Exclusions from the Japanese CFC rules

March 15, 2010  |  Japanese CFC

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This post outlines criteria that, if met, would allow certain foreign subsidiaries of Japanese companies that would normally be treated as tax haven subsidiaries subject to Current Taxation (referred to as ‘Specified Foreign Subsidiaries’ or SFSs below) to be exempted from such treatment. Similar to the US Subpart F rules, the criteria are broadly are aimed at excluding certain active businesses managed in the foreign country concerned. On the other hand certain businesses, where there is a presumption that the business could be run from Japan, cannot be excluded from Current Taxation despite meeting these other criteria.

The headings below discuss businesses that can never be exempted from being an SFS and the criteria that can allow a company to be so excluded.

Criteria for SFS to be exempted from Current Taxation

It is possible for a company that would otherwise be a SFS to be excluded from the THCML provided certain criteria are met concerning the business carried on by the SFS concerned. These criteria vary with the type of business of the SFS and some companies, based on their underlying business, can never be exempted. Back to top

Businesses that prevent an SFS being exempted from Current Taxation

If the main business of the SFS is any of the businesses listed below then the SFS cannot be exempted from the application of the THCML. The underlying logic seems to be that these businesses could reasonably be carried on in Japan, so the “economic logic” in their being carried on outside Japan is lacking.

  • holding equity
  • holding debt (saiken/債権)
  • the provision of industrial ownership rights
  • the provision of copy rights
  • the leasing of ships or aircraft (limited to bare boat, aircraft leasing)

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Criteria to exempt an SFS from Current Taxation applicable to all businesses

The following two conditions have to be met by the main business carried out by an SFS in order to allow the SFS to be exempted from Current Taxation. In addition to these basic criteria below there are further criteria, explained in the following section, that must also be met but that depend on the type business concerned.

The criteria are:-

  1. The SFS has in its country of incorporation sufficient staff to execute its business and sufficient fixed assets and premises – an office, shop, factory – or other fixed premises as required by the business. This is referred to below as the ‘Substance Standard’
  2. The SFS itself carries out in its country of incorporation the management, control and governance or administration required by its business in that country. This is referred to below as the ‘Management and Control Standard’.

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Criteria to exempt an SFS from Current Taxation applicable depending on business

The main business of an SFS has to be examined to consider whether it is one of a list of specified businesses (‘Listed Businesses’) that have to meet a >50% non related party income. All other businesses (‘Non Listed Businesses’) have to meet a different criteria around the amount of business carried out in the country of incorporation of the SFS concerned.

Listed Businesses

The listed businesses are:

  • wholesaling
  • banking
  • securities business
  • insurance business
  • trust business
  • water transport
  • freight

For these Listed Businesses, more than 50% of the main transactions of the business concerned (not incidental transactions) should be with unrelated persons. Some commentators have said that the logic behind this approach is that the transactions of the businesses concerned are not always limited to transactions with persons in the country of incorporation of the SFS concerned, so a requirement related to carrying out business in the country of incorporation may not be appropriate. Accordingly the a measure of transactions done with persons other than those related to the SFS parent is chosen as a criteria for these businesses.

Also, where an unrelated intermediary is involved in transactions between the SFS and its related parties and, accordingly, transactions are carried out indirectly with related parties of the SFS then, unless there is an appropriate reason for the unrelated intermediary to so act, such indirect transactions between the SFS and the related party are deemed to be direct.

For transactions for a wholesaleing business when applying the criteria for the >50% transactions with unrelated persons then the 50% measure is tested against either the sales amount or the purchases amount of the entity and if either is greater than 50% then the criteria will not be met. This is an important point as it will tend to capture most captive importers/distributors in a particular jurisdiction owned by a Japanese parent.

Non Listed businesses

For SFSs whose main business not one of the Listed Businesses, the business of such an SFS has to be carried out mainly in the country of incorporation of the SFS. Clearly this is an important consideration for a Japanese company setting up a subsidiary in a lowly taxed jurisdiction that may be exporting outside its country of incorporation or carrying out contract manufacturing of components or similar on behalf of its parent that would be re-exported to Japan.
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Discussion points re exemption of an SFS from Current Taxation

Application of the Management and Control Standard

Within the THCML, unsuprisingly, the application of the above criteria has given rise to many issues and disputes. Application of the Management and Control Standard has beenparticularly controversial. This standard was tested in a court case (Tokyo District Court Showa 61 1-5-1) which said that application of this test had to be looked at comprehensively taking into account factors such as the following:-

  • Is the shareholder’s general meeting held in the country of incorporation of the SFS?
  • Are the directors of the SFS resident in its country of incorporation?
  • Are material management decisions taken by the SFS (rather than being referred back to the parent in Japan for example?)
  • Are the books of the SFS prepared and kept in its country of incorporation?

Shenzen subsidiaries – contract manufacturing

Another topical issue that has arisen in the application of the tax haven system is that Hong Kong subsidiaries of Japanese manufacturers have been using Chinese companies based in Shenzen or similar preferred locations for contract manufacturing and similar and receiving favorable customs treatment. However there is a question mark over whether these, or similar arrangements elsewhere in Asia, will prevent the Hong Kong subsdiary from being excluded from the THCML because, for example, the Hong Kong subsidiary may not maintain sufficient activities in Hong Kong for the business concerned.
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