On December 14, 2018, Japan’s ruling coalition government, led by the Liberal Democratic Party (LDP), released its 2019 tax reform outline, which includes proposed amendments to Japan’s controlled foreign company (CFC), interest expense limitation, and general transfer pricing rules, among others. Each proposal is addressed below.
Editor’s Note: the LDP is expected to table draft legislation, to implement the 2019 tax reform measures, in Japan’s Parliament (Diet) in the coming days.
CFC Amendments (BEPS Action 3)
Undistributed profits of a foreign subsidiary located in a tax haven are included in the Japanese parent company’s taxable income, pursuant to Japan’s CFC rules (Section 7-4 of the Act on Special Measures Concerning Taxation (“STML”) for corporate taxpayers, and Section 4-2 for individuals). A Japanese corporation owning a 10% or more direct or indirect interest in a CFC is required to include its pro rata share of the taxable retained earnings of the CFC in its gross income in certain situations. Dividends paid by the CFC are not deductible when calculating the undistributed income.
Japan’s 2017 tax reform amended the CFC rules to subject a “Foreign Related Company” that has an effective income tax rate of 20% or lower in its jurisdiction of residence to Japan’s CFC regime, when it is one of three types of companies:
- A “paper company.”
- A “cash box.”
- A “black-list company.”
The 2019 tax reform outline proposes to amend the CFC rules by expanding the definition of a “cash box” entity, while narrowing the definition of a “paper company”, among other changes.
Interest Limitation Amendments (BEPS Action 4)
Japan has interest deduction limitation provisions (Section 66-5-2 of the STML) to prevent companies from claiming excess interest deductions. The regime limits deductibility of interest, royalty, lease and other payments, where the interest payments to foreign parties are excessive compared with the company’s income (i.e. more than 50% of adjusted income). Adjusted income is defined as taxable income, adding back interest expense, depreciation expense, and exempted dividend income, but excluding extraordinary income or loss. Interest expenses that are not deductible can be carried forward for up to seven years.
The 2019 tax reform outline proposes to amend the foregoing rules to align with the BEPS Action 4 final recommendations by (i) expanding their application to include interest payments to unrelated parties, and (ii) lowering the limitation ratio from 50% to 20% of adjusted income, among other changes.
Transfer Pricing Amendments (BEPS Action 8-10)
Japan introduced transfer pricing rules on April 1, 1986, which are found in Sections 7-2 and 22 of the STML, and apply the arm’s-length standard. Pursuant to Section 66-4 of the STML, Japan will impose an arm’s length price for a transaction between a domestic or foreign corporation and a foreign related person that is not priced in accordance with the arm’s length principle. Foreign related person includes any corporation related to the taxpayer directly or indirectly through 50% or more shareholdings, or through substantial control due to business, financial, or other dependence.
On March 3, 2016, Japan’s NTA Deputy Commissioner of International Tax Affairs said that Japan intends to implement the BEPS Actions 8 through 10 recommendations on transfer pricing, but provided no timeline on when the implementation may take place.
The 2019 tax reform outline proposes to amend Japan’s transfer pricing rules to align with the BEPS Action 8 final report on treatment of intangibles, including for hard-to-value intangibles (HTVIs).
With respect to BEPS Action 8, the final OECD report provides a new Chapter V of the OECD Transfer Pricing Guidelines, with specific guidelines on determining arm’s length conditions for intangibles. A functional and comparability analysis should be performed to determine arm’s length conditions for transactions involving intangibles by identifying the intangibles and associated risks in contractual arrangements, supplemented by the actual conduct of the parties based on the functions performed, assets used, and risks assumed.
The final Action 8 report also provides guidance on identifying intangibles, determining their legal ownership, and determining arm’s length requirements for HTVIs. HTVIs include intangibles or rights in intangibles for which, at the time of their transfer in a transaction between related parties, no sufficiently reliable transfer pricing comparables exist, and there is a lack of reliable projections of future cash flows or income expected to be derived from the transferred intangible, or the assumptions used in valuing the intangible are highly uncertain. According to the OECD, tax administrations face difficulties in verifying the arm’s length price for taxpayers engaging in transactions with HTVIs.
On June 21, 2018, the OECD released final guidance (Guidance for Tax Administrations on the Application of the Approach to Hard-to-Value Intangibles) on the application of the approach to HTVI and the transactional profit split method (TPSM). The June 21st guidance should reduce the risk of double taxation by providing principles to apply the HTVI approach. The guidance also includes examples to clarify the application of the HTVI approach in different scenarios. This guidance has been incorporated into the 2017 OECD Transfer Pricing Guidelines as an annex to Chapter VI.
In applying the HTVI approach, tax administrations may make appropriate adjustments, including adjustments that reflect an alternative pricing structure that differs from what the taxpayer adopted, but reflects one which would have been made by independent enterprises in comparable circumstances (taking into account the valuation uncertainty in the pricing of the transaction). Since HTVI do not have reliable comparables, tax administrations cannot substantiate adjustments to the pricing structure by referring to uncontrolled transactions involving comparable intangibles.
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