Article 9 (Associated Enterprises) — U.S. Income Tax Treaty

This Article incorporates in the Convention the arm's-length principle reflected in the OECD Transfer Pricing Guidelines and U.S. domestic transfer pricing provisions, particularly Code section 482 and the regulations thereunder. It provides that when related enterprises

engage in a transaction on terms that are not arm's-length, the Contracting States may make appropriate adjustments to the taxable income and tax liability of such related enterprises to reflect what the income and tax of these enterprises with respect to the transaction would have been had there been an arm's-length relationship between them.

Paragraph 1

This paragraph addresses the situation where an enterprise of a Contracting State is related to an enterprise of the other Contracting State, and there are arrangements or conditions imposed between the enterprises in their commercial or financial dealings that are different from those that would have existed in the absence of the relationship. Under these circumstances, the Contracting States may adjust the income (or loss) of the enterprise to reflect what it would have been in the absence of such a relationship and thus in accordance with the arm’s length principle.

The paragraph identifies the relationships between enterprises that serve as a prerequisite to application of the Article. As the Commentary to Article 9 of the OECD Model makes clear, the necessary element in these relationships is effective control, which is also the standard for purposes of section 482. Thus, the Article applies if an enterprise of one Contracting State participates directly or indirectly in the management, control, or capital of the enterprise of the other Contracting State. Also, the Article applies if the same third person or persons participate directly or indirectly in the management, control, or capital of enterprises of different Contracting States. For this purpose, all types of control are included ( i.e., whether or not legally enforceable and however exercised or exercisable).

Paragraph 5 of the Protocol clarifies the basis for determining the profits of an enterprise under the arm’s-length principle. The arm’s-length analysis is generally based on a comparison of the conditions in the transactions made between associated enterprises and those made between independent enterprises. The qualifier “generally” is used because in some cases an analysis based on transactions between independent enterprises is not possible, either because comparable transactions have not taken place or because data regarding such transactions is not available to the associated enterprises. Paragraph 5 sets out five factors that could affect comparability: (1) the comparability of the property or services transferred; (2) the functions of the associated enterprises, taking into account the assets used and risks assumed by the associated enterprises; (3) the contractual terms between the associated enterprises; (4) the economic circumstances of the associated enterprises, and (5) the business strategies pursued by the associated enterprises. These five comparability factors correspond to those set out in the OECD Transfer Pricing Guidelines (paragraphs 1.19 through 1.35), and are consistent with U.S. domestic transfer-pricing provisions, particularly Treas. Reg. section 1.482-1(d).

Paragraph 3 of the Notes sets out the understanding of the Contracting States that double taxation can be avoided only through a common understanding of the principles to be applied in resolving transfer pricing case. Paragraph 3 of the Notes further provides that the Contracting States shall undertake to conduct transfer pricing examinations of enterprises and evaluate applications for advance pricing arrangements in accordance with the OECD Transfer Pricing Guidelines. The domestic transfer pricing rules, including the transfer pricing methods, of each

Contracting State may be applied in resolving transfer pricing cases under the Convention only to the extent that they are consistent with the OECD Transfer Pricing Guidelines.

The OECD Transfer Pricing Guidelines reflect the consensus of OECD member countries (including the United States and Japan) on the application of the arm’s length principle in the context of Article 9 of the OECD Model and of their respective bilateral treaties that are consistent with the OECD Model. Thus, it is generally understood that transfer pricing cases in the context of mutual agreement procedures between OECD member countries should be resolved with reference to the OECD Transfer Pricing Guidelines. Paragraph 3 of the Notes confirms and extends this understanding. Paragraph 3 reflects the intention of each Contracting State to conduct transfer pricing examinations of enterprises related to enterprises of the other Contracting State in accordance with the OECD Transfer Pricing Guidelines, rather than to utilize the OECD Transfer Pricing Guidelines solely in the context of the mutual agreement procedures under Article 25 of the Convention. Further, paragraph 3 clarifies that while each country may apply its domestic transfer rules in resolving transfer pricing cases, such rules may be applied only to the extent that they are consistent with the OECD Transfer Pricing Guidelines. The U.S. transfer pricing provisions, particularly Code section 482 and the regulations thereunder, generally are consistent with the current OECD Transfer Pricing Guidelines.

The reference in paragraph 3 of the Notes to the OECD Transfer Pricing Guidelines is to that document as it continues to evolve, rather than to the document as it exists at a certain point in time. It is well understood that the OECD Transfer Pricing Guidelines are periodically updated to reflect the ongoing development of international standards in this area. Thus, as the OECD Transfer Pricing Guidelines change, there may be corresponding changes in the respective obligations of the Contracting States under the Convention. Because the OECD is a consensus organization, the OECD Transfer Pricing Guidelines cannot be updated without the acquiescence of all of its members, including the United States and Japan.

The fact that a transaction is entered into between such related enterprises does not, in and of itself, mean that a Contracting State may adjust the income (or loss) of one or both of the enterprises under the provisions of this Article. If the conditions of the transaction are consistent with those that would be made between independent persons, the income arising from that transaction should not be subject to adjustment under this Article.

Similarly, the fact that associated enterprises may have concluded arrangements, such as cost sharing arrangements or general services agreements, is not in itself an indication that the two enterprises have entered into a non-arm's-length transaction that should give rise to an adjustment under paragraph 1. Both related and unrelated parties enter into such arrangements ( e.g., joint venturers may share some development costs). As with any other kind of transaction, when related parties enter into an arrangement, the specific arrangement must be examined to see whether or not it meets the arm's-length standard. In the event that it does not, an appropriate adjustment may be made, which may include modifying the terms of the agreement or recharacterizing the transaction to reflect its substance.

The “commensurate with income” standard for determining appropriate transfer prices for intangibles, added to Code section 482 by the Tax Reform Act of 1986, was designed to

operate consistently with the arm's-length standard. The implementation of this standard in the section 482 regulations is in accordance with the general principles of paragraph 1 of Article 9 of the Convention, as interpreted by the OECD Transfer Pricing Guidelines. See paragraphs 6.28 through 6.35 of the Transfer Pricing Guidelines.

It is understood that the Contracting States preserve their rights to apply internal law provisions relating to adjustments between related parties. They also reserve the right to make adjustments in cases involving tax evasion or fraud. Such adjustments -- the distribution, apportionment, or allocation of income, deductions, credits or allowances -- are permitted even if they are different from, or go beyond, those authorized by paragraph 1 of the Article, as long as they accord with the general principles of paragraph 1 ( i.e., that the adjustment reflects what would have transpired had the related parties been acting at arm's length). For example, while paragraph 1 explicitly allows adjustments of deductions in computing taxable income, it does not deal with adjustments to tax credits. It does not, however, preclude such adjustments if they can be made under internal law. The OECD Model reaches the same result. See paragraph 4 of the Commentary to Article 9.

This Article also permits tax authorities to deal with thin capitalization issues. They may, in the context of Article 9, scrutinize more than the rate of interest charged on a loan between related persons. They also may examine the capital structure of an enterprise, whether a payment in respect of that loan should be treated as interest, and, if it is treated as interest, under what circumstances interest deductions should be allowed to the payer. Paragraph 2 of the Commentary to Article 9 of the OECD Model, together with the U.S. observation set forth in paragraph 15 thereof, sets forth a similar understanding of the scope of Article 9 of the OECD Model in the context of thin capitalization.

Paragraph 2

When a Contracting State has made an adjustment that is consistent with the provisions of paragraph 1, and the other Contracting State agrees that the adjustment was appropriate to reflect arm's-length conditions, that other Contracting State is obligated to make a correlative adjustment (sometimes referred to as a “corresponding adjustment”) to the tax liability of the related person in that other Contracting State. Unlike the Convention the OECD Model does not specify that the other Contracting State must agree with the initial adjustment before it is obligated to make the correlative adjustment, but the Commentary makes clear that the paragraph is to be read that way.

When an adjustment under Article 9 has been made, one of the parties will have in its possession funds that it would not have had at arm's length. The question arises as to how to treat these amounts in excess of the arm’s length amounts. As explained in the Commentary to Article 9 of the OECD Model, Article 9 leaves the treatment of so-called “secondary adjustments” to the laws of the Contracting States.

In the United States the general practice is to treat such funds as a dividend or contribution to capital, depending on the relationship between the parties. Under certain circumstances, the parties may be permitted to restore the funds to the party that would have the

funds at arm's length, and to establish an account payable pending restoration of the funds. See Rev. Proc. 99-32, 1999-2 C.B. 296.

Articles 11 (Interest), 12 (Royalties), and 21 (Other Income) provide specific rules in the context of adjustments in the amount of interest, royalties, or other income. These rules are discussed below in the explanation of paragraph 8 of Article 11, paragraph 4 of Article 12, and paragraph 3 of Article 21.

The competent authorities are authorized by paragraph 3 of Article 25 (Mutual Agreement Procedure) to consult, if necessary, to resolve any differences in the application of the provisions of paragraphs 1 or 2 of Article 9. For example, there may be a disagreement over whether an adjustment made by a Contracting State under paragraph 1 was appropriate.

If a correlative adjustment is made under paragraph 2, it is to be implemented, pursuant to paragraph 2 of Article 25 (Mutual Agreement Procedure), notwithstanding any time limits or other procedural limitations in the law of the Contracting State making the adjustment. If a taxpayer has entered a closing agreement (or other written settlement) with the United States prior to bringing a case to the competent authorities, the U.S. competent authority will endeavor only to obtain a correlative adjustment from Japan. See Rev. Proc. 2002-52, 2002-31 I.R.B. 242, Section 7.04.

Paragraph 3

Paragraph 3 provides a procedural limitation on the authority of a Contracting State under paragraph 1 to adjust the amount of profits of an enterprise with respect to arrangements between that enterprise and a related person in the other Contracting State, when such arrangements differ from those that would obtain between unrelated persons. Paragraph 3 provides that a Contracting State may not make an adjustment with respect to the profits of an enterprise in the circumstances referred to in paragraph 1 if an examination of the enterprise is not initiated within seven years from the end of the taxable year in which the profits that would be subject to change would have accrued to that enterprise.

The limitation in paragraph 3 is unlikely to apply in the case of the United States because of the generally applicable three-year statute of limitations under Code section 6501 and the policy of the Internal Revenue Service to initiate and close examinations on as current a basis as possible even where extensions to the statute of limitations could be obtained. Further, the limitation in paragraph 3 generally could not apply in the case of Japan under current Japanese tax law because of the generally applicable six-year statute of limitations that generally is not subject to extension.

The provisions of paragraph 3 shall not apply in the case of fraud or willful default or if the inability to initiate an examination within the seven-year period is attributable to the actions or inaction of that enterprise. A significant purpose of this limitation on the general rule of paragraph 3 is to prevent taxpayers from using the general rule to attempt to avoid adjustments by delaying the conduct of examinations in prior periods.

Relationship to Other Articles

The saving clause of subparagraph 4(a) of Article 1 (General Scope) does not apply to paragraphs 2 and 3 of Article 9 by virtue of the exceptions to the saving clause in paragraph 5 of Article 1. Thus, even if the statute of limitations has run, a refund of tax can be made by a Contracting State to its residents in order to implement a correlative adjustment under paragraph 2. Statutory or procedural limitations, however, cannot be overridden to impose additional tax, because paragraph 2 of Article 1 provides that the Convention cannot restrict any statutory benefit. Similarly, the procedural limitation of paragraph 3 may apply to a potential adjustment by a Contracting State to the profits of an enterprise of that Contracting State that also is a resident of that Contracting State.