January 2009 Ernst & Young Shinnihon Tax JAPAN Newsletter Tax Treaties that have recently become effective Revisions to China s Turnover Tax System (This is an abridged translation of the Japan Newsletter posted on 30 January 2009.) Contents Tax Treaties that have recently become effective 1. Japan-Australia Tax Treaty 2. Japan-Pakistan Tax Treaty 3. Amendments to the Japan- Philippines Tax Treaty 4. Japan-Brunei Darussalam Tax Treaty 5. Basic Agreement on Double Tax Treaty with Kuwait Revisions to China s turnover Tax System 1. Summary of turnover tax system 2. Points of revisions to the turnover tax system This newsletter contains information on the currently revised tax treaties. The Japan-Australia Tax Treaty and the Japan-Pakistan Tax Treaty were replaced with new tax treaties respectively after a long period of time. Also, the first tax treaty between Japan and Brunei Darussalam was concluded and signed on 20 January 2009. Lastly, this newsletter provides a summary of the key points of China s turnover tax reform and the potential impact to Japanese companies operating in China.
Tax Treaties that have recently become effective 1. Japan-Australia Tax Treaty The Convention between Japan and Australia for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income (hereafter New Japan-Australia Treaty ) was brought into effect on 3 December 2008, and is applicable for amounts taxable on or after 1 January 2009 with respect to withholding tax. The new treaty provides reduced withholding tax rates on dividends, interest and royalties made on or after 1 January 2009, and introduces new limitation of benefits ( LOB ) rules to prevent abuse of the treaty. (1) Taxation of investment income 1 Dividends (Article 10) Withholding tax rates on dividends have been reduced or exempted as follows: Group dividends Other dividends Former Treaty 15% New Japan-Australia treaty Exempt 5% Conditions for new treaty rate to apply Corporations which hold at least 80% of the voting power and meet other requirements Corporations which hold at least of the voting power - Under the former treaty, the withholding tax rate on dividends was 15%. Under the new treaty, if certain conditions as set out below are met, the rate can be reduced to 5% or 0%. A rate applies in all other cases. (A) A 5% withholding tax rate will apply if the beneficial owner of the dividends is a company which owns directly shares representing at least of the voting power of the company paying the dividends; and (B) Dividends will be exempt from withholding tax if the beneficial owner of the dividends is a company that has owned directly shares representing at least 80% of the voting power of the company paying the dividends for the 12 month period ending on the date on which entitlement to the dividends is determined and the company that is the beneficial owner of the dividends: i. is a listed company as stipulated in the LOB article; ii. has at least 50% of the aggregate vote and value of its shares owned directly or indirectly by 5 or fewer companies referred to in subparagraph i); or iii. is granted benefits with respect to those dividends as stipulated under the LOB article. Notwithstanding the above changes, with regards to dividends paid by a Japanese company such as a special purpose company (tokutei mokuteki kaisha or TMK ), investment company (i.e. J-REIT), etc., which are entitled to deduct dividends paid when computing taxable income in Japan, the 15% withholding tax rate is applicable if more than 50% of the assets of such a company consist of real property situated in Japan. In all other cases dividends are subject to withholding tax. 1
2 Interest (Article 11) Former Treaty New Japan-Australia Treaty (Interest derived by governments, financial institutions, etc, is exempt) The withholding tax rate on interest is, in principle, the same as it was in the former treaty. However, under the new Japan-Australia treaty, interest is exempt from withholding tax if it is derived by a country s government body, political subdivision or local authority, the Bank of Japan or the Reserve Bank of Australia, or by certain other financial institutions. 3 Royalties (Article 12) Former Treaty New Japan-Australia Treaty 5% Under the former treaty the withholding tax rate on royalties was, however this has been reduced to 5%. In addition, royalties as consideration for the use of or the right to use industrial, commercial or scientific equipment has been removed from the definition of royalties. (2) Prevention of tax avoidance Under the former treaty, a beneficial owner of income was entitled to benefit from the provisions of the treaty provided the conditions under the relevant article were met. As the new Japan-Australia treaty provides greater benefits to potential taxpayers, the following provisions were established to prevent abuse of these benefits. 1 Limitation on Benefits (Article 23) In order to be entitled to the treaty benefits of tax exemption for business income, dividends, interest, and capital gains ( income subject to the LOB article ), the beneficial owner of income subject to the LOB article must be a resident of the relevant country, as well as meet one of the requirements listed under (A) to (C) below and the conditions that are stipulated in each of the articles concerning the income subject to the LOB article. (A) Qualified Person Test A beneficial owner of income subject to the LOB article is a resident of the relevant country and is deemed an individual, a qualified governmental entity, a certain type of pension fund, a certain type of listed entity, a certain type of non-listed entity, etc. (B) Active Trade or Business Test Where a resident is not a Qualified Person of the relevant country as specified in (A), however the resident is carrying on business in that country, income subject to the LOB article is derived in connection with, or incidental to, the business, and the conditions stipulated under each article concerning the income subject to the LOB article are met. (C) Benefits granted by competent authorities Where the beneficial owner does not meet the conditions stipulated under provisions (A) and (B) above, treaty benefits may be granted by the competent authority of the source country which determines under domestic law or administrative practice that the establishment, acquisition or maintenance of such a resident and the conduct of its operations are considered as not for the purpose of obtaining the benefits of the treaty. 2
2 Benefits do not apply due to the purpose or structure of the transaction (Article 10, 11 and 12) It has been made clear that with regards to income from dividends, interest, or royalties, the treaty benefits will not apply in cases of abuse of the treaty benefits in light of the purpose or structure of a transaction. 3 Taxation of a Sleeping Partnership (tokumei kumiai) (Article 20) Under the former treaty, there were no provisions with regards to the taxation of income from a sleeping partnership. In order to prevent tax avoidance by using a sleeping partnership, under the new Japan-Australia treaty, income arising from such partnerships will be taxed under domestic law of the source country. (3) Others 1 Treatment of income derived through fiscally transparent entities (Article 4, Paragraph 5) There may be cases where an entity, such as a partnership that is a resident of one country derives income from another country and is therefore subject to tax in that other country. At the same time, a partner in the same partnership is subject to tax in the resident country. In such cases, the partnership shall not be eligible for the benefits of the treaty since the partnership is not treated as a taxable person in its resident country, therefore it is not deemed a resident under the treaty although the partnership is subject to tax in the other country, the source country. A new provision has been included to deal with the taxation of entities which are treated differently in Japan and Australia, whereby income derived by such an entity will be taxed in the resident country of the entity that derived the income. 2 Transfer Pricing (Article 9) A new article has been included to effectively provide a statute of limitations of 7 years for the tax authorities of either country to make a transfer pricing assessment. The tax authorities of a country shall not make transfer pricing adjustments to the profits of an enterprise that is a resident of that country for enquiries that are initiated after 7 years from the end of the tax year in question. 3 Capital Gains (Article 13) While the former treaty did not provide for the taxation of capital gains, the new Japan-Australia treaty includes a new article which clarifies this point and is consistent with Japan s other tax treaties and the OECD Model Tax Treaty. Capital gains realized from the alienation of (i) real property, (ii) shares in certain real property holding companies, (iii) shares in a company in which 25% of the total issued shares are owned and at least 5% of the total issued shares are transferred, (iv) property, other than real property, forming part of the business property of a permanent establishment, and (v) ships or aircraft operated in international traffic, shall be taxable in the source country. All other capital gains shall only be taxable in the resident country. (4) Entry into force The new Japan-Australia treaty shall be applicable as follows: 3
1 With respect to taxes withheld at source, for amounts taxable on or after 1 January 2009. 2 With respect to taxes on income which are not withheld at source, for income of a taxable year beginning on or after 1 January 2009. 3 With respect to other taxes, for income of a taxable year beginning on or after 1 January 2009. 2. Japan-Pakistan Tax Treaty The new tax treaty between Japan and Pakistan was brought into effect on 9 November 2008 and is applicable for amounts taxable on or after 1 January 2009 with respect to withholding tax. The new Japan-Pakistan treaty completely revises the provisions of the former treaty and clarifies taxation in both countries. It makes clear the application of reduced withholding tax on royalties, interest, and dividends, and includes a provision regarding capital gains on the transfer of properties that was not included in the former treaty. Amongst the tax treaties concluded with Japan, the former treaty was the only treaty that used the force of attraction principle to tax business income, however this has been changed to the attributable income principle. Furthermore, the tax sparing credit system has been abolished with immediate effect. (1) Withholding tax on investment income (Articles 10, 11 and 12) Withholding tax rates on dividends, interest, and royalties have been reduced or exempted as follows: Income Former Treaty New Japan-Pakistan Treaty Dividends Group Dividends One third or more of the voting power is held 15% 50% or more of voting power is held (Note 1) 25% or more of voting power is held (Note 1) 5% 7.5% Other Dividends 20% (Domestic Law) Interest 30% (15% or 20% based on domestic law) Interest Exempt Interest Government bonds, securities, etc. Loan interest received by the government or financial institutions owned by the government Interest received by government institutions or the interest on debt-claims guaranteed by government institutions. Royalties Exempt (limited to royalties received by parties that do not have a permanent establishment) Note 1: Held by the beneficial owner of the dividend for a period of six months ending on the date on which entitlement to the dividends is determined. 4
(2) Clarification of taxation in the source country 1 Business Profits (Article 7) The system of taxing business profits has changed from the force of attraction principle to the attributable income principle. Under the former treaty, the force of attraction principle was used, whereby if a company resident in one country had a permanent establishment in the other country, all of the company s income that was derived in the country where the company had a permanent establishment would be subject to tax in that country. Under the new Japan-Pakistan Treaty, and similar to most of Japan s tax treaties, the taxation system has been changed to the attributable income principle so that only the income that is attributable to the company s permanent establishment in a country will be taxable in that country. 2 Fees for technical services (Article 13) Under a new provision in the new Japan-Pakistan treaty, consideration for technical services will be subject to withholding tax at a rate of in the source country. (3) Others 1 Capital Gains (Article 14) Under the former treaty, there was no provision with regards to the taxation of capital gains. A new article has been included to clarify the taxation of capital gains which is consistent with Japan s other tax treaties and the OECD Model Tax Treaty. Capital gains realized from the alienation of (i) real property, (ii) shares in certain real property holding companies, (iii) shares in a company in which 25% of the total issued shares are owned and at least 5% of the total issued shares are transferred, (iv) property, other than real property, forming part of the business property of a permanent establishment, and (v) ships or aircraft operated in international traffic, shall be taxable in the source country. All other capital gains shall only be taxable in the resident country. 2 Tax Sparing Credit System (Article 14 (3) of the former treaty) The tax sparing credit system was immediately abolished under the amendments. (4) Entry into force The new Japan-Pakistan tax treaty shall be applicable as follows: 1 With respect to taxes withheld at source, for amounts taxable on or after 1 January 2009. 2 With respect to taxes on income which are not withheld at source and enterprise tax, for income of a taxable year beginning on or after 1 January 2009. 5
3. Amendments to the Japan-Philippines Tax Treaty The Protocol amending the Japan-Philippines tax treaty ( the Amendments ) as of 5 December 2008 is applicable to amounts taxable on or after 1 January 2009 with respect to withholding tax. The Amendments have reduced withholding tax rates on royalties, interest, and dividends, as well as provided the content for the future abolishment of the tax sparing credit system. (1) Investment Income (Articles 3, 4 and 5 of the Amendments) Withholding tax rates on dividends, interest, and royalties have been reduced as follows: Dividends Interest Royalties Income Former Treaty Amendments Group dividends 25% or more of the subsidiary is owned and other conditions are met of the subsidiary is owned and other conditions are met Other dividends 25% 15% Certain government institutions, etc Government securities, or bonds or debentures Exempt All other cases 15% Royalties for the use of cinematograph films and films or tapes for radio or television broadcasting Exempt 15% 15% (no change) All other royalties 25% Note: The treatment of interest for certain government institutions, etc has been added. (19 March 2009) (2) Tax Sparing Credit System (Articles 6, 9 (3) of the Amendments) There are plans for the future abolishment of the tax sparing credit system which will be enforced within the next 10 years, however during this time tax sparing credit will also be expanded with regards to other dividends, other interest and other royalties. In addition, under the 2009 tax reforms, there are plans to make dividends from subsidiaries deductible, which should be taken into consideration when applying tax sparing credit to dividends. (3) Entry into force The Amendments shall be applicable as follows: 1 With respect to taxes withheld at source, for amounts taxable on or after 1 January 2009. 2 With respect to taxes on income which are not withheld at source, for income of a taxable year beginning on or after 1 January 2009. 6
4. Japan-Brunei Darussalam Tax Treaty In June 2008, the governments of Japan and Brunei Darussalam made a basic agreement in relation to a tax treaty which had been negotiated since November 2007. Consequently, the first tax treaty between the two countries was concluded and signed on 20 January 2009. (1) Reduced withholding tax rates on investment income (Articles 10, 11 and 12) The withholding tax rates on investment income (dividends, interest and royalties) derived from the source country shall be taxed as follows: Dividend Interest Income Maximum rate Group Dividends ( or greater shareholder)* 5% Other Dividends Certain government institutions, etc. Exempt Others Royalties * Held by the beneficial owner of the dividend for a period of six months ending on the date on which entitlement to the dividends is determined. (2) Clarification of the taxation of companies in investment countries (Articles 5 and 7) The Japan-Brunei tax treaty will introduce the principle of taxation of business income that is generally provided in other treaties which Japan has concluded. Thus, in the case where Japanese corporations invest in Brunei and set up a permanent establishment such as a branch to conduct business, the Japanese corporation will be subject to tax in Brunei on income derived from business activities conducted by the permanent establishment (limited to income of the permanent establishment). (3) Mutual Agreement Procedures (Article 24) Under the treaty's mutual agreement procedure provision, a taxpayer that considers itself subject to taxation by an investment country that is not in accordance with the treaty may request the tax authorities of the country of residence to resolve the issues via negotiations between the tax authorities of Japan and Brunei. (4) Information Exchange (Article 25) The treaty will provide for the exchange of information between the tax authorities of Japan and Brunei to ensure proper enforcement of their respective tax laws. (5) Entry into force After being approved in accordance with the legal procedures of each country, the Japan-Brunei tax treaty shall enter into force on the thirtieth day following the date of exchange of diplomatic notes indicating the completion of such procedures, and shall be applicable from the year following the year of entry into force. If the treaty is effective before 31 December 2009, it shall become applicable in Japan as follows: 1 With respect to taxes withheld at source, for amounts taxable on or after 1 January 2010. 7
2 With respect to taxes on income which are not withheld at source, for income of a taxable year beginning on or after 1 January 2010. 5. Basic Agreement on Double Tax Treaty with Kuwait Following negotiations since November 2006 regarding a tax treaty between Japan and Kuwait, the Ministry of Finance announced that an agreement in principle was made on 13 January 2009. Once both countries have gone through their respective government procedures, the tax treaty will be put into effect after the articles have been confirmed and the treaty is signed. According to the announcement by the Ministry of Finance, the main content of the treaty has been agreed as follows: (1) Clarification of the taxation of companies with investments in Kuwait In the case where Japanese corporations invest in Kuwait and set up a permanent establishment (branches, etc.) to conduct business there, only the income derived from the business activities conducted by the permanent establishment will be taxable in Kuwait. (2) Reduced withholding tax rates Source country withholding tax rates on income shall be as follows: Income Tax Rate Dividends Group Dividend ( or greater shareholder) 5% Others Interest * Royalties * Interest received by governments, central banks, or certain government-related financial institutions is exempt from withholding tax. (3) Negotiations between the tax authorities of Japan and Kuwait Under the treaty's mutual agreement procedure provision, a taxpayer that considers itself subject to taxation not in accordance with the treaty may request resolution via negotiations between the tax authorities in each country (mutual agreement procedures). (4) Information exchange between the tax authorities of Japan and Kuwait The treaty will provide for information exchange between the tax authorities of Japan and Kuwait to ensure the proper enforcement of their respective tax laws. For further information on the above treaties, please visit the Ministry of Finance link below: http://www.mof.go.jp/jouhou/syuzei/kokusaiz.htm 8
Revisions to China's Turnover Tax System The Chinese government revamped its tax system relating to three different types of turnover taxes - Value-Added Tax (VAT), Business Tax (BT) and Consumption Tax (CT), and put the provisional regulations and implementation rules on the three turnover taxes into effect on 1 January 2009. This following is a summary of the key points of the turnover tax reform and the potential impact to Japanese companies operating in China. 1. Summary of turnover tax system In China, three different types of taxes - Value-Added Tax (VAT), Business Tax (BT) and Consumption Tax (CT), are currently levied on the sale of products and the provision of services. VAT, BT and CT are levied on different items as set out below and collectively referred to as turnover tax. Type of turnover tax Value-Added Tax Business Tax Consumption Tax Main taxable items Sale, process, repair and import of goods Provision of services and sale of intangible assets Sale of particular goods (tobacco, alcohol, accessories, etc.) China established provisional regulations and implementation rules on VAT, BT and CT in 1993, creating the current turnover tax system which is comprised of these three types of taxes. As an overhaul of the turnover tax system, the provisional regulations and implementation rules on each turnover tax were revised in 2008. The revised provisional regulations and implementation rules came into effect on 1 January 2009. One of problems stemming from the previous turnover tax system was that the system, because it combines VAT and BT, forces a particular industry to bear an excessive tax burden. For example, construction and shipping companies sometimes had to bear the full amount of input tax because it was not allowed to be credited against output tax as two different types of turnover tax were applied on sales and purchases. The 2008 tax system reform was said to have the intention of ensuring a fairer tax burden by better combining VAT and BT. Judging from the provisions of the latest reform however, it is not a full reform but rather mere partial revisions. Nonetheless, it should be noted that the partial revisions include some important reforms such as a change in the treatment of input tax on the purchase of fixed assets under the VAT law and a change in the scope of charge under the BT law. 2. Points of revisions to the turnover tax system The following sets out the main points of revisions to the VAT, BT and CT provisional regulations that came into effect on 1 January 2009. (1) VAT The main point of the VAT revision is that input VAT on the purchase of fixed assets can now be credited against output VAT. Normally, taxpayers remit tax after deducting input VAT from output VAT, which is collected upon sales of products. The deduction of input VAT on the purchase of fixed assets was previously not allowed. This revision will reduce the tax burden on companies, which may result in increased capital investment. 9
(2) BT (3) CT However, foreign investment companies (foreign companies in China which obtain investment from abroad) can be exempted from tax on import of equipment and receive a tax refund for the purchase of China-made equipment even before the latest revision and therefore companies that have already been enjoying these tax benefits would not receive much direct benefit from the latest revision. Meanwhile, there is a possibility that the revision may cause an increase in production costs for companies that outsource processing and related services to companies in China because the import of equipment used for processing with supplied materials which was previously exempted from tax, was removed from the tax exemption list. In addition, segment calculation is required for sales if a taxpayer is in the business of selling goods and concurrently providing services. The revision stipulates that the tax authorities will classify sales into those from goods and others from services in cases where segment calculation cannot be done. Under the revision, the input tax credit is not allowed for small-scale taxpayers and a simplified method is used for calculating the tax amount. Previously, the tax rate of 4% was applied on commercial businesses and 6% for other companies, but a unified rate of 3% is applied under the simplified method. Other revisions include the extension of VAT reporting, a change in criteria of small-scale taxpayers and a change in tax base amount. The important point of revisions of BT is that criteria of service providers subject to BT was changed from location of services provided to location of taxpayers (companies or individuals). Previously, services provided in China were taxable, but the revision newly requires that service providers or recipients must be in China for the services provided to be taxable. In reality, however, many companies had to pay BT even for services they provided outside China because it was difficult to obtain a tax exemption certificate which is necessary for overseas money remittance. Therefore, the revision this time, although it is an important change, is expected to have a minor impact on companies because it only means that past practices will become consistent with the law. In line with the revision, the location where BT is payable was changed from the place where services are rendered to the place where the taxpayer s office is located or the taxpayer resides. Also, the period of BT reporting was extended and the provision concerning differential tax on subleasing operation was removed. The main point of CT revisions is the introduction of a new method, referred to as the combined method, which combines the existing methods, the rate-on-value method and the amount-on-volume method, and all three methods have been applied to calculate the tax amount. Cigarettes and distilled alcoholic beverages which were previously subject to the rate-on-value method are now subject to the combined method. In addition, the period of CT reporting was extended and special exception for individuals acceptance of processing on commission was added. Under the latest reforms to China s turnover tax system, the revision concerning VAT on the purchase of fixed assets is considered to have the most significant impact to Japanese companies. The combination of the two revisions that allows input VAT credit for the purchase of fixed assets on one hand and abolishes tax exemption for import of equipment to be used for processing with supplied materials on the other hand, practically give a favorable result to production types other than processing with supplied materials. In light of these reforms, manufacturing companies may want to consider what type of production methods should be adopted in China in the future. 10
Contact Ernst & Young Shinnihon Tax Kasumigaseki Bldg. 32nd Floor, 3-2-5, Kasumigaseki, Chiyoda-ku, Tokyo 100-6032 Tax Treaties that have recently become effective Jun Tamura, Partner 03-3506-2084 jun.tamura@jp.ey.com Revision to China s Turnover Tax System David Huang, Director 03-3506-2244 david.huang@jp.ey.com About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 135,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential. For more information, please visit www.ey.com. Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. About Ernst & Young Shinnihon Tax Ernst & Young s tax professionals in Japan provide you with deep technical knowledge, both global and local, combined with practical, commercial and industry experience. Our highly regarded tax and M&A advisory, compliance and transfer pricing professionals, consistent methodologies as well as unwavering commitment to quality service help you to build the strong compliance and reporting foundations and sustainable tax strategies that help your business achieve its ambitions. It s how Ernst & Young makes a difference. 2009 EYGM Limited. All Rights Reserved. This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither Ernst & Young Shinnihon Tax nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor. www.eytax.jp