Japanese tax haven rules (CFC, Subpart F) – overview/タックスヘイベン対策税制

March 15, 2010  |  Japanese CFC

Torii in a shrine in Akasaka

Introduction

The Japanese tax system includes rules that are intended to tax currently the undistributed earnings of certain foreign subsidiaries of Japanese companies that operate in low taxed jurisdictions – the Tax Haven Counter Measure Laws (‘THCML’) . These rules are particularly important for Japanese outbound investment given there are a number of low taxed Asian jurisdictions, Hong Kong and Singapore being two obvious ones, where Japanese companies may set up manufacturing, distribution or other operations.

The Japanese THCML rules share many close similarities with the US Subpart F and UK CFC rules. Different aspects of these rules are listed below linked to related posts on the topics. A good starting point is the glossary of terms and abbreviations used in the posts. Try the link below.

  • Glossary of terms
  • Scope of the THCML I – definition of Foreign Related Companies (‘FRC’s) – what foreign entities may be within the scope of the rules
  • Scope of the THCML II – and Specified Foreign Subsidiaries (‘SFS’s) – what foreign related entities in scope are actually subject to taxation on undistributed earnings
  • Companies excluded from being a SFS – can a foreign company that would be subject to taxation on undistributed earnings be excluded from such taxation on other grounds?
  • How to calculate undistributed earnings subject to current taxation
  • Adjustments to avoid double taxation

In a fundamental change to Japanese outbound taxation in 2009, Japan has moved from a “tax on dividends plus foreign tax credit” approach to taxing dividends from overseas subsidiaries to exempting from tax dividends from foreign subsidiaries. However the foreign tax measures still apply in principle although any motivation to retain profits outside Japan to avoid taxation has cleary been greatly reduced. Finally, tax reform in 2010 proposes lowering the rate of tax paid that would result in a company being treated as a tax haven company from 25% to 20%.

The rest of this post is a chronology of the THCML. Click on the link below to jump to the relevant section.

Establishment of THCML in 1978

The THCML was established in 1978 and was intended to prevent Japanese companies from reducing their tax burden by retaining profits in subsidiaries (‘Specified Foreign Companies or SFSs) formed in certain lowly taxed foreign territories specified by the Minister of Finance.

Unless certain exemptions applied then when Japanese domestic companies or Japanese resident individuals owned more than a specified percentage of the SFS concerned then the undistributed income of the SFS would be combined with the income of the Japanese investorsin the SFS and taxed currently (i.e. gousan kazei/合算課税) would apply.

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THCML reform 1985

Japanese tax planners seem to have found a flaw in the 1978 system. Japanese outbound investors could establish a subsidiary (‘Tier 1 Co’) in a country that is not a specified lowly taxed country but which also does not tax dividends from its foreign subsidiaries. Holland would be an example of such a country. Tier 1 Co would then establish its own subsidiary (‘Tier 2 Co’) in one of the tax haven countries. Dividends from Tier 2 Co to Tier 1 Co would not be treated as retained profits subject to the THCML system despite not being subject to tax at the Tier 1 Co level. Reform in 1985 addressed this problem by restricting the deduction of dividends when calculating the undistributed dividends of the SFS.

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THCML reform 1992, 1998, 2000, 2005

Tax reform in Heisei 1992 replaced the list of specified low tax countries with a general rule to treat specified foreign related subsidiaries subject to tax at a rate of 25% or below as potentially being SFSs. In the same reform the shareholding limit below which the rules would not apply to a Japanese outbound investors was lowered from 10% to 5% or below. Also the scope of shareholdings that could cause a foreign company to be treated as an SFS was expanded to include not only owning 50% or more of the total number of issued shares but also to the ownership of 50% or more of the voting shares only.

Tax reform in 1998 saw additions to the system around rules around identifying the person responsible for paying tax on income included from the SFSs and also around the calculation of the undstributed profits. 2000 saw the inclusion of specified foreign related trusts in the THCML system, although these rules were dropped in 2007. 2005 saw further changes: Certain items could be exempted from taxation further to the THCML (e.g. the deduction of 10% of personnel costs from undistributed profits); the lifetime of taxed foreign undistributed profits was extended to ten years; the carryforward of losses in the SFS for up to seven years (consistent with Japanese regulations) was recognised; rules relating to taxtion of income from special foreign related trusts were established.

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THCM reform from 2006 to 2009

Reform in 2006 reflected changes in the Japanese corporate law ithrough changing the definition of what could be treated as a dividend and the timing of deduction of dividends in the calculation of the undistributed profits subject to taxation under the THCML. Limits on the number of distributions that could be made in a year (similar to those that had existed under Japanese corporate law) were also abolished.

2007 saw rules that addressed the definition of a foreign related party for THCML purposes for foreign companies that had issued shares with either differing voting rights or other rights that varied. Also for foreign companies that may be outside the scope of the THCML by virtue of their activities, if such companies did not maintain proper accounting records they could not take advantage of such an activity based exclusion.

2008 saw the inclusion of companies under the control of directors of a Japanese domestic company being included in the scope of members of a group of family companies and excluded related parties. Finally 2009 saw measures to coordinate the THCML with the introduction of the exemption from Japanese tax of dividends from foreign affiliates.
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