Japanese International Tax Policy and Corporate Taxation

Japanese International Tax Policy and Corporate Taxation Tadao Okamura Professor of Law, Kyoto University, Japan

Summary • Basic structure of Japanese international taxation and its recent policy • Global system and territorial system • Entire income taxation and attributable income taxation • Recent changes in Japanese international taxation • Introduction of Dividend exemption and change in CFC • Recent changes in Japanese Corporate Tax Act (CTA) and interaction between corporate taxation and international taxation

Global system • Worldwide taxation • All income is subject to taxation without regard to the place where income derived. • In the case of resident individuals and domestic corporations • Income of non-resident aliens and foreign corporations is subject to taxation to the extent of their domestic source income. • Because of this treatment, the concepts such as source and territory appear.

Territorial system • Territorial taxation • Only domestic source income is subject to taxation. • However, in almost all the cases, residents are subject to taxation on their worldwide income with the limited exemption of foreign source income. • Neutrality • A territorial system has been said to enhance CIN. • In contrast, a global system has been said to promote CEN.

Japanese Treasury American type source rules Germany China Corporation Attribution Japan Branch • In Japanese international taxation, income from sale by the branch located in Japan may not be sourced in Japan.

Japanese Treasury Entire income principle Germany Corporation Corporation Attribution Japan Branch Investment Bank • In Japanese international taxation, income from investmentby German headquarters is taxed on the branch located in Japan.

Attribution and Sourcing • Difference exists between attribution and sourcing. • Income may not be sourced in Japan though it is attributable to Japanese branch. • Japanese branch is subject to taxation on income sourced in Japan but attributable to German headquarters. • Income attribution as a personal concept • It reveals who earns income.

Movement towardattributable taxation • United States • Some (not all) passive income is subject to the branch located in United States without regard to its attribution. • Effective connected income is mixed up with business income of that branch. • A kind of attribution rule was introduced. • Japan • All the treaties follow OECD model based on attribution principle.

From Indirect foreign tax creditto dividend exemption • Indirect foreign tax credit • This system deemed domestic corporation to pay the tax to which its foreign subsidiary is subject on income of that subsidiary and allowed it to credit. • Dividend exemption from foreign subsidiary • Dividend other than 5% is exempt. • The reasons why Japan introduced this system are: • promotion of the repatriation of accumulated profits in foreign subsidiaries • simplicity

Exemptionand a territorial system • Exemption of foreign source income and a territorial system • Some commentators and scholars are discussing the movement toward a territorial system by exempting all foreign source income. • Is this understanding of the relationship between that exemption and a territorial system correct?

Germany Treasury Chinese Treasury Japanese Treasury Exemption of all foreign sourceincome and its problems (1/2) Germany China Corporation Japan Branch • Chine cannot both practically and theoretically tax the net income from sale of the branch located in Japan.

Necessity for attribution rules • (Net) income as a personal concept • (Net) income cannot be calculated on an item-by-item basis because of the necessity of connection between revenue and expense. • Attribution rules deem a fixed place of business to be a taxpayer and make sure the association between revenue and expense.

Germany Treasury Chinese Treasury Japanese Treasury Operation ofattribution rules (1/2) Germany China Corporation Japan Branch • The branch located in Japan would be treated as a person just like a corporation and subject to net income taxation.

Germany Treasury Chinese Treasury Japanese Treasury Operation oftypical worldwide taxation (1/2) Germany China Corporation Japan Branch • The net income of the branch located in Japan would be taxed exclusively by German.

Germany Treasury Japanese Treasury Exemption of all foreign sourceincome and its problems (2/2) Germany Corporation Corporation Japan Branch Investment Bank • The expense which the headquarters in German costs could not be deducted in Japanese withholding taxation.

Attribution rulesand a territorial system • No application of attribution rules • Source country has the tax jurisdiction on passive income. • The passive income which is attributable to the headquarters in German would be exempted. • Adoption of attribution rules on a territorial system • Possible from the point of view of policy and consistent with the OECD model treaty

Germany Treasury Japanese Treasury Operation ofattribution rules (2/2) Germany Corporation Corporation Japan Branch Investment Bank • Both revenue and expense would be subject to exclusively Germany taxation.

Germany Treasury Japanese Treasury Operation ofworldwide taxation (2/2) Germany Corporation Corporation Japan Branch Investment Bank • Revenue would be taxed both on Japanese withholding taxation and German taxation. The headquarter in German would credit the taxes burdened by Japan.

Fiction in international taxationand its questions • What degree would branch be deemed as an independent taxpayer? • Borrowing relationship between headquarters and branch • Contribution and distribution between headquarters and branch • Conflict between developing and developed countries exists.

Net income taxationand attribution of income • Necessity for attribution rules on a territorial (net) income taxation system • Not for sales tax or investment surcharge • It is impossible to limit the scope in the case of net income taxation. • Source rules and attribution rules • In Europe, the place of resident to which income is attributable seems to be regarded as the source.

CIN and a territorial system • Does a territorial system always enhance CIN? • Probably no. A territorial system which does not base on attribution rules may make difference in tax base and differentiate the treatments according to the place where any investment comes. • In Japanese withholding taxation on passive income, the tax base is gross revenue. In the contrast, residents are subject to net income taxation on passive income.

CEN and a global system • Does a global system enhance CEN? • Maybe yes. The answer depends on the degree in which both CFC taxation (worldwide taxation) and foreign tax credit work correctly. • A global system and expatriation • A global system itself cannot prevent residents from expatriation and enhance the neutrality of person’s movement between countries.

Japanese Treasury Promotion of CEN with worldwide taxation Germany Germany Treasury Corporation China Japan Branch • Corporation would be subject to the same burden without regard to the way of business or the place if Germany provides foreign tax credit correctly.

Japanese Treasury Violation of CENwith non-accrual type worldwide taxation? Germany Germany Treasury Corporation China Japan Subsidiary • If income of subsidiary should be subject to the same burden as that of sale of product directly, CEN should be considered to be violated because of deferral.

Germany Treasury Japanese Treasury Violation of CEN for shareholderwith non-accrual type worldwide taxation? Germany United States shareholder Corporation China Japan Branch • In the situation where CEN viewed from corporation in German is promoted, CEN viewed from shareholder in U.S. should be considered to be violated because of deferral.

Japanese Treasury Promotion of CENwith non-accrual type worldwide taxation Germany Germany Treasury Corporation China Japan Subsidiary • If the independence of subsidiary should be respected with regard to calculation of income, CEN should be considered to be promoted. In this viewpoint, deferral does not exist!

Japanese Treasury Promotion of CENwith attribution rules Germany Germany Treasury Corporation China Japan Branch • If the independence of branch should be respected with regard to calculation of income, CEN should be considered to be promoted. In this viewpoint, deferral does not exist!

Germany Treasury Promotion of both CEN and CINwith non-accrual type worldwide taxation Investment Bank Germany Corporation Corporation Japan Japanese Treasury Subsidiary Investment Bank Corporation • Domestic investment in both German and Japan is subject to the same burden. Income from investment by corporation in German is equally taxed without regard to the target if foreign tax credit works.

Germany Treasury Japanese Treasury Promotion of CEN and violation of CENwith non-accrual type worldwide taxation Investment Bank Germany Corporation Corporation Japan Branch Investment Bank Corporation • CIN for Investment bank in Japan is violated. CEN for corporation in German and CIN for investment bank in German are promoted.

Germany Treasury Promotion of both CEN and CINthrough attribution rules Investment Bank Germany Corporation Corporation Japan Japanese Treasury Branch Investment Bank Corporation • If the independence of branch should be respected with regard to calculation of income, CIN would be considered to be promoted. Foreign tax credit in German is not necessary.

Dividend exemptionin Japanese corporate taxation • Indirect foreign tax credit substituted • Only dividends from subsidiary with 25% interest are exempt. • Different tax burden because of the difference in the way to repatriate • Lower burden in the case of dividend • Only after the introduction dividend exemption • Lower burden in the case of deductible payment

X country Treasury X country Treasury Japanese Treasury Japanese Treasury Preference for royalty over dividendscenario Japan Royalty Scenario Japan Dividend Scenario Corporation Corporation 65 58.5 Corporation Corporation 25 X country X country 100 65 Subsidiary Subsidiary 100 100 10 6.5 0 35 • If effective tax rate of corporate income tax in both Japan and X country is the same, domestic corporation in Japan would prefer royalty payment because of foreign tax credit for withholding tax.

X country Treasury X country Treasury Japanese Treasury Japanese Treasury Preference for dividend over royaltyscenario Japan Royalty Scenario Japan Dividend Scenario Corporation 65 Corporation 67.5 Corporation Corporation 25 X country X country 100 75 Subsidiary Subsidiary 100 100 10 7.5 0 25 • If effective tax rate of corporate income tax in X country is significantly lower than that in Japan, domestic corporation in Japan would prefer dividend payment.

X country Treasury Japanese Treasury CFC taxation Japan Corporation Corporation X country German Income from passive investment Subsidiary Investment Bank Income from sale of product

Japanese CFC taxationand its new rule • Undistributed income has been mixed up • Its target is foreign subsidiary in the country where tax rate is 25% or less. • All undistributed income is subject to Japanese CFC (not to the extent of tainted income). • Since last year, distributed dividend has been mixed up too. • This new rule prevents domestic corporation from avoiding CFC taxation through the distribution of dividend.

X country Treasury X country Treasury Japanese Treasury Japanese Treasury Operation of new rule in CFC taxation Japan Without new CFC rule Japan With new CFC rule 0 60.75 20 80.75 Corporation Corporation Corporation Corporation X country X country 85 85 Subsidiary Subsidiary 100 100 4.25 4.25 15 15 • If effective tax rate of corporate income tax in X country is significantly lower than that in Japan, domestic corporation in Japan would prefer dividend payment.

X country Treasury X country Treasury Japanese Treasury Japanese Treasury Foreign tax credit vs.dividend exemption with new CFC rule Japan Japan Before dividend exemption After dividend exemption 60.75 20 Corporation Corporation 65 Corporation Corporation 15.75 X country X country 85 85 Subsidiary Subsidiary 100 100 4.25 4.25 15 15 • If effective tax rate of corporate income tax in X country is significantly lower than that in Japan, domestic corporation in Japan would prefer dividend payment.

CFC taxation and treaties • Article 7 of the OECD model • No PE, no taxation on business income. • Foreign subsidiary subject to CFC taxation has no PE in Japan. • CFC taxation as deemed dividend taxation • When U.S. introduced CFC taxation, it is considered to prevent the deferral of shareholder level taxation. • This explanation no longer applies to Japan.

Two explanations ofJapanese CFC taxation • CFC taxation as attribution rule • If foreign subsidiary is just a paper company, its income should be considered to be attributable to domestic corporation (or personal resident). • CFC taxation as a weapon against low-level taxation

X country Treasury Japanese Treasury CFC taxationas attribution rule Japan Corporation Corporation X country German Income from passive investment Subsidiary Investment Bank Income from sale of product

X country Treasury Japanese Treasury CFC taxationas weapon against low-level tax Japan Corporation Corporation X country German Income from passive investment Subsidiary Investment Bank Income from sale of product

Limit of deduction of salaryin Japanese corporate tax • Requirement for deduction of salary for officer • Regularity • Reasonable amount • One-book and book-tax conformity • Currently, salary for officer is deductible for the purpose of financial statement • Nevertheless, this salary is subject to limitation and rather has introduced new type limitation.

Change of corporate tax into consumption tax • Corporate tax without salary deduction • This feature would make corporate tax a consumption tax. • This change may be a solution instead of increasing consumption tax rate directly.

Japanese Treasury Japanese Treasury Implication oftax base in corporate taxation shareholder Corporation officer Disallowance to deduct salary for officer shareholder Corporation officer

Japanese Treasury Origin-basedconsumption type corporate tax Germany China Subsidiary Japan Subsidiary Corporation

Japanese Treasury Destination-basedconsumption type corporate tax Germany China Subsidiary Japan Subsidiary Corporation

Group taxationin Japanese corporate tax • Group taxation and consolidated tax return • Mandate vs. Eligible • Each member calculates its own taxable income in group taxation system. • No need to apportion the tax burden • Deferral of recognition • Transferor will be subject tax on gain or loss when transferred asset gets away from the group. • Determination at level of group • Gradual rate, etc. applied according to the size of group

Germany Treasury Japanese Treasury Transfer pricing and group taxation 5.25(15 x 0.35) + 5.25 (15 x 0.35) Corporation 0 ((100-100) x 0.35) 85 FMV:100 BASIS: 85 Subsidiary FMV:100 BASIS: 85 Japan 85 100 German Subsidiary

Implications of group taxationin international taxation • Between separate accounting and unitary tax • Setting off loss and income • Deferral of taxation on intra-group transactions

Formulary apportionment • Arm’s length standard • It determines two arm’s length price: • Intra-group: Transfer pricing regulation • Intra-corporation: income attribution to branch • It differs from American type source rules. • A substitution or backstop or any other? • American type source rules adopt the formulary apportionment.

Japanese International Tax Policy and Corporate Taxation