The following article is a case study looking at the application of the Japanese thin capitalisation regulations to a stock borrowing transaction.
This article should be read in conjunction with the articles outlining Japanese thin capitalisation regulations which can be found here.
Terms in capitals are as defined in the thin capitalisation articles unless otherwise explained below.
Case Study Facts
A Japanese company (‘Japan KK’) borrowed equities from its foreign parent company (a ‘Foreign Controlling Shareholder’ for Japanese thin capitalisation purposes – ‘Parent Inc’). Japan KK repo’d the equities out to a third party in Japan in order to raise funds.
Would Parent Inc be treated as a Capital Supplier for Japanese thin capitalisation purposes?
Looking at the strict legal form of the definition of Capital Supplier, Parent Inc does not fall within the definition.
However the loan of securities from Parent Inc may be treated, from the point of view of economic substance, as equivalent to a guarantee or alternatively treated as indirect finance for the benefit of Japan KK.
Accordingly there is room for the tax authorities to characterise the liabilities arising as a result of the transaction as being within the scope of the Japanese thin capitalization rules leading to their inclusion in the calculation of related party debt and disallowance of Interest for Thin Cap purposes paid to Parent Inc or the lender concerned.
As outlined in this article, under the Special Taxation Measures Law (‘STML’) article 66-5,1 (link in Japanese) where a Japanese domestic company pays Interest for Thin Cap purposes to a Foreign Controlling Shareholder or a Capital Supplier then such interest may be subject to disallowance for Japanese tax purposes when the average balance of borrowings from those two classes of persons exceeds three times the net assets of the Japanese domestic company concerned.
Capital Supplier for thin capitalisation purposes
Article 39 no 13 (13) (link in Japanese – included in reference materials below) of the Special Taxation Measures Law Enforcement Order (‘STMLEO’) defines a Capital Supplier as a person who provides funds to a domestic company or a person related to the provision of funds to a domestic company and specifically as:
A third party where a Foreign Controlling Shareholder has provided funding to Japanese borrower through that third party.
A third party where that third party has provided funds to a Japanese borrower further to a guarantee from a Foreign Controlling Shareholder given to that third party.
Circumstances where debt securities are borrowed from a Foreign Controlling Shareholder and either given to a third party as collateral for a loan, transferred under a Japanese repo transaction (in Japanese a ‘現先’ or ‘gensaki’ transaction) or are transferred to the third party under a cash secured loan of debt securities (in Japanese a ’現金担保付株券貸借’ or ‘genkin tanpo tsuki kabuken taishaku’ transaction) and accordingly the third party is recognised as a Capital Supplier to a Japanese borrower.
In ｔhis case study, equity securities (rather than debt securities) have been borrowed from a Foreign Controlling Shareholder and transferred to a third party under a Japanese repo transaction. As a result the Japanese domestic company has raised funding. The wording of the regulations summarised above does not explicitly include transactions in equities in the definition of Capital Supplier, but the purport of the regulation and the underlying substance of the transaction under consideration is clearly intended to allow Japan KK to raise capital from the third party using assets provided by Parent Inc. Hence the lender to Japan KK in addition to Parent Inc may be treated as a Capital Supplier for Japanese thin capitalisation purposes.
Notwithstanding the above analysis, it is also possible that the transaction could be treated as being in substance equivalent to a guarantee or an indirect financing within items (1) and (2) listed above and hence still within the scope of Japanese thin capitalisation regulations.
The Japanese definition of Capital Supplier for Japanese thin capitalisation purposes under STMLEO article 39 no 13 (13)