TAX NEWS - January 2010
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Japan Tax Reform 2010
Corporate tax
The corporate tax measures will be of key interest to multinationals with 100% groups in Japan that have not been able to take advantage of the existing tax qualifying merger, split-off and share exchange regimes. Under the proposals, many transactions within 100% groups would be able to take place without any corporate tax implications, allowing for more efficient commercial planning and better effective tax rate management in Japan.
Taxation of capital transactions within a 100% group –
- Assets would be able to be transferred between 100% group companies on a no-gain/no-loss basis. As such, any gains or losses on assets transferred within a 100% group would be deferred until the assets are sold outside the group and gain or loss is realized. This measure would be applicable for transactions closing on or after 1 October 2010.
- Non-qualified share exchanges within a 100% group would no longer be subject to mark-to-market. This would eliminate the distinction between tax-qualifying and non-qualifying share exchanges within a 100% group, and multinationals with 100% groups in Japan would be better able to effect reorganizations in Japan. This change also would be applicable for transactions closing on or after 1 October 2010.
- Share redemptions within a 100% group would be able to take place on a no-gain/no-loss basis, again deferring the realization of gains or losses. Currently, a Japanese parent company can recognize a capital loss and an equal deemed dividend upon a share redemption by a Japanese subsidiary, which will qualify for a 100% dividends received deduction, the overall effect of which is a reduction in the Japanese parent company's taxable income. In general terms, this would no longer be possible under the tax reform proposals.
- Currently, when a parent company enjoys an exclusion on dividends received from a 100% subsidiary, it is required to deduct interest expense incurred in relation to the shareholding. The deduction would not be required under the tax reform proposals for tax years starting on or after 1 April 2010.
Donations within a 100% group – As from 1 October 2010, donations between companies within a 100% group would no longer be deemed taxable income for the recipient. As such, the donor company would not be able to recognize any expense and the recipient would not recognize any taxable income.
Tax consolidation system –
- Net operating losses (NOLs) incurred by a subsidiary before joining a consolidated tax group currently may not be carried forward and used to offset the taxable income of the consolidated group. Under the tax reform proposals, in certain circumstances (e.g. where the subsidiary has been 100% owned by the parent company for at least five years), such NOLs would be available to be carried forward and offset against the taxable income of the consolidated group to the extent of the subsidiary's own taxable income.
- Under existing law, a group must submit an application for consolidated filing at least six months before the beginning of the first fiscal year in which the group intends to submit a consolidated return. This deadline would be shortened to at least three months before the start of the first fiscal year.
Liquidation income – Liquidation income tax would be abolished and general income tax principles would apply to income derived during the liquidation period. Currently, a corporation pays tax in its liquidation period based on its liquidation income. Liquidation income is calculated as the value of residual assets less the sum of paid-in capital, capital surplus and retained earnings for tax purposes, all at the date of dissolution. Necessary measures, such as the allowance of the use of expired losses, would be introduced and the dissolution of a consolidated subsidiary would, in principle, be excluded from the reasons for disallowing a tax consolidation. These rules would apply for liquidations taking place on or after 1 October 2010.
Other proposals –
- Certain beneficial provisions (e.g. the one-year loss carryback) for small and medium-sized enterprises (SMEs) would cease to be available for SMEs that are owned by companies with share capital of JPY 500 million or more (or if owned by an insurance company). These rules would be applicable for the tax year starting on or after 1 April 2010.
- Additional R&D tax credits in respect of incremental expenditure, or expenditure in excess of 10% of sales revenue, would be extended for an additional two years.
- Various special measures in respect of specific acquisitions or reserves would be extended or abolished.
- Compensation paid to director-managers of one-man companies would be allowed as a deduction in fiscal years ending on or after 1 April 2010. Additional measures to promote the equality of taxation between one-man companies and unincorporated businesses will be introduced in Tax Reform 2011.
International tax
The Japanese government overhauled the taxation of foreign dividends earned by Japanese parent companies and the taxation of controlled foreign companies (CFCs) owned by Japanese companies in Tax Reform 2009. The 2010 proposals move one step further in respect of CFCs, generally reducing Japanese companies' requirements to report CFCs' income. However, this is counter-balanced by a tax regime that would tax passive income of many foreign subsidiaries of Japanese parent companies on a current basis. Unless otherwise stated below, the proposals are due to take effect for CFC tax years starting on or after 1 April 2010.
Anti-tax haven rules –
- The trigger rate at which a CFC's income would be subject to the anti-tax haven rules would be reduced from 25% to 20%. Therefore, if a CFC's effective tax rate is above 20%, it should not be subject to the anti-tax haven rules.
- Currently, a CFC may be subject to the anti-tax haven rules if Japanese corporations together own more than 50% of the share capital of the CFC. In this case, a Japanese shareholder is required to recognize CFC income where it individually owns 5% or more of the CFC. The tax reform proposal would increase the second threshold to 10%.
- Where a CFC is an operating holding company, shares it owns in operating subsidiaries would be excluded for purposes of the "business test." An operating holding company is a company that operates a substantial business in its jurisdiction and also holds shares in affiliates, defined as 25% or more owned subsidiaries.
- For wholesale companies, transactions between the operating holding company and its affiliates would not be considered related party transactions for purposes of the "non-related transactions" test.
- Currently, where a CFC does not satisfy the place of business test or the unrelated transactions test, but does satisfy the business test, substance test and control test, 10% of total labor costs may be deducted in calculating taxable income. This deduction would be abolished under the tax reform proposals.
- Dividend income received from a CFC currently is entirely excluded from its Japanese parent's taxable income to the extent of previously taxed income. However, only 95% of dividend income received by a Japanese parent indirectly from a second tier CFC through a first tier CFC is excluded. To correct this difference, the following change will be applicable for a Japanese parent's tax year starting on or after 1 April 2010. The dividend exclusion would be the lesser of:
. The share of dividends received by a first tier CFC from a second tier CFC; or
. The share of the second tier CFC's income already included in the taxable income of the Japanese parent company under the anti-tax haven regime.
Taxation of passive income of CFCs – Under the tax reform proposals, even where a CFC meets the active business test, the following types of passive income would be subject to tax in the hands of the Japanese parent company:
- Dividend income and capital gains on listed shares in which the company holds less than 10%;
- Interest income and capital gains on listed bonds;
- Income arising from industrial rights and copyrights; and
- Leasing income from ships and aircraft.
Certain de minimis limitations would apply and direct expenses would be deductible against any taxable income arising.
Transfer pricing
From the details of discussions published by the Tax Commission, it was widely expected that the Tax Reform 2010 proposals would announce the introduction of a contemporaneous transfer pricing documentation requirement. The final wording of the tax reform proposals does not go that far, but does clarify the documentation that the tax authorities may request from a taxpayer. This would include a description of intercompany transactions and an analysis explaining the arm's length nature of intercompany transactions.
We anticipate that the tax authorities will expect taxpayers to have prepared such documentation at the time of a tax audit. If not, the authorities may assess additional taxation, potentially using "secret comparable" data. Moreover, as this is a clarification, rather than the introduction of new legislation, it is possible that the documentation rules would apply to all open years. Given that the transfer pricing statute of limitations is six years, taxpayers may need to prepare enhanced documentation, including a justification of the transfer pricing methodology and an economic analysis, for all open years.
Detailed guidance as to the major issues to be negotiated between related parties when calculating and analyzing arm's length pricing would be circulated. The rules specifying transfer pricing documentation to be submitted during a tax audit would be clarified.
Taxation of financial and securities transactions
The proposed changes to the taxation of financial and securities transactions primarily focus on encouraging foreign investment in Japanese bonds, covering Japanese government bonds (JGBs), municipal bonds and corporate bonds. While most of the proposed measures are welcome and have been lobbied for by various industry groups, the proposed change to the requirements for a tax-qualified securitization vehicle (tokutei mokuteki kaisha, or TMK) may require foreign investors to reconsider existing structures when acquiring Japanese real estate in the future.
Foreign-issued Japanese corporate bonds – Special measures granting an exemption from withholding tax on foreignissued Japanese corporate bonds would be extended indefinitely. This measure would be applicable for bonds issued on or after 1 April 2010. Certain aspects of the rules would be amended and the documentation requirements for specified foreign-issued Japanese corporate bonds would be clarified.
Japanese government bonds – The original issue discount on interest-bearing JGBs held through the book-entry transfer system would be exempt from tax for nonresidents and foreign corporations. This measure would be applicable for bonds issued on or after 1 June 2010 and interest calculation periods starting on or after that date.
- Documentation requirements to qualify for an exemption from withholding tax on JGBs held through the bookentry transfer system would be simplified.
- Sub-custodians would no longer be required to submit a statement of the holding period when filing for a
withholding tax exemption on JGB interest. This would be replaced by a system of specified account management.
Corporate bonds – Interest income and redemption gains on corporate bonds issued through the book-entry transfer system would be exempt from tax for nonresidents and foreign corporations for bonds issued on or after 1 June 2010, but before 31 March 2013, and interest calculation periods starting on or after 1 June 2010. This exemption would not apply for bonds issued to related parties (i.e. parties that have a common shareholding of more than 50%).
Domestic ownership of TMKs – Currently, a TMK is required to issue more than 50% of any bonds onshore. The Tax Reform 2010 would abolish this requirement. However, under existing rules, whilst a tax-qualified TMK is required to issue more than 50% of its preference shares onshore, it is able to issue all of its ordinary equity offshore. Under the Tax Reform 2010 proposals, a tax-qualified TMK would be required to issue more than 50% of its ordinary equity onshore. This may significantly impact the structuring and effective tax rates of many commonly used structures for acquiring real estate in Japan.
Taxation of individuals
To implement one of the DPJ's main pledges, Tax Reform 2010 proposes changes to the dependent deductions to help fund the introduction of child allowances and free high school tuition for all, regardless of income levels. Other changes include the introduction of a new "tax-free" investment account, presumably to encourage investment in the Japanese stock market, and some additional limits on the capital gains deferral on the replacement of residential property and certain other deductions.
Deductions from income –
- Revision of dependent deductions – In light of the introduction of a "child allowance," the deduction taken against a taxpayer's income for dependents under 16 years of age (currently JPY 380,000 for national tax and JPY 330,000 for inhabitants tax) would be abolished. In addition, due to the introduction of free tuition for high school pupils, the additional deduction for dependents aged 16 and over, but under 19 years of age (currently JPY 250,000), would be abolished. It still would be possible to claim the original dependent deduction (JPY 380,000 for national tax and JPY 330,000 for inhabitants tax) for these dependents. These revisions would be effective from the 2011 tax year for national tax purposes and 2012 for inhabitants tax purposes. The child allowance and free high school tuition would be tax exempt.
- Insurance premium deductions – For life or disaster insurance policies concluded on or after 1 January 2012, an additional insurance premium deduction, limited to JPY 40,000, would be permitted for insurance policies covering nursing care expenses. The deduction amount for life insurance or annuity premiums for insurance policies concluded on or after 1 January 2012 would be reduced to JPY 40,000 (currently JPY 50,000).
"Tax-free" accounts – From 2012, a "tax-free" account for dividends and capital gains from listed stocks would be introduced for residents who are aged 20 years or over on 1 January of a tax year. Only one tax-free account would be allowed per resident and up to JPY 1 million of listed stock, by reference to the acquisition cost, could be held in the account. Dividends and capital gains from listed stock held in the "tax-free" account would be exempt from national income tax and inhabitants tax.
Capital gains deferral on replacement of residence – The current deferral of capital gains, available under certain conditions, on the replacement of a taxpayer's residence, would be extended for an additional two tax years and it would also be required that the capital proceeds were no more than JPY 200 million. This change would be effective for transactions taking place on and after 1 January 2010.
Japanese "401K" pension plans – The 2010 Tax Reform includes a proposal that matching contributions made by employees to a defined contribution plan would be deductible in full. Previous reforms have also included such a proposal, but its implementation relies on the enactment of other additional legislation. As such, the timing of when this measure would come into law is unclear.
Gift tax – Cash gifts made by parents and grandparents to a child or grandchild to purchase a residence currently are exempt from gift tax for gifts up to JPY 5 million per year. This threshold would be increased to JPY 15 million for 2010 and reduced to JPY 10 million for 2011 with the exemption valid until the end of 2011. However, the exemption would only apply to beneficiaries whose taxable income during the year the gift is received is JPY 20 million or less.
Tax administration
The Tax Reform 2010 proposals contain a number of potential measures in respect of the future administration of tax matters in Japan, including the following:
- Establishment of a "Taxpayers' Charter" setting out the rights and obligations of taxpayers in Japan.
- Introduction of a Taxpayer Identification Number system that would apply for both tax and social security purposes.
- Abolition of the Social Insurance Agency and a merger of its operations with the National Tax Agency to create a Revenue Agency that would levy and collect tax and social security payments in a unified manner.
- Reform of the National Tax Tribunal to separate the appeals process further from the National Tax Authority.
- As taxpayers' rights are enhanced, their obligations to comply with tax law should be ensured, and stricter penalties would apply for non-compliance.
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