The ‘TMK’ (in Japanese the ‘特定目的会社’ or ‘tokutei mokuteki kaisha’ )、a special purpose entity commonly used in Japanese real estate transactions, is regarded as having a corporate nature for Japanese tax purposes and hence is taxed as a corporation rather than as a fiscally transparent entity.
However, a number of special tax provisions apply to the entity introduced in order to help promote the securitization of assets held under the TMK structure. The key one of these provisions allows the deduction of dividends paid by the TMK provided certain criteria are met. This allows a de facto pass through treatment to apply to the TMK for tax purposes similar to the treatment applied to US REITS.
This article outlines some of the special tax provisions that apply to a TMK as well as listing the key qualifying criteria that a TMK has to meet in order to treat its dividends as tax deductible or apply other tax benefits.
TMKs compared to Japanese domestic corporations
A TMK is treated as a domestic corporation for Japanese tax purposes.
Accordingly, a TMK has the same basic tax filing and payment obligations as a normal Japanese domestic corporation and many of the regulations that apply to ordinary Japanese domestic corporations – such as transfer pricing regulations, the thin capitalization regulations, Japanese CFC rules and the regulations regarding taxation of retained profits of a family company also apply to a TMK.
However, there are some regulations that apply only to a TMK while the entity is exempted from some other regulations that apply to Japanese domestic companies. Both of these sets of regulations are discussed further below.
The tax deductibility of dividends paid
A key tax benefit to for TMK is the ability to treat dividends paid, up to a certain limit, as tax deductible provided certain qualifying conditions are met, including distributing at least a 90 per cent of the TMKs profits each financial year.
This treatment may allow a foreign investor to reduce the effective rate of tax suffered on his Japanese real estate investment.
For example, the Japanese tax rate suffered may approach a lower withholding tax rate on dividends (20 per cent without treaty protection) rather than the full Japanese corporate tax rate of approximately 42 per cent.
The use of leverage may reduce the effective tax rate to further if, for example, the withholding tax on interest paid by a TMK on its cross border debt was lower than the withholding tax rate applied to dividends.
Conditions under which the TMK may treat dividends as tax deductible
There are two sets of criteria that a TMK must meet in order to treat it to dividends as tax deductible (below two sets of ‘Deductibility Criteria’).
One set of Deductibility Criteria would, in general, be met at a time of establishment of the TMK while the second set of Deductibility Criteria must be met at each financial year end of the TMK.
When both sets of criteria are met for a particular TMK financial year end then, in principle, the dividends paid for the financial year concerned are treated as tax deductible for the TMK up to a limit of the taxable income of the TMK for that financial year (calculated as the amount of taxable income before the offset of brought forward tax losses or dividends paid).
Note that in order to claim TMK specific tax benefits the entity must file a tax return for the year end which records the deduction of the dividends along with attached details of the related calculation of the dividends paid.
The TMK must also maintain evidence that it met to the Deductibility Criteria required for TMK qualification at the time of establishment. Failure to file such a return or provide appropriate evidence would likely lead to the non recognition of the tax benefits and the full 42 per cent Japanese corporation tax rate applying to the entity’s profits.
General deductibility criteria
The TMK must be registered as a TMK according to the requirement in article 8 of the SPC Law (the ‘Law Concerning the Liquidation of Specified through a Special Purposes Company’, in Japanese the ‘特定目的会社による特定資産の流動化に関する法律’ or ‘or tokutei mokuteki kaisha ni yoru tokutei no shisan non ryudouka ni kansuru houritsu’)
At least one of the following four conditions must be met
The TMK Specified Debt and Preferred Equity Securities (in Japanese collectively the ‘特定社債券’ or ‘tokutei shasai ken’) of the TMK must be publicly issued and the total amount so issued must be at least 100,000,000 yen
It is anticipated that the only investors to hold Specified Debt and Preferred Equity Securities issued by the TMK will be Institutional Investors (as defined see Note 1 below) or other persons who resemble Institutional Investors.
Preferred Equity Securities (in Japanese ‘優先出資証券’ or ‘yuusen shusshi shouken’) issued by the TMK were underwritten by at least 50 or more persons.
Preferred Equity Securities were only underwritten by Institutional Investors
The solicitation of investment for the Specified Capital (in Japanese ‘特定出資’ or ‘tokutei shusshi’ issued by the TMK (the part of the capital structure most similar to equity) and for the Preferred Equity Securities was mainly carried out in Japan (see Note 2 and the relevant section below for further background).
The length of the financial year of the TMK is one year or less.
Also note that the amount and terms of many of the securities referred to in the above list will have been specified in the asset liquidation plan submitted when the TMK commenced business, as discussed in this article.
Note 1: Institutional Investors are defined in paragraph 9 of article 2 of the Financial Products Transaction Law (in Japanese the ‘金融商品取引法’ or ‘kinyuu shouhin torihiki hou’) as persons who are carrying out the business of transacting in financial products but limited to, out of the persons carrying on the first type of financial transactions business defined under article 28 paragraph 1 of the same law, those carrying on a business related to marketable securities regulated in the same article paragraph 8 or a person’s carrying out an investment business in the same article paragraph 4. Persons resembling Institutional Investors are defined in article 2 paragraph 3 as including certain TMK’s that invest in certain specified securities issued by other TMK’s.
Note 2: Prior to 2010 tax reform the underwriting of Specified Bonds (in Japanese ‘特定社債’ or ‘tokutei shasai’) have to be carried out mainly in Japan. See below for how the term “…mainly in Japan…” is interpreted in this context.
Deductibility Criteria that must be met at each financial year end
The following Deductiblity Criteria must be met at each financial year end of the TMK.
In practice this means that close attention should be made to these criteria prior to the year end to make sure that they can be met at that time.
This may require close consideration of the accounting and tax position of the TMK in order to make sure that the criteria that more than 90 per cent of the profit of the TMK be distributed each year can be met. The financial year end Deductibility Criteria are as follows:
The activity related to the liquidation of the assets of the TMK and related incidental activities have been carried out according to the relevant asset liquidation plan.
Activities other than those related to the liquidation of the assets of the TMK or other than incidental related activities have not, in fact, been carried during the year.
Either the specified assets of the TMK have themselves been placed in trust or the activity related to the management or and disposition of the specified assets have been entrusted to another person.
At the end of the financial year concerned the TMK is not a family company as defined in the Japanese tax law. However, this condition does not apply to TMK’s which met the Deductibility Criteria 2 A and B above.
In excess of 90% of the amount of profits available for distribution at the year end are distributed.
The TMK has not become a member subject to unlimited liability under paragraph to article 195 of the SPC Law.
The TMK does not own assets other than the specified assets initially registered in the asset to liquidation plan.
Where the TMK has made specified borrowings during the year, such borrowings are only from Institutional Investors and not from persons who are hold and investment in Specified Capital in the TMK concerned (in other words, the borrowings are not “shareholder loans”).
‘Family company’ status and Deductibility Criteria
Note that if a TMK is held as a close investment or principle investment of a group it may have “family company status” for Japanese tax purposes. In such a case it may be important to make sure that Deductibility Criteria 2 A and B above are met.
Solicitation for Specified Capital and for Preferred Equity Securities is “…mainly in Japan…”
The detailed interpretation of solicitation “…mainly in Japan…” included in the above Deductibility Criteria is explained further in cabinet orders.
The cabinet orders clarify in relation to the value of Preferred Equity Securities or Specified Capital that for each class of capital, more than 50 per cent must be raised in Japan.
Note that prior to the 2010 tax reform the criteria requiring 50 per cent or more of the Specified Capital to be raised in Japan did not exist and instead more than 50 per cent of the TMKs Specified Bonds should be raised in Japan.
Given that many of the Deductibility Criteria must be met at the year end and given the complexity of these criteria, proper professional advice should always be obtained to confirm that a TMK can receive the tax benefits anticipated.
The TMK and exemption from additional land taxation
When TMK disposes of land then, provided it meets the Deductibility Criteria listed above in relation to the deduction of dividends (excluding the 90 per cent distribution) then the additional 5 per cent Japanese tax on the sale of land is not applicable.
Note that the additional 10 per cent taxation on profit from the sale of land held for a short time period is not exempted for a TMK. However the imposition of his tax has been suspended until the 31st of December 2013.
Real estate acquisition tax
In principle, on the acquisition of real estate, Japanese real estate acquisition tax is assessed at rate of 40 to1000 (although for specified to residential property and land the rate is reduced to 30 to 1000 up until 31 March 2012).
However for certain specified the TMK entities, when it is clear to the relevant local finance office that the conditions specified below are met then for the period up until 31 March 2011, the tax base for the imposition of real estate acquisition tax is reduced to one third of its normal amount. The conditions that have to be met are:
The asset liquidation plan states that the TMK will issue securities corresponding to its assets and that the ratio of the specified real estate assets including trust beneficiary rights is 75 per cent or more of the total specified assets of the TMK.
When raising capital, such capital is borrowed from persons other than investors in the Specified Capital of the TMK.
The ratio of specified real estate to total assets be at least 75 per cent (or on account of the acquisition of real estate, becomes 75 per cent or more).
Special landholding tax for a TMK
When purchasing certain specified land, special landholding tax may be assessed at a rate of 30 to 1000 on the acquisition value of the land. However, since 2003 this tax has not been assessed.
Registration and licensing tax for a TMK
When purchasing real estate in, principle registration tax applies to the required re-registration of real estate ownership rights involved on the acquisition at a rate of 20 to 1000 (for land until 31 March 2011 10 out of 1,000; to 31 March 2012 ,13 out of 1,000; to 31 March 2013 ,15 out of 1,000). However when specified conditions are met the same as the above in relation to real estate acquisition tax than the rate of tax assessed on the read registration of real estate ownership is reduced to 8 out of 1000.
Note that according to the 2010 tax reform warehouses and the land used for warehouses was excluded from assets subject to the reduction in tax although certain reduced rates can still apply for later years.
Credit for foreign taxes
A TMK cannot apply the general principles applicable to Japanese domestic companies for the credit of foreign taxes.
When a TMK has paid foreign corporation tax on its foreign source income then it may be possible to credit to such foreign taxes. However, such credit is limited to the amount of tax that would apply on dividends distributed by the TMK. This is somewhat similar in effect to applying a conduit treatment to the credit for foreign taxes.
Special treatment of interest earned on assets invested in by a TMK
Where the main specified assets of a TMK are, principally, marketable securities (as defined) then provided certain other conditions are met, the dividends and interest from the investment in those assets is exempted from Japanese withholding tax at source. Given that such taxes are recoverable, this is a timing benefit rather than an absolute tax saving.
Regulations not applicable to a TMK
The following regulations, which apply to ordinary Japanese domestic companies, do not apply to TMK’s:
The dividends received deduction (note to in any event that investment in shares is restricted for a TMK).
The reduction in taxation rates applicable to small or medium sized corporations
The special allowance for that debt reserves applicable to small or medium sized enterprises
The limitation on the deductibility of entertaining expenses