japanese tax: Foreign dividend exemption in 2009 Japanese tax reform

Legislation to amend Japan's Income Tax Law and Local Tax Law based on the 2009 tax reform proposals was passed on 27 March 2009. The legislation includes the implementation of a foreign dividend exemption system and the revision of the anti-tax haven rules, as announced in December 2008. This article looks at these two key elements of the 2009 tax reform. While much of this legislation came into effect from 1 April 2009, the effective date will depend on a company's fiscal period and will not have effect for some companies or in respect of some profits until much later. This article clarifies these changes for corporations.


Overview of foreign dividend exemption system

Where a Japanese domestic corporation receives dividends from a foreign subsidiary, it will be allowed to exclude 95% of such dividends in calculating its Japanese corporation tax for the fiscal year. To qualify for the dividend exemption, certain conditions must be satisfied, including a minimum shareholding of at least 25% of the subsidiary.

With the introduction of the foreign dividend exemption, the indirect tax credit system has been repealed and foreign tax credits for underlying tax are no longer available.

Where dividends received by a Japanese corporation from a foreign subsidiary are 95% non-taxable, any foreign withholding tax imposed on the dividends will be nondeductible in calculating the domestic corporation's taxable income. The foreign withholding tax imposed on such dividends will be excluded from foreign corporate taxes available for a foreign tax credit.

In certain circumstances, a reduction of foreign corporate tax may occur after a credit for the tax suffered has already been taken in Japan. This may occur where there are later adjustments made by the tax authorities in the foreign territory. For example, a refund of withholding tax is provided. The tax reform contains measures to deal with reductions that occur during a period in which the new rules have taken effect to ensure this does not result in credited tax in excess of the final amount of foreign tax suffered.

Under the new rules, where foreign corporate tax that has already been credited is later reduced, the amount may be offset against foreign tax credits available in the year in which the reduction occurs to the extent the reduction occurs during a fiscal year up to seven years following the period in which the credit was originally taken. Where the reduction occurs more than seven years after the original credit, it must instead be added to taxable income of the corporation.


Anti-tax haven rules

The Japanese anti-tax haven rules or controlled foreign company (CFC) rules are also amended under the new legislation to provide consistency with the new dividend exemption rules. Previously, foreign dividends, including those paid by CFCs, were generally taxable when received by the Japanese corporation. To avoid double taxation, a deduction was allowed when dividends were paid out of previously taxed retained earnings of a CFC. Under the new rules, dividends paid by a CFC will generally be 100% exempt from tax on receipt. Therefore, a deduction will no longer be given for dividends paid by a CFC when calculating the taxable profits of the CFC attributable to the Japanese corporation.

The new rules will apply to the calculation of CFC taxable profits for fiscal years of the CFC commencing on or after 1 April 2009 and in respect of dividends paid out of profits of the CFC for fiscal years commencing on or after 1 April 2009. Dividends paid out of profits of a CFC for its fiscal years commencing before 1 April 2009 will be taxable under the old rules. However, such dividends will also be deductible when calculating the taxable profits of the CFC.

Deductible amount in respect of CFC dividends distributed – Dividends paid by CFCs to a Japanese corporation will be 100% exempt from taxation on receipt up to the amount of the CFC's taxable profits for the current period and undistributed taxable profits of the previous 10 fiscal periods. This will apply in respect of dividends paid out of profits of fiscal periods of the CFC commencing on or after 1 April 2009. This rule is intended to prevent double taxation of CFC profits already taxed when directly attributed to the domestic corporation. However, by limiting the "profits pool" to the previous 10 years, the legislation is also intended to prevent payments out of previously untaxed profits becoming 100% exempt dividends.

Anti-tax haven rules and foreign tax credit – Where the income of a CFC is attributed to a domestic corporation under the anti-tax haven rules, a portion of the foreign corporate taxes on the income of the CFC relating to such profits will remain eligible for foreign tax credit, using the same method as under the current laws. This will continue to apply to attributable profits of a CFC for fiscal periods beginning on or after 1 April 2009.


Transitional rules

Technically, a CFC is any foreign corporation with an effective tax rate of 25% or less. However, many foreign corporations with a low rate of tax are not taxed as CFCs because they are eligible for exemption due to qualifying trading activities. The timing of the changes to the foreign dividend exemption rules applies to all CFCs, including those that qualify for an exemption and are therefore not taxed as CFCs. The transitional rules require that dividends paid out of profits of a CFC in respect of periods commencing prior to 1 April 2009, are taxable under the old legislation. For a CFC that qualifies for an exemption from current taxation as a CFC, this means that dividends paid out of periods commencing prior to 1 April 2009 will continue to be fully taxable under the old rules, with foreign tax credit available.

Case – Japan Co and its three wholly owned subsidiaries (Ireland Co, Cayman Co, and US Co) have a 31 March year-end.

Each subsidiary pays a dividend on 1 July 2009 to Japan Co, in respect of profits for the year ended 31 March 2009:

- Ireland Co has a tax rate of 12.5%, but has qualifying trading activities. Under the CFC rules, although the Irish corporation is by definition a CFC, the profits of the Irish company will not be treated as directly attributable to the domestic corporation and the company is exempt from CFC taxation. However, the transitional rules require that, as the dividend is paid out of profits of fiscal periods commencing prior to 1 April 2009, it must be taxed on receipt under the old rules (and foreign tax credit available under the old rules).

- Cayman Co is a CFC with no exemption. The dividend paid by Cayman Co will be taxed on receipt and deducted from the pool of taxed profits, reducing the attributable profits of Cayman Co in the period paid (year commencing 1 April 2009).

- US Co has a tax rate of 40% and is not a CFC. The dividend paid by US Co will be 95% exempt from tax on receipt by Japan Co, with no indirect foreign tax credit available. The new rules are applied in this case with reference to the fiscal period of receipt for Japan Co, not the period out of which the profits are paid. Therefore, groups should consider carefully the classification of each overseas entity prior to declaration of any dividends.