Foreign dividend exclusion and foreign companies

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This post explains the scope of foreign companies to which the Japanese Foreign Dividend Exclusion System (FDES) applies, allowing Japanese companies to exclude the dividends of certain of their affiliated companies from Japanese taxation provided appropriate conditions are met. This post should be read in conjunction with the post discussing Qualifying Distributions that can apply the FDES system.

Scope of companies that can apply the FDES under domestic law

For Japanese domestic law purposes dividends from a foreign company whose holding for FDES purposes by Japanese domestic companies (i.e. whose ‘FDES Holding Ratio’) is 25% or more (below the ‘FDES Threshold’) can apply the FDES system provided the shares have been held directly and continuously six months or more from the date that the obligation to pay the dividend concerned was established. (CTLEO 22-3(1), CTL23 no 2(1) )

The FDES Holding Ratio is the higher of either of the following ratios:

  1. The ratio of holding by a Japanese company of shares or Invested Capital out of the total number of total amount of shares or Invested Capital issued by the foreign company (excluding shares or Invested Capital held by the foreign company in itself) (referred to below as the Issued Shares).
  2. The ratio of holding by a Japanese company of, out of Issued Shares, those shares or Invested Capital that has a voting right

Also, the holdings in a particular foreign company of different Japanese companies that belong to the same consolidated Japanese tax group can be aggregated when calculating the FDES Holding Ratio (CTLEO 22 no 3(1) ichi). Note however, as discussed below, this rule is modified when applying the lower FDES Threshold allowed by tax treaties, when each Japanese company’s FDES Holding Ratio has to meet the lower FDES Threshold defined in the applicable treaty as discussed further below.

Note that the FDES Holding Ratio calculation looks at the total number of shares when calculating the ratio of shares that have voting rights and ignores the the issue by a foreign company of more than one class of shares with voting rights. This is not the same as the rule that is applied in the Japanese tax haven countermeasures system which does look at different share holdings when considering if a company is an FRC for THCML purposes.

Scope of companies that can apply the FDES when tax treaties apply

Where Japan has entered into a tax treaty with another country that has criteria that allow a Japanese company to avoid double taxation – e.g. through the application of an indirect foreign tax credit – that are more generous than those of the Japanese domestic law (e.g. under the treaty the FDES Threshold is less than 25%) then the more generous rules in the treaty may apply. (CTLEO 22 no 3 (4) )

The above may sound more generous than it actually is in practice as only a handful of treaties seem to have a more generous FDES Threshold lower than 25%, being America, Australia, Brazil and France. Note that the treaties of each individual country should be examined to consider applicability.

The relaxed criteria for applying FDES under a treaty must be met by each Japanese domestic company on their own account that has a holding of shares in the foreign company concerned, regardless of the status of any Japanese consolidated tax group in which they are a member.

US Japan tax treaty

Taking the US/Japan treaty as an example, the treaty allows an indirect foreign tax credit under Article 23 when a Japanese domestic company holds 10% or more of the shares with voting rights in a US company. Accordingly a Japanese company that did not hold 10% of the voting rights of the US company could not apply the FDES benefits if, for example, it still held 20% of the non-voting shares in the company as the 10% voting right criteria under the treaty has not been met and a 20% shareholding is still less than the 25% holding of non voting shares required under Japanese domestic law.

As a further example, if companies A and B are both domestic Japanese companies in the same consolidated tax group and company A owns 15% of the voting shares in a US subsidiary while company B owns 5% of such shares, then company A can apply FDES (i.e. holding of voting shares is greater than 10% in US/Japan treaty) while company B cannot apply FDES (the consolidated group’s holding is still less than 25% required under domestic law).

The 6 month holding period requirement in FDES rules corporate reorganisations

The Japanese FDES rules recognise a deemed extension to the time a Japanese company is seen as having held shares in a foreign company for the purposes of applying the FDES when the Japanese company acquired the shares as part of certain qualified corporate reorganisations (CTLEO 22 no 3(3) ). These rules accordingly recognise that there has been continuous economic ownership of the foreign company within a Japanese group even though the entity may have changed as a result of such a reorganisation.

Under these rules where a Japanese company receives shares in a foreign company that meet the FDES Threshold noted above from a company that transfers such shares as part of a qualifying merger, corporate split, capital contribution (genbutsu shusshi) or post event establishment (jigo setsu ritsu) then the recipient company will be deemed to have held the shares for the period held by the transferring company.

This is an important point to note in tax planning to re-organize a Japanese group’s foreign operations!

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