According to the legislative history, on March 2, 2019, both houses of Japan’s Diet (i.e. House of Representatives and House of Councilors) adopted Cabinet Bill No. 198-3, which contains amendments to Japan’s controlled foreign company (CFC), interest expense limitation, and general transfer pricing rules, among others. The legislation also introduces rules on the tax treatment of virtual currency. Each BEPS-related proposal is addressed below.
Editor’s Note: The legislation will enter into force once signed by Japan’s Prime Minister. Unless otherwise stated below, the measures would apply to tax years that begin on or after April 1, 2019.
Japan’s cabinet sent the legislation to both houses of the Diet for consideration on February 5, 2019. See also February 5th Ministry of Finance outline of the legislation. The measures were originally announced by Japan’s ruling coalition government, led by the Liberal Democratic Party (LDP), on December 14, 2018, in an outline format.
Cryptocurrency (BEPS Action 1)
Cabinet Bill No. 198-3 would add a new Article 48-2 to the Income Tax Act to require taxpayers to recognize any gain or loss on virtual currency that is traded on an open market at the end of each year, whose value would be based on application of the mark-to-mark method.
Also, capital gains or losses would have to be recognized on the contract date of any sale of virtual currency.
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.”
Cabinet Bill No. 198-3 would amend Japan’s CFC rules by expanding the definition of a “cash box” entity. The legislation would also narrow the definition of a “paper company” to exclude certain foreign related entities (e.g., real estate activities). A paper company is a CFC that does not meet the substance or administration and control test, while being subject to tax at less than 30%.
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.
Cabinet Bill No. 198-3 would amend Section 66-5 of the STML to align with the BEPS Action 4 final recommendations by:
- Expanding their application to include interest payments to unrelated parties.
- Lowering the limitation ratio from 50% to 20% of adjusted income.
- Increasing the annual exemption amount from JPY 10 million to JPY 20 million.
- Any disallowed interest expense that is carried forward would be limited to 20% of adjusted taxable income (currently 50%), among other changes.
The interest limitation amendments would apply from April 1, 2020.
Transfer Pricing Amendments (BEPS Action 8)
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.
Editor’s Note: 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.
Cabinet Bill No. 198-3 would amend Japan’s transfer pricing rules as follows to align with the BEPS Action 8 final report on treatment of intangibles, including for hard-to-value intangibles (HTVIs):
- Include a new definition of “intangible assets” that would be subject to the transfer pricing rules.
- Adding the discounted cash flow method for intangibles that do not have any comparable transactions.
- Japan’s tax authority (National Tax Administration or NTA) would be allowed to make transfer pricing adjustments for HTVI transactions, whose ex post value is more than 20% different than the ex ante projection.
- Extend the statute of limitations from 6 years to 7 years for transfer pricing purposes.
Editor’s Note: 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.
The transfer pricing amendments would apply from April 1, 2020.
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