On 15 September 2010 the 12th division of the Tokyo High Court issued a judgment concerning the taxation of gain arising from the extinguishment of debt in a debt equity swap (‘DES’) transaction.
The case was an appeal from a taxpayer who asserted that the DES transaction concerned was a single capital transaction not involving the transfer of assets and liabilities and not giving rise to the realization of any taxable gain.
Multiple steps in a debt –equity swap
The Court determined that a DES transaction should be seen as comprising three steps, for Japanese tax purposes, firstly the contribution of the debt was a “contribution in kind” (i.e. of assets other than cash – in Japanese a ‘現物出資’ or ‘genbutsu shusshi’) that increased the capital of the company, secondly the extinguishment of the contributed debt against the corresponding liability the company had originally recognized in its accounts and thirdly the issue of new shares by the company.
The Court determined that the second DES transaction step above should not treated as a “capital transaction” (in Japanese a ‘資本取引等’ or ‘shihon torihiko dou’) for Japanese tax purposes given that the step did not involve an increase or decrease in the capital of the company.
Accordingly, the company should recognize taxable gain equivalent to the difference between the face value of the outstanding liability and its value at the time the corresponding debt was contributed to the company in the DES transaction. This gain would also be expected to be the difference between the value of shares issued in step three and the face value of the debt extinguished.
Japanese tax law and corporate law
The Court noted that theories under the Japanese Corporate Law concerning whether or not a contribution to capital should be accounted for as at face value or at market value were not relevant to the analysis for Japanese Corporation Tax Law (‘JCL’) purposes.
The taxpayer had asserted that a DES transaction should not be seen as comprising separate steps, but rather was a single capital transaction not involving a transfer of either assets or liabilities and hence not giving rise to gain or loss within the relevant article 22 of the JCL.
The tax authorities’ position was that article 22 comprised a comprehensive definition of taxable income covering all sources of income or gain. Whether or not the receipt of an asset (i.e. the contribution of debt in the first stage of the DES transaction) was regarded as being made for no consideration was not relevant to the interpretation of article 22 given that taxable gain could still arise from such a transaction. Given that the extinguishment of debt was not a capital transaction gains from such extinguishment should be treated as taxable within the scope of JCL article 22.
Article 22 of the JCL referred to in the taxpayer’s argument is a very basic charging section of the Japanese tax code, assessing Japanese corporation tax on taxable income less deductions. For reference the first two paragraphs of the section together with an English translation are reproduced below.
“…Article 22, Calculation of taxable income for each taxable year. (1) The amount of taxable income of a domestic company for each taxable year is the amount of taxable revenue for the year concerned after the deduction of deductible expenses for the year concerned. (2) A calculation of the amount of taxable revenue for a domestic company for a taxable year should include, excluding cases where another provision applies, the sale of assets, the transfer of assets for consideration or for no consideration, the provision of services, the receipt of assets for no consideration and other transactions that are not capital transactions related to the revenue of the year concerned…”.
Position of taxpayer
The taxpayer’s argument depended on the position that the transaction did not involve multiple steps but instead was a single, capital transaction explicitly excluded from the scope of article 22 in the wording above.
While this argument does seem to have some merit, the Court was very critical of this interpretation which it criticised as being an “..independent interpretation of the taxpayer…” and noting that even if the transfer of the original debt to the company in the first step of the DES was regarded a for no consideration (for example, given the corresponding issue of equity) it would still fall within the terms of article 22 above.