On July 1, 2004, the withholding tax related sections of the treaty became effective.   The following illustrates the reduced withholding tax rates provided under the treaty:

Please note that the new treaty includes the Limitation on Benefits clause, which restricts the application of the treaty to individuals or organizations which do not meet the definition of Japan residents.   The treaty became more selective in determining residency relative to the previous treaty.   For example, if a corporation incorporated in Japan was majority owned by non-Japanese, this corporation is not considered a Japan corporation within the meaning of the new U.S.-Japan income tax treaty.

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In order to receive the benefit of the reduced withholding tax rates as provided under the new U.S.-Japan Income Tax Treaty, a Japanese recipient of dividends, interest or royalty payments must complete a U.S. federal form W-8BEN and submit to a payer requesting to apply reduced tax rates.   If a Japanese recipient fails to submit the form, the U.S. payer, who is also the U.S. withholding agent, must withhold at the tax rate of 30%.

For example, if a U.S subsidiary pays dividends to its Japanese parent company, the parent company must complete, sign and submit form W-8BEN (link) to the U.S. subsidiary prior to receiving the payments.   To fill out the form, the parent company needs the U.S. Federal Employer Identification Number which can be obtained from the IRS by submitting a form SS-4.

The companies received benefit of the reduced withholding tax on U.S. source dividend are required to file U.S. federal form 8833 attached to form 1120F to report the transaction.   If the company received either interest or royalty in excess of $500,000 is also required to file the form.   If the reporting was neglected, the company may face $10,000 penalty per incident.

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In the United States, the transfer pricing rules are provided in Section 482 of the Internal Revenue Code and related Treasury Regulations.   The Section provides that, in case of two or more organizations owned or controlled directly or indirectly by the same interests, Internal Revenue Service ("IRS") is authorized by law to allocate gross income, deductions, credits or allowances between controlled organizations, trades or businesses, if the Service determines that such an allocation is necessary to clearly reflect the income of any such organization or to prevent evasion of taxes. The burden of proof that the organization's transactions among related-parties are arm's length is on a taxpayer.

A typical example of related-party transactions subject to transfer pricing rules is the transactions between the parent and subsidiaries.

For example, let's assume the Company A, a U.S. corporation, is a wholly owned subsidiary of the Company P, a Japan corporation.   The Company A imports finished goods from the Company P.   The Company A, in turn, sells those goods to unrelated third parties in the U.S. market.   The transactions between the Company A and the Company P is considered related-party transactions within the meaning of transfer pricing rules.

Since the Company P is a sole shareholder of the Company A and the Company A is under the control of the Company P, the IRS thinks that the Company P can freely adjust its prices in selling goods to the Company A.   If the Company P raises its prices in selling goods to the Company A, the Company A's U.S. taxable income will decrease, which means the U.S. government's loss in tax revenue.   Even if the pricing between these related parties are not influenced by the tax avoidance motive, the IRS is authorized to adjust transfer prices if the IRS determines that the transactions are not arm's length.   It is not rare that this type of income adjustments may result in double taxations by two or more taxing authorities (i.e., the IRS of the U.S. and the NTA of Japan).

There are two types of penalties associated with transfer pricing:

The Transactional Penalty

The transactional penalty generally applies to any Section 482 transaction if the price for any property or services claimed on the taxpayer's return is 200% or more (or 50% or less) of the amount determined by the IRS examiner to be the correct price.   If the price claimed on a taxpayer's return is 200% or more, or 50% or less, of the amount determined under Section 482, the 20% transactional penalty may apply.   In addition, if the price claimed on return is 400% or more, or 25% of less, of the ?gcorrect?h price, the 40% penalty may apply.

The Net Adjustment Penalty

The net adjustment penalty applies when a taxpayer's net increase in taxable income resulting from transfer pricing adjustments for a year exceeds the lesser of two thresholds: $5,000,000 or 10 percent of the taxpayer's gross receipts for a year, after taking into account all Section 482 adjustments. If a taxpayer's transfer pricing adjustments as a result of the IRS examination exceed the lesser of the above two thresholds, the 20% net adjustment penalty may apply. In addition, if the adjustments exceed the lesser of $10,000,000 or 20% of the taxpayer's gross receipts for a year, the 40% penalty may apply.

Avoidance of Transfer Pricing Penalties

The transfer pricing penalty regulations explain how taxpayers may avoid the transfer pricing penalties imposed by the Internal Revenue Code.   To avoid the transactional and net adjustment penalties, the taxpayer must perform transfer pricing analysis by: (1) selecting and applying (in a "reasonable" manner) a transfer pricing methodology; and (2) contemporaneously document the selection and application process.   These processes are often called contemporaneous documentation of transfer pricing studies.   Whether or not a taxpayer has capabilities in performing this type of analysis is not considered in assessing penalties.

If you have further questions with respect to this topic, please call one of our tax professionals at HLS.