Japanese companies may have to reorganise their holding company and shareholder structures if the government succeeds in enacting new tax reform proposals, reports Karry Lai. Jurisdictions such as the UK and US may be labelled as tax havens if the new rules go through.
The Japanese government has set out tax reform proposals for 2017, including changes to the anti-tax haven controlled foreign corporation (CFC) rules. Prime Minister Shinzo Abe’s administration wants to minimise tax avoidance by companies through the use of foreign subsidiaries of Japanese companies, so is proposing to change the CFC rules in accordance with action 3 (designing effective controlled foreign company rules) of the OECD’s base erosion and profit sharing (BEPS) project. The changes would conform the rules with the principle that profits should be taxed where economic activities occur and where value is created.
“The new regime will be effective for controlled foreign subsidiaries’ fiscal year which will start on April 1 2018 or later,” says Makoto Sakai, partner at Mori Hamada & Matsumoto. “The basic concept was announced in December 2016 and the government will need to finalise the rules for implementation after the law gets passed.”
“Foreign corporations with Japanese subsidiaries and Japanese companies that have subsidiaries in other countries will be affected,” adds Sakai.
Entity approach vs income approach
The CFC rules take two approaches to the tax treatment of a foreign subsidiary’s income. For the entity approach, the whole income of a foreign subsidiary is aggregated with that of the Japanese company, while the income approach focuses on the nature of the income of the foreign subsidiary. The nature of the income is divided into active income (income through business) and passive income (interest, dividends and royalties). The passive income of a foreign subsidiary is aggregated with that of the Japanese company but the active income is not aggregated.
“Previously, the CFC rules mainly looked at the threshold of 20% and the income-based inclusion rule was very limited,” says Sakai. “The US’ rule, although it is under discussion for further amendments, looks at the kind of income received, but Japan looked mainly at the trigger rate and generally took on an entity approach, with the exception of passive income taxed. While partially adopting the income approach, the Japanese government thought it needed to adopt the new approach but it has maintained the old approach in that there is still a trigger rate.”
“Many countries use the income approach and it is suggested by BEPS; however, Japan uses both approaches,” says Nobuaki Iwashina, partner at TMI Associates. “Japanese companies must analyse whether the nature of the income of the foreign subsidiary is active or passive.”
Key amendments to the CFC rules
The changes set out in the proposal are:
- The tax rate exemption rule, where the CFC regime applies only to a foreign related company whose effective income tax rate is less than 20%, will be abolished.
- A foreign related company whose effective income tax rate is 20% or more will be subject to the CFC regime when it is one of three types of companies (a paper company, a cash box or a black-list company). There are proposals to establish a threshold test of 30% for the effective income tax rate.
- A paper company is one that maintains a fixed place of business to conduct its primary business or one that functions with its own administration, control and management in the jurisdiction of its head office.
- A cash box company is one that is within a larger company that owns assets but is located in a low tax jurisdiction, allowing the company’s profits generated from those assets to benefit from a low tax rate.
- A black-list company is a foreign related company whose head office is located in a jurisdiction that does not participate in the exchange of tax information, as designated by Japan’s finance minister.
- The scope of passive income will be expanded.
- A de facto control test will be included in the criteria of a foreign related company and Japanese shareholder subject to the income inclusion rules. This means that a foreign company which has certain relationships, even when the shareholding ratio is not more than 50%, such as the right to claim the residual property of the foreign company, will be treated as a foreign related company.
“Before the tax reform, for a paper company set up in the country whose tax rate is 20% or more, like the Netherlands, Japanese CFC rules did not apply,” says Iwashina. “However, after the next tax reform, the rules will apply. Therefore many global companies may need to transfer that holding function conducted by paper companies in Netherlands to other subsidiaries.”
“The passive income inclusion is the most important of the changes,” says Tsuyoshi Ito, partner at Nishimura & Asahi. “Dividends and the capital gains/losses from transfer of securities where the company has less than 25% of equity will be included whereas it is currently at 10%.”
How business should be prepared for the new regulation
Businesses should be sensitive to how their shareholding structures are organised to minimise their impact. “It may be necessary for companies with subsidiaries in countries like the UK and the Netherlands to re-organise their group holding regime and they may need to review their shareholding structures,” says Sakai.
“For example, for a Japanese company with an intermediary holding company in the Netherlands with shares in country A with a shareholding ratio of 20%, there may be a case in which the holding company should not keep its shareholding in company A, but should transfer shares to another holding company located in other countries,” adds Sakai.
“Japanese companies need to carefully prepare documentation for their foreign subsidiaries,” says Iwashina.
“With the Japanese CFC rule’s trigger rate of 20%, if the tax rate of a country is under 20%, the country is deemed as a tax haven under the Japanese CFC rules,” says Iwashina. “If President Trump reduces the US corporate tax rate to 15%, and Prime Minister May reduces the UK corporate tax rate to 10%, the US and UK will be tax havens and subsidiaries in the US and UK may be subject to Japanese CFC rules.” The UK’s rate, which is 20% now, will be under the trigger rate in less than two months’ time, and is due to go lower, as it will fall to 19% from April 1 2017 and 17% from the same date in 2020.
The proposed amendments to the anti-tax haven rules will move Japan closer to implementing BEPS proposals and is a sign that the country is taking tax evasion seriously.