Businesses generally adopt a corporate form, either a joint-stock company (Kabushiki-Kaisha – KK) or a limited liability company (Godo-Kaisha – GK). The KK is intended for a business with a number of shareholders and subject to certain disclosure obligations, although it is used for a closed business as well, while the GK is only for a closed business with limited disclosure. Corporate forms of businesses (including KK and GK) are taxed as separate legal entities.
Civil Partnerships (Nin-i Kumiai) and Investment Business Limited Partnerships (Toshi-jigyo Yugen Sekinin Kumiai) are commonly used for the purposes of various funds since they are transparent for Japanese tax purposes. Investment Business Limited Partnerships are used in particular as they afford limited liability protection for investors. A silent partnership (Tokumei Kumiai – TK) arrangement can achieve an effect similar to a transparent treatment.
The test for the residence of incorporated businesses is the “location of head or principal office” test. Under Japanese domestic tax law, a corporation is treated as a Japanese corporation (having a corporate residence in Japan) if it has its head office or principal office in Japan, regardless of the place of effective management. For transparent entities, the residence of each partner must be determined for Japanese tax purposes; if a partner is an individual, the residence is determined to exist at the place of the centre of his/her life, while if a partner is a corporation, it is subject to the location of head or principal office test. Please note that foreign limited partners must satisfy certain conditions in order to be exempt from the potential permanent establishment taxation due to attribution by Japanese resident partners.
The nominal rate of national corporation tax (combined with local corporation tax) is approximately 26%, and the effective corporation tax rate – relevant national and local taxes combined – for companies operating in Tokyo for the fiscal year beginning on or after 1 April 2020 is as follows:
Businesses owned by individuals or through transparent entities are subject to a progressive individual tax rate, with a maximum of 55.945% (national and local taxes combined).
The tax base for corporation tax is the net taxable income, which is calculated based on the results reflected in the taxpayer company’s profit and loss statements, prepared in accordance with Japanese generally accepted accounting principles. The main differences between the tax accounting and the financial accounting include, but are not limited to, the treatment of donations and entertainment expenses. Donations, including any kind of economic benefit granted for no or unreasonably low consideration, are generally deductible only up to a certain limited amount. The deductibility of entertainment expenses is subject to certain qualifications and a certain ceiling.
Profits are generally taxed on an accrual basis, with certain exceptions for significantly small businesses.
Japan does not adopt a patent box, but Japanese tax law does provide for special tax credits and deductions on certain research and development expenses.
A number of special incentives apply to capital expenditures in terms of special depreciation or tax credits. There are other special taxation measures aimed at increasing wages and improving productivity.
In general, the tax losses of past fiscal years can be carried forward to offset (by deduction) the taxable income of the current fiscal year, with such deduction being limited to a maximum of 50% (for a fiscal year beginning beginning on or after 1 April 2018) of the before-tax-loss-deduction taxable income. Losses survive for ten years (for losses accrued in a fiscal year beginning beginning on or after 1 April 2018). Please note that these limitations are not applicable (thus, a deduction of losses of up to 100% of the income is available) to the small and medium-sized companies that are stipulated under Japanese tax law – ie, that have a stated capital of JPY100 million or less and are not a wholly-owned subsidiary of a company (Japanese or non-Japanese) with a stated capital of JPY500 million or more.
The tax loss of the current year can be carried back to offset (by deduction) the taxable income of the previous year for the above-stated small and medium-sized companies. For taxable years ending between 1 February 2020 and 31 January 2022, the carry-back is extended to companies that have a stated capital of more than JPY100 million and no more than JPY1 billion (with certain exceptions), as a special relief against COVID-19.
Income losses can be offset against capital gain and vice versa.
Thin Capitalisation Rules
The payor company of interest may be denied a deduction of the interest paid to a non-resident recipient for its own corporation tax purposes, due to the application of the “thin capitalisation” rules under Japanese domestic tax law. Such rules deny the deductibility of interest expenses paid to the payor company’s foreign affiliates upon the portion of the debt exceeding three times the shareholder's equity when such company’s annual average ratio of debt to equity exceeds 3:1, subject to an exemption available based on separate criteria.
Earnings Stripping Rules
Japan has earnings stripping rules, under which a deduction for “net interest payments” (as defined in such rules) in excess of 20% (or 50% before 1 April 2020) of an “adjusted taxable income” (as defined in such rules) will be disallowed, and the disallowed amounts may be carried forward for seven ensuing business years. If the disallowed interest amount under the earnings stripping rules is smaller than the amount disallowed for deduction under the thin capitalisation rules, then deduction is disallowed to the extent of the larger of the two disallowed amounts.
The old 50% (of an adjusted taxable income) threshold was less rigorous than the standard recommended by BEPS Action 4 Report, “Limiting Base Erosion Involving Interest Deductions and Other Financial Payments” (ie, 10% to 30%). Accordingly, in 2019 the Japanese government tightened its earnings stripping rules by lowering the threshold from 50% to 20% and widening the scope of the rules (subjecting interest on third party loans to the rules, and excluding dividends from an adjusted taxable income), in line with the OECD recommendations and suggestions.
Even if deductibility is denied under the earnings stripping rules, the relief under a treaty (ie, the reduced withholding tax rate) available to the non-resident recipient of such interest would nevertheless not be restricted.
Transfer Pricing Rules
Japanese transfer pricing rules apply to interest that is paid by a Japanese corporation to its foreign related parties, where the interest that is deemed to be in excess of an arm’s-length interest is not deductible.
There are two categories of tax grouping rules under Japanese tax law:
A group of Japanese companies in which a Japanese parent company owns – directly or indirectly through other Japanese companies – no less than 100% of other Japanese subsidiaries can elect to file a consolidated tax return. The consolidated tax is calculated on the basis of the aggregate net taxable income of the parent company and all consolidated subsidiaries. With certain exceptions, when a company participates in the consolidated tax return group from outside, the participating company’s carry-forward losses will be lost and cannot be used to offset the income of the existing companies in the consolidated tax return group. The consolidated tax return rules were significantly amended in 2020 and the new rules will be applicable to taxable years beginning on or after 1 April 2022, under which restrictions on the carry-forward of losses will be more stringent.
Separate from these consolidated tax return rules, there are special rules for intra-group transactions (the “Group Taxation Rules”), which apply to group companies in a “100% group” (ie, companies that have a direct or indirect 100% shareholding relationship), even if they do not elect to file a consolidated tax return. The Group Taxation Rules apply to Japanese companies that are wholly owned by a foreign or Japanese company or an individual (to which certain family members’ ownership is attributed). The Group Taxation Rules include the following rules, among others:
Under the Group Taxation Rules, the losses of one company are not allowed to be used to offset income of other group companies.
In Japan, neither the consolidation rules nor the Group Taxation Rules allow for relief for losses of overseas subsidiaries.
For purposes of income taxes imposed on a company in Japan (not an individual), generally all of the taxable income of a company is aggregated, regardless of whether such income is classified as capital gains or ordinary/business profits.
Japan applies Consumption Tax, which is a Japanese version of Value Added Tax. The current tax rate is 10%. No rate reduction has yet been implemented, announced or planned by the Japanese government in response to COVID-19.
Certain enumerated items of revenue derived by Japanese residents (either individuals or corporations) are subject to income tax withheld at the source by the payer. Items payable by an incorporated business that are subject to withholding tax include payments of interest and dividends, and payments of salary and remuneration to employees. See 4.1 Withholding Taxes regarding withholding tax for income payable by non-Japanese individual residents and foreign corporations.
There are some transaction taxes in Japan, including Stamp Duty, Registration and Licence Tax, Real Property Acquisition Tax and Automobile Acquisition Tax, among others.
Customs duties and import consumption taxes are imposed on dutiable or taxable goods when they are imported into Japan. The rates of the customs duty for imported items are listed in the tariff schedule. The rate of the import consumption tax is 10%.
Local enterprise tax is imposed by local governments on enterprises located in their jurisdictions. In addition, among local taxes, Prefectural Inhabitant Tax per capita levy, Municipal Inhabitant Tax per capita levy, Fixed Assets Tax and Automobile Tax are of general application to the business operations of incorporated businesses in Japan.
Most closely held local businesses operate in corporate form, as either a joint-stock company (KK) or a limited liability company (GK).
In Japan, generally speaking, corporate rates (approximately 31% or 35% depending on the amount of the stated capital) would be lower than individual rates for individuals who earn sufficiently large income (a maximum of 55.945%). No specific avoidance rules apply to a corporation that consists effectively of an individual's income, which are intended to prevent high-income earners from earning income at corporate rates. However, the Japanese tax authority may attempt to attribute a corporation's income to an individual, and hold him/her personally liable for the income purported to have been earned by a corporation.
Japanese corporation tax is generally imposed at the same rate upon all corporate taxable profits, regardless of whether such profits are distributed or retained. As an exception, a certain additional surtax (at the rate of 10%, 15% or 20%) may be imposed on certain portions of retained earnings of certain types of so-called family companies, unless such family company is a small and medium-sized company as stipulated under Japanese tax law (ie, a company with a stated capital of JPY100 million or less that is not a wholly owned subsidiary of a company (Japanese or non-Japanese) with a stated capital of JPY500 million or more).
Japanese resident individuals are taxed on dividends from closely held corporations at progressive rates up to approximately 50% after dividend credits. They are taxed on the gain on the sale of shares in closely held corporations at 20.315%, which is an efficient manner for the exit of an investment in closed held corporations. For taxation on sales of shares by non-resident individuals, see 5.3 Capital Gains of Non-residents.
Japanese resident individuals are taxed on dividends from publicly traded corporations at 20.315%. They are taxed on the gain on the sale of shares in publicly traded corporation at 20.315%. For taxation on sales of shares by non-resident individuals, see 5.3 Capital Gains of Non-residents.
Under Japanese domestic tax law, generally, a non-resident (either a company or individual) is subject to Japanese withholding tax with respect to interest on loans, dividends and royalties at the rate of 20.42%, and with respect to interest on government and corporate bonds and bank deposits at 15.315%, in the absence of income tax treaties.
However, most of the income tax treaties currently in force in Japan generally provide that the reduced treaty rate in the source country shall be 15% or 10% for portfolio investors and 10% or 5% for parent and other certain major shareholders. Furthermore, under the Japan/US Treaty and a certain limited number of other modernised tax treaties recently executed by Japan (including those with Australia, France, the Netherlands, Sweden, Switzerland and the United Kingdom), the withholding tax rate is reduced to 10% for portfolio investors and 5% or 0% for parent and other certain major shareholders.
If real property (land or any right on land or any building or auxiliary facility or structure), commercial or otherwise, that is located within Japan is alienated by a non-resident (either a individual or company), the gross amount of the consideration received by such non-resident for such alienation is subject to Japanese withholding tax at the rate of 10.21%, with certain exceptions (including no withholding tax for an alienation to an individual for use as a personal or family residence for a consideration of JPY100 million or less).
As of 1 November 2020, there are 66 income tax treaties (including an agreement between private associations of Japan and Taiwan) applicable to 75 jurisdictions currently in force in Japan, including OECD countries and non-OECD countries.
The Japanese tax authorities may challenge the use of an entity that is a resident of a country that has a tax treaty with Japan, if such entity is effectively owned or controlled by a non-treaty country resident. Legal bases for denial of benefits include the following:
Japanese transfer pricing rules are applicable to inbound investors operating through a local corporation, and by and large follow the OECD Transfer Pricing Guidelines. Generally speaking, a local corporation controlled by a non-Japan shareholder is often afforded only a limited function, such as limited risk distribution. For such a limited function entity, the most appropriate transfer pricing method would be the transactional net margin method (TNMM). If the TNMM applies, a party that performs simple or routine functions is deemed a contractor who does not assume business risk, and is often viewed to be compensated with the same operating margin as comparable companies in the same industry and business. The Japanese tax authorities may challenge the comparable companies selected by a taxpayer, arguing that the arm's-length price should have been lower or higher.
The Japanese tax authorities may challenge the use of related-party limited risk distribution arrangements for the sale of goods, and recharacterise it as a reseller. In fact, in the Adobe case, the Japanese tax authorities viewed a limited risk marketing subsidiary as a reseller and applied a transfer pricing rule accordingly. However, the Tokyo High Court rejected such recharacterisation in its judgment dated 30 October 2008, and nullified the tax authorities' adjustment. Still, the Japanese tax authorities may attempt to challenge the use of such arrangements on various legal bases.
Japanese transfer pricing rules by and large follow the OECD Transfer Pricing Guidelines.
Generally speaking, in a transaction involving a country where competent authority relief is effective, taxpayers tend to seek such relief. The Japanese tax authorities have received a number of requests for competent authority relief, including mutual agreement procedures (MAPs) and advance pricing agreements (APAs), with OECD member countries. With Australia, Germany, Korea, the United Kingdom and the United States in particular, most of the requests have been successfully resolved by agreements between the relevant governments. In addition, the Japanese government has had MAPs and APAs with non-OECD member countries, including China, Hong Kong, India, Indonesia, Singapore, Taiwan, Thailand, Malaysia and Vietnam; however, with respect to competent authority relief with non-OECD member countries, precedents are relatively few.
The Japanese tax authorities are generally positive in negotiating and resolving issues, although they may be reluctant when the case involves countries where there are no or few MAP or APA precedents.
When transfer pricing claims are settled through MAPs, compensating adjustments are allowed/made.
If a foreign parent forms a Japanese subsidiary that is a corporation, such Japanese subsidiary will be treated as a Japanese taxpayer and will be subject to Japanese corporation tax on its worldwide income in the same manner as any other domestic Japanese corporation, subject to the exclusion of 95% of dividends from certain foreign subsidiaries. A branch of a non-resident corporation, by contrast, is generally only subject to Japanese corporation tax on the profits attributable to its permanent establishment in Japan. There is no branch profits tax or other similar tax that is applicable to a branch of a non-resident company, but not a subsidiary.
With respect to capital gains on the sale of stock in a Japanese company, when a non-resident shareholder (either a company or individual) that has no permanent establishment in Japan alienates its shares in a Japanese company, such shareholder is not subject to any Japanese taxation, with certain exceptions, including the following.
First, where such shareholder owns 25% or more of the issued shares of a Japanese company in a three-year period and sells 5% or more of the issued shares in aggregate in a single fiscal year, such non-resident alienator is required to file a tax return in Japan and is subject to Japanese personal income tax or corporation tax (but not withholding tax), as the case may be, on a net income basis with respect to any capital gains.
Second, the special rules for a Real Property Related Company (defined below) apply when a non-resident individual or a non-resident company and his/her/its special related parties, in aggregate, hold more than 2% (5% if listed) of the shares issued by a company, the value of whose assets are 50% or more attributable directly or indirectly to real property (land or any right on land or any building or auxiliary facility or structure), commercial or otherwise, that is located within Japan (“Real Property Related Company”), or shares of other Real Property Related Companies.
If the special rules for a Real Property Related Company are applicable, such non-resident company or individual is required to file a tax return in Japan and is subject to Japanese personal income tax or corporation tax (but not withholding tax), as the case may be, on a net income basis with respect to any capital gains.
When either of the aforementioned exceptions applies, the capital gains are taxed at the general national corporation tax rate on a non-resident company or at 15.315% on a non-resident individual. Treaty relief may be available, depending on the jurisdiction of the non-resident shareholder.
Generally speaking, the disposal of an indirect holding in a Japanese corporation by a non-Japanese group will not trigger any tax or tax charges in Japan. However, there are a few exceptions where a change of control of non-Japanese shareholders in a Japanese corporation will trigger Japanese taxation (see 5.3 Capital Gains of Non-residents).
A change of control does not generally restrict a corporation from utilising its accumulated tax losses incurred in prior years. However, under certain specified events that take place within five years of the date of the change of control (measured, in principle, by more than 50% of the issued and outstanding shares), the utilisation of the tax losses of the company may be restricted. The restriction applies in the following circumstances, for example:
No specific formulas are used to determine the taxable income of foreign-owned Japanese corporations selling goods or providing services to third parties. In many cases, for Japanese transfer pricing purposes, the TNMM would be the most appropriate method to produce the arm's-length price for a Japanese entity selling goods or providing services.
There is no established standard applied in allowing a deduction for payments by a Japanese corporation for management and administrative expenses incurred by it. Whether payments for management and administrative expenses are deductible is determined according to their substance – ie, if the management or administrative services are so valuable in terms of benefits the corporation receives, compared to payments to be made to an independent service provider under similar circumstances.
See 2.5 Imposed Limits on Deduction of Interest.
The foreign income of local corporations is not exempt from Japanese corporate tax, except for dividends from certain foreign subsidiaries. See 6.3 Taxation on Dividends from Foreign Subsidiaries.
There are limitations on deductibility on certain local expenses, including but not limited to donations and entertainment expenses. Donations, including any kind of economic benefit granted for no or unreasonably low consideration, are generally deductible only up to a certain limited amount. The deductibility of entertainment expenses is subject to certain qualifications and a certain ceiling.
With respect to dividends paid to a Japanese company by its foreign subsidiary, a participation exemption from Japanese income taxation is granted for 95% of such dividends if the Japanese company owns at least 25% of such foreign subsidiary’s issued and outstanding shares or voting shares for at least six months. The 25% threshold requirement may be altered if a tax treaty explicitly so provides, or if a particular taxpayer is eligible for treaty benefits under an applicable tax treaty in which a lower threshold is required for a treaty-based indirect foreign tax credit eligibility (for example, a 10% shareholding threshold is provided under Article 23(1)(b) of the Japan/US Treaty).
When the intangibles developed by a Japanese corporation are used by non-Japanese subsidiaries, the Japanese corporation should be entitled to a royalty payment as a licensor from licensee non-Japanese subsidiaries. Accordingly, even if the non-Japanese subsidiaries do not pay a royalty, for the purpose of Japanese transfer pricing rules, the Japanese corporation would be deemed to receive an arm's-length royalty from the non-Japanese subsidiaries, and would be taxed accordingly.
Japan has its own CFC rules. If such CFC rules are applied to any particular overseas subsidiary, the net profits (but not the net losses) of such subsidiary shall be deemed to constitute the Japanese parent shareholder's taxable income in proportion to its shareholding percentage, regardless of whether or not such profits are distributed to the Japanese shareholder. These rules apply to Japanese tax payers that own 10% or more of the shares in a certain overseas subsidiary that is more than 50% owned, in aggregate, by Japanese resident individuals or companies directly or indirectly.
The Japanese CFC rules were overhauled in 2017 in line with BEPS Action 3, “Designing Effective Controlled Foreign Company Rules”, and the new rules became applicable for the relevant subsidiaries’ fiscal years beginning on or after 1 April 2018. Under the new rules, the following applies:
See 6.5 Taxation of Income of Non-local Subsidiaries Under CFC-Type Rules.
Japanese corporations are taxed on the gain on the sale of shares in non-Japanese affiliates, and subject to the general Japanese corporate income taxation. There is no participation exemption for the gain on the sale of shares in non-Japanese affiliates.
Japanese tax law does not have a general anti-avoidance rule, but it does include a so-called “specific” anti-avoidance rule for a family company (ie, a company where more than 50% of the shares are held by three or fewer shareholders and certain related persons). Japanese tax law also has specific anti-avoidance rules that involve corporate reorganisation transactions and consolidated tax return filings.
In addition, there is an anti-avoidance rule for transactions regarding income attributable to a permanent establishment of overseas corporations, which is applicable to internal and other dealings between a non-Japanese company and its Japanese branch.
Under these specific anti-avoidance rules, transactions that are viewed as “unjust” can be recharacterised and reconstructed to a “normal” or “natural” form of transactions, with different tax implications (presumably higher tax burdens).
The Japanese tax authorities invoke specific anti-avoidance rules against corporate reorganisation transactions utilising intra-group losses, sometimes successfully in cases such as the Yahoo Japan case (the Supreme Court case dated 29 February 2016) and sometimes unsuccessfully in cases such as the IBM case (the Tokyo High Court judgment dated 25 March 2015).
There are no statutory or regulatory rules setting forth a regular routine audit cycle in Japan; the Japanese tax authorities are free to choose when they audit a certain taxpayer. However, significantly large corporations commonly go through audits every three to five years.
The Japanese tax authorities encourage corporations to co-operate with them and to voluntarily disclose certain information for compliance purposes. As an incentive, if the authorities acknowledge that a certain taxpayer is in compliance with tax laws, they may refrain from auditing that taxpayer for one year in addition to the period customarily taken to audit that taxpayer in the past. However, this is up to the discretion of the authorities, and a voluntary disclosure will not necessarily entail the exemption or relaxation of any tax audit or other procedural requirements, nor will it reduce any tax.
Japan has implemented a majority of the OECD’s recommendations on the BEPS project, as summarised in the following sections.
The Japanese government is proactive in leading the BEPS initiative and has implemented a majority of its actions.
No specific legislation has yet been created to capture digital presence, although the Japanese tax authorities appear to be eager to capture digital presence in enforcement. For example, in 2009, it was reported that the Japanese tax authorities made adjustments on a certain Japanese affiliate of Amazon.com because such affiliate was viewed as a permanent establishment of Amazon, based on the finding that Amazon US’s computers were used in Japan, Japanese employees were instructed by Amazon US and the Japanese affiliate functioned in more than just a logistical capacity. Amazon sought relief from a MAP with competent authorities, and the US and Japanese tax authorities reached an agreement in 2010 that resulted in no significant tax expense for Amazon. If the OECD makes specific recommendations for taxing digital activities, the Japanese government may move to enforce or take legislative actions in line with them.
Certain cross-border digital services rendered by foreign enterprises are now subject to Japanese Consumption Tax.
The Japanese government has not adopted any aggressively competitive tax regime in order to attract foreign investments, although the recent administration abolished an entrenched high corporate tax rate, reducing the effective corporate tax rate to approximately 30%. However, this is in line with the global standard, or not competitive with it. The Japanese governmental competitive tax policy objective is not against the BEPS project.
The Japanese tax system does not appear to be more vulnerable to aggressive tax avoidance schemes than other jurisdictions, since Japan has not adopted significantly competitive tax systems such as patent boxes or harmful tax rulings.
Japan introduced legislation in response to BEPS Action 2 Report, “Neutralising the Effects of Hybrid Mismatch Arrangements”, which denies exclusion for dividends received from 25%-owned non-Japanese companies (see 6.3 Taxation on Dividends from Foreign Subsidiaries), as long as they are deductible in the payer country, including dividends on MRPS issued in Australia and dividends from a Brazilian company.
Japan has a worldwide income taxation regime, where Japanese affiliates of a foreign group are subject to Japanese corporation tax on their worldwide income in the same manner as any other domestic Japanese corporations, subject to the exclusion of 95% of dividends from certain foreign subsidiaries. See 6.3 Taxation on Dividends from Foreign Subsidiaries.
While Japan has adopted a worldwide income taxation system in general, it also has comprehensive CFC rules that combine an entity approach and an income approach, and are perceived as being sufficiently broad to capture movable income shifted to low-tax jurisdictions. The exemption from CFC taxation afforded to a company with substance is an important element of the current Japanese CFC rules. A sweeper CFC rule may make offshore subsidiaries of Japanese corporations whose profits are taxed at a “low rate" vulnerable to CFC apportionment, as those doing active business have been exempt under the current Japanese CFC rules. Please see 6.5 Taxation of Income of Non-local Subsidiaries Under CFC-Type Rules.
The double taxation convention limitations and anti-avoidance rules that were introduced under BEPS projects are unlikely to have a significant impact on inbound and outbound investors, as Japan has already adopted the limitation on benefits clauses and the “beneficial owner” provisions in many of the existing double tax conventions.
On the other hand, the impact of the “principal purpose test” that was introduced by the MLI is uncertain since the language of the test (ie, a benefit under the treaty shall not be granted "if it is reasonable to conclude... that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit”) is vague and no clear interpretation is established.
The transfer pricing changes proposed by the BEPS projects were mostly introduced into the Japanese transfer pricing rules, including three-tiered documentation rules and the rules for evaluating hard-to-value intangibles. As the exchange of country-by-country reports has begun between a number of countries, it is expected that the tax authorities will use them to identify potential targets for audit. Corporations are required to be more careful against potential tax audits from multiple tax authorities.
Even though the rules for hard-to-value intangibles have been introduced, it is still hard to measure the value of intangibles in practice. The taxation of profits from intellectual property is and will be a particular source of controversy in Japan as well as in other jurisdictions.
In response to BEPS Action 13, “Guidance on Transfer Pricing Documentation and Country-by-Country Reporting”, the Japanese government introduced transfer pricing legislation to adopt the three-tiered documentation approach consisting of a country-by-country report, a master file and a local file. Against moves of certain European countries, the Japanese government is reluctant to make information available to the public or to the countries that may make information public. According to the Japanese tax authorities, they have provided country-by-country reporting information filed by Japanese taxpayers only to the jurisdictions that satisfied the standards set by the OECD, including those for confidentiality and appropriate use of such information. Under such policy, Japan provided country-by-country reporting information to 52 jurisdictions for 844 multinational enterprise groups, and received such information from 44 jurisdictions for 1,751 multinational enterprise groups in 2019.
See 9.3 Profile of International Tax.
Although the Japanese government has not officially announced its position, it appears to favour a unified form of the “Pillar One” options that are proposed by the OECD. Apparently, the Japanese government is wary of supporting a revenue-based digital service tax (such as that adopted by France and other countries).
Japan has not introduced any other provisions than stated herein dealing with the taxation of offshore intellectual property.
2021 Tax Reform
On 26 January 2021, the government presented the 2021 Tax Reform proposals to the Japanese Parliament (the "Diet"). The reform is expected to be passed into law by the end of March. The proposals aim to establish Japan as an international financial hub, by attracting fund managers and other high-skilled human resources.
Capital gain treatment to be allowed for carried interest for individuals
Where a fund in the form of a (limited) partnership invests in shares and earns capital gains from the sale of such shares, the fund managers, as general partners, are entitled to certain returns in excess of their capital contribution based on their investment performance under the terms and conditions of the fund (the so-called “carried interest”).
Under Japanese tax law, it is uncertain whether the carried interest paid to the Japanese resident individual fund manager (directly or through a partnership) is taxed as a capital gain on shares (at 20.315%) or as ordinary income for the rendering of personal services (at a maximum of 55.945%).
Under the 2021 Tax Reform proposal, the carried interest paid to a resident (individual) of Japan will be treated as stock capital gain (taxed at 20.42%) as opposed to ordinary income (taxed at a maximum of 55.945%), on the promulgated conditions, including the requirement that the distribution ratio is economically reasonable and that certain documentation is filed.
Deduction of performance-linked remuneration paid to unlisted asset management companies operating in Japan
Currently, performance-linked remuneration paid to directors of a Japanese company is deductible only if the calculation thereof is disclosed in the Annual Securities Report, thereby effectively limiting its availability to listed companies only. Under the 2021 Tax Reform proposal, the scope of deduction will cover certain unlisted asset management companies that make certain filings under the Financial Instruments and Exchange Act (FIEA), unless such companies are certain family-owned companies. The rationale is to encourage the payment of performance-linked remuneration to non-listed companies, thereby attracting talented fund managers, in circumstances where tailor-made remuneration for fund managers' interests is not expected.
The eligible asset management companies must earn 75% or more of their revenue from the following businesses:
Deductions are subject to transparency requirements, including the following:
Extended scope of exemption from permanent establishment taxation for foreign limited partners
In general, when non-Japanese residents (individuals or corporations) invest in Japan as limited partners of either a Japanese or non-Japanese limited partnership, they can be taxed on any allocated income from the limited partnership that is attributable to a permanent establishment (PE) in Japan where a general partner is a Japanese resident. As an exception, a non-Japanese resident limited partner is exempt from the PE taxation if it holds less than 25% of the investment, subject to certain filing requirements.
Regarding application of the 25% test above, where the foreign partner invests in the relevant limited partnership ("Master Fund") through another upper-layer partnership ("Feeder Fund"), the 25% test is only applied by requiring the investment of all foreign investors in the Feeder Fund to be aggregated. For example, if a Feeder Fund, composed of independent non-Japanese investors A (24%), B (24%), C (24%) and D (24%) and a Japanese general partner, has 50% of the investment in the Master Fund, they do not qualify for the exemption as A, B, C and D has 48% (=50% x (24+24+24+24)%) in the Master fund in total.
The 2021 Tax Reform proposal is intended to relax the requirements for the 25% investment test. Specifically, the 25% test will be applicable to the investment ratio at the level of the Feeder Fund, effectively widening the scope of exemption from PE taxation to the foreign investors investing through the Feeder Fund. In the example above, the non-Japanese investors A, B, C and D will each be viewed as holding 12% investment, below 25% in the Master Fund (= 50% x 24%), thereby qualifying for the exemption.
Relaxed inheritance tax for foreign nationals
In the past, when a foreign national and non-Japanese resident (heir) inherits assets from a foreign national and non-Japanese resident (the deceased), Japanese inheritance tax was imposed (at a maximum of 55%) on the inheritance asset located outside Japan if the deceased had stayed in Japan for more than ten years.
This taxation was criticised as being an obstacle to attracting foreign management candidates, skilled employees, and professionals, who are afraid that their assets outside Japan would be subject to Japanese inheritance tax (at the maximum 55%) if they are a resident in Japan for more than ten years.
Under the 2018 Tax Reform, limitations were introduced on the scope of Japanese inheritance taxation, so that inheritance tax is not imposed on assets located outside Japan with respect to the foreign national and non-Japanese resident who inherits said assets from a foreign national and non-Japanese resident (the deceased), regardless of the term of the deceased's past residency in Japan. Under this reform, when a foreign national had stayed in Japan for work and left Japan, later to become a non-Japanese resident, their assets located outside Japan will not be subject to Japanese inheritance tax even if they had stayed in Japan for more than ten years.
The 2021 Tax Reform will introduce further limitations on the scope of inheritance taxation, so that inheritance tax will not be imposed on the assets located outside Japan inherited by the foreign national and non-Japanese resident heir, or the foreign national and Japanese resident heir who stays in Japan under certain visas (including a working visa), from even the Japanese-resident foreign national (the deceased) staying in Japan under certain visas, regardless of the term of the deceased's residency in Japan. Under the new law, when a foreign national who is now staying in Japan under a working visa, their assets located outside Japan will not be subject to Japanese inheritance tax even if they stay in Japan for more than ten years. This reform is expected to attract high-skilled human resources to Japan.
Shionogi case – tax-free reorganisation in the transfer of shares of a foreign partnership
The treatment of a foreign partnership under Japanese tax law has been unclear for a number of years. In particular, the scope of tax-free reorganisation involving a foreign partnership is ambiguous, creating uncertainty for taxpayers contemplating cross-border restructurings.
Last year, a case involving a Japanese pharmaceutical corporation set an important precedent. In such case, Shionogi & Co., Ltd. (the Taxpayer) formed a joint venture in 2001 with GlaxoSmithKline (GSK) in order to develop drugs for HIV treatment. The legal form of the joint venture was a Cayman Islands Special Limited Liability Partnership (CILP), with the Taxpayer and GSK each owning 50% evenly. After such initial formation, it was decided that Pfizer would join the joint venture, and therefore, the joint venture was reorganised, including the subject transaction. For the reorganisation, the Taxpayer contributed its share of the CILP interest (foreign partnership interest) into its UK subsidiary in exchange for its corporate shares, thereby converting its holding structure into one through a UK subsidiary.
The Taxpayer intended the contribution to be tax-free, which the Japanese tax authority disputed, viewing the contribution as a transfer of assets from inside Japan to outside Japan since the partnership interest had originally belonged to the Taxpayer, which was a Japanese corporation. From this perspective, the contribution resulted in a revenue loss for the Japanese government on the built-in gain of domestic assets. Based on this finding, the Japanese tax authority made an adjustment on the alleged realised capital gain in the amount of approximately USD500 million.
The issue here is whether the contributed assets (ie, the Taxpayer's share of the foreign partnership interest) are viewed as having been located outside Japan. If so viewed, it would qualify for tax-free reorganisation under Japanese tax law because the transaction took place completely outside Japan. The Japanese tax authority regarded the contributed assets (the foreign partnership interest) as having existed inside Japan because the foreign partnership interest was registered in the Taxpayer’s books and under the administration of the Taxpayer's headquarters.
In its judgment dated 11 March 2020, the Tokyo District Court rejected the tax authority's findings and nullified the adjustment. The court held the Taxpayer's share of the foreign interest to be an "integral/inseparable combination of (i) a share of the partnership assets, and (ii) contractual status as a (limited) partner." The court stated that the origin of value of the share of the foreign partnership lies in the partnership assets, as opposed to the contractual status and, accordingly, the location of the contributed asset – the share of the foreign partnership – corresponds to where the primary partnership assets are located (ie, where the data relating to the clinical tests and other intangible assets are stored). The court held that such data and other valuable intangible assets were located outside Japan (ie, in the office of the US affiliate of GSK), so the transfer of the foreign partnership interest qualified for tax-free treatment. Based on such judgment, it would appear the court believes that the capital gain had not accrued in Japan since the value principally lay in the assets (located outside Japan) and not the contractual status embodied in the partnership interest.
At present, cross-border joint ventures organised as foreign partnerships have become prevalent, and reorganisation is common in order to keep up with rapid changes in today's economic environment.
The above case has been appealed and is currently pending before the Tokyo High Court.
Thin capitalisation rules
In a rare application of the Japanese thin capitalisation rules, the Tokyo District court approved, in a judgment dated 3 September 2020, the Japanese tax authority's adjustment based on denial of a deduction of interest on a loan borrowed by a Japanese company from its quasi-foreign controlling shareholder.
The case concerned a Japanese company that borrowed a total of JPY16.4 billion from a well-known fund manager and activist at an interest rate of 14.5% per annum, which had been deducted by the borrower company for its corporate income tax return. The Japanese tax authority invoked the Japanese thin capitalisation rules based on the finding that the fund manager, a Japanese national yet not a resident of Japan, was a legislative equivalent to a "foreign controlling shareholder".
Japan has the type of thin capitalisation rules where the payor Japanese company of interest may be denied a deduction of the interest paid to a non-resident related recipient for the company's corporation income tax purposes. The rationale of the rules is to prevent income tax base erosion utilising interest payment deductions. Such rules deny the deductibility of interest expenses paid to the payor company’s foreign controlling shareholder when such company’s annual average ratio of debt to equity exceeds 3:1, subject to an exemption available based on separate criteria. The subject payments are principally those made from the Japanese company to its controlling shareholders. However, the rules extend coverage to someone who is able to determine the direction of the company, and subject such person to the same treatment as a "foreign controlling shareholder".
According to the news report, the amount of the loan from the fund manager accounted for 59.1% and 75.24%, respectively, of the total assets of the company for the relevant years and, therefore, the court found that the company raised a substantial portion of its funds for its business activities through borrowing from the fund manager. The court held that the fund manager exercised significant influence on the company's businesses given that the company's borrowing from the fund manager accounted for an extremely large portion of the raised funds of the company.
This case suggests that the Japanese tax authority is paying attention to the base erosion through Japanese companies' interest payments to non-residents which are made not only to its controlling shareholders, but also to someone who has an effective influence without any formal controlling relationship.