Tax controversy update vol. 8 - Discussion on DCF - Part 1

As mentioned in Issue 7, this issue will kick off the discussion on DCF by further exploring Patterns 1 and 2 shown in the below diagram.

To recap, Pattern 1 refers to cases in which even though taxpayers valued assets using DCF as the valuation method, the tax authorities determined that DCF cannot be used under such circumstances and that other valuation methods should be relied upon instead.

A Tokyo District Court case dated 1 October 2020 falls under this pattern. In said case, a calculation of share value was required in relation to gift taxes that had arisen. The value of a shipping vessel owned by the company which had issued the shares came into dispute as a result. The taxpayer in this case originally used DCF to measure the value of the vessel, but the tax authority determined the valuation should be performed with a depreciation method specifically related to shipbuilding. Volume 136 of the Basic Property Valuation Directive states that the value of a vessel shall, barring exceptions, take into consideration real-world trading prices and prices deemed appropriate by industry experts. As such, the tax authorities employed the depreciation method related to shipbuilding after consulting the opinions of industry experts for more accurate values.

In a separate Tokyo District Case regarding inheritance taxes dated 3 March 2017, the value of property for which leasehold rights had been set was disputed. The taxpayer again used DCF for their valuation, but the tax authorities determined a deduction method specifically for the value of property leasehold rights should be used. This valuation method is based on Volume 25 of the Valuation Directive, which stipulates the value should be determined by deducting the value of the leasehold rights from the value of the residential land.

Switching to Pattern 2, these are cases in which taxpayers valued assets using DCF as a valuation method, but the tax authority insists on a valuation amount based on a different DCF calculation than the original.

In a National Tax Tribunal case dated 25 March 2021, the transfer price of overseas subsidiary shares transferred to foreign related parties was the primary issue. The tax authorities determined that a portion of the DCF methodology adopted by the taxpayer was inapplicable, and instead used their own DCF methodology to perform the valuation.

The tax authorities were able to refer to circulars which clearly outlined valuation methodologies other than DCF for their decisions in the reference cases described for Pattern 1. This fact is likely related to their thought process for denying the values calculated by the taxpayers. However, in the Tokyo District Case from 1 October, the courts upheld the position of the taxpayer in that DCF could be relied upon in a similar fashion as the opinion of an industry expert would be. Which is why, in the event the tax authorities refute a valuation performed under DCF, it should be a must for any taxpayer to analyze and confirm whether there is some regulation or directive which the tax authorities are relying on that actually disallows the use of DCF.

As for the case in Pattern 2, the market value of unlisted shares at the time of transfer was the issue at hand. It is fair to say that the Fundamental Directive of Corporation Tax Act, in particular sections 9-1-13 and 9-1-14 related to the treatment for recording loss on valuations, are most often referred to for such an issue. In the National Tax Tribunal case from 25 March 2021, there is an argument to be made that the DCF issue was the lowest hanging fruit for the authorities when it came to denying the taxpayer’s valuation. Regardless, it is still likely that the lack of any clear regulation or directive pertaining to calculation methodology for market value at the time of transfer had an influence on the tax authorities’ insistence for their own DCF calculation.

In summary, it is evident from the above discussion that the stance taken by the tax authorities in Patterns 1 and 2 relies heavily on the existence of regulations or directives which clearly stipulate how the valuation of an asset in question should be calculated.