The Japanese government has announced a cabinet decision formalizing the 2017 comprehensive tax reform plan. The proposed changes to the Japanese CFC rules, also referred to as the anti-tax haven rules, were one of the major reform topics discussed in the Tax Reform Plan.
Under the current CFC rules, a problematic situation arises whereby certain income of economic substance derived by a CFC is apportioned to its Japanese parent, while certain income of non-economic substance is not apportioned to the Japanese parent. The Tax Commission has depicted the situation in the following chart:
To address this situation and to conform the Japanese CFC Rules with the BEPS principle that profits should be taxed "where economic activities occur and where value is created," the Tax Reform Plan revises the definition of a Foreign Controlled Company and proposes several necessary amendments in the new CFC Rules.
- Definition of Foreign Controlled Company
The CFC rules apply to any “Foreign Controlled Company,” which is defined as any foreign entity:
(i) a majority of the shares of which are held directly or indirectly by a Japanese parent company or
(ii) which has a relationship with a resident individual in Japan or a Japanese company, such that the individual or company may claim “almost all of the residual assets of the foreign entity.”
- New CFC Rules
Under the current CFC rules, only Foreign Controlled Companies that are subject to an income tax rate of less than 20 percent are considered "Specific Foreign Subsidiaries" and subjected to entity-based inclusion (i.e., income of the subsidiary is apportioned to the income of the Japanese parent and subject to taxation at the level of the Japanese parent company), unless an exemption test is satisfied.
The proposed CFC rules add complexity to the current CFC rules. The proposed CFC rules consist of three tests under which the income of a Foreign Controlled Company may be apportioned and subject to taxation at the level of the Japanese parent company:
(i) general full inclusion for Foreign Controlled Companies that do not satisfy the economic substance test (the General Full Inclusion Rule)
(ii) full inclusion for specified Foreign Controlled Companies (the Specific Full Inclusion Rule) and
(iii) partial inclusion of passive income (the Partial Inclusion Rule).
Whether one or more of the new CFC rules apply depends on the effective tax rate (the Applicable Tax Rate) of the Foreign Controlled Company. The following chart identifies which rules may apply to apportion income to the Japanese parent based on the Applicable Tax Rate of the Foreign Controlled Company:
General Full Inclusion Rule, Specific Full Inclusion Rule, and Partial Inclusion Rule would apply
Specific Full Inclusion Rule would apply
Exempt from CFC Rules
(1) Applicable Tax Rate of Less Than 20 Percent
As demonstrated in the above table, a Foreign Controlled Company with an Applicable Tax Rate of less than 20 percent could be subject to all of the new CFC rules:
(a) General Full Inclusion Rule
The income of a Foreign Controlled Company with an Applicable Tax Rate of less than 20 percent is apportioned to the Japanese parent, i.e., full inclusion, unless the Foreign Controlled Company satisfies the economic substance tests. The economic substance tests are essentially the same as the tests under the current CFC rules, however, the tests have been redefined as "economic substance tests." The proposed amendment includes additional changes to the economic substance tests that apply to Foreign Controlled Companies engaged in certain businesses (for details about the exemption tests under the current CFC rules, please see our December 2016 article).
(b) Specific Full Inclusion Rule
In addition to the General Full Inclusion Rule, which existed under the previous CFC regime, the newly-proposed Specific Full Inclusion Rule will apply to Foreign Controlled Companies that satisfy at least one of the following criteria:
- A Foreign Controlled Company that is not:
- A Foreign Controlled Company with a fixed location necessary for the primary business of the Foreign Controlled Company or
- A Foreign Controlled Company that manages, controls, or operates businesses in the foreign jurisdiction in which the Foreign Controlled Company is located
- A Foreign Controlled Company with:
- Over 50 percent of its total assets consisting of securities, loans and intangibles, etc. and
- Over 30 percent of its total income derived from the categories of assets listed in (i)-(x) of (c) below or
- A Foreign Controlled Company located in a country or jurisdiction that the Minister of Finance designates as uncooperative regarding exchange of taxation information.
(c) Partial Inclusion Rule
Under the current CFC rules, certain income of a Foreign Controlled Company derived from passive assets is apportioned to the income of its Japanese parent. The Tax Reform Plan expands the types of income considered "passive income" and subject to inclusion under the Partial Inclusion Rule.
The proposed amendment includes the following categories of passive income, including new categories (iii), (v), (vii), (x), (xi):
(iii) Securities lending
(iv) Capital gain from transfer of securities
(v) Income from derivative transactions
(vi) Income from foreign exchanges
(vii) Any other financial income from assets which generates the income above
(viii) Fees from lending fixed tangible assets
(ix) Royalties from intangibles, etc.
(x) Capital gains from the transfer of intangibles and
(xi) Extraordinary excess profit remaining after deduction of the items above and the amount of the income tax deduction.
In addition to the exemptions currently applicable, a Foreign Controlled Company subject to income tax of 20 percent or more is exempt from the Partial Inclusion Rule.
(2) Applicable Tax Rate between 20 Percent and 30 Percent
Only the Specific Full Inclusion Rule applies to a Foreign Controlled Company in this scenario. Thus, the company would only need to confirm whether the criteria listed in (1)(b) are satisfied.
(3) Applicable Tax Rate of 30 Percent or More
A Foreign Controlled Company with an Applicable Tax Rate of 30 percent or more is exempt from the proposed CFC rules.
An amendment bill regarding the above changes will be submitted to the National Diet in early 2017, and the amended tax laws are expected to come into force on April 1, 2018.