Japan's tax commission under the Cabinet Office has announced its intention to amend the tax rules regulating CFCs (controlled foreign corporations), which are also known as the Anti-Tax Haven Rules. These CFC rules are derived from Action Item 3 in the final BEPS report under the sub-heading "Designing Effective Controlled Foreign Company Rules."
In their current manifestation, these proposed rules would emulate the CFC rules of the United States, which prevent US citizens and corporations from deferring taxable income through the use of foreign entities by differentiating between income of a foreign related entity that is not derived from business activities ("passive income") and income that is derived from business activities ("active income").
While Japan’s new CFC rules, announced in late September, are subject to further deliberation, here we provide a comparison of the current rules and the proposed legislation:
1. Current CFC Rules
Income of a foreign related company , which is subject to an income tax rate of less than 20 percent and is apportioned to the income of the Japanese parent company – i.e., is subject to tax at the level of the Japanese parent company unless the Specific Foreign Subsidiary qualifies for an exemption by satisfying all of the following tests:
a. Active Business Test
The Specific Foreign Subsidiary does not have as its primary business (i) the holding of shares or equities, (ii) the licensing of industrial rights or copyrights, or (iii) the leasing of vessels or aircraft
b. Substance Test
The Specific Foreign Subsidiary exists in a fixed location that is necessary for the primary business of the Specific Foreign Subsidiary in the foreign jurisdiction where a head office of the Specific Foreign Subsidiary is located
c. Management and Control Test
The Specific Foreign Subsidiary manages, controls, or operates businesses in the foreign jurisdiction where a head office of the Specific Foreign Subsidiary is located
d. Unrelated Party Test / Domiciled Country Test
More than 50 percent of the Specific Foreign Subsidiary's transaction volume is derived from non-related parties (Unrelated Party Test) or
The Specific Foreign Subsidiary conducts its business primarily in the foreign jurisdiction where a head office of the Specific Foreign Subsidiary is located (Domiciled Country Test).
Under the current rules outlined above, all income subject to income tax within the threshold rate (i.e., under 20 percent) is apportioned to the income of the Japanese parent company, whether it is Passive Income or Active Income.
2. Proposed CFC Rules Amendment
The CFC rules outlined above are inconsistent with the BEPS principle that profits should be taxed "where economic activities occur and where value is created". To conform with this principle, the new CFC rules will treat Active Income and Passive Income differently. The specific criteria that will be used to differentiate between these two types of income is still under consideration; however, Passive Income is currently defined as income earned from certain financial activities and businesses that lack economic substance. Conversely, Active Income is understood as income containing economic substance, such as revenues from the subsidiary's creation of products and provision of services through utilization of the subsidiary's capabilities and exposure to risk.
The details surrounding the proposed changes and the specific criteria for categorizing passive income and active income are still subject to further deliberation by the Tax Commission. However, the proposed amendment is expected to be published, along with a comprehensive tax reform plan, in late December. After publication of the comprehensive tax reform plan, an amendment bill will be discussed in the national Diet and is expected to come into force in 2017. We intend to follow up with a more detailed analysis once this plan is made public.