Case study: Thin cap and stock borrowing

February 9, 2011  |  Thin Capitalisation

A rainy night in Shinjuku, probably taken on the streets of Kabukicho, one of the liveliest districts in town.

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?

Expected treatment

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.

Analysis

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:

  1. A third party where a Foreign Controlling Shareholder has provided funding to Japanese borrower through that third party.

  2. 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.

  3. 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.

Reference

The Japanese definition of Capital Supplier for Japanese thin capitalisation purposes under STMLEO article 39 no 13 (13)

13  法第六十六条の五第四項第二号に規定する内国法人に資金を供与する者及び当該資金の供与に関係のある者として政令で定める者は、次に掲げる者とする。

一  当該内国法人に係る国外支配株主等が第三者を通じて当該内国法人に対して資金を供与したと認められる場合における当該第三者

二  当該内国法人に係る国外支配株主等が第三者に対して当該内国法人の債務の保証をすることにより、当該第三者が当該内国法人に対して資金を供与したと認められる場合における当該第三者

三  当該内国法人に係る国外支配株主等から当該内国法人に貸し付けられた債券(当該国外支配株主等が当該内国法人の債務の保証をすることにより、第三者から当該内国法人に貸し付けられた債券を含む。)が、他の第三者に、担保として提供され、債券現先取引(法第四十二条の二第一項に規定する債券現先取引をいう。第二十七項において同じ。)で譲渡され、又は現金担保付債券貸借取引(法第六十六条の五第四項第八号に規定する現金担保付債券貸借取引をいう。第二十七項において同じ。)で貸し付けられることにより、当該他の第三者が当該内国法人に対して資金を供与したと認められる場合における当該第三者及び他の第三者


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