare recharged expenses with the price of locally sourced equivalents. If (as noted above in Rule 2) invoices contain sufficient detail for the auditor to make arm’s length comparisons, and if the transactions pass such tests, all should be well. If there is not enough detail, the auditor will contact the Japanese company to ask for more detail and possibly start a full audit. It’s essential to ensure intercompany management fees and recharged expenses pass such arm’s length comparisons, because if not, and if a company is charging high intercompany management fees and recharges to its Japanese subsidiary company or office, the National Tax Agency will demand the company restate all affected financial statements and tax-returns. That can be very expensive both in CPA fees to prepare and file restated tax-returns and in additional taxes and late interest.
While following the above three rules can’t guarantee the National Tax Agency accepting intercompany management fees and recharges to your company’s Japanese subsidiary company or office, nor guarantee avoiding a tax audit, it will at least minimize the risk of both.