23 March 2018
Japanese 2016 tax reforms
Consistent with annual procedures, the Japanese government proposed Japanese tax reforms for 2016 last December. Several of the proposed reforms are focused on further advancing the overall economic reform program of the coalition government led by Prime Minister Abe (often referred to as 'Abenomics'). The entire reform package provides for reforms in the corporate tax, consumption tax and individual tax areas as well as addressing long standing issues such as online sales and the OECD anti-tax avoidance project known as BEPS. This update focuses solely on those reforms specific to corporate tax payers. The effective date of the proposed reforms discussed below was April 1, 2016 and includes:
- the reduction of national corporate tax rates
- the changes to the enterprise tax and special local corporate taxation scheme;
- the changes to the Net Operating Loss carry-forward and deduction limitation;
- the provisions related to corporate reorganizations;
- the controlled Foreign Corporation Reforms;
- the Income Attribution Rules;
- a new taxation scheme for online sales by foreign based entities;
- certain measures related to commitments under the OECD's Base Erosion and Profit Shifting (BEPS) project.
In addition to the reforms discussed in further detail below, other reforms include:
- the retention of the current 8% consumption tax rate for food and drink purchases as well as newspaper subscriptions;
- the special extensions of certain tax benefits for SME’s;
- the modification of special economic zones;
- the special provisions regarding securities and the exit tax;
- Transfer pricing; and
- the provisions relating to the Japan-Taiwan double taxation agreement (DTA).
These additional provisions are not covered in this article as they are beyond the scope of this discussion but will be discussed at a later date.
National corporate tax rate reduction
In keeping with its previously stated commitments to lower the corporate tax rate in Japan (historically one of the highest in the world) a corporate tax rate reduction was introduced which will be effected over a two-year period. The new rate effective from April 1, 2016 is 23.4%, down from the previous rate of 23.9%. The rate will also be reduced even further to 23.2% from 2018 onwards. This brings the rate more in line with that of other developed countries and is a significant reduction from the longstanding rate of over 40% which was in effect until 2012, when the government decided that reform of the rate was needed in order to stimulate the Japanese economy. It is hoped that these new lower rates will not only help to attract foreign investment into the country but also provide much needed tax relief for Japanese corporates.
Modification of the enterprise tax and repeal of the special local corporation tax
The Enterprise Tax is a multi-layered tax on companies with a capital base of more than JPY100 million (approximately USD900,000). This tax is computed by taxing three different components: a Value Added component, a Capital component, and an Income component. Various rates of taxation are applied to each of these components. The enterprise tax system was revised, under a previous tax reform, by splitting the tax into two parts, the corporate enterprise tax and a newly created 'special local corporate tax'. This newly created tax was a measure introduced to provide local governments with a portion of the proceeds from the national enterprise tax.
Under the 2016 tax reforms, this special local corporate tax is to be phased out during the 2016 tax year and will be abolished from 2017 onwards. Whilst this special tax will be abolished, the enterprise tax will revert to its pre-modified format.
Change in NOL limitations
Many countries, including Japan, have provisions for the utilization of net operating losses (NOL) in subsequent tax periods in order to offset taxable income in those periods. These NOL carry-forwards are often subject to limitations as to the percentage of income that may be offset and also to a limitation as to the number of years such losses can be carried forward. The new Japanese tax rules make an adjustment to the limitation rules on the use of NOL carry-forwards. The income offset limitation will be lowered incrementally over the next three years from the current rate of 65% to 60% from April 1, 2016, 55% from April 1, 2017, finally settling at a rate of 50% from April 1, 2018 and beyond. While this is a significant reduction in the previous NOL utilization limitation level of 80%, an offsetting extension of the NOL carry-forward period from nine to ten years will be implemented for tax years from April 1, 2018 onwards. This will effectively lead to more taxes being collected earlier and may result in a larger amount of NOLs expiring unutilized, even with the one-year additional carry-forward extension.
Corporate reorganization modifications
Japanese tax rules provide exemptions from tax for certain types of corporate reorganization transactions. To qualify for tax-exempt treatment, various requirements must be met as to the continuity of management and shareholder identity, so as to prevent abuse of the tax-free reorganization rules in transactions in which tax should be recognized. The 2016 tax reforms relax the restrictions on the resignation of specified directors and provide clarification around the continuity of shareholding rules for certain types of mergers, share splits and other share transfers.
As regards the continuity of management requirement for tax-exempt share exchanges and transfers, the resignation of specified directors will no longer disqualify the transaction from tax-exemption so long as at least one director remains as a director. Consequently, where the resignation of a director used to be problematic in the share exchange/transfer context, now there is more flexibility in the planning process since the resignation of all but one director will not negatively impact the tax-exempt nature of such transactions. Further, in transactions where a parent company acquires subsidiary shares in a qualifying share exchange or transfer, so long as the subsidiary has at least 50 shareholders prior to the acquisition, then such acquisition can be valued at the most recent tax return’s reported net asset value plus an adjustment for capital acquired.
CFC (Anti-tax haven) revisions
Japan, like many other developed countries, has special rules to prevent Japanese tax base erosion through the use of off-shore related-party companies located in jurisdictions with lower tax rates. The Japanese rules can be quite harsh and can result in significant tax liabilities and are also complex and difficult to apply in practice. The rules apply to related-party transactions with certain types of entities and provide special exemptions from classification in certain circumstances.
The 2016 tax reforms revise the exemption rules to include insurance companies which are active in the Lloyd’s market and also to exempt intra-group transactions between related-party tax haven entities as long as these entities are 100% owned, either directly or indirectly, by the same Japanese parent company. This effectively addresses the issue regarding Japanese taxation of transactions that were in effect not abusive and did not result in the reduction of the Japanese tax base.
An additional revision addresses the computation of foreign tax credits associated with taxable income in the tax haven context and specifically the application of the exempt foreign dividend rules. Under these new rules the computation of foreign taxes available for credit will be computed as follows:
Importantly, dividends which are exempt from the taxation on the CFC level are also excluded from the CFC’s subsidiary income in the above calculation.
Income attribution rules
As part of the 2014 tax reforms, specific provisions were enacted to address the issue of income attribution to permanent establishments (PE). While these reforms were comprehensive, special clarifications were required to support the adoption of the new income attribution rules which came into effect from April 1, 2016. These clarifications specifically address issues raised in the context of the computation of foreign tax credits and utilization of NOL carry-forwards of a PE after a qualifying merger.
The first of these clarifications focuses on the amount of foreign income used in computing the foreign taxes available for credit where a PE is allocated losses from a home based company. In cases where the amount of income allocated to the PE directly from the home based company is actually a loss (i.e., less than zero) then the balance of the loss is used for foreign tax credit computation purposes. However, in cases where the amount of income allocated to the PE plus other foreign sourced income results in a loss, then the loss is not taken account of in the foreign tax credit computation and the income amount is instead simply zero. This prevents the importing of foreign losses into the foreign tax credit computation.
The second clarification applies in a narrow set of circumstances whereby a previous Japanese PE’s losses are effectively reimported into Japan through a qualifying merger of two foreign entities. For example, if foreign company A and foreign company B each have PE’s with NOL carry-forwards (foreign company A having a current Japanese PE and foreign company B having a former Japanese PE) then, by undergoing a qualifying merger, these two companies can effectively reimport the losses of the former PE back into Japan. These new rules eliminate the NOL’s of the former Japanese PE and limit the deductibility of NOLs to the extent of the NOLs of the current Japanese PE only. This prevents the importing of NOLs into the Japanese tax regime and the trafficking in NOLs.
Taxation of online sales
Electronic (online) sales transactions have been a challenging issue for countries throughout the world. How to determine the source of the income and the incidence of taxation have been particularly troublesome with the OECD even weighing in on the subject as part of its Base Erosion and Profit Shifting (BEPS) project. The Japanese tax system has historically considered and defined the incidence of taxation for digital services to be either the domicile or residence of an individual or in the case of corporate service recipients, the location of the head office or principal office. This has led to difficulties in taxing certain B2B transactions where a foreign service provider provides a digital service to a recipient PE located outside Japan but belonging to a Japanese customer and where the service recipient is the Japanese based PE of a foreign business customer.
The new rules amend the incidence of taxation determination and provide that:
where the recipient is a foreign (i.e., not Japanese) PE of a Japanese customer, the service will be considered a foreign supply of services and not taxable in Japan; and
where the recipient is a Japanese PE of a foreign customer, the service will be considered as a domestic supply of services inside Japan and subject to Japanese taxation.
These new taxation rules will be effective from January 1, 2017.
BEPS adoption measures
Of course, no tax update is complete without considering the progress being made on the adoption of BEPS and any measures related thereto being adopted by the respective participating governments. Japan has fully committed to the BEPS project and has begun to implement the procedures and legislation required to progress the program in Japan. The Japanese transfer pricing rules are being modified to require MNEs to prepare the three types of documentation required under BEPS, namely the Country-by-Country Report, the Master File and the Local File. The first of these two will be mandatory from fiscal year 2016 onwards with the latter, the Local File, being mandatory from 2017 (tax year 2018) onwards. Whilst a discussion of the requirements of each of these reports is beyond the scope of this update, MNEs should make themselves aware of the requirements and implement documentation production and maintenance procedures accordingly.