www.pwc.com/jp/tax Japan Tax Update Background to the potential revision to the Japanese tax rules for attributing profits to permanent establishments Issue 93, October 2013 The release of the report by the Ministry of Finance (MOF) with potential amendments to align the taxation of branches with the OECD's authorised approach represents a fundamental modification of Japanese tax law; in line with international tax trends and the approach of Japan's major trading partners. This article explores the contextual background to the report, the rationale for any change and where it may lead. This article is published together with our technical newsletter on MOF's report, as a complementary analysis. In late 2012 MOF announced its intention to change the existing rules for the attribution of profit to a permanent establishment (PE). The MOF proposal is that the authorised OECD approach to the attribution of profit (AOA) be adopted into the Japanese tax legislation. As set out in the OECD s 2010 Report on the Attribution of Profits to Permanent Establishments 1, the AOA states that the profits to be attributed to a PE are the profits that the PE would have earned at arm's length, if it were a separate and independent enterprise, taking into account the functions performed, assets used and risks assumed. That is, the AOA hypothesises the PE as a separate legal entity and, applying the OECD's Transfer Pricing Guidelines by analogy, attributes an arm's length return for the functions performed, assets used and risks assumed by the PE. Since that time MOF has expended considerable energy and resources to canvass taxpayer views on the proposed changes. In particular, MOF has been interested to identify the key issues that most concern taxpayers in relation to the scope and application of any change in law. There can be no doubt that this is an extremely complex area of tax law. To help companies understand and navigate through the relevant issues, this article provides some background on the key issues that are likely to arise and the impact they may have on taxpayers, regardless of industry and regardless of whether Japanese or foreign headquartered. 1 Part I, 8. See: http://www.oecd.org/ctp/transferpricing/45689524.pdf.
Current Japanese tax rules for attributing profit to a permanent establishment Under the current Japanese domestic tax rules for attribution of profit to PEs, all Japan sourced income is taxable in Japan, regardless of whether it is attributable to the PE or not 2. Japanese tax law further regulates what is the Japanese sourced income where the business is conducted both in and outside Japan. Except in certain specific cases, Japan sourced income for a PE is generally calculated as the portion of the enterprise s business income to be earned by the Japan PE, based on the separate enterprise theory or the degree of the contribution by the Japan PE 3. However, there are no further guidelines as to how this separate enterprise theory would be applied. Although deduction of certain costs incurred for the purposes of the business in Japan is permitted by the PE, this does not include certain expenses arising from dealings with another part of the enterprise to which the PE belongs. For example, deductibility is denied for interest expenses on funding or on royalty payments from use of intangible assets provided by head office (or another PE) 4. This position may be mitigated somewhat where there is a treaty in place, insofar as only the income attributable to the activities of the PE should then be taxable. However, none of Japan s tax treaties has an impact on the recognition of dealings between a head office and its PE (or between two PEs of the same enterprise) and therefore none of them changes the treatment of items such as interest or royalties. Why should Japan follow the OECD? Given the complexity of the issues raised by the proposed law change and the scope of existing tax laws that will need to be amended or rewritten if the AOA is adopted, many taxpayers may wonder whether it is in Japan s best interests to follow the OECD on this issue. The size of the task faced by the Japanese legislators can best be understood by the fact that it took the OECD 10 years to finalise its report on this topic. The obvious question is therefore whether the introduction of the AOA into the Japanese tax law is really necessary. Nevertheless, and despite the concerns described above, the answer to this question would appear to be yes, given Japan s status as an OECD member. One obligation of membership is that Japan is in principle required to ensure that its laws are consistent with OECD principles as far as possible. This is particularly the case when, as now, the Chairman of the OECD s Committee on Fiscal Affairs is Japanese 5. In addition, as other OECD member countries begin to incorporate the AOA into their own domestic legislation, and as the OECD Model Tax Treaty and its Commentary are updated to reflect the AOA principles, increasing gaps in interpretation of treaty provisions and in expectations between Japan and its treaty partners will arise if Japanese domestic law is not also updated. Moreover, the difficulties Japan may face around drafting and implementing legislation on an issue as complex as the attribution of profit to PEs should be somewhat mitigated by the significant body of work that already exists on this topic. This includes both work attributable to the efforts of the OECD in its collective capacity, as well as experience derived from the actions of individual member states (e.g., Australia), which have already implemented or are considering to implement the AOA themselves. It also includes a large volume of research and commentary written by both academics and professional advisers within the industry, who have followed the OECD s work over the course of many years. As a result, Japan benefits from extensive thought leadership and available knowledge in relation to the issues that need to be considered when making a significant change of this nature. Finally, bringing Japan s domestic legislation in alignment with what is increasingly seen as the international standard may improve Japan s attractiveness as a place of operation in Asia for multinationals. As will be explained in subsequent articles, the current domestic legislation can result in a need to use tax treaties or other additional structuring to achieve an end similar to what is currently achievable in Singapore or Hong Kong, key financial hub competitors of Japan in the region. On balance therefore, the Japanese government s intention to pursue this legislative change would appear to be a positive step forward. 2 Article 141-1 of the Corporate Tax Act and Article 176(1)-7 of the Corporate Tax Act Enforcement Order. 3 Article 176(1)-7 of Corporate Tax Act Enforcement Order. 4 In practice an exception is made to permit the deductibility of interest payments by bank branches (i.e., PEs) in Japan, however this is not legislated and is only permitted up to the amount of LIBOR. 5 Mr. Masatsugu Asakawa. PwC 2
What is the scope of the proposed law change? Reaching this conclusion is the easiest part of the implementation process. The breadth and scope of the existing laws that may need to be amended to fully reflect the principles of the AOA are significant. They cover not only the obvious issues such as the definition of domestic source income and the rules for attributing profit, but also include areas such as transfer pricing, withholding taxation, thin capitalisation, the taxation of certain incomes earned by offshore parties even without a PE, earnings stripping and foreign tax credits. There also remain issues for which the OECD provides different alternatives, i.e., identifying the most suitable approach to the allocation of capital to the PE. For these, the Japanese government will first be required to analyse the available options and select their preferred position(s) before drafting and implementation work can even be started. As part of this introduction to the AOA, the discussion below provides further background on a selection of these topics. Applicability of transfer pricing The application of transfer pricing rules to determine the profit to be attributed to PEs based on the functionally separate entity approach is the underlying principle of the AOA. Consistent with this, the generally accepted position in discussions around the AOA is that transfer pricing rules will be applied by analogy, including the transfer pricing rules governing documentation. At first glance it would appear that transfer pricing is one area where there is already sufficient and clear guidance that may be easily adapted for the purposes of applying the AOA. The Japanese transfer pricing rules, similar to those in many other jurisdictions, provide detailed guidance on (i) methodologies for determining arm s length pricing and (ii) documentation that should be maintained by the taxpayer in order to support the conclusions reached through application of those methodologies. The fact is however, that application of the transfer pricing rules by analogy may require some additional legislative amendment. This is because a subsidiary-to-subsidiary transaction physically exists, in contrast to a dealing between a PE and its head office (or other PE). As a result, additional guidance will need to be provided as to the standard to be met in order for a dealing to be recognised before the transfer pricing rules can be applied by analogy for the purposes of profit attribution. This will be particularly important if inadequate documentation by the taxpayer is sufficient cause for the Japanese tax authorities to invoke taxation by presumption in the case of an attribution of profit to a PE (just as it is cause under the Japanese transfer pricing rules for transactions between separate legal entities). Foreign tax credits Where income earned by a PE in Japan under the AOA is subject to taxation in another country, a question arises as to whether that PE should be able to take a foreign tax credit in Japan. For example, take the case where a US multinational enterprise earns income from a third country, say Korea, and that income is subject to withholding tax in Korea. If a portion of that income is allocated to a Japanese PE of the US head office, that income will be subject to double taxation (withholding tax in Korea and income tax in Japan). Even if foreign tax credits will be available to a Japanese PE in such cases, it does not mean that a foreign tax credit will be provided where the withholding taxation is imposed by the jurisdiction of the head office, i.e., the US in the above example. That is, if the Japanese PE earns income from activities carried on in the US, which is subject to withholding tax in the US, the position may well be taken that the obligation is on the head office jurisdiction to provide the foreign tax credit to avoid double taxation. A similar issue may arise if the income earned by the Japanese PE is subject to corporate income tax in the jurisdiction of the head office. While it is relatively simple to understand the exclusion in the latter case similarly, no foreign tax credit would be available to a Japanese subsidiary of a multinational in such situations it is more difficult in the former. That is, if a Japanese subsidiary of a multinational earned income from business activities in the parent jurisdiction, which was subject to withholding tax in that jurisdiction, in contrast that Japanese subsidiary would generally be entitled to a foreign tax credit in Japan. The treatment of foreign tax credits for foreign PEs of Japanese headquartered companies raises different questions, such as how to apply the definition of foreign source income. PwC 3
Allocation of capital In order to determine the arm s length interest expenses that should be borne by a PE, it is necessary to consider the amount of capital that should be allocated to it. Although three methods are proposed by the OECD, it is likely that any future Japanese legislation will focus on two of these, namely: (i) a capital allocation approach, i.e., where the enterprise s actual capital is allocated in accordance with the attribution of assets and risks, thus leading to attribution of an amount of capital to the PE 6 ; and (ii) the thin capitalisation approach, i.e., where the PE is allocated the same amount of capital as would an independent enterprise carrying on the same or similar activities under the same or similar conditions as the PE 7. Practical difficulties exist with both these approaches. For the former, the obvious method is to allocate capital based on the amount of assets borne by the PE out of the corporation s total assets. However, not all corporations will track assets, particularly financial assets in the banking context (i.e., risk-weighted assets), to this level. The OECD also illustrates an example where the assets of the PE are of a different class or character than those of the enterprise as a whole 8. In such cases, a purely mathematical calculation of capital using an allocation formula may over or understate the capital of the PE, depending on whether its assets carry more or less risk than those of the rest of the enterprise. In contrast under the thin capitalisation approach, there is the opposite concern that it will over or understate the capital of the enterprise as a whole 9. This is because the capital held by independent enterprises in different jurisdictions will be impacted by local market conditions or the local regulatory environment. In any case, given the conservative nature of the thin capitalisation approach in Japan, taxpayers in the financial services industry may be unlikely to adopt this option. **************************** Finally, while there is a large amount of guidance from the OECD and other industry sources on the profit attribution issue for financial institutions, guidance for taxpayers in other industries is far more limited 10. Although some of the most difficult questions raised by this topic are indeed related specifically to financial institutions, such as the allocation of capital within a bank, this does not avoid the need for careful consideration of the impact of these new rules on other taxpayers. With this background in mind, a rewrite of the Japanese legislation is likely to be more prescriptive than the OECD and other guidance in this area if it is to be comprehensive. Indeed, given that many OECD member countries are still only in the process of considering implementation of the AOA and have yet to take any legislative steps, the Japanese government may well be at the forefront of decision-making around some of these uncertainties. Implementation of the AOA Determining the scope and drafting the contents of the proposed legislation requires a significant amount of theoretical analysis. As outlined above however, there is existing thought leadership available to guide the Japanese government in this area, even if it is primarily focused on financial institutions. Once drafted however, more practical considerations will arise. For example, will the law be effective immediately, or will there be a phased approach to implementation? This will be particularly relevant where the attribution of profit to the PE requires data that may not yet be available in the taxpayer s information or accounting systems, such as may be necessary for allocating capital. Similarly, consideration will need to be given to the training and education of tax examiners in Japan in relation to application of the new rules. Considering the degree of the change from the current domestic rules, there is potential for much confusion in future investigations if training is not undertaken adequately and within a reasonable timeframe following the enactment of the new law. 6 OECD s 2010 Report on the Attribution of Profits to Permanent Establishments, Part I, 121-128. 7 OECD s 2010 Report on the Attribution of Profits to Permanent Establishments, Part I, 129-134. 8 OECD s 2010 Report on the Attribution of Profits to Permanent Establishments, Part I, 124. 9 OECD s 2010 Report on the Attribution of Profits to Permanent Establishments, Part I, 134. 10 Although see Attributing profits to a dependent agent permanent establishment, Australian Taxation Office at http://www.transferpricing.com/pdf/australia_pe.pdf for one example. PwC 4
The impact of the law change on Japan s treaty network will also need to be addressed. First, how should Japan itself interpret the relationship between the new domestic law and existing treaties, drafted as they were under the pre-aoa framework? At the same time, it will also be incumbent on the Japanese tax authorities to continue to monitor the implementation of the AOA by other governments, both within and without the OECD. Where another government has also implemented the AOA in its domestic rules, how should the provisions of the existing treaty with that counterparty be (re-)interpreted? On the other hand, where key trading partners have not yet (or do not intend to) implement the AOA, the potential impact on treaty negotiations with those jurisdictions will need to be carefully considered. Conclusion Through the discussion above it is hoped that taxpayers will obtain an overview of the likely scope and impact of the proposed law change, and as a result will begin to consider and to prepare themselves for the introduction of the amended legislation as it pertains to them. As highlighted in this article, areas of particular focus for taxpayers going forward should be on beginning to document dealings for recognition purposes, and on considering what arm s length pricing might look like for those dealings that are identified. In addition, as the proposal from the Japanese government becomes more defined in the coming months, it will be important for taxpayers to continue to monitor its impact on these and other issues. Nevertheless, and as described above, the Japanese government s intention to pursue this legislative change is a positive step forward for taxpayers. It will ensure that Japan remains aligned with global best practices in this area, as well as minimising the possibility of differences in interpretation of profit attribution principles between Japan and other OECD member countries, many of whom still remain among Japan s largest trading partners. For more information, please consult your tax representative or contact any of the following members listed below: Zeirishi-Hojin PricewaterhouseCoopers Kasumigaseki Bldg. 15F, 2-5, Kasumigaseki 3-chome, Chiyoda-ku, Tokyo 100-6015 Telephone: 81-3-5251-2400, http://www.pwc.com/jp/tax Corporate Tax Consulting Yoko Kawasaki Marc Lim Financial Services Corporate Tax Consulting 81-3-5251-2450 81-3-5251-2867 yoko.kawasaki@jp.pwc.com lim.marc@jp.pwc.com Akemi Kito 81-3-5251-2461 akemi.kitou@jp.pwc.com Stuart Porter 81-3-5251-2944 stuart.porter@jp.pwc.com Transfer Pricing Consulting Ryann Thomas 81-3-5251-2356 ryann.thomas@jp.pwc.com Director Naoki Hayakawa 81-3-5251-6714 naoki.hayakawa@jp.pwc.com PwC Japan Tax (Zeirishi-Hojin PricewaterhouseCoopers), a PwC member firm, is one of the largest professional tax corporations in Japan with more than 500 people. In addition to tax compliance services our tax professionals are experienced in providing tax consulting advice in all aspects of domestic/international taxation including financial and real estate, transfer pricing, M&A, group reorganisation, global tax planning, and the consolidated tax system to clients in various industries. PwC firms help organisations and individuals create the value they re looking for. We re a network of firms in 158 countries with more than 180,000 people who are committed to delivering quality in assurance, tax and advisory services. Tell us what matters to you and find out more by visiting us at www.pwc.com This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. 2013 Zeirishi-Hojin PricewaterhouseCoopers. All rights reserved. PwC refers to Zeirishi-Hojin PricewaterhouseCoopers, a member firm in Japan, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. PwC 5