In October 2008, a Japanese court for the first time ruled in favour of a taxpayer in a transfer pricing case. The Tokyo High Court rejected a transfer pricing assessment that had been imposed by the Japanese tax authority on Adobe Systems Co Ltd (the Japanese affiliate of Adobe Systems Inc). The company’s petition had previously been rejected by the Tokyo District Court in December 2007 and the High Court reversed the district court’s ruling on appeal.
The transfer pricing assessment on Adobe Systems covered the fiscal years ended November 2000, November 2001 and November 2002. The transactions at issue were services performed by the taxpayer in support of its parent’s sales of software products in Japan. The company had been receiving remuneration in the form of cost reimbursements plus a commission on sales revenue recorded by the parent. The tax examiners identified a seller of software which they claimed was comparable with the taxpayer and used that company’s gross margin on sales of graphic software for comparison with the gross margin of the taxpayer. The identity of the comparable was not disclosed; in other words, it was a secret comparable of the type that has been used historically in examinations of some other taxpayers and which has attracted great criticism from taxpayers, practitioners and even some other governments.
The taxpayer appealed the assessment to the National Tax Tribunal, disputing both the technical merits of the assessment and the legality of secret comparables. Its petition was denied in December 2005. After this, the company filed litigation, but its lawsuit was rejected by the Tokyo District Court in December 2007. The company then filed an appeal with the Tokyo High Court, which reversed the District Court’s ruling and found for the taxpayer on October 30 2008.
The Tokyo High Court ruled that the tax authority’s comparable transaction was not appropriate because the comparable company had significant functional differences with the taxpayer. The court concluded that the taxpayer performs only services supporting software sales in Japan, while the comparable performs a fundamentally different function of purchasing and re-selling software. In addition, the court noted a significant difference in risk in that the taxpayer, via the reimbursement of its costs, bears no risk of losses, whereas the comparable could potentially experience losses if its sales are insufficient to cover its costs.
The court did not, however, rule on the legality of secret comparables, nor did it state whether the taxpayer’s transfer pricing methodology was acceptable. It simply rejected the approach used by the tax authority to make its assessment.