This post discusses the scope and logic in used to determine which foreign companies the THCML will apply to tax their foreign income currently for their Japanese shareholders.
Important stages in this determination are as follows:
- Out of all non-Japanese companies in the world, determine which companies are Foreign Related Companies or ‘FRC’s
- For companies which are FRCs, determine if they are Specified Foreign Subsidiaries subject to Current Taxation in Japan. This will involve considering the rate of tax they suffer in the foreign country and whether or not they meet certain criteria, which vary by type of main business. Meeting these criteria may allow an FRC not to be treated as SFSs despite paying a very low local tax rate
- If a company is an SFS, determine the Ownership Ratio of each of its Japanese owners and hence the share of its undistributable reserves subject to Current Taxation
- Foreign Related Companies – FRCs
- Specified Foreign Subsidiaries – SFSs
- Domestic persons subject to current taxation under the THCML
- Calculating the ownership ratio
- Miscellaneous points
A foreign company is an FRC for THCML purposes when the following three classes of persons (collectively the ‘Domestic Owners’) own directly or indirectly more than 50% of the total number or more than 50% of the total value of the total shares issued by the foreign company concerned. The there classes of people who may be Domestic Owners for these purposes are
- Japan resident individuals,
- Japanese companies, and
- specially related non-residents (tokutei kankei hikyojusya/特殊関係非居住者 – here ‘SRNR’s)
When a foreign company has issued shares that do not have one voting right per share or where the foreign company has issued different classes of shares with Preferred Rights then the following rules apply: The ownership ratio will be the higher of the ratio under the basic rule (the 50% ownership rule described above) and the following ratios. If any ratio is more than 50% then the company is an FRC.
- For companies who have issued shares where each share does not carry a voting right (but excluding shares under (3) below), the ratio of voting shares held directly or indirectly by the Domestic Owners
- For companies that have issued shares Preferred Rights (but excluding shares under (3) below), the share of distributions that can be received by Domestic Owners based on the rights of the shares issued by the foreign company concerned.
- For companies that have both issued shares were each shares does not carry a voting right and issued classes of shares Preferred Rights, then the higher ratio of (1) or (2) above
A FRC which…
- has its head or main office in a country or territory (below referred to as the ‘Foreign Country of Incorporation’ or FCI) which does not assess tax on the income of a company; or
- for the financial year concerned the income of the FRC is subject to tax at the Minimum FRC Tax Rate or below (25% in 2009)
…is treated as an SFS.
As described below the Actual FRC Tax Rate is in principle calculated by dividing the foreign tax paid by the FRC (the numerator) by the taxable profits of the entity calculated further to local tax law (the denominator). However both the numerator and denominator are subject to adjustments under the THCML as described below . Also note that Actual FRC Tax Rate is tested each financial year, so an FRC may be a SFS in some years when it is paying a low rate of foreign tax in the FCI but may not be an SFS in other years if the Actual FRC Tax Rate is above the Minimum FRC Tax Rate for the financial year concerned.
The calculation of the Actual FRC Tax Rate is performed on a schedule to the tax return that can be found here. Foreign second and lower tier subsidiary companies are subject to the same rules. Note that the latest tax reform has proposed lowering the Minimum FRC Tax Rate to 20%. Back to top
The denominator in calculating the Actual FRC Tax Rate is the amount of taxable income calculated under the tax law of the territory or country of incorporation of the foreign company, but with adjustment for the following:
- Addition of non-taxable income, but excluding dividends – including deemed dividends – from other companies which are incorporated in the same country as the FRC. Also dividends from other foreign countries that are excluded from taxation by virtue of a specified share holding ratio are also excluded from the denominator. In other words, if the if the FCI operates a foreign dividend exemption system then the dividends concerned are excluded from the denominator, tending to increase the Acutal FRC Tax Rate
- Dividends paid when such dividends are treated as tax deductible – i.e. this would exclude dividends paid by REIT-like entities from the denominator and
- Foreign taxes (when foreign taxes paid are treated as deductible)
- Reserves similar to insurance reserves to the extent they exceed the tax deductible limit
- Reductions in foreign corporation tax (in cases where the repayments of corporation tax are included in taxable income)
The numerator in calculating the Actual FRC Tax Rate is the amount of foreign corporation tax assessed by the country of incorporation or other foreign countries on the income of the FRC for the financial year concerned. The actual cash taxes paid are considered – deferred taxes are not taken into account.
Note that if the final amount of corporation tax due has not been finallly confirmed (perhaps because tax filing deadlines for the country concerned are due later than those of Japan) then the amount of foreign tax used in the denominator is based on the amount of foreign tax calculated for the financial year concerned of the FCI).
The numerator is adjusted for the following items:
- The addition of indirect foreign tax credits and similar claimed by the company
- The addback of exempted foreign taxes – i.e. for example the amount equivalent to the taxes that would be exempted under the tax sparing provisions of treaties that Japan has entered into
There are some final special rules for calculating the Actual FRC Tax Rate:
- For cases where the rate of corporation tax for the FCI varies according to the taxable income of the foreign company then the highest rate can be used. The thinking behind this rule is likely to be to prevent the inclusion of companies that may have been only marginally profitable in a given year and hence paying a concessionary rate of tax in the foreign country concerned.
- Where a company has a loss but where income has been earned out of the revenue of the main business of the foreign related party, then the tax rate that is applied to such income can be used to calculate the Actual FRC Tax Rate.
Similar to the US Subpart F system the Japanese THCML has to have rules to define the scope of Japanese resident persons who are subject to Current Taxation on the undistributed earnings of the SFS.
- Japanese residents, and
- Japanese domestic corporations, and
- Japanese residents and Japanese domestic corporations (plus also non resident directors that hold shares in the FRC) that are in a “family group” as defined for Japanese tax purposes
who each hold directly or indirectly 5% or more of the shares in the SFS (excluding shares in the SFS holds in itself) are subject to Current Taxation on the undistributed earnings of the SFS and have to include a pro-rata share of such income in their Japanese tax returns.
For domestic Japanese companies subject to Current Taxation of their share of the SFS income no special tax rate applies. For Japanese resident individuals the income is treated as “sundry income” (zasshotoku/雑所得). Credit is in principle allowed for the foreign taxes concerned (see later post).
If the SFS has issued shares with Preferred Rights (i.e. are companies under item (2) above then the actual Ownership Ratio used to assess whether the 5% or greater limit above has been exceeded is calculated in the same manner as in item (2). Back to top
Once the Japanese resident persons holding 5% or more of the SFS are identified the actual Ownership Ratio used to calculate the inclusion of undistributed earnings for those persons has to be calculated.
The Ownership Ratio is calculated by following the method for calculating ownership interests under the Japanese transfer pricing rules with two important changes: (1) the “in substance” controlling relationships defined in the Japanese TP rules are not applied – i.e. tracing of ownership is only through a shareholding relationship not through in substance control through lending to, appointing directors of a foreign company or similar; and (2) the Ownership Ratio is calculated through multiplying the share ownership ratios through the chain of ownership to the SFS concerned – a logical approach to prevent the total Ownership ratio exceeding 100%! Back to top
There will of course be circumstances where a Japanese domestic parent company owns a Japanese subsidiary that in turn owns a SFS. However in these circumstances the Japanese domestic parent company is not treated as holding shares in the SFS. The direct and indirect shareholdings used to determine the status or Ownership Ratio of an SFS are traced starting from a domestic company through to the first tieir foreign subsidiary and not between domestic companies. In other words Current Taxation applies to domestic companies “at the border” between the Japanese company holding the first tier foreign companies that either is or in turn owns an SFS. This is similar to the approach taken to Subpart F income in the US. Back to top
Capital relationship is not important in assessing whether the 50%+ test for being a FRC applies. A foreign company can be a FRC if its shareholders making up the 50% are unrelated. Again this is similar to the US CFC rules. Back to top
For the domestic Japanese companies that incur a tax obligation through having 5% or more of an SFS, again the capital relationship between those domestic companies is also not important. The capital relatinship would be considered in assessing whether the members of a family group exceed the 5% ratio initially. Also if the members of a family group individually own less than 5% of the shares in the SFS then they are still subject to tax on their Inclusion Ratio even if below 5% given that the group as a whole has a 5% or more holding. Back to top