Thin capitalization – kashou shihon zeisei
The Japanese thin capitalization system is intended to prevent foreign over-leveraging their Japanese subsidiaries or branches in order to claim excess corporation tax deductions through interest charges. It can be compared to earning stripping legislation in the US.
In more concrete terms, the system has applied from financial years starting on or after 1 April 1992 in circumstances where interest is paid on liabilities due to a Foreign Controlling Shareholder (kaigai shihai kabunushi) or a Capital Supplier (shihon kyouyosha). Where the average balance of liabilities due to either a Foreign Controlling Shareholder or Capital Supplier exceeds three times of the capital in the paying entity held by the Foreign Controlling Shareholder then the amount of interest payable on the excess amount of such liabilities is not deductible. However in cases where the total average liabilities for a year of a company that may be subject to this rule do not exceed three times its own capital then disallowance due to thin capitalization does not apply. This exception is essentially saying that where a company is not thinly capitalized overall (because it is maintaining a less than three to one debt to equity ratio) it would not be treated as thinly capitalized with respect to a particular Foreign Controlling Shareholder even if lending from them exceeded three times their equity interest. (STML 66-5-1).
Furthermore, in the Japanese tax reform of 2006 the scope of liabilities subject to thin capitalization was reformed. In particular a special exception was instituted for certain repo transactions (Qualifying Repos – tokutei saiken gensaki torihikitou) with related parties as discussed below.
- Definition of foreign controlling shareholders
- Definition of Capital Suppliers
- Definition of Interest for Japanese thin capitalization purposes (‘Interest for Thin Cap’)
- Application of the safe harbor rules
- Exception for repos with related parties
- Thin capitalization and Japanese Tax Consolidation
- Application of thin capitalisation to Japanese branches of foreign companies
- Thin capitalisation and foreign companies without branches in Japan
- Securitisation and thin capitalisation – the Japanese double SPV structure
The above parties are defined by reference to their relationship to the company which may be subject to thin capitalization disallowance – the ‘Japanese Target Co’.
The definition of Foreign Controlling Shareholder can be looked at in three parts – “parent-subsidiary relationship”, “brother-sister company relationship” and “in substance controlling relationship” includes the following:
- Parent-subsidiary relationship: a non resident or foreign company (collectively a Non Resident) that owns 50% or more of the issued share capital (excluding own shares held by the Target Company – also below) or invested capital of the Target Company, directly or indirectly.
- Brother-sister company relationship: where the same person (who does not have to be non-resident) owns more than 50% or more of the issued share capital of both the Target Company and the Non Resident then the Non Resident is a Foreign Controlling Shareholder for Japanese thin capitalization purposes.
- In-substance controlling relationship: even though not meeting the above criteria, Non Residents who can in substance decide all or some part of the business plans of the Target Company due to the following sort of circumstances would also be treated as Foreign Controlling Shareholders. Such circumstances are:
- a significant part of the business activity of the Target Company depends on transactions carried out with the Non Resident
- the Target Company has borrowed a significant part of the funds it uses for its business operations directly
from the Non Resident or relying on a guarantee of the Non Resident
- half or more of the of the executives (yakuin) of the Target Company or executives with rights to represent the Target Company are executives concurrently with being employees of the Foreign Resident company or are either employees or directors of the Foreign Resident Company.
The definition of Capital Suppliers seems intended to bring into the scope of the thin capitalization regulations domestic Japanese companies that may be involved in financing the Target Company with the help of a Foreign Controlling Shareholder through back to back or similar arrangements. The definitions, which are somewhat unclear, covers the following parties:
- Where it is recognized that a Foreign Controlling Shareholder provides funding to the Target Company through a third party, the third party concerned. This would seem to cover back to back arrangements.
- When, by virtue of a guarantee by the Foreign Controlling Shareholder of loans from a third party to the Target Company, the third party is recognized as providing funds to the Target Company then the third party is a Capital Supplier. This would seem to cover most circumstances where a parent company guaranteed a local Japanese bank lending to its subsidiary.
- Where a Foreign Controlling Shareholder lends securities to a Target Company (including guaranteeing a loan to the Target Company from a third party) and that Target Company uses such securities to raise funds from a third party through either providing them as security to third party, transferring them further to a repo contract or lending them in a stock loan secured by cash and where by virtue of such transactions the third party is recognized as providing capital to the Target Company then that third party is seen as a Capital Provider. This would seem to capture attempts to use a securities loan + lending fees as an alternative to a straightforward loan from a Foreign Controlling Shareholder to prevent the thin capitalization rules applying.
A key point in the definition of Interest for Thin Cap under the Japanese rules is that it excludes amounts that are treated as taxable income for the recipient (or which are paid to certain public purpose or public benefit companies that may be exempt from taxation). The implication of this part of the definition is that, for example, when a Japanese subsidiary of a multi-national borrows from a Japanese bank under a guarantee from its parent then the interest paid to the Japanese Bank itself will still be deductible however given that the Japanese Bank would be a Capital Supplier as defined above the increased leverage from including such borrowing in the calculations may make other cross border borrowing from related parties come within the scope of thin capitalization and be disallowed. Interest on borrowing from a Japanese branch of a group company would also not itself be disallowed.
Other than the above the definition of Interest for Thin Cap is very broad and includes interest on liabilities, discount on Japanese cheques (tegata) and other items whose economic nature is equivalent to interest. Where debt is guaranteed by a Foreign Controlling Shareholder as in the second bullet above then guarantee fees are included. If the third bullet point above applies then stock loan or guarantee payments arising paid to the Foreign Controlling Shareholder or third party are also treated as Interest for Thin Cap purposes. Back to Top
As noted in the introduction, in order for the Target Company to be thinly capitalized then it has to be:
- thinly capitalized at the overall company level – i.e. regardless of whether lending is from related parties or not, the company itself is more leveraged than the safe harbor ratio; and
- the company has to be thinly capitalized in respect of the lending from a particular Foreign Controlling Shareholder – i.e. the ratio of debt to equity held by such a shareholder has to be more than the safe harbor ratio
The safe harbor ratio is three to one debt to equity (or two to one if the special treatment for certain related party cross border repos is applied) or the ratio that applies to a comparable company. This comparable company ratio is apparently rarely used given the difficulties in finding a comparable company and details have to be included in a schedule to the tax return.
The formulas applied to calculate the debt equity ratio for each year end is given below and if the ratios in both of these formulae exceed the safe harbor ratio then thin capitalization applies:
A = B/C – where
- A = safe harbor ratio with respect to Foreign Controlling Shareholders and Capital Providers
- B = the average balance of liabilities owed to the Foreign Controlling Shareholders or Capital Providers
- C = the amount of capital held by the Foreign Controlling Shareholders
D = E/F – where
- D = overall leverage ratio
- E = average balance of total liabilities
- F = total amount of the Target Company’s capital
Note that E is limited to liabilities the interest of which may be a factor in the thin capitalization calculation. The average balance of liabilities has to be calculated based on values recorded in the books of account according to a logical method. This would seem to prevent trying to distort the calculation by, for example, paying down debt just before the quarter end and doing a quarterly calculation for example.
The capital held by the Foreign Controlling Shareholder is calculated as the amount of the Target companies own capital (jikoshihon) multiplied by the number of shares or invested capital held by the Foreign Controlling Shareholder directly or Indirectly, divided by the total shares of the Target Company. Back to Top
The exception for repo transactions discussed above works as follows: Where a Japanese company has entered into Qualifying Repo transactions with a Foreign Controlling Shareholder or Capital Supplier, the amount of interest paid or amount of liabilities arising with those persons can be deducted from the total amount of interest paid or liabilities due to such persons. Then provided the debt to equity ratios described above that would normally be three to one are maintained at two to one, then the thin capitalization rules don’t apply. In other words, if you are entering into Qualifying Repo transactions with defined related parties you can remove them from your thin capitalization calculations but for your remaining activity have to keep within a more restrictive 2:1 rather than a 3:1 ratio. Back to Top
Thin capitalisation is assed by reference to individual entities rather than by looking at the whole of a consolidated group. Accordingly when lending cross border to Japanese entities in a consolidated group an approach may be to lend to each of the entities to the limit of the safe harbour limit for the entity rather then lending to, for example, the parent company of the consolidated group and then that entity lending to other entities within Japan. Back to Top
Thin capitalisation also applies to non-Japanese companies doing business in Japan through a Japanese branch or permanent establishment. Some points to bear in mind are as follows:
- “Internal interest” (i.e. interest shown as paid from branch to head office) is treated as non deductible for Japanese tax purposes and is also outside the scope of interest for Japanese tax purposes. However interest that is recorded as paid from branch to head office that is traced to debt raised from third parties is potentially deductible and if the borrowing is from a Foreign Controlling Shareholder is within the scope of think capitalisation.
- The Foreign Controlling Shareholders “equity” in a Japanese branch for the purposes of a thin capitalisation calculation is calculated as [A=the capital of the company having a branch in Japan x (B=assets used in the business of the branch in Japan x C=total assets of the foreign company) x D=Foreign Controlling Shareholder’s share of the company business]
Thin capitalisation also applies when foreign companies that do not have a permanent establishment file tax returns based on their net income and include interest as a deduction in calculating such net income. Such interest is also subject to think capitalisation. A good example of such a tax filing is gain on sale of shares in a substantial interest in a Japanese company (e.g. of a stake of 25% or more under some circumstances under Japanese law). Back to top
Thin capitalisation is an issue in double SPV transactions historically used in Japan for securitisation transactions. If the relationship between either the SPVs or the investors came within the scope of the relationships described above then then thin capitalisation could become an issue.