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“Sell cheaper to your relatives” or “buy higher from your relatives” are likely to create tax issue.
Especially if your relatives are affiliates abroad, it is going to be troublesome.
You may end up with making less profit but paying more tax than usual.

The principle for tax, “market price”

From a taxpayer’s point of view, an idea that “it is better to make customers feel happy by reducing profit rather than paying tax on profit” may be acceptable as an “appropriate” idea from business perspective.
However, sometimes, some taxpayers come up with “inappropriate” idea colluding with an interested person to reduce their tax burden.

For example, assuming that company A is so profitable and does not want to pay taxes any more, company B is making loss and cannot expect any taxable income in the foreseeable future.
As both A and B understand their situation each other, they agreed to manipulate buy/sell price so that A is able to reduce corporation tax due amount.
Specifically, they can do it by either “A Co lowers the price of products sold to B Co” or “A Co raises the price of goods purchased from B Co”.

If company B remains in loss in either way, it simply ends up with less taxable income for company A therefore A is able to reduce the tax burden.
Even if company B gets profitable, B Co can enjoy tax benefit utilizing tax loss carry-forward from previous years that B could not have been able to utilize without A.
If the profit of B is increased by the amount of profit reduced at A, the aggregated income of the two companies will remain the same however there may be a room for tax saving depending on the applicable tax rate or availability of tax credits.

In this way, if the parties who know situation collaborate, it will be possible to create tax implication that can not be achieved under normal commercial conditions.
Although the parties can freely decide the terms and conditions of business between companies, transaction that gives rise to inappropriate tax implication is not acceptable from “fair taxation” perspective.

Therefore, tax laws provide rules to deem as if transaction were made at market price regardless of actual transaction price when it deviates from the appropriate transaction price (so-called “market price principle “) for example, the Income Tax Law (Article 59 Para 1), the Corporation Tax Law (Article 22-2 Para 4, etc.), the Consumption Tax Law (Article 28 Para 1, etc.), and so on.
Also, the appraisal value of the inherited property is to be calculated based on the market price (the Inheritance Tax Law Article 22).
In this way, the tax law considers that market price principle is the basic rule for “fair taxation”.

Transfer pricing

In the case where the counterparty is also in Japan, even if the transaction deviates from the market price, the total tax amount paid to the government may not change as a whole.
In the above example, it is possible that the amount of tax payment by company B increases by the amount of tax saved by company A. So there may be no tax leakage from the viewpoint of the government.
Considering such possibility, in principle, for transactions made in between domestic enterprises, market value principle is applied only to abnormal transactions that are concerned about tax abuse, i.e, “extremely” deviated from market prices.

However, if the counterparty is outside the country, it is sure that the difference with the market price will affect the tax amount paid to the government.
Therefore, when the transaction price with “related party” abroad diverges from the market price, there is a rule to calculate the corporate tax amount on the assumption that there was a transaction at the market price regardless of size of the difference.
This is “transfer pricing rule” (Special Taxation Measures Law (hereinafter referred to as “the law”) Article 66-4).

The “related party” mentioned here means who are in a relationship where one controls the other or one is controlled by the other through holding of stocks or dispatching officers and so on.
The parent company and subsidiary are typical examples that become mutually related party.
Compared with third parties, since it is easy to control the transaction price among “related parties” under such controllable relationship, it is reasonable to anticipate a probability that income is transferred to overseas through transaction with the related parties.
On the other hand, it is too stringent to apply the transfer pricing rule to all transactions with non-related parties that diverge from the market price out of the control, so it is also reasonable that scope of the transfer pricing rule is limited to the transactions with the related parties.

However, since the transfer pricing rule Japan is designed applicable only to transactions where taxable income of a Japanese company decreases, if you sell higher than market price to overseas affiliates, or if you purchase cheaper than market price, in other words you earned more income on the Japan side, the rule does not apply to such situation (Article 66-4, Paragraph 1 of the law).
Regarding this point, you may be under the impression that it is unfair, but it may be inevitable as the rule is to secure Japanese tax revenue.

Arms-Length Price (ALP)

“Market price ” for transfer pricing rule is a special price called “arms-length price”.
This is a price that “non-related parties would normally agree” and is abbreviated as ALP.
This can also be said to be a kind of “market price”, but ALP concept is specifically developed for the transfer pricing purpose considering the situation where transactions are done between only related parties therefore no prevailing “market price” is observed.

Definition of ALP varies depending on tax law of each country.
The Japanese tax law defines the price calculated by the following method as ALP (each item of Article 66-4 Paragraph 2 of the law).
As this ALP calculation method is enough complicated to be a summarized in a thesis, I will introduce only the essence here rather going into details.

① Comparable Uncontrolled Price method (CUP method)

It is a method to see the amount of consideration for comparable transactions (transaction between third parties or transaction between a company and a third party) as ALP. Abbreviated as the CUP.
This method can be applicable when there are third party transactions having similarity enough to be compared with the related party transactions to be verified.
In short, it is a method of obtaining ALP based on a prevailing sales price (sales price at market) to a third party.

② Resale Price method (RP method)

It is a method of seeing ALP as the amount obtained by subtracting B below from A, that is, the selling price (market price) to a third party minus the amount of ordinary profit.
A. Amount of consideration that the buyer of inventory related to foreign affiliated transactions sold the asset to a third party
B. Amount of gross margin on comparable transactions (transaction between third parties or transaction between a company and a third party)

③ Cost method (CP method)

It is a method of seeing ALP as the sum of the following C plus B, that is, the bid price (market price) from a third party plus the amount of ordinary profit.
C. Acquisition value of the seller of assets related to overseas related transactions
B. Amount of gross profit on comparable transactions (transaction between third parties or transaction between a company and a third party)

④ Method similar to methods ① through ③ the above

There are “Profit Split method” and “Transactional Net Margin Method” (Article 39-12 Para 8 of the Enforcement Order of the Law)

· Profit Split method (PS method)
It applies to transactions that multiple related parties make profits making use of and playing complementary roles each other.
It is a method of splitting the aggregated profit of the related parties based on split factor.
PS methodology can be divided into three types depending on the way of aggregation of the profit to be split and the split factor; the Contribution Profit Split Method, the Comparable Profit Split Method, and the Residual Profit Split Method.

· Transactional Net Margin Method (TNMM)
Compare the net margin of a seller or a buyer of the related party transactions with the net margin of non-related party transactions.
It is a method to calculate ALP indirectly verifying if the net margin of the related party transaction can achieve normal margin level that would result from transactions between independent parties.

Which method of the above ① to ④ to apply should be discussed examining duly the nature of transaction with foreign related parties, then the best method should be selected (Article 66-4 Paragraph 2 of the Law).

The practical difficulty of transfer pricing lies in the verification of transaction details for the selection of this best method and whether it is possible to find non-related parties transactions (benchmark) to be compared.
Competitors will not disclose data that can be used for benchmarks.
You would be able to obtain basic data for benchmarking from some data providers (Thomson Reuters, etc.) but similarity check with the foreign related party transactions should be done by yourself.
Transfer pricing is said to be a special area among the taxation because such verification requires knowledge of tax law and analytical techniques as well.

On the other hand, the government that conducts tax audit has been collecting and accumulating data from various taxpayers.
The partiality of such information makes it difficult for taxpayers to deal with the transfer pricing practice, especially the tax audit.

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I suppose that the major premise of the transfer pricing is “law of one price”.
However, as you can see in the “The Big Mac Index“, even if you are selling the same goods, if its value is converted into a single currency for comparison, such value looks quite different depending on the exchange rate.
For Japanese corporation tax purpose, ALP will eventually be converted into Japanese yen.
If a third party transaction price had been deviated from the intrinsic value of goods or service, I am wondering what should be benchmarked.