Note that an underlying intention in the definition of Qualifying Distributions seems to be to include income type return to shareholders but exclude return of capital (a return of capital could still give rise to taxable capital gain or loss). While for the majority of dividends paid from foreign companies it may be relatively easy to apply the FDES rules and identify Qualifying Distributions in some cases definitional difficulties may arise. Such difficulties will tend to arise from trying to apply Japanese company law definitions of distributions to foreign law corporate actions. Accordingly at the very least it would be wise to read this post along with the glossary post found here and referring to the detailed Japanese company law definitions that are referenced below.
Qualifying Distributions – definition
The following distributions qualify for Foreign Dividend Exclusion treatment if meeting other required conditions:
- Dividends out of Surplus, being dividends or distributions paid by companies or co-operative associations to the extent that they are paid on shares (or Invested Capital in the case of such associations). For a company this does not include amounts that would be treated as a reduction in share capital. Also, shares received by a company’s shareholders in a Bunkatsu Style Corporate Split are excluded as are certain defined transactions of co-operatives that could be a return of capital. Note also the treatment of Deemed Dividends discussed below.
- Profit Dividends – but again excluding shares distributed as part of a Bunkatsu Style Corporate Split.
- Distributions out of Surplus – that is distributions made by mutual companies and some other entities, but only including distributions related to capital (i.e. this means that certain dividends made to members of the mutual organisation which are also deductible for Japanese tax purposes would not be included).
There are a number of points worth noting to come out of the above definition.
The fairly straight forward definition of Qualifying Distributions above would seem to include dividends from REITs or similar companies where the dividends may be deductible under local law for tax purposes. This could make investing in such entities on a post tax basis far more profitable given they may have a very low local tax rate and their dividends would not suffer further taxation in Japan.
Also some countries (the US being a notable example) allow distributions to be made by reference to consolidated financial statements. This may allow a Japanese entity to receive, without further taxation, a dividend that is effectively received from a second tier subsidiary.
Deemed Dividends (as defined in CTL 24-1) are included in Qualifying Distributions subject to the FDES given that their economic character under this definition is presumed to be similar to dividends. Deemed Dividends arise in the circumstances listed below when, there being an exchange of monetary or other assets in respect of return shares, the Deemed Dividend would be calculated by reference to the total value of those monetary and other assets less the amount that was treated as a reduction in the capital of the company concerned. Examples of circumstances giving rise to a deemed dividend are:
- Merger (excluding qualified mergers)
- Bunkatsu Style Corporate Split (excluding tax qualified transactions)
- Return of capital (limited to Dividends out of Surplus where there is an accompanying reduction in surplus capital and not including returns of capital arising from a Bunkatsu Style Corporate Split which are not treated as deemed dividends)
- Distribution of residual assets on a winding up – note that there are significant changes proposed to taxation of liquidations in the 2010 tax reform
- Acquisition of own shares or Invested Capital (excluding some specified items)
- Return of Invested Capital on retirement of members, departure or for other reasons (applicable to co-operative associations, some other special entities)
- Corporate reorganisations – limited to amounts of consideration other than shares or Invested Capital (i.e. boot)
Under pre 2010 tax reform a Deemed Expense amount equal to 5% of the amount of Qualifying Distributions must be deducted and the net amount excluded from income, this amount being intended to be equivalent to expenses associated with earning the dividend income. The 2010 tax reform proposes abolishing this arrangement.