This article outlines an anti-avoidance measure included in the 2010 tax reform that prevents a shareholder applying the Japanese Dividends Received Deduction (‘DRD’) on a Deemed Dividend arising on the purchase by a company of its own shares.
Under Article 24 of the CTL, a Deemed Dividend arises when a company purchases its own shares (see here for examples of other transactions that create deemed dividends). Prior to the 2010 tax reform, a shareholder receiving a Deemed Dividend was treated as disposing of the shares concerned and realizing a taxable gain or loss on the difference between the shareholder’ original acquisition cost and the consideration received for the disposal. However the amount treated as a Deemed Dividend in these circumstances was excluded from consideration for disposal when calculating the gain or loss (CTL 61 no 2(1)). Furthermore, in addition to excluding the Deemed Dividend from taxation as part of the shareholder’s proceeds on sale of the shares, shareholder may also be able to apply the Japanese DRD to the amount of the Deemed Dividend, subject to the normal DRD qualifying conditions related to holding period, disallowance of attributable interest and similar. If the DRD did not apply the income would be taxed as dividend income.
The net overall result of the pre 2010 law may be to allow the shareholder to recognise a loss on disposal of the shares concerned which could be set off against their other taxable income or the income of a consolidated tax group of which they were a member (there is no distinction between capital gain and loss and income gain or loss for Japanese domestic corporate tax purposes) while also enjoying the DRD. In contrast, if the shareholder had sold the shares to a third party other than the issuer of the shares, then consideration received by the shareholder would not have included a Deemed Dividend element which could be excluded from total consideration and on which the Japanese DRD could be applied.
In revising the law the authorities were concerned that the rules were open to use in tax avoidance schemes. For example, a company may lend money to a subsidiary in its consolidated group which would then buy back its own shares applying the DRD and generating a loss at the parent company level that could reduce overall group taxable profits without the group as a whole suffering any economic loss. This is illustrated in the diagram.
2010 tax reform
The 2010 tax reform introduced the following changes to address potential tax avoidance under the prior law.
- Where, in a purchase by a company of its own shares, the shares in a Domestic Company that is 100% owned by its parent company are transferred by that parent company to the Domestic Company concerned, then any gain or loss arising on such transfer is treated as non taxable or non-deductible by the parent company.
- Where arrangements exist for a company to purchase its own shares then the Deemed Dividend arising to the shareholder from the acquisition of the shares concerned cannot be excluded by the shareholder from taxation through the application of the Japanese DRD. Furthermore, the Foreign Dividend Exclusion rules cannot be applied to a Deemed Dividend received by a Japanese company from a Foreign Company buying its own shares.
Point 2 above also applies to an acquisition by a company of its own shares further to carry over in a Tax Qualified Merger or a Tax Qualified Bunkatsu Style Corporate Split.
However note that as an exception to rule 2 above the parent company of the 100% group owned company can still apply the Japanese DRD when its wholly owned subsidiary purchases its own shares.
Summarizing this in a table:
|There are arrangements for a company to purchase its own shares||No arrangements for a company to purchase its own shares.|
|Shareholder owns 100% of the purchasing company||Gain or loss on transfer is not treated as taxable or deductible.
Japanese DRD can be applied (without deduction for Attributable Interest)
|Shareholder does not own 100% of the purchasing company.||Gain or loss on transfer is treated as taxable or deductible.|
Deemed Dividend is treated as taxable without applying the Japanese DRD.
|Gain or loss on transfer is treated as taxable or deductible.
Japanese DRD can be applied to Deemed Dividend where other qualifying conditions are met.