I. Japanese CFC Rules and the 2010 tax reforms

Transcription

1 New developments in Japan s CFC rules: liberalisation, expansion, and clarification by Yasutaka Nishikori, Tsuyoshi Ito, James Emerson and Atsushi Mizushima, Nishimura & Asahi 50 This chapter provides an overview of how the Japanese government and the Supreme Court of Japan have recently liberalised and clarified Japan s controlled foreign companies rules (CFC Rules) on the one hand, while potentially expanding taxation on the other. These changes may have a significant impact on Japanese multinational corporations, as well as foreignowned Japanese corporations that control foreign subsidiaries. Therefore, foreign companies that own or are contemplating the acquisition of a Japanese corporation that owns non-japanese subsidiaries should also take note. I. Japanese CFC Rules and the 2010 tax reforms The 2010 tax reforms On March 24, 2010, the Japanese Diet amended Japan s Income Tax Law and other tax laws including those that make up the CFC Rules (Reforms), based on the 2010 tax reform proposals issued by the tax commission portion of the Japanese Cabinet on December 22, Overview of the current Japanese CFC Rules Below is a brief overview of the current state of Japanese law as a result of the Reforms 1 : (i) The CFC Rules only apply to the income of a specified foreign subsidiary (SFS), which is defined as a The CFC Rules, originally established in 1978, were in need of revision to accommodate changes to modern business practices and corporate structures. The Reforms liberalised the tax rules by generally reducing Japanese companies requirements to report the income of their controlled foreign companies. At the same time, however, the Japanese government instituted a tax regime involving the taxation of the passive income of many controlled foreign companies of Japanese parent companies, which could lead to greater levels of taxation. Yasutaka Nishikori Tsuyoshi Ito Yasutaka Nishikori, Partner tel: y_nishikori@jurists.co.jp Tsuyoshi Ito, Partner tel: t_ito@jurists.co.jp

2 company: (a) of which more than 50% of the shareholders are Japanese residents, Japanese legal entities, or related parties thereto; and (b) that is incorporated in a country in which the tax rate calculated pursuant to the CFC Rules is 20% or less. (ii) If a Japanese company 2 owns, either directly, indirectly, or with other group companies, at least a 10% interest in an SFS, then the Japanese company shall be required to report, as taxable income, its proportionate share of the taxable income of the SFS (Aggregate Tax Rule), unless an exemption is available. (iii) The income of an SFS (except for its passive income) will not be included in the taxable income of its Japanese shareholders if the SFS meets all of the following requirements (each of which will be discussed later in this chapter): (a) a business purpose test; (b) a substance test; (c) a management and control test; and (d) either an unrelated party test or a country of location test. (iv) Even if an SFS satisfies the above exemption requirements, an SFS s proportionate passive income (income arising out of certain assets held by it) shall be combined with the income of the aforementioned Japanese shareholders. Changes brought about by the Reforms The Reforms include amendments to: (i) taxpayer scope; (ii) SFS scope; (iii) CFC Rule exemptions; and (iv) the scope of income subject to aggregate taxation. Each of these changes is analysed further: 1. Taxpayer scope The Reforms changed the shareholding criteria for the scope of taxpayers to 10% from 5%. This change is intended to reduce the burden on a Japanese company to gather information about non- Japanese portfolio companies in which the Japanese company is a minor shareholder. 2. Scope of SFSs Reduction of Trigger Tax Rate With respect to the scope of companies that are included in SFSs, the Reforms changed the tax rate threshold from 25% to 20%. Because the number of companies that qualify as SFSs has significantly increased in recent years due to the global trend toward reduced corporate income tax rates, the Reforms may have a significant effect on Japanese companies with subsidiaries in countries that have corporate income tax rates that fall between 20% and 25%, for example: China, Indonesia, Korea, Malaysia, and Vietnam. It is noteworthy that subsidiaries located in Taiwan (20%), Singapore (17% from 2010), and Hong Kong (16.5%) are not affected by the reduction in the threshold rate. Trigger Tax Rate Calculation The tax rate for an SFS is calculated on the basis of each fiscal year using the following broad formula: Foreign corporate taxes on taxable income Ta xr a t e = Taxable income Note that taxable income in the formula, above, is an James Emerson Atsushi Mizushima James Emerson, Foreign Attorney tel: j_emerson@jurists.co.jp Atsushi Mizushima, Associate tel: a_mizushima@jurists.co.jp 51

3 52 adjusted version of the SFS s income, and non-taxable income, such as income from certain foreign dividends, is generally included therein. However, certain non-taxable items should not be reinserted because that could lead to double taxation. Prior to the enactment of the Reforms, the scope of foreign dividends received by an SFS that did not need to be included was limited to those which were non-taxable on the condition that the SFS held a certain shareholding percentage in such foreign companies. As such, if a subsidiary was located in a country (home country) that had a foreign dividend exclusion rule not specifying a requirement for minimum share ownership, such as the UK (where foreign dividends are deductible unless such dividend payment constitutes a scheme for tax avoidance), the non-taxable foreign dividends would be reinserted into the above denominator, consequently reducing the tax rate and giving rise to the possibility that the subsidiary, located in a country not seen as a tax haven, would still be deemed to be an SFS. The Reforms help to address the foregoing concern by stipulating that foreign dividends, which are non-taxable on the condition that those dividends do not constitute a scheme to reduce taxation, should not be included. 3. Exemptions relating to the Aggregate Tax Rule If an SFS meets all of the conditions described in Exhibit 1 during any given fiscal year, the Aggregate Tax Rule shall not apply to the SFS s income (excluding passive income) for such fiscal year. However, prior to the Reforms, some companies would not qualify for the exemptions even if they conducted a business that had real substance to it. The Reforms represent a means of trying to deal with this problem. As mentioned above, the Reforms introduced the regional headquarters (RHQ) concept. Today, many companies establish regional headquarters for the management of all group companies in a particular region, for the sake of effective group management. However, before the Reforms, regional headquarters were unable to satisfy the exemption requirement described above, and this created the possibility that the CFC Rules might impose undue additional taxation on economically reasonable activities. The Reforms resolved this issue by introducing the RHQ concept. The Reforms also created a wholesale business-related exclusion in the Unrelated Party Test. Under the previous version of the Unrelated Party Test, a non-japanese company that acted as a distributor for its Japanese parent company by purchasing products from its related companies, constituting a large portion of the non-japanese company's purchases, and selling the same to other related companies, could not satisfy the test. However, with increased business globalisation, many companies desire such a group structure to more effectively manage their inventory levels. The Reforms are intended to remedy this point. 4. Amendment to scope of income to be aggregated Previously, 10% of an SFS s personnel costs were deductible from the SFS s aggregated income attributable to its Japanese shareholders to assist SFSs that could not satisfy some of the exemption tests even when the SFS conducted business with actual employees. With the introduction of the RHQ concept, which is designed to address similar concerns, the personnel costs deduction was abolished by the Reforms. However, it is clear that for Japanese companies that own non-rhq SFSs, this modification of the CFC Rules could result in an expansion of taxation, due to the loss of the 10% personnel costs deduction. 5. Passive income changes When an SFS satisfied applicable exemptions, the Aggregate Tax Rule was not applied to any of the SFS s income prior to the Reforms. Pursuant to the Reforms, however, even when the SFS satisfies Aggregate Tax Rule exemptions, Japanese companies must now aggregate with their other taxable income a proportionate share of some types of passive income of its SFS. Consequently, a number of foreign subsidiaries will no longer be able to shelter low-taxed passive income by combining such income with active business income.

4

5 Exemption tests after and before Reforms Exhibit 1 54 Reforms (i) Business Purpose Test : The SFS s main business is not: share/bond holding; intellectual property right/copyright licensing; or aircraft/ship leasing. If an SFS s main business is the holding of shares and it falls under a company serving as an RHQ (as defined in the Previous Law column) and meets certain requirements, such business shall not be considered when determining the SFS s business purpose. (ii) Substance test : The SFS has an office, factory, shop, or other fixed business place that is needed to conduct its business in its home country. (iii) Management and control test : The SFS manages, controls and administers its business by itself. (iv) Either of the following: -- Where the SFS s main business is in wholesale sales, banking, trusts, securities, insurance, or air/ marine transportation -- Unrelated Party Test : No more than 50% of the transactions of the business of the SFS are conducted with related parties (as defined under the CFC Rules). With respect to an SFS mainly engaged in a wholesale sales business that falls under an RHQ, the SFS s CCs shall not be considered related parties. -- OR, where the Unrelated Party Test above does not apply -- Country of Location Test : The business of the SFS is conducted mainly in its home country. Previous law The RHQ exemption (underscored in the Reforms column) did not exist, however, a definintion for 'RHQ' is provided below for convenience. An RHQ is an SFS: (i) of which all of the shares are held, directly or indirectly, by a single Japanese entity; (ii) that holds two or more controlled companies (CCs, i.e., certain types of companies controlled by the SFS and its affiliates) and manages the operations (as defined in the CFC Rules) of the CCs; (iii) that has an office, factory, shop or other fixed business relating to operations management in its home country; and (iv) that has employees necessary for the management of operations (provided that such employees engage exclusively in managing operations; the officers of the SFS and parties related thereto shall not be counted as employees ). Unchanged. Unchanged. The wholesale business-related exclusion (underscored in the Reforms column) did not exist. Unchanged. Source: Nishimura & Asahi, 2010

6 Passive Income The following types of SFS income are now characterised as passive income: (i) Share dividends in a case where the SFS possesses less than 10% of the shares in an entity, and capital gains from share sales made through exchanges/over-the-counter transactions where the SFS possesses less than 10% of the shares in an entity. (ii) Bond interest, gains from bond redemptions and capital gains from bond sales through an exchange or over-the-counter transactions. (iii) Intellectual property rights/copyright royalties received, apart from rights created by the SFS. (iv) Income derived from aircraft/ship leases. Passive Income Exemptions Unless the SFS s main business is any of the types of business listed in the Business Purpose Test, the Aggregate Tax Rule will not apply to an SFS s passive income derived under (i) or (ii), above, if it is through certain essential activities of the SFS Dividends paid by SFSs Dividends paid by an SFS were usually fully exempt under the previous law when paid within 10 years, in order to avoid double taxation (i.e., taxation under the Aggregate Tax Rule and taxation of the Japanese shareholders own income). Although, this rule only applied to an SFS whose dividends were directly paid to its Japanese shareholders. The Reforms expanded the scope of the foregoing exemption. Now, when Japanese parent companies receive dividends from foreign subsidiaries, such dividends will be exempt to the extent of the proportionate share of the lesser of: (i) dividends that the foreign company received from a lower-tier foreign subsidiary during the past three years; or (ii) such lower-tier foreign subsidiary s income is attributable to its Japanese parent during the past three years. II. Japanese Supreme Court clarifications of CFC Rules As discussed above, the CFC Rules have been elaborated on and modified via legislative changes to accommodate trends in international business practices. However, despite this elaboration, some fundamental concepts and issues relating thereto still remain unclear and require judicial clarification. The Supreme Court of Japan (the Court) did its part at the end of 2009 to offer some additional clarifications in rendering two significant CFC Rule-related decisions, which are briefly summarised. What constitutes Foreign Corporate Tax? Any tax assessed by authorities outside of Japan (Foreign Corporate Tax), which is an element of the trigger tax rate calculation formula discussed earlier in this chapter, is defined under the CFC Rules as a tax based on the income of corporations, imposed by foreign countries or municipal governments, pursuant to the laws of the relevant countries. According to that definition, taxes not based on income such as value added taxes or franchise taxes do not fall under Foreign Corporate Tax. Beyond the definition, though, for clarification purposes, the CFC Rules also include lists of categorised items that fall under Foreign Corporate Tax and other items that do not. From a practical perspective, the lists provided obviously cannot cover every conceivable tax that may exist from time to time in every different country. On December 3, 2009, the Court passed judgment on a case dealing with a tax that had not been specifically mentioned in the CFC Rules. Guernsey (located in the Channel Islands) permits its taxpayers to select their own rate of income taxation, ranging anywhere from 0% to 30%. The question for the Court was whether such a tax should be considered Foreign Corporate Tax. Because the choice of the tax rate must be approved by the Guernsey tax authority, and because, once approved by the Guernsey tax authority, the payment of taxes at the chosen rate cannot be avoided, the Court agreed that the Guernsey tax could be considered Foreign Corporate Tax because it was not wholly discretionary. 55

7 56 Compatibility between the CFC Rules and tax treaties Various countries courts have reached different conclusions about whether controlled foreign company regulations are compatible with tax treaties based on the Organisation for Economic Co-operation and Development (OECD) Model Tax Convention. For example, the French Conseil d État ruled that French CFC Rules violated an applicable international tax treaty; whereas, in contrast, the Supreme Administrative Court of Finland determined that Finnish CFC Rules did not conflict with a given international tax treaty. On October 29, 2009, the Court held that Japanese CFC Rules do not violate the Japan-Singapore Tax Treaty, which follows the OECD Model Tax Convention, nor do they contradict the philosophical underpinnings thereof. The Court reached its conclusion by finding that while the CFC Rules provide for the taxation of a company by the authorities in the country in which such company is located, what the treaty restricts is limited to taxation by authorities in one country that is a party to the tax treaty on companies located in the other country that is a party to the tax treaty, whereas the Japanese CFC Rules are tailored to respond to unfair tax avoidance and provide reasonable exemptions and deductions, and therefore the Japanese CFC Rules are reasonable in their own right. III. Conclusion The Japanese government and the Court have liberalised, expanded and clarified the CFC Rules in certain significant respects. Going forward, it will be interesting to follow the ways in which the Reforms and the Court s recent decisions are implemented, interpreted and enforced, and we will continue to monitor the evolution of the CFC Rules and their potential impact on Japanese multinational corporations and foreign-owned Japanese corporations that control foreign subsidiaries. Notes: 1. While the Reforms took effect on April 1, 2010, the Reforms generally apply to Japanese shareholders who own SFSs whose fiscal years commenced on or after April 1, The tax treatment of individuals who are residents in Japan, and who are also subject to the CFC Rules, is beyond the scope of this Article. 3. Also, as a de minimis rule, if an SFS s gross passive income is JPY10m or less or its total passive income is 5% or less of the SFS s income before tax, the Aggregate Tax Rule shall not apply.