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

2 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

3 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.

4 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.

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

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

7 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.

8 Movement toward attributable 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.

9 From Indirect foreign tax credit to 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

10 Exemption and 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?

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

12 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.

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

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

15 Branch Corporation Exemption of all foreign source income and its problems (2/2)  The expense whichthe headquarters in German costs could not be deducted in Japanese withholding taxation. Investment Bank Germany Japan Japanese Treasury Germany Treasury

16 Attribution rules and 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

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

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

19 Fiction in international taxation and 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.

20 Net income taxation and 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.

21 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.

22 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.

23 Promotion of CEN with worldwide taxation  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. Branch Corporation Germany Japan China Japanese Treasury Germany Treasury

24 Subsidiary Violation of CEN with non-accrual type worldwide taxation?  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. Corporation Germany Japan China Japanese Treasury Germany Treasury

25 Branch Violation of CEN for shareholder with non-accrual type worldwide taxation?  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. Corporation Germany Japan United Statesshareholder Germany Treasury Japanese Treasury China

26 Subsidiary Promotion of CEN with non-accrual type worldwide taxation  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! Corporation Germany Japan China Japanese Treasury Germany Treasury

27 Branch Promotion of CEN with attribution rules  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! Corporation Germany Japan China Japanese Treasury Germany Treasury

28 Subsidiary Corporation Promotion of both CEN and CIN with non-accrual type worldwide taxation  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. Investment Bank Germany Japan Germany Treasury Corporation Japanese Treasury Investment Bank

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

30 Branch Corporation Promotion of both CEN and CIN through attribution rules  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. Investment Bank Germany Japan Germany Treasury Corporation Japanese Treasury Investment Bank

31 Dividend exemption in 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

32 Subsidiary Corporation Preference for royalty over dividend scenario  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. Japan X country X country Treasury Royalty Scenario Subsidiary Corporation Japan X country X country Treasury Dividend Scenario Japanese Treasury

33 Subsidiary Corporation Preference for dividend over royalty scenario  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. Japan X country X country Treasury Royalty Scenario Subsidiary Corporation Japan X country X country Treasury Dividend Scenario Japanese Treasury

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

35 Japanese CFC taxation and 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.

36 Operation of new rule in CFC taxation  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. Without new CFC rule Subsidiary Corporation Japan X country X country Treasury With new CFC rule Subsidiary Corporation X country X country Treasury Japan Japanese Treasury 020

37 Foreign tax credit vs. dividend exemption with new CFC rule  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. Before dividend exemption Subsidiary Corporation Japan X country X country Treasury Subsidiary Corporation X country X country Treasury Japan Japanese Treasury After dividend exemption

38 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.

39 Two explanations of Japanese 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

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

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

42 Limit of deduction of salary in 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.

43 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.

44 Implication of tax base in corporate taxation Corporation shareholder Japanese Treasury Corporation shareholder Japanese Treasury officer Disallowance to deduct salary for officer

45 Origin-based consumption type corporate tax Corporation Germany Japan Subsidiary Japanese Treasury China Subsidiary

46 Destination-based consumption type corporate tax Corporation Germany Japan Subsidiary Japanese Treasury China Subsidiary

47 Group taxation in 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

48 Corporation Transfer pricing and group taxation Japan GermanGermany Treasury Japanese Treasury (15 x 0.35) (15 x 0.35) Subsidiary 85 FMV:100 BASIS: (( ) x 0.35) FMV:100 BASIS: 85

49 Implications of group taxation in international taxation  Between separate accounting and unitary tax –Setting off loss and income –Deferral of taxation on intra-group transactions

50 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.

51 Corporate tax reform and international taxation  CBIT (Comprehensive Business Income Tax) –No difference between corporation and branch  BAT (Business Activity Tax) –The concept of income attribution does not work.  Any other formula –Destination-based or origin-based

52 Conclusion  Japanese international taxation system –On surface, old-fashioned global system –American type source rules and entire income taxation In reality, attribution rules of treaties apply.  Recent changes and implications –Movement into territorial system –Change of corporate tax into consumption tax Formulary apportionment needed

53 Any questions?