Japan has seen many changes in its approach to taxing corporate groups in recent years with the introduction of consolidated taxation, group-reorganization rules and in 2010 rules allowing deferral of taxation on certain intra-group transactions.
The Japanese corporate law has also seen significant reform in this period, for example with the new corporate law allowing much greater flexibility in assigning a range of rights to different classes of shares. Critical to the proper application of these changes to Japanese group taxation is an understanding of the different tax group definitions adopted by the new legislation.
In Japan at the present time the legal form of an instrument as debt or equity is respected for tax purposes. Unlike in the US, there is no doctrine that treats an instrument issued by a corporation as debt or equity based on a wider range of criteria than legal form.
Also, one key Japanese tax group definition explained further below (the ‘Complete Controlling Relationship’) requires ownership of all the issued shares in another company before the relationship is established (although after allowing for some ownership by a company of its own shares and shares for employee stock option and similar purposes). Both of these factors make it somewhat easier to identify Japanese tax group relationships.
Three Japanese tax group definitions
There are three basic Japanese tax group definitions used for a variety of different purposes in Japanese tax legislation relating to tax groups.
- The Controlling Relationship (below ‘CR’ and in Japanese shihai kankei or 支配関係) is used in the taxation of mergers and other Japanese corporate reorganizations to define Mergers Within an Affiliated Group.
- The Complete Controlling Relationship (below ‘CCR’ and in Japanese kanzen shihai kankei or 完全支配関係) is the key group relationship for Japanese tax purposes used in the IGTS system, for defining Mergers Within a Wholly Owned Group and for determining whether or not a small or medium sized company is entitled to reduced rates of corporate tax (such reduces rates are not allowed when the company is a wholly owned subsidiary of a larger group).
- The Consolidated Complete Controlling Relationship used for the purposes of defining a Japanese tax consolidated group. Unlike the CCR the Consolidated Complete Controlling Relationship cannot be traced through foreign companies or Japanese special purpose companies.
This diagram illustrates these three relationships while this diagram shows how they apply to a group of companies. This diagram illustrates how shares a company owns in itself and stock options or similar shares issued to employees and similar are treated.
Note that tax reforms in 2010 require companies to submit a structure chart with future tax returns which the authorities would be expected to examine when auditing whether tax benefits arising out of the above group relationships can apply.
Complete Controlling Relationships and issue of shares with differing rights
Changes to Japanese corporate tax law in recent years have made it possible for Japanese companies to issue shares with a range of rights including differing voting rights, rights to distributions out of profit, out of residual assets or on a winding and rights of priority or subordination.
However the determination of whether a Complete or Consolidated Complete Controlling Relationship arises depends on ownership of the total number of shares issued by a company (in Japanese 発行済株式等の保有割合) without reference to differing rights. Accordingly, although there may be some uncertainty in the view, it would seem that all issued shares regardless of rights should be held (subject ownership of own shares and use for stock option schemes etc) in order for a CCR to arise.
Nominee shareholdings and group relationships
Tax Instruction (‘TI’) 1-2-2 (link in Japanese) addresses how nominee shareholdings (in Japanese meigi kabu or 名義株) are treated under CTL article 4 no 2 in relation to controlling relationships. TI 1-2-2 states that when determining whether a controlling relationship exists attention should be paid to shareholders recorded in the share register, member’s register or articles of the other company. However when such shareholders are merely nominees and someone other than the registered shareholder is in substance the person with authority over the shares then that other person should be treated as the owner of the shares for establishing a group relationship.
While the above seems straightforward, it may be best to avoid any subjectivity in assessing whether a person who is not registered as the owners of shares is in fact their owner for tax group purposes by avoiding any nominee arrangments.
Application of group relationships to transactions
It is important to appreciate that while two persons may be in a CCR or other tax group relationship outlined above, the tax treatment of a particular transaction may still depend on who the parties to a transaction actually are – whether individuals, foreign corporations or domestic corporations.
For example, transactions between a company and an individual in a CCR are not able to apply the IGTS system given that individuals are not included in the scope of counterparties to a transaction allowed to defer taxation under the system. However, if two companies are owned by the same individual in a CCR then transactions between those two companies can still qualify for tax deferral under the system.
The application of the CCR to different types of counterparties in potentially tax preferred transactions is explained in the following article.