TAX NEWS - DECEMber 2009

Japan Tax: Requests for exemption from withholding tax on corporate bonds

Japan's recently reconstituted Tax Committee has been tasked with reviewing the overall tax system and is expected to complete an outline of the 2010 tax reforms by mid-December, with submission of a draft tax bill expected in early 2010. In making its review, the Committee has, among other actions, held hearings with interested public and private parties.

A reading of the related comments and requests indicates a common theme among the various interested parties - the introduction of a withholding tax exemption for overseas investors in bonds issued by Japanese corporations.

Japanese companies traditionally have relied heavily on banks to finance their operations, rather than using the capital markets. Where Japanese companies have issued bonds domestically, nonresident investors are subject to a 15% withholding tax on interest. The withholding tax disadvantages Japanese corporate bonds as compared to both Japanese public bonds (national and municipal) and corporate bonds issued by corporations based in other jurisdictions (e.g. the U.S. and the U.K) in which foreign investors have long enjoyed a withholding tax exemption on any bond interest they receive.

Alongside the treatment of domestic bonds, Japanese corporations have the option of issuing Eurobonds (a separate offshore issuance) that must be taken up by nonresident investors or qualified financial investors (QFIs), with interest
payments made offshore. Interest payments on such Eurobonds are exempt from withholding tax to the extent investors submit required documentation in a timely manner. However, a bond issuance must be either all Eurobond - thus excluding the domestic market (other than QFIs) - or all domestic bonds - thus imposing a withholding tax requirement on foreign
investors.

The issue has been thrown into sharp focus as Japanese companies and their investors wait for the 2010 tax reform to be published. Japan's banks have become increasingly reluctant to increase credit lines. This reluctance is occurring at the same time that raising capital on the equity markets has become more challenging than it has been for many years.

Consequently, Japanese corporations must look to the debt capital markets for their funding needs. Given the traditionally conservative nature of Japanese investors, many Japanese corporations need access to the relatively higher-risk-taking foreign investor market. The current withholding tax regime clearly limits such access.

The various bodies lobbying in respect of next year's tax reform are, therefore, requesting a leveling of the playing field for Japan's bond market: (1) an exemption from withholding tax on interest for foreign investors in Japanese corporate bonds; and (2) that the administrative procedure for applying for such an exemption should be as simple as possible to encourage investors to take advantage of the scheme. The latter may further be applied to the existing exemption regime for municipal bonds, which requires investors to apply for the exemption in respect of each issuance in which they invest. A one-off application, for example, that is valid for either three years or until there is a material change in circumstances would prompt investors to take full advantage of the exemption, thus encouraging foreign investors to provide capital to Japanese companies.

Clearly, the Japanese government will have to consider the potential loss in revenue any such measures would create and balance this against the obvious benefit of smoother access to foreign capital that the measures would afford and the additional capital inflows that would likely result. That said, a measure that encourages foreign investors to invest in Japanese corporate bonds, while maximizing the administrative ease of doing so, should be supported to help stimulate economic growth in the world's second largest economy.

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