Tax controversy update vol. 10 - Application of the DCF method under transfer pricing rules

In issues 8 and 9 we referred to published cases to introduce and discuss three different patterns for applying the DCF (Discounted Cash Flow) method in areas in which there were no codified provisions regarding DCF. In this issue we will explore the area in which there does exist codified provisions for DCF.

As a recap, the tax reforms of 2019 added the discounted cash flow method as an additional method available for calculating an arm's length price. The below citation is from the Enforcement Order of the Special Taxation Measures Law Article 39-12, Paragraph 8, Item 6, in which the DCF method is stipulated (we have underlined a portion to discuss later on).

“A method to calculate an arm's length price by evaluating the total of discounted present value of the projected profits (including other equivalent profits, the same herein below) at the time of their purchase or sale of any inventory assets related to a foreign related transaction, derived for each fiscal year from the use of the inventory assets or other actions over a projected profit-generating period, by applying a reasonable discount rate at the time of purchase or sale of said assets .”

The above DCF method provision is applicable to corporation tax for fiscal years beginning on or after 1 April 2020. In practice, the use of a method equivalent to DCF is expected in situations such as the purchase or sale of intangible assets and business transfers occurring within business reorganizations.

“Kaisei Zeihou no Subete” (Okura Zaimu Kyokai, 2019), p. 594

The potential problem that arises for taxpayers is that the three computational elements used when applying the DCF method - “projected period," "projected profit," and "discount rate” - are only abstractly defined in the above provision, and there is a lack of a definitively clear explanation of what each entails. As an example, a taxpayer and a tax examiner are likely to disagree on what standards constitute “a reasonable discount rate.”

The lack of specificity and clarity within the provision gives rise to the challenge of how best to prevent the tax authority’s denial of a taxpayer’s methodology during a future tax examination. (In the next issue we will discuss how to address “specified intangible asset transactions,” which were also introduced by the 2019 tax reform and can be considered to be a practical application of the DCF method, during a tax examination.)

One method to prevent the tax authority’s denial may be to refer the explanations given in the Commissioner's Directive on the Operation of Transfer Pricing, Section 4-13 (Treatment of DCF Method), which contains important points to note when applying the DCF method. The following passage is an example of its contents: “It is necessary to analyze whether the amount of projected profit is calculated based on information relevant to the foreign related transaction which has been ensured to be reliable , such as business plans and similar items.” However, a passage such as this poses the question of what exactly is required to substantiate that a business plan “has been ensured to be reliable.”

These types of questions are exactly where the assistance of independent experts is invaluable. The “reliability” of the business plan in question can be enhanced and even ensured as a result of an objective verification performed by independent experts. As for the “reasonable discount rate” also in question, independent experts possess specialized knowledge gained from a multitude of cases and experience which allows them to determine what “a reasonable discount rate” is from an independent perspective.

In addition, as the 2019 tax reform made documents related to calculating the total of discounted present value at the time of a transaction a required portion of Local File documentation, the assistance of independent experts when preparing these documents is particularly advantageous.