Taxation of mergers

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For many years I was looking for the ox. I was so stupid! In fact I found a Cow! - A attractive photo-montage illustrating a Zen Koan

This article is an outline of the taxation of Japanese corporate reorganizations, focusing on mergers and looking at the key criteria that will determine how Ceasing KK in the merger will be taxed.

Please also see this article for diagrams with an outline of Japanese merger transactions and this article with an overview of the accounting treatment of Japanese enterprise combinations.

This article explains Japanese IRFS convergence and this accounting for intangible assets in enterprise combination accounting.

Tax qualified versus non tax qualified mergers

The key tax issue in any Japanese merger is whether the transaction will be treated as tax qualified or non-tax qualified.

In a tax qualified merger the transfer of assets and liabilities from Ceasing KK to Surviving KK is treated as made at book value at the time of the merger.  Accordingly in a tax qualified merger Ceasing KK does not recognize any taxable gain or loss on the transaction. Surviving KK records assets and liabilities taken over from Ceasing KK at their book value and as a result taxation is on the merger is deferred until the assets concerned are sold or liabilities discharged by Surviving KK.

In a non tax qualified merger the transfer of assets and liabilities from Ceasing KK to Surviving KK occurs at their market value at the time of the transfer.  Accordingly, Ceasing KK recognizes taxable gain or loss as a result of the merger and will report such gain or loss on its final corporate tax return.  If Ceasing KK has tax losses these can be used to offset any gains arising.  As explained in the Japanese corporate tax FAQs there is no distinction between ordinary taxable income and capital gains for Japanese domestic corporate tax purposes.

In a non-tax qualified merger Surviving KK records the assets and liabilities at their market value.  This should include intangible assets of Surviving Co and goodwill, although, for tax purposes goodwill is not strictly referred to as goodwill but is represented by a debit to specific tax accounts referred to as the Asset Adjustment Account (or Liability Adjustment Account for negative goodwill).

Which is better, a tax qualified merger or a non tax qualified merger?

Do not assume that a tax qualified merger is always preferable.  It is not uncommon for a non-tax qualified merger to produce a better economic result – especially in an internal group reorganization or where a cross border investment is involved.  The tax qualified and non tax qualified alternatives should be modeled under appropriate assumptions to assess which is best.

Issues that arise in assessing whether a tax qualified or non- tax qualified merger is preferable may include the following:

  • A non-tax qualified merger can allow a de-facto carry over of tax losses from Ceasing KK to Surviving KK.  Losses in Ceasing KK at the time of the merger can offset gains arising from the recognition of goodwill in the transferred business.  However such goodwill can still be amortized in Surviving KK against the income of the combined post merger businesses.
  • Where the shareholders in the merging companies are foreign their tax profile and tax credit position should be considered carefully.  For example, if the foreign shareholders of Ceasing KK are able to credit Japanese taxes that arise at the time of the merger and the shareholders of Surviving KK are able to benefit in their consolidated financial statements from the reduced local rate of tax created by the amortization of goodwill generated in Surviving KK this could have a significant pricing impact on any merger transaction.
  • In a tax qualified merger there is a risk that the criteria required for tax qualification are challenged by the tax authorities, as occurred to Softbank in this reported case.  In a non-tax qualified merger there is no risk of unanticipated taxes, interest and penalties arising from a successful tax authority challenge as to whether the criteria for tax qualification had been met.

Criteria for tax qualification

Mergers categories for Japanese tax purposes

Mergers categories for Japanese tax purposes

Japanese tax law classifies merger transactions into different categories depending on the extent of concentration of ownership of shares in the merging entities as explained in the diagram.  These categories are referred to below as ‘Merger Within a Wholly Owned Group’, Merger Within an Affiliated Group’ and ‘Merger Within an Un-affiliated Group’.  Depending on which of these categories the merger transaction falls into, all of or a subset of specified criteria (the ‘Qualification Criteria’) have to be met in order for the merger to be tax qualified.

For mergers between entities where there is no common ownership in excess of a fifty percent level,  all of the Qualification Criteria have to be met.  For mergers between subsidiaries that are in a wholly owned group then very few of the Qualification Criteria have to be met.  The flowchart in this article reflects the application of the Qualification Criteria and can be read in conjunction with the more detailed explanation below.

‘No Boot Criteria

A Qualification Criteria common to all types of merger is the “No boot Criteria”.

“Boot” is the term applied to cash, debt or any assets other than shares issued as consideration in a merger or other corporate reorganization.  In principle, for a Japanese merger to be tax-qualified only shares of Surviving KK (or its parent in a triangular merger) should be issued to the shareholders of Ceasing KK.  However there are three exceptions to this “no boot” principle:

  • An amount is paid to the shareholders of Ceasing KK as a dividend for Ceasing KKs final accounting year.
  • Amounts are paid to the shareholders opposing the merger as compensation for exercise of rights to purchase their shares.
  • Amounts paid for the liquidation of fractional shares.  Such payment is a step in one of a number of approaches used as a minority squeeze-out technique in a Japanese take over bid.

Mergers Within a Wholly Owned Group

A wholly owned group for the purpose of this definition is a group where either:

  1. Surviving KK owns directly or indirectly all of the shares of Ceasing KK (see this diagram for impact of the company owning shares in itself and treatment of stock option rights) or vice versa. or
  2. All of the shares issued by both Surviving and Ceasing KK are held directly or indirectly by the same person (who may be in an individual, in which shares held by those having a Special Relationship with the individual are also included).

For a transaction to be a tax qualified Merger Within a Wholly Owned Group then in addition to the No Boot Criteria above, if the merger is between brother and sister companies (i.e. the second ownership condition above applies) then in addition at the time of the merger it must be “..expected that the wholly owned group relationship will continue to apply…”. In other words, at the time of the merger the common parent of Ceasing and Surviving KK must be expected to continue to hold shares in Surviving KK after the merger.  This referred to below as the Continuity of Share Ownership Criteria.

Mergers Within an Affiliated Group

An affiliated group for these purposes is defined as a group where either:

  1. Surviving KK owns directly or indirectly more than fifty percent but less than all of the shares issued by Ceasing KK (the same rules apply as above for a company owning shares in itself and treatment of stock option rights) or vice versa; or
  2. More than fifty percent but less than all of the shares issued by both Surviving and Ceasing KK are held directly or indirectly by the same person (who may be in an individual, in which shares held by those having a Special Relationship with the individual are included).

If case two above applies, the Continuity of Share Ownership Criteria applies in relation to the shares in Surviving KK held by the person who gave rise to the affiliated relationship between Ceasing KK and Surviving KK.

In addition to the above criteria a Merger Within an Affiliated Group has to meet both the following ‘Continuity of Employment’ and ‘Continuity of Business Operation’ Criteria:

  • Continuity of Employment Criteria – around eighty percent or more of the employees actually working in the business of Ceasing KK prior to the merger should continue to work in the business of Surviving KK post the merger.
  • Continuity of Business Operations Criteria – it should be anticipated that the main business operated by Ceasing KK prior to the merger should be carried on by  Surviving KK after the merger.

Merger in an Un-affiliated Group

This is the default category for any merger not treated as belonging to either of the prior two categories. 

In order for a Merger in an Un-affiliated Group to be tax qualified the following six criteria must bet met, except that only one out of the Business Scale and Carry Over of Specified Officers Criteria explained below have to be met.  Furthermore the Continuous Share Ownership Criteria only applies where the number of shareholders of Surviving KK is fifty or less.  The criteria, which include some of the same criteria discussed above, are:

  • Business Reciprocity Criteria – the business carried out by the Ceasing Co prior to the merger (below the Merged Business) is similar to related to a business carried out by the Surviving Co (the Surviving Business) prior to the merger.  Details around this criteria were legislated in greater detail in 2007 and will be the subject of a further article.
  • Business Scale Criteria – the relative scale of the Merged Business with respect to the  Surviving Business or vice versa, measured by reference to the revenues, number of employees, capital of the Ceasing and Surviving Cos, is not more than approximately five times.
  • Carry Over of Specified Officers Criteria – it is foreseen that certain Specified Corporate Officers of Ceasing Co and Surviving Co prior to the merger become Specified Corporate Officers of Surviving Co post the merger.
  • Continuity of Employment Criteria – as applied for Mergers Within an Affiliated Group above.
  • Continuity of Business Operations Criteria – as applied for Mergers Within an Affiliated Group above.
  • Continuity of Share Ownership Criteria – as also applied for certain Mergers Within Wholly Owned and Within Affiliated Groups described above.

Additional Issues

Further articles will look in more detail at how the criteria above are interpreted, how shareholders are taxed in mergers, the application of tax anti-avoidance criteria specific to mergers and other matters.

Note that proper advice should always be taken from a qualified Japanese tax accountant based on the facts of a particular transaction before any action is taken.



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