Where a foreign company earns income with the economic nature of interest (referred to below as ‘Funding Income’) from lending to a business carried out in Japan, investing in a bond with a Japanese issuer or from a similar transaction (referred to below as a ‘Funding Transaction’), Japanese withholding tax (‘WHT’) will apply if the income is treated as falling within defined categories of Japan source income.
Accordingly, in order for a foreign company to identify when its Funding Income may be exposed to Japanese WHT the company has to understand how the definition of Japan source income is applied to such income and to the transactions concerned.
Domestic law and treaty WHT exemptions
If a foreign company identifies Funding Income on which WHT applies the company should then consider either whether any Japanese domestic law WHT exemptions or any of Japan’s tax treaties can apply to reduce or eliminate the WHT liability concerned. Mitigation of Japanese WHT on the application of tax treaties or through domestic tax law will be considered in subsequent articles.
This article reviews the definition of Japan source income arising from Funding Transactions received by corporations. The definition of such income for individuals is wider in scope and is not considered in this article.
Readers may also want to refer to the outline of different categories of Japan source income given in this article, a summary of the rate of withholding tax on interest under Japan’s tax treaties given in this article, the English text of certain tax treaties in this article and the forms required to claim treaty benefits in this article.
Two types of ‘interest’ under Japanese domestic law
The Japanese domestic tax law definition of foreign source Funding Income (which typically includes interest, bond coupon, bond discount and similar items of income) is made complicated by the fact that Japanese domestic law defines two categories Japan source income to which the Funding Income may be allocated, the allocation depending on the underlying Funding Transactions concerned.
The income in these two categories is economically almost identical, however the definition and sourcing rules are different for each of these categories. This is often the source of great confusion for foreign investors.
Category 1 Funding Income: Coupon Income
The first category of Japanese source Funding Income for a foreign corporation is defined in article 138-4 (link in Japanese) of the Japanese Corporate Tax law (‘CTL’). For reference the paragraph from 138-4 is reproduced in Japanese, together with a translation, below:
This paragraph identifies the following four classes if income, (イ to ニ above) referred to below as ‘Coupon Income’, as being:
- Interest on bonds issued by Japanese domestic companies, Japanese municipal bonds and Japanese government bonds.
- Out of the interest on bonds issued by foreign companies, the amount of such income attributable to the business of a branch, office or similar location of the foreign company in Japan.
- Interest on deposits identified under the Japanese Income Tax Law article 2-1-10, deposited in a branch, office or similar location in Japan. [note this is referring to deposits at banks and similar financial institutions]
- Distributions of income from [defined] ‘Co-operatively Invested Trusts’ (合同運用信託) ‘Bond Investment Trusts’ (公社債投資信託) ‘Publically Offered Bond and Similar Investment Trusts’ (公募公社債等運用投資信託) defined in Japanese Income Tax Law article 2-1-15 no 3 when entrusted to a place of business in Japan [note this refers to certain collective investment schemes with a trustee in Japan whose underlying investments would be mostly fixed income instruments]
Source rule for Coupon Income
It can be seen from the above definition that, for Coupon Income, the source rule is largely based on the identity of the creditor of the funds concerned.
The coupon on bonds issued by, for example, a Japanese company or the Japanese government is included in Coupon Income and hence treated as Japan source income subject to Japanese WHT, regardless of where the funds raised from the original bond issue were used.
Coupon paid by a foreign company attributable to its Japanese branch
Note, however, that where a foreign company issues a bond, the coupon on the bond is treated as foreign source income except to the extent that it is allocated to a Japanese branch or similar of the foreign company concerned, in which case it is treated as Japan source income on which Japanese WHT will apply.
This rule was introduced relatively recently and was intended to curtail the use of the so-called ‘double SPV structure’ which was reportedly employed to mitigate Japanese WHT on cross border lending into Japan.
Category 2 Funding Income: Loan Interest
CTL article 138-6, reproduced immediately below with a following translation, defines the second category of Funding Income that is treated as Japan source income (referred to below as ‘Loan Interest’). Loan Interest is here defined as:
“…Interest from a loan (including items resembling a loan) to a person carrying on a business in Japan to the extent related to the business concerned (excluding interest defined in cabinet orders, including the gain or loss arising from the purchase and resale of bonds or of transactions to sell bonds with attached repurchase conditions as determined in cabinet orders)….”.
The important point to note in relation to the source rule for Loan Interest is that, in contrast to the source rule for Coupon Income, it depends on the location of the use of the monies lent in the Funding Transaction rather than on the nature of the borrower of the funds concerned.
Under Japanese domestic law if a Japanese company borrowed funds from a foreign company for the use in its non-Japanese branch (for example, for its Hong Kong branch) then the interest on the loan would in principle not be treated as Japan source Loan Interest. This assumes that the interest was also outside the definition of Coupon Income as well. The Japanese company would also have to prove that the funds were used outside Japan.
Note that (probably to the surprise of Japan’s tax treaty partners) Japan’s tax treaties are interpreted as overriding the Japanese domestic law definitions of Japan source income and can result in the imposition of Japanese WHT which would not have been imposed under Japanese domestic law. This topic will also be discussed in a later article.
The scope of Loan Interest under Tax Instruction 20-1-19
Tax Instruction 20-1-19 (link in Japanese) lists examples of items that are included in the definition of Loan Interest under CTL 138-6. This list is not intended to be exhaustive. Some of the items included in this list are:
- interests on monies provided as a guarantee deposit, rental deposit or similar
- interest on prepayments or similar
- interest on transactions where the payment of consideration has been deferred
- interest due on unpaid amounts recoverable further to the exercise of a guarantee
- interest on deferred compensation payments
- interest on deposits (other than those giving rise to Coupon Income referred to above)
Loan Interest arising from a business in Japan
Finally, Tax Instruction 2-1-18 (link in Japanese) gives some guidance on the question as to whether Loan Interest arises from a business carried out in Japan.
TI 2-1-18 (1) notes that interest from a loan to the Japanese office or similar place of business of a Japanese company (or of a Japanese resident individual) is treated as giving rise to Japan source income.
TI 2-1-18 (2) notes that interest from a loan made to a foreign company or a non- resident is treated as being made to a business in Japan and giving rise to Loan Interest if either:-
- The interest arises on a loan made to a branch or similar place of business of the foreign company or individual in Japan; or
- If the interest is treated as a tax deductible expense when calculating the Japan source income of the foreign company (or individual).
Note that meeting the second of the above conditions – tax deductibility against income in Japan – would generally require the clear and unambiguous tracing of a loan made to a foreign company outside Japan to the business concerned in Japan.