This post is the first of a series which outlines precedents arising from a number of tax cases that have been heard in the Japanese courts concerning the application of the Japanese tax haven countermeasures law (THCML). These cases provide some useful guidance on the interpretation of the law concerned, but of course proper professional advice should be obtained about their application to a particular taxpayer’s specific circumstances.
The first case addresses the definition of main business for a financial year and also considers what factors are relevant to determining main business.
Outline of case
In this case (the ‘Numazu Case’) the Numazu local tax office in Shizuoka-ken (west of Tokyo including Mount Fuji on its northern border) asserted that the foreign subsidiary (‘FCo’) of a Japanese company (‘JKK’) was a Special Foreign-related Subsidiary (‘SFS’) of JKK and further that the main business purpose of FCo was the holding of shares, and accordingly that profits retained in FCo could not be excluded from the application of the Japanese tax haven countermeasures law (THCML). The Numazu tax office assessed FCo to additional Current Taxation on such retained profits that they asserted should have been included in JKKs tax return for the financial year concerned.
The flowchart in this post gives useful background to how this case fits into the overall THCML scheme.
Point of dispute
The key point of dispute in the Numazu Case was whether or not the main business (主たる授業) of FCo was the holding of shares 「株式の保有」, which is an activity that, if the main activity of a foreign company, prevents the foreign company being excluded from the application of the THCML.
Assertion of the taxpayer
The taxpayer asserted that FCo was not a company set up simply for the purposes of holding shares but that, in the financial year concerned, was already active in Hong Kong with the objective of raising finance for the business of the JKK group. FCo was still in a period when it was setting up its business and in order to raise finance it had purchased shares that it thought would go up in value. These shares had been held for a short period before being sold for a profit and it was clear that the holding of these shares by FCo was carried out along with the development of its money lending business. The purchase and sale of the shares and was just one step in the carrying out of FCos main financial business. This activity had a different nature from the holding of shares and the related earning of income from holding shares.
Accordingly the taxpayer asserted that the “main business” of FCo for THCML purposes should be considered comprehensively based on economic logic, also considering subjective circumstances such as the reasons behind setting up FCo, the details of the company’s establishment, the acquisition of the shares FCo purchased, the purpose behind their being held, the use of the profit gained from the transaction, the attribution of the results of the transaction and similar factors.
Assertion of the tax authorities
The objective result of FCo’s business activity for the financial year concerned was, when looking at FCos revenue and net income, that 96% of its gross revenue was due to either gains on disposals of shares or dividend income. Given these facts, the main business of FCo for the financial year concerned was found to be the holding of shares. This finding should not be disturbed by the fact that in subsequent financial years the main business of FCo was a financial business (other than holding shares).
Judgment of the court concerning the point of dispute
The THCML was aimed at cases where it could be foreseen that a subsidiary company was set up in a country with a low tax rate (a tax haven) in order to inappropriately reduce the shareholder’s tax burden. From the point of view of fairness of the tax burden among Japanese taxpayers the THCML system was set up to prevent such a situation, although it was not intended to apply to normal business activity. In circumstances where the foreign company concerned met all of certain specified conditions (the Substance Standard, the Management and Control Standard, the Non Related Person Standard the Local Business Standard) then the company could be excluded from the application of the THCML.
Where the main business of a foreign company included certain specified businesses such as the holding of shares (and other businesses listed here) then from the start foreign companies carrying on those businesses as their main business could not be excluded from the application of the THCML rules. The reason for this was that, looking at the nature of the businesses concerned, it should be easily possible to carry out those businesses in Japan. It is difficult to see any compelling economic logic as to why such businesses should be carried on overseas. Right from the beginning such sorts of business were not premitted to be excluded from the application of the THCML.
Accordingly the rules relating to the exclusion from the THCML were not based on the nature of the person (the foreign company concerned) but rather were a question of whether or not, for the financial year concerned, profits retained in the foreign company should be included in the taxable income of the Japanese company. Accordingly it is natural to judge the application of the criteria for exclusion from application of the THCML each financial year. Also, when the foreign company carries on more than one business a judgment around which of these businesses is its main business for the purposes of the THCML should be made based on the objective results of the business activity. Such judgment would be expected to be based on comprehensive consideration of matters such as the state of the company’s revenues or income, the number of employees, the state of the company’s premises and similar. When making this assessment, these facts that are related to an assessment of taxation of the foreign company under the THCML have the nature of things that can be confirmed as existing or otherwise for each financial year. Matters such as circumstances after the last day of the financial period are matters that cannot be assessed and hence should not be taken into consideration for the financial period concerned.
This result of this case may be rendered moot by the 2010 tax reform which introduced Current Taxation on “Asset Related Income” including dividends or gains from shares where less than 10% are held. The case is useful in emphasizing that the test is applied each financial year rather than being determined at one time and the applied for all years and also for noting that more weight is given to (arguably) more objective matters such as the type of revenue, activities of employees etc rather than subjective matters such as intent in setting up the foreign subsidiary or similar.