Table of Contents ： ZEIDAI RONSO No.60-63
|2009||63||Implications of Japan's Move to Foreign Dividend Exemption Method
- Focus on Its Effect on Transfer Pricing and Tax Avoidance -
|2009||63||Reconsideration of the income attribution approach and exceptions under CFC rules in Japan||BAN, Tadahiko|
|2009||63||Review of Withholding Tax System on Income Sourced in Japan
- Focus on Withholding Tax on Royalties for Intellectual Property -
|2009||63||Tax Arrear Issues concerning Aggregate Mortgage
- Focus on Problems after Supreme Court Ruling on Feb. 15, 2007 -
|2009||62||Taxation of Dividend
- Research from the Viewpoint of Integration of Classical Dividend Concept and Deemed Dividend -
|2009||62||Timing of Income Recognition of Compensation for Embezzelement||YADA, Kouichi|
|2009||62||Taxation of Family Corporation
- Focus on Adjustment as a Consequence of Application of Anti-avoidance Provisions on Family Corporations -
|2009||62||Tax Treatment of Air Rights||IKEDA, Makoto|
|2009||62||Difference between Capital and Debt of Small and Mid-Size Companies
- Focus on Capital Nature of Loan from Shareholders -
|2009||62||On Treatment of Service Contribution for Corporate Income Tax Purpose||TAKAHASHI, Masaaki|
|2009||61||Analysis of Revenue Raising Function and Wealth Redistribution Function of Income Tax||NARUSHIMA, Yasuo|
|2009||61||On Environmental Taxes and Energy-Related Taxes||SHINOHARA, Katsutake|
|2009||61||Assets Valuation and Tax Avoidance
- Focus on Analysis of Relevant Court Cases -
|2009||61||Review of Gift Tax
- Focus on Prevention of Tax Avoidance -
|2009||61||On Taxation of Income from Life Insurance Contract||TERAUCHI, Masahiro|
|2009||60||High-Income Individuals and Large Corporations in Japan : Behaviors and Their Implications on Tax Administration||OKA, Naoki|
|2009||60||Discussion Points and Future Direction of Integrated Taxation of Financial Income||HARA, Takehiko|
|2009||60||Blue Return System's Significance and Its Future||HINO, Masahiko|
Summary of Articles
Implications of Japan's Move to Foreign Dividend Exemption Method
- Focus on Its Effect on Transfer Pricing and Tax Avoidance -
by MATSUDA,Naoki(Professor of National Tax College)
Issue of Concern
Japan's 2009 tax reform package included a measure to move from the foreign tax credit method to the exemption method for dividend received by a domestic parent company from its foreign subsidiary if the ratio of the parent's holding of its subsidiary's share is 25% or above. Consequently, such dividend, which was used to be subject to Japan's corporate income tax at the rate of 30% after foreign tax paid abroad is credited against, is now not to be included as taxable income for corporate income tax purpose. Behind this move to the dividend exemption method is the Ministry of International Trade and Industry's request maintaining that such move should induce more repatriation to a Japan's parent company of those earnings accumulated by its subsidiaries abroad and those repatriated earnings would help activate the economy by being used for the parent company's domestic R&D and capital investment.
It is uncertain how much the move to the foreign dividend exemption method will actually induce repatriation of accumulated foreign earnings but it will surely simplify the procedure to alleviate international double taxation on dividend and this merit of simplification of the procedure is to be highly-evaluated. Even so, there remains a question of whether it is right to adopt practically no measure to supplement this move to the dividend exemption method in order to cope effectively with some demerits and negative consequences associated with this move. It is generally said that under the dividend exemption method it becomes more difficult to have a good grip on cross-border transactions and there are more incentives for companies to shift their income and production bases abroad.
In fact, the move to the dividend exemption method might also have some other demerits and downsides that should not be underestimated. So, it would become necessary for the tax authority in Japan to take some complementary measures to reduce those negative aspects. Now that it can be expected that there should arise such necessity sooner or later to some extent, this paper attempts to research and shed some light on those negative aspects and find ways to cope effectively with them. In doing such research, it is noted that there have been a lot of arguments in such countries as US and UK over the idea of moving to the dividend exemption method and there are in the case of UK concrete actions recently taken in line with the argument for the move to the exemption method. Therefore, in this paper, lessons are mostly to be drawn from those arguments and recent actions in those countries.
Chapter 1 - Background of Japan's Move to Dividend Exemption Method
In this Chapter, research is made into the classical arguments over merits and demerits of the credit method and the exemption method. According to the classical “production efficiency theorem”, Pareto efficiency is to be realized under the credit method because, under the exemption method, investment gets an incentive to flow to low-tax countries even if production efficiency is low in those countries, so, the credit method is preferable in order to contain such incentive and realize the global product efficiency. However, it did not take long for the “production efficiency theorem” to lose its supporters in the face of such an argument that even under the credit method, so long as repatriation tax exists, foreign earnings accumulate to a point where foreign subsidiaries do not need additional input of capital, with the result that the credit method's effect of clearing impediments for the production efficiency becomes inoperative.
Also, in reality, there has lately been a growing move from the credit method to the exemption method in many EU countries. Behind such move is a fact that in the midst of acceleration of the removal of the national barriers for capital movement, etc., the European Court of Justice ruled, for example, in Petri Mikael Manninen case ( C-319/02 ), that the imputation method as a method of adjusting double taxation on dividend contravenes the principle of free movement of capital now that under the imputation method in question, as is often the case with the imputation credit method adopted in many other countries, the imputation credit is not to be granted to foreign investors to whom dividend is paid while it is to be granted to domestic investors, and this kind of different treatment can not be justified by relying solely on the principle of allocation of taxing powers.
The above-mentioned growing move to the exemption method and the increasing need for establishing such a tax system that does not stand as an unnecessarily high hurdle for the international investment also seem to have exerted some influence lately on the way of thinking in Japan about the exemption method. Manifestation of such influence could be detected in the comparison of the Tax Commission's report released in July 2000( in which it said that it is a widely-held view among many countries that the exemption method fosters such harmful tax competition as tax havens )with its report released in November 2007( in which it said that it is also important to pay attention to such countries as US and UK where, in the face of the accumulating foreign subsidiaries' earnings abroad, attempts are underway to modify their method of adjusting international double taxation on dividend.)
Chapter 2 - Analysis of Recent Arguments and Moves in US
As mentioned in the Tax Commission's 2007 report, there have been arguments in US over the idea of moving to the territorial taxation method. The idea was shown for example in the report released in November 2005 by the President's Advisory Committee. The report proposed that the territorial method for taxing active foreign income should be adopted to help strengthen US multinational companies' tax competitiveness, prompt them to repatriate earnings accumulated much in low tax countries, simplify the procedure for adjusting international double taxation, etc. However, the idea of moving to the territorial taxation method is only one of various reform proposals intended to address many problems the US tax system has brought about and there are also some who voice various concerns about the possible consequences of moving to the territorial taxation method.
Particularly grave is the concern that the move to the territorial method would be bound to aggravate the transfer pricing problem because such move is very much likely to prompt US companies to shift income to its subsidiaries in low tax countries and repatriate it back to them tax-free. In fact, even under the current tax system, the US tax authority even with such a powerful tool as IRC§482 providing for the commensurate with income standard, has lost in some transfer pricing cases. Particularly problematic are cases involving the transfer of intangibles. For example, in the Xilinx tax court case( 2005 ), the tax authority's maintenance that the cost for the stock option provided by the US parent company to its research development staff working in its subsidiary in Ireland should also be included in their cost-sharing arrangement was not accepted by the court.
Furthermore, now that President Obama who had been a Senator supporting “Stop Tax Haven Abuse Act” sworn in 2009, priorities have come to be placed on such tax reform plans that would help increase tax revenue by counteracting tax evasion and avoidance. Those reform plans include measures to codify economic substance doctrine, strengthen the earning stripping rule and transfer pricing rule. It is true that there are some who are against such reform direction but it is deemed certain that some of those reform plans shall be adopted under the 2010 Budget Act. Therefore, in the future there might be a chance for the plan of moving to the territorial taxation method to be on the table for tax reform discussion, but at least for now it is not the option to be adopted in any forms whatsoever.
Chapter 3 - Analysis of Recent UK Moves and Implications of Dividend Exemption Methods in Europe
Some UK's multinational companies have also complained about the recent decline of their international competitiveness and showed their intention to move their operations away from UK unless measures are taken to lessen their tax burden. It was also a blow to the government that, in the Test Claimants in the FGroup Case ( C-446/04 ), the ECJ ruled that the UK's partial imputation system was possibly in contravention of the EC Treaty. Against such background, the Treasury decided to include in the 2009 Finance Bill a plan to adopt the foreign dividend exemption method. The Treasury gave up for the moment the idea of including in the Bill a supplementary measure of adopting the stricter CFC rule, but it managed to include in it some anti-avoidance measures to cope with the negative effects that are likely to be caused by the move to the exemption method.
Particularly noteworthy among the above-mentioned anti-avoidance measures is the one to introduce the worldwide debt cap on interest aimed at the upstream loan that could be resorted to in order to shift income from a UK parent company to its foreign subsidiary. The worldwide debt cap on interest disallows such interest and finance costs payable by a UK company on intra-group borrowings (the “tested amount”) that exceed the net external finance costs of the worldwide group (the “available amount”). Also significant is the measure to expand the scope of the unallowable purpose rule that is incorporated in 1994 Finance Act Part Chapter 2§168A and so forth. This latter anti-avoidance measure is another example of the principle-based approach taken against finance products avoidance. This approach is similar to the main purpose test and is said to overcome the limit inherent in the conventional black-letter approach to tax avoidance.
In the background of those measures, there are such facts as (1) the UK tax authority realized around the end of 1990s the difficulty of introducing a general anti-avoidance rule in the face of the high hurdle set for its introduction by the Tax Law Review Committee and had to lean more towards other routes to strengthen anti-avoidance measures, (2) ECJ's ruling on Test Claimants in the Thin Cap Group Case( C-524/04 ) restricted the effectiveness of the UK's thin capitalizaion rule, (3) there are many examples that take advantage of or even abuse those preferential tax treatment given to dividend in some European countries and tax authorities have not been so successful in denying them as it was exemplified by such rulings as those handed down by Cour administrative d'appel de Nancy on Societe Pleiade case( 2002 ), the German supreme court on Dublin Docks cases( 2000 ), and so forth.
Chapter 4 - Lessons for Japan
In my writing entitled “Taxation of International Investment Income -- In Consideration of Major Countries' Recent Move and Trend”( Zeidai Ronso No.59, 2008, pp.1-138 ), I maintained that, as in the case of other major countries, the increasing number of tax measures to promote international investment should accompany measures to strengthen anti-avoidance provisions. Now that Japan's adoption of the foreign dividend exemption method is a very significant and effective measure for the promotion of international investment, and the analysis in the Chapter 2 & 3 also suggests that the exemption method would provide further incentives to cross-border income shifting and tax avoidance, it should be reasonable, from the global perspective on the balance of the measures to foster international investments and the measures to counteract tax avoidance, to take follow-up measures to counteract negative effects of the exemption method.
From the above perspective, the follow-up measures contemplated or actually taken in US and UK should serve as good lessons and the tax authority in Japan should, with the introduction of the foreign dividend exemption method, guard particularly against the problem of transfer pricing and international tax avoidance. In fact, through recent cases on transfer pricing disputes such as the one handed down on Oct. 30th in 2008 by the Tokyo High Court, it has been confirmed that the tax authority's primary fulfillment of the burden of proof on arm's length price is often very difficult. Such being the case, if the move to the exemption method aggravates the transfer pricing problem as it is so argued in US and others, such difficulty would increase vis-á-vis the transactions involving intangibles that have lately plagued the US tax authority even if in US the burden of proof on arm's length price falls in principle on taxpayers.
The counter-measures against tax avoidance adopted in UK also provide useful lessons and insights. In fact, until recently Japan had a lot in common with UK. Even now, they are similar in that they both do not have a codified general anti-avoidance rule and the supremacy of textualism is significant enough to impose quite a limit on the usefulness of the uncodified substance-over-form doctrine against tax avoidance. However, UK's recent move to the principle-based approach and the 2009 Finance Act's measure to expand the applicational scope of the unallowable purpose rule is to open up a gap between Japan and UK in terms of the effectiveness of the available counter-measures against financial tax avoidance. Another gap can be found in the fact that Japan lacks a thin capitalization rule or an excessive interest disallowance rule that could cope effectively with excessive upstream loan aimed at shifting income to a foreign subsidiary in a low tax country.
Japan might as well take advantage of those lessons that could be drawn from the follow-up measures contemplated or adopted in US and UK in relation to the foreign income or dividend exemption method now that Japan's move to the foreign dividend exemption method is also likely to give rise to those problems at which those measures are targeted. When it comes to the question of how those lessons should actually be applied, it might be worth reconsidering in some cases the conventional view of the arm' s length principle( or even considering the adoption of the commensurate with income standard ) now that such review is in line with the US Appeals court's ruling on Xilinx case( 2009 ), the UK Special Commission 's decision on DSG Retail Limited case( 2009 ), and some recent approaches adopted in the OECD Transfer Pricing Guidelines as well as the EU's Common Consolidated Corporate Tax Base.
As for measures to take agaist income shifting through interest deductions, the thin capitalization rule provided for under§66-5 of the Special Taxation Measures Law must be reformed in such a way that it could also cope with excessive upstream loans. In implementing such reform, it is important that it also reflects the 2006 and amendment made to provision so that it could also cope with such cases where an indirect loan or a third party guarantee is implicated in lieu of a foreign parent's direct loan to its subsidiary in Japan. Also, an option of adopting a provision to deny certain tax avoidance based on the purpose rule or test may also have to be considered to make anti-avoidance regime more effective. The merit of such option lies in the fact that a hurdle for adopting such provision should be lower than the one for adopting a general anti-avoidance rule with a purpose test and it poses a possibility of the future expansion of the applicational scope of such provision to become a mini-GAAR as in the case of UK.
It is true that the hurdle for the option of adopting a provision based on the purpose test is by no means low. However, the number of countries adopting the purpose test or strengthening it for the benefit of the tax authorities has been increasing lately and the main purpose test, which was not adopted in the revised Japan-US tax treaty in 2003, was adopted in the revised Japan-UK tax treaty in 2006 and the revised Japan-France tax treaty protocol in 2007. Furthermore, in the Japan-Australia tax treaty revised in 2008, the main purpose test was adopted in such a way that it could cast a larger net to treaty shopping. It should also be noted that in a famous gift tax avoidance case the Tokyo High Court ruled on January 23, 2008 that the taxpayer's intention to avoid tax is also a very important factor in deciding where his residence is. These examples might suggest that the hurdle for adopting a main purpose test in Japan is getting lower lately.
To strengthen the anti-tax haven provision is also another option to consider. In this paper, due to constraints on the allotted research time, writing space and so forth, it was not possible to look into the conceivable reform options for strengthening the anti-tax haven provision while it is evident from the analysis in the Chapter 3 that such reform options could also be good candidates for the effective supplementary measures. At least it can safely be said that lowering the threshold of the shareholding ratio that triggers the application of the provision could be one good reform option. Adoption of some of the supplementary measures proposed in this paper should help correct the current imbalance between the measures to foster international investment and the measures to counteract tax evasion and avoidance while some more effective proactive measures to enable the tax authority to catch cross-border tax avoidance early enough are also needed to correct the imbalance sufficiently.