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Japanese International Tax Policy and Corporate Taxation

Tadao Okamura

Professor of Law,

Kyoto University, Japan

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Summary

Basic structure of Japanese international taxation and its recent policy– Global system and territorial system

– Entire income taxation and attributable income taxation

– Recent changes in Japanese international taxation• Introduction of Dividend exemption and change in CFC

Recent changes in Japanese Corporate Tax Act (CTA) and interaction between corporate taxation and international taxation

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Global system

Worldwide taxation– All income is subject to taxation without regard to

the place where income derived.• In the case of resident individuals and domestic

corporations

– Income of non-resident aliens and foreign corporations is subject to taxation to the extent of their domestic source income.

• Because of this treatment, the concepts such as source and territory appear.

4

Territorial system

Territorial taxation– Only domestic source income is subject to

taxation.• However, in almost all the cases, residents are subject to

taxation on their worldwide income with the limited exemption of foreign source income.

Neutrality– A territorial system has been said to enhance CIN.

• In contrast, a global system has been said to promote CEN.

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Branch

American type source rules

In Japanese international taxation, income from sale by the branch located in Japan may not be sourced in Japan.

Corporation

Germany

Japan

China

Attribution

Japanese Treasury

6

Branch

CorporationCorporation

Entire income principle

In Japanese international taxation, income from investment by German headquarters is taxed on the branch located in Japan.

Investment Bank

Germany

Japan

Japanese Treasury

Attribution

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Attribution and Sourcing

Difference exists between attribution and sourcing.– Income may not be sourced in Japan though it is

attributable to Japanese branch.– Japanese branch is subject to taxation on income

sourced in Japan but attributable to German headquarters.

Income attribution as a personal concept– It reveals who earns income.

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Movement towardattributable taxation

United States– Some (not all) passive income is subject to the

branch located in United States without regard to its attribution.

• Effective connected income is mixed up with business income of that branch.

– A kind of attribution rule was introduced. Japan

– All the treaties follow OECD model based on attribution principle.

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From Indirect foreign tax creditto dividend exemption

Indirect foreign tax credit– This system deemed domestic corporation to pay

the tax to which its foreign subsidiary is subject on income of that subsidiary and allowed it to credit.

Dividend exemption from foreign subsidiary– Dividend other than 5% is exempt.– The reasons why Japan introduced this system are:

• promotion of the repatriation of accumulated profits in foreign subsidiaries

• simplicity

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Exemptionand a territorial system

Exemption of foreign source income and a territorial system– Some commentators and scholars are discussing

the movement toward a territorial system by exempting all foreign source income.

Is this understanding of the relationship between that exemption and a territorial system correct?

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Exemption of all foreign sourceincome and its problems (1/2)

Branch

Corporation

Germany

Japan

ChinaGermany Treasury

Chinese Treasury

Chine cannot both practically and theoretically tax the net income from sale of the branch located in Japan.

Japanese Treasury

12

Necessity for attribution rules

(Net) income as a personal concept– (Net) income cannot be calculated on an item-by-

item basis because of the necessity of connection between revenue and expense.

– Attribution rules deem a fixed place of business to be a taxpayer and make sure the association between revenue and expense.

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Operation ofattribution rules (1/2)

Branch

Corporation

Germany

Japan

ChinaGermany Treasury

Chinese Treasury

The branch located in Japan would be treated as a person just like a corporation and subject to net income taxation.

Japanese Treasury

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Operation oftypical worldwide taxation (1/2)

China

Chinese Treasury

The net income of the branch located in Japan would be taxed exclusively by German.

Branch

Corporation

Germany

Japan

Germany Treasury

Japanese Treasury

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Branch

CorporationCorporation

Exemption of all foreign sourceincome and its problems (2/2)

The expense which the headquarters in German costs could not be deducted in Japanese withholding taxation.

Investment Bank

Germany

Japan

Japanese Treasury

Germany Treasury

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Attribution rulesand a territorial system

No application of attribution rules– Source country has the tax jurisdiction on passive

income.– The passive income which is attributable to the

headquarters in German would be exempted. Adoption of attribution rules on a territorial

system– Possible from the point of view of policy and

consistent with the OECD model treaty

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Branch

CorporationCorporation

Operation ofattribution rules (2/2)

Both revenue and expense would be subject to exclusively Germany taxation.

Investment Bank

Germany

Japan

Japanese Treasury

Germany Treasury

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Branch

CorporationCorporation

Operation ofworldwide taxation (2/2)

Revenue would be taxed both on Japanese withholding taxation and German taxation. The headquarter in German would credit the taxes burdened by Japan.

Investment Bank

Germany

Japan

Japanese Treasury

Germany Treasury

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Fiction in international taxationand its questions

What degree would branch be deemed as an independent taxpayer?– Borrowing relationship between headquarters and

branch– Contribution and distribution between

headquarters and branch Conflict between developing and developed

countries exists.

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Net income taxationand attribution of income

Necessity for attribution rules on a territorial (net) income taxation system– Not for sales tax or investment surcharge– It is impossible to limit the scope in the case of net

income taxation. Source rules and attribution rules

– In Europe, the place of resident to which income is attributable seems to be regarded as the source.

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CIN and a territorial system

Does a territorial system always enhance CIN?– Probably no. A territorial system which does not

base on attribution rules may make difference in tax base and differentiate the treatments according to the place where any investment comes.

– In Japanese withholding taxation on passive income, the tax base is gross revenue. In the contrast, residents are subject to net income taxation on passive income.

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CEN and a global system

Does a global system enhance CEN?– Maybe yes. The answer depends on the degree in

which both CFC taxation (worldwide taxation) and foreign tax credit work correctly.

A global system and expatriation– A global system itself cannot prevent residents

from expatriation and enhance the neutrality of person’s movement between countries.

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Promotion of CEN with worldwide taxation

Corporation would be subject to the same burden without regard to the way of business or the place if Germany provides foreign tax credit correctly.

Branch

Corporation

Germany

Japan ChinaJapanese Treasury

Germany Treasury

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Subsidiary

Violation of CENwith non-accrual type worldwide taxation?

If income of subsidiary should be subject to the same burden as that of sale of product directly, CEN should be considered to be violated because of deferral.

Corporation

Germany

Japan ChinaJapanese Treasury

Germany Treasury

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Branch

Violation of CEN for shareholderwith non-accrual type worldwide taxation?

In the situation where CEN viewed from corporation in German is promoted, CEN viewed from shareholder in U.S. should be considered to be violated because of deferral.

Corporation

Germany

Japan

United States shareholderGermany Treasury

Japanese Treasury

China

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Subsidiary

Promotion of CENwith non-accrual type worldwide taxation

If the independence of subsidiary should be respected with regard to calculation of income, CEN should be considered to be promoted. In this viewpoint, deferral does not exist!

Corporation

Germany

Japan ChinaJapanese Treasury

Germany Treasury

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Branch

Promotion of CENwith attribution rules

If the independence of branch should be respected with regard to calculation of income, CEN should be considered to be promoted. In this viewpoint, deferral does not exist!

Corporation

Germany

Japan ChinaJapanese Treasury

Germany Treasury

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Subsidiary

CorporationCorporation

Promotion of both CEN and CINwith non-accrual type worldwide taxation

Domestic investment in both German and Japan is subject to the same burden. Income from investment by corporation in German is equally taxed without regard to the target if foreign tax credit works.

Investment Bank

Germany

Japan

Germany Treasury

Corporation

Japanese Treasury

Investment Bank

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Branch

CorporationCorporation

Promotion of CEN and violation of CENwith non-accrual type worldwide taxation

CIN for Investment bank in Japan is violated. CEN for corporation in German and CIN for investment bank in German are promoted.

Investment Bank

Germany

Japan

Germany Treasury

Corporation

Japanese Treasury

Investment Bank

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Branch

CorporationCorporation

Promotion of both CEN and CINthrough attribution rules

If the independence of branch should be respected with regard to calculation of income, CIN would be considered to be promoted. Foreign tax credit in German is not necessary.

Investment Bank

Germany

Japan

Germany Treasury

Corporation

Japanese Treasury

Investment Bank

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Dividend exemptionin Japanese corporate taxation

Indirect foreign tax credit substituted– Only dividends from subsidiary with 25% interest

are exempt. Different tax burden because of the difference

in the way to repatriate– Lower burden in the case of dividend

• Only after the introduction dividend exemption

– Lower burden in the case of deductible payment

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Subsidiary

CorporationCorporation

Preference for royalty over dividendscenario

If effective tax rate of corporate income tax in both Japan and X country is the same, domestic corporation in Japan would prefer royalty payment because of foreign tax credit for withholding tax.

Japan

X country

X country Treasury

Royalty Scenario

Subsidiary

CorporationCorporation

Japan

X country

X country Treasury

Dividend Scenario

100

10

25

65

6.5

65 58.5

100 100

0 35

Japanese Treasury

Japanese Treasury

33

Subsidiary

CorporationCorporation

Preference for dividend over royaltyscenario

If effective tax rate of corporate income tax in X country is significantly lower than that in Japan, domestic corporation in Japan would prefer dividend payment.

Japan

X country

X country Treasury

Royalty Scenario

Subsidiary

CorporationCorporation

Japan

X country

X country Treasury

Dividend Scenario

100

10

25

75

7.5

65 67.5

100 100

0 25

Japanese Treasury

Japanese Treasury

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CFC taxation

Subsidiary

CorporationCorporation

X countryX country Treasury

Japan

Japanese Treasury

Investment Bank

German

Income from sale of product

Income from passive investment

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Japanese CFC taxationand its new rule

Undistributed income has been mixed up– Its target is foreign subsidiary in the country where

tax rate is 25% or less.– All undistributed income is subject to Japanese

CFC (not to the extent of tainted income). Since last year, distributed dividend has been

mixed up too.– This new rule prevents domestic corporation from

avoiding CFC taxation through the distribution of dividend.

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Operation of new rule in CFC taxation

If effective tax rate of corporate income tax in X country is significantly lower than that in Japan, domestic corporation in Japan would prefer dividend payment.

Without new CFC rule

Subsidiary

CorporationCorporation

Japan

X country

X country Treasury

With new CFC rule

85

4.25

60.75

100

15

Subsidiary

CorporationCorporation

X country

X country Treasury

85

4.25

80.75

100

15

Japan

Japanese Treasury

Japanese Treasury

0 20

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Foreign tax credit vs.dividend exemption with new CFC rule

If effective tax rate of corporate income tax in X country is significantly lower than that in Japan, domestic corporation in Japan would prefer dividend payment.

Before dividend exemption

Subsidiary

CorporationCorporation

Japan

X country

X country Treasury

85

4.25

60.75

100

15

Subsidiary

CorporationCorporation

X country

X country Treasury

85

4.25

100

15

Japan

Japanese Treasury

Japanese Treasury

2015.7565

After dividend exemption

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CFC taxation and treaties

Article 7 of the OECD model– No PE, no taxation on business income.– Foreign subsidiary subject to CFC taxation has no

PE in Japan. CFC taxation as deemed dividend taxation

– When U.S. introduced CFC taxation, it is considered to prevent the deferral of shareholder level taxation.

– This explanation no longer applies to Japan.

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Two explanations ofJapanese CFC taxation

CFC taxation as attribution rule– If foreign subsidiary is just a paper company, its

income should be considered to be attributable to domestic corporation (or personal resident).

CFC taxation as a weapon against low-level taxation

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CFC taxationas attribution rule

Subsidiary

CorporationCorporation

X countryX country Treasury

Japan

Japanese Treasury

Investment Bank

German

Income from sale of product

Income from passive investment

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CFC taxationas weapon against low-level tax

Subsidiary

CorporationCorporation

X country Treasury

Japanese Treasury

Investment Bank

German

Income from sale of product

Income from passive investment

X country

Japan

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Limit of deduction of salaryin Japanese corporate tax

Requirement for deduction of salary for officer– Regularity– Reasonable amount

One-book and book-tax conformity– Currently, salary for officer is deductible for the

purpose of financial statement– Nevertheless, this salary is subject to limitation

and rather has introduced new type limitation.

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Change of corporate tax into consumption tax

Corporate tax without salary deduction– This feature would make corporate tax a

consumption tax.– This change may be a solution instead of

increasing consumption tax rate directly.

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Implication oftax base in corporate taxation

Corporation

shareholder

Japanese Treasury

Corporation

shareholder

Japanese Treasury officer

officer

Disallowance to deduct salary for officer

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Origin-basedconsumption type corporate tax

Corporation

Germany

Japan

Subsidiary

Japanese Treasury

China

Subsidiary

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Destination-basedconsumption type corporate tax

Corporation

Germany

Japan

Subsidiary

Japanese Treasury

China

Subsidiary

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Group taxationin Japanese corporate tax

Group taxation and consolidated tax return– Mandate vs. Eligible

– Each member calculates its own taxable income in group taxation system.

• No need to apportion the tax burden

Deferral of recognition– Transferor will be subject tax on gain or loss when

transferred asset gets away from the group. Determination at level of group

– Gradual rate, etc. applied according to the size of group

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Corporation

Transfer pricing and group taxation

Japan

German Germany Treasury

Japanese Treasury

85

5.25(15 x 0.35) + 5.25 (15 x 0.35)

Subsidiary

Subsidiary

85

FMV:100

BASIS: 85100

0 ((100-100) x 0.35)FMV:100

BASIS: 85

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Implications of group taxationin international taxation

Between separate accounting and unitary tax– Setting off loss and income– Deferral of taxation on intra-group transactions

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Formulary apportionment

Arm’s length standard– It determines two arm’s length price:

• Intra-group: Transfer pricing regulation

• Intra-corporation: income attribution to branch

– It differs from American type source rules. A substitution or backstop or any other?

– American type source rules adopt the formulary apportionment.

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Corporate tax reformand international taxation

CBIT (Comprehensive Business Income Tax)– No difference between corporation and branch

BAT (Business Activity Tax)– The concept of income attribution does not work.

Any other formula– Destination-based or origin-based

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Conclusion

Japanese international taxation system– On surface, old-fashioned global system– American type source rules and entire income

taxation• In reality, attribution rules of treaties apply.

Recent changes and implications– Movement into territorial system– Change of corporate tax into consumption tax

• Formulary apportionment needed

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Any questions?