This post looks at the Japanese tax concept of Tax Based Capital, or in Japanese 資本金等/shihonkintou. The Japanese tax law seeks to tax shareholders on either income from their shareholdings or on capital gain or loss while simultaneously avoiding or mitigating the double taxation of corporate earnings. The concept of Tax Based Capital together with Tax Based Retained Profits are two concepts in the tax law that are part of this intent. Since a company receiving an distribution on shares in one of its subsidiaries may be able to apply the Japanese Dividends Received Deduction if the amount is treated as a dividend for tax purposes (but would be taxed on capital gain or loss if not so treated) treatment as income or capital gain or loss is often a critical tax issue.
In some respects Tax Based Capital and Tax Based Retained Profits have some similarities to “outside basis” and “earnings and profit” in the US tax code. Tax Based Retained Capital and Tax Based Retained Profits are two tax attributes that are well worth understanding in any Japanese tax due diligence exercise. Japanese tax law also defines a Capital Transaction (in Japanese 資本金取引/shihonkintou torihiki) by reference to Tax Based Capital as explained further below.
Capital Transactions are defined by reference to Tax Based Capital. The definition is found in CTL 22-5 and is brief: A Capital Transaction is either a transaction which increases or decreases Tax Based Capital or a distribution by a company of its profit or its surplus. In this context distribution would include not only Dividends out of Surplus or other returns defined in the Japanese Corporate Law but also transactions that are treated as Deemed Dividends for Japanese tax purposes, such as acquisition by a company of its own shares or returns of capital and similar. A key feature of a Capital Transaction is that it is not included in the calculation of annual taxable income for Japanese tax purposes but rather goes to increase or decrease the amount of Tax Based Capital and hence potentially influence future tax liabilities that depend on the amount of Tax Based Capital.
Tax Based Capital
The definition of Tax Based Capital in the Japanese tax law is much more extensive than that of Capital Transactions. The term is first defined relatively simply in CTL Article 2-16 as the amount of investment received by a company from its shareholders. However this brief, conceptual definition is supplemented by a much more extensive definition in CTLEO Article 8. Article 8 includes an extensive list of transactions that are treated as giving rise to an increase or decrease in a company’s Tax Based Capital.
Below is a list of items that increase or decrease the amount of Tax Based Capital. Note that some of these items are applicable to Japanese companies while some others apply to Defined Japanese Co-operative Association or other specified Japanese corporate tax paying entities. Some of the items below are technical tax terms arising in Corporate Reorganisation Transactions. More detail on how these amounts are calculated will be found in the M&A and corporate reorganisation section in due course.
Items acting as a source of Tax Based Capital
- Amount of Core Capital or Invested Capital
- Out of the amounts received on an issue of new shares or received by a company in consideration for a sale of its own shares, any amount that was not accounted for as an increase in Core Capital. Note that this item is recognising that for tax purposes some transactions are seen to be Capital Transactions but they may not be accounted for as increasing Core or Invested Capital for financial accounting purposes and hence the tax law requires the amount to be added on to these amounts in calculating Tax Based Capital. Similar thinking applies to many of the items below.
- Out of amounts paid in to a company on the issue of shares further to the exercise of share options (新株予約権), any amount that was not accounted for as an increase in Core Capital
- On the acquisition of Share Options with Attached Acquisition Rights through the company issuing its own shares, out of the book value of those rights any amount that was not treated as an increase in Core Capital.
- Amount paid on entry into a Defined Japanese Co-operative Association
- Merger Gain
- Amount of Surplus carried over on a Bunkatsu Style Corporate Split
- Amount of Surplus carried over on a Bunsha Style Corporate Split
- Amount of Surplus carried over on a Tax Qualified Capital Contribution
- Amount of Surplus carried over on a Non Tax Qualified Capital Contribution
- Excess on accounting for shares in a 100% Subsidiary Company in a Share Exchange
- Excess on accounting for shares in a 100% Subsidiary Company in a Share Transfer
- Reduction in Core Capital or Invested Capital on a Capital Decrease (note that Capital Decrease does not involve repayment of funds to shareholders but rather is a legal procedure to reduce the amount of capital to supplement retained losses for example)
Items that reduce Tax Based Capital
- Amount of Legal Reserves incorporated into Core Capital (i.e. from a legal perspective historic earnings or profit reserves are being converted to Core Capital, but from a tax perspective the tax law wants to maintain and ultimately tax the amounts concerned according to their original nature as income rather than capital. This approach can also be seen in some of the other items below).
- On conversion of a company to an Non Invested Company (i.e. certain somewhat rare associations, for example in the fishing industry) the amount of Capital Surplus just prior to conversion.
- Loss on Capital Decrease arising from split Non Tax Qualified Bunkatsu Style Corporate Split
- Loss on Capital Decrease arising from carry over in a Tax Qualified Bunkatsu Style Corporate Split
- Amount of Capital Decrease arising from a Capital Repayment
- Amount of Core Capital acquired further to an acquisition of own shares
- Consideration for acquisition of own shares
Given the above list for tax due diligence purposes it is advisable to understand the transactions that have given rise to changes in Tax Based Capital for entities in a Japanese group especially when planning post acquisition reorganisations as this tax attribute may have an important influence on future related tax liabilities.