Tax Strategy Vs. Countermeasures

By Naoki Matsuda

In todays world, where it has become fairly easy for a taxpayer to move back and forth from one country to another, it has become quite a common tax strategy, especially among wealthy individuals and multinational companies, to transfer their residence, income, and assets abroad mainly to reduce tax burden. Particularly in Europe, many wealthy individuals have moved their residence abroad mostly for tax purpose. Thus, tennis legend Bjorn Borg, who was known to have transferred decades ago his residence from Sweden to Monaco, is obviously not alone. A more recent, well-publicized case was Grard Depardieu, who showed his intention of leaving France after having acquired Russian citizenship in 2013. This famous French actor and entrepreneur is reported to have made a comment that the French governments recent plan of raising the top marginal individual income tax rate is just like penalizing talented people who have achieved success in their careers.

• Language: English
• Publisher: Xlibris US
• Release date: Dec 19, 2015
• ISBN: 9781514413395

Naoki Matsuda

The author, Naoki Matsuda, doctor of law, is a visiting scholar ( August 2013–July 2015 ) sent from the Ministry of Finance in Japan to Columbia Business School and Weatherhead East Asian Institute in Columbia University, New York. He was a professor at Kaetsu Graduate School in Tokyo (2010–2013), a visiting professor at Graduate School of Seigakuin University in Saitama Pref. (2010–2013), a visiting professor / associate professor at Graduate Research Institute of Public Policies in Tokyo (2002–2013), a lecturer at Hitotsubashi Law School in Tokyo (2005–2007), and principal administrator of the Directorate for Financial, Fiscal, and Enterprise Affairs (DAFFE) at OECD in Paris (1997–1999).

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Part I

Analysis of Japan’s Countermeasures against

Tax Strategy

Chapter I

Problems with Countermeasures against Tax Avoidance

1. Contemporary View on GAAR

Tax authorities can rely on various measures to counteract tax avoidance. But in order to counteract tax avoidance effectively, it is crucial for tax authorities to have both ex-ante and ex-post countermeasures. Ex-ante countermeasures could be defined to represent those that function at the earlier stage of the tax authority’s confrontation with tax avoidance while ex-post countermeasures function at the later stage of the tax authority’s encounter of tax avoidance. If this definition is followed, one of the most common ex-ante countermeasures against tax avoidance is a set of disclosure rules that require certain categories of tax avoidance schemes to be reported to the tax authority. While one of the most common ex-post countermeasures is a set of antiabuse provisions relied upon in denying the grant of tax benefit or tax relief to a tax avoidance scheme. General Anti-Avoidance Rule (GAAR) is also included in such ex-post countermeasures.

GAAR could be an effective countermeasure to prevent tax avoidance schemes from eroding tax base but there has been pros and cons to it. Arguments for its adoption tend to emphasize such merits as the increase in equity in taxation, its deterrent effect on tax avoidance, simplification of tax rules, reduction of courts’ burden, etc., while arguments against its adoption usually raise concerns about its risk of overkill and abuse, its restrictive effect on normal transactions, and so on. Those concerns are by no means groundless and also views are divided on whether GAAR increases predictability in taxation. Therefore, it is not definite if GAAR’s merits overweigh its demerits, but recently, especially in the face of growing upsurge of tax avoidance, increase and progress in its complexity and sophistication, the tax authority’s inability to deter it effectively, and so forth, the arguments for its adoption have gained more ground.

It seems that the OECD’s view on comprehensive antiavoidance rules as expressed in the OECD Model Tax Convention on Income and on Capital (2010 version, hereinafter called OECD MTC (on Income ) is not negative. For instance, para 20 of the Commentary on Article 1 supports the adoption of the Limitation of Benefit (LOB) clause as a measure to help prevent international double nontaxation and treaty shopping. Moreover, paras 22-22.1 of the Commentary clarify that such comprehensive anti-avoidance rules as the substance-over-form principle, the economic substance doctrine and so forth that are stipulated in domestic statutes do not conflict with provisions of tax treaties because they deal with spheres outside of tax treaties. In fact, many OECD countries have GAAR (or its equivalent) in their domestic tax statutes, so that in the OECD there are more member countries with GAAR (or its equivalent) than those without GAAR.¹⁵

Those OECD member countries with GAAR (or its equivalent) include Australia (1986 ITAA Part IVA),¹⁶ Austria (BAO §21), Belgium (ITA §344), Canada (ITA §245(2))¹⁷, France (CGI §64), Germany (AO §42), Ireland (Tax Consolidation Act §811), Korea (LCITA §2-2), Luxembourg (StAnpG §5&§6), UK (2013 FA §206-§215),¹⁸ US (IRC §7701(o)),¹⁹ etc. Certainly, there are some OECD member countries without GAAR, but even among them, there are some that have judicially-developed comprehensive antiavoidance doctrines. In particular, many OECD member countries in Continental Europe often rely on uncodified abuse of law principle (fraus legis) that is originated from Roman law. As regards EU Member States (MSs), there is also so-called Euro-GAAR developing in the context of direct taxes and indirect taxes mainly through the rulings of the European Court of Justice (ECJ).²⁰

Needless to say, there are also some non-OECD member countries with GAAR. They include China (new CITA §47),²¹ Hong Kong (IRO §61A),²² India (1961 ITA Chapter 10A),²³ South Africa (ITA Part 2A),²⁴ and so forth. In this connection, it is to be noted that the UN Model Tax Convention between developed and developing countries (2011 version, hereinafter called UN MTC) also seems to hold a positive view on comprehensive antiavoidance rules. For example, in light of the fact that specific anti-abuse rules do not provide a comprehensive solution, UN MTC stipulates in para 36 that benefits provided for by this Convention shall not be available where it may reasonably be considered that a main purpose for entering into transactions or arrangements has been to obtain these benefits and obtaining the benefits in these circumstances would be contrary to the object and purpose of the relevant provisions of this Convention.²⁵

Furthermore, there are such facts as follows: (i) The EU Commission issued in 2012 a recommendation for the MSs to adopt GAAR;²⁶ (ii) The OECD’s positive view on comprehensive antiavoidance rules is more conspicuous in Chapter 5 of the BEPS report which cites GAAR as one of the promising measures to prevent tax base erosion and the BEPS Action Plan 5 also stresses the merits of having comprehensive antiabuse rules not only in tax treaties but also in domestic tax statutes; (iii) UN MTC warns in para 33 on Article 1 against underestimating the risks of relying extensively on specific treaty antiabuse rules to deal with tax treaty avoidance strategies because they are based on the existing tax avoidance strategies and complex specific antiabuse rules are needed to deal with complex strategies. Therefore, it could be highly expected that there will be a larger number of comprehensive antiabuse rules and more countries with GAAR in the future.

2. Dominant View on GAAR in Japan

(1) Arguments Over Proposal to Codify Substance-over-form Principle

As mentioned in the above 1, there is a growing global trend of viewing comprehensive antiabuse (or antiavoidance) rules as measures with more merits than demerits. On the other hand, in Japan, they (particularly GAAR) seem to be considered by many as unnecessary even if there is not a single well-established comprehensive judicial doctrine which overcomes the limit of specific anti-abuse provisions in tax statutes. It is true that, in Japan’s tax statutes, there are some semicomprehensive antiabuse rules or mini-GAARs such as ITA §157 (Denial of act or calculation involving a family corporation, etc.), CITA §132 (Denial of act or calculation of a family corporation, etc.), CITA §37 (Limit on creditability of corporate contribution), etc. and many of them have been applied successfully to a majority of cases that could have eroded the tax base if it had not been for them.²⁷

But there are also tax avoidance schemes that are out of the applicability scope of semi-comprehensive anti-abuse rules such as those mentioned above. So, it is not that there is little use for Japan to adopt GAAR. But those who are not in favor of adopting GAAR in Japan includes a majority of the academics in the field of taxation that seem to have such views as follows: (i) Providing for ex-post specific antiavoidance provisions on an ad hoc basis without retrospective effect is a royal road to deal with newly-emerged tax avoidance strategies and it is to accord with the principle of taxation based on law as it is stipulated in the Article 84 of the Constitution;²⁸ (ii) There may be more demerits than merits in adopting it. Such a negative view on GAAR was actually expressed by many in the academics when the Tax Commission (Zeiseichousakai) issued a report in 1951 proposing to codify the substance-over-form principle.²⁹

The Tax Commission tried to explain how the codified substance-over-form principle that was proposed in the 1951 report could apply by making references to some of its applicability criteria adopted in some countries (in particular, judicially-developed business purpose test in US). But such explanation was not persuasive enough to many scholars in the field of taxation, and some of them also criticized the lack of safeguards that should effectively deter its abuse by the tax authority. Moreover, some others were negative about the business purpose test developed in US and they instead cited West Germany’s Tax Act (StAnpGz) §6 which was based on the principle of abuse of legal forms as a better example to follow because Japanese tax system may be less accommodating to the business purpose test relied on in common law countries than the principle of abuse of legal forms adopted in such civil law countries as Germany.

In the face of such criticism and problems as mentioned above, the Tax Commission’s proposal to codify the substance-over-form principle did not see the light of day and thenceforth, no concrete proposal to introduce the codified substance-over-form principle or GAAR has been put on the Commission’s tax reform table. In fact, it seemed that the Ministry of Finance and legislators were also conscious of such predominant negative view on GAAR especially when Consumption Tax Act was introduced in 1988 without incorporating in it GAAR or mini-GAAR and when the semicomprehensive antiavoidance rule with a setup similar to the one adopted in the aforementioned §132 of CITA was embodied in 2001 under §132-2 of the Act in order to deal with tax avoidance that takes advantage of the corporate reorganization rules inappropriately.³⁰

(2) Abuse of the System Concept and Its Usefulness

In fact, the aborted attempt in 1951 in Japan to codify the substance-over-form principle and the subsequent rise in the supremacy of literalism has a lot to do with the current situation where GAAR has not been adopted, and it has made it necessary in some cases for the courts to rely on uncodified concept or principle to invalidate the effect of tax avoidance schemes. One such example is found in the Supreme Court 12/19/2005 judgment (2003 Gyou-Hi, No.215) that upheld the assessment of denying the application of foreign tax credit to a series of transactions in question based on the idea that such transactions constitute an abuse of the foreign tax credit system laid down in CITA §69.³¹ It was exceptional that the supreme court based its decision on a concept not embodied in the tax statutes to deny tax benefits to tax avoidance, so there are arguments over what the nature of this ‘abuse of the system’ concept is and how broad its potential applicability scope is.

It may be argued that this abuse of the system concept is identical to abuse of law principle relied on in civil law countries in Europe that originated from Roman law,³² and that its applicability standard should also be identical to it. While this concept could be interpreted rather as something different from abuse of law principle and may not apply to some of those tax avoidance schemes that may fall under the applicable scope of the principle. In fact, as one example of such interpretation, there is such a view that abuse of the system concept is not a principle that exists behind Japanese tax statutes as the uncodified tax principle and its application might violate the abovementioned Article 84 of the Constitution.³³ Another example of such interpretation explains that this concept is not a universal principle to deny tax avoidance in cases where there are no relevant provisions to rely on but rather an example of purposive interpretation of CITA §69.³⁴

It seems that Nagoya High Court 3/8/2007 judgment (2006 Gyou-Ko, No.1) on so-called ship lease scheme also interprets the applicability scope of abuse of the system concept narrowly. In this case, NTA asserted that the return the taxpayers/respondents earned is miscellaneous income and relied on this concept to claim that the collective investment vehicle which they invested in employed the scheme which abused the depreciation system. But the court upheld the preceding Nagoya District Court 12/21/2005 judgment (2004 Gyou-Ko, No.59-61) by ruling that, even if the taxpayers’ primary objective in entering this transaction is to gain the tax benefit with respect to the depreciation system applicable to the ships in question, it is quite natural for them to take advantage of such tax savings, and that the loss allotted to them for the tax years of 1998-2000 by the vehicle is real estate income and its offsetting against their other income should be allowed.

The above Nagoya high court judgment seems to imply that taxpayers’ motive is not critical in deciding whether a transaction in question constitutes abuse of the system or not and that the depreciation system should be applicable so long as the asset in question is a depreciable asset irrespective of how it is used in transactions. It is not clear enough whether the court went so far as to support the respondent’s claim that the depreciation system does not give rise to the question of abuse of the system. But if this respondent’s claim is correct, there might not be any act that constitutes abuse of the depreciation system even if such act employs a scheme to concoct expenses or misappropriate tax benefits so long as they result from actual transactions.³⁵ Anyhow, it seems that there is not a little limit to the usefulness of relying on this abuse of the system concept to counteract various kinds of tax avoidance and it is aggravated by the opacity about its essence and applicability criteria.³⁶

In the face of such limit as mentioned above that seems to be inherent in the abuse of the system concept, the tax authority, in order to counteract ship lease scheme and the like, introduced in 2005 STMA §41-4-2(1) which dictates that, in a case where a partner does not get involved in the decision-making in the partnership business, loss in real estate income allotted to such partner from the partnership shall not be set off against his/her other income. Also the amended Administrative Ruling §36 · 37-21 on ITA provides that profit distributed or allotted to a partner in accordance with a silent partnership contract is miscellaneous income unless the partner is involved together with the management in the decision-making in the partnership’s business. In this case, profit allotted to the partner is, depending on the content of the operation of the management, either business income or other category of income.³⁷

Chapter II

Problems with Outbound Transfer of Individual’s Residence

1. Implications for Inheritance/Gift tax

The problem of tax base erosion has been aggravated not only by tax avoidance but also by globalizing tax strategy. Takefuji case referred to in the Preface is one example of such global tax strategy. In this case, the taxpayer stayed approximately 2/3 of the days in HK and 1/3 of the days in Japan between Jun. 1997 and Dec. 2000. He kept most of his assets in Japan during these periods and Takefuji Corp. in Japan must have remained as the center of his professional activity while it was true that he had work to pursue in HK as well. Siding with NTA’s assessment of gift tax on the taxpayer for the tax year 1999, the Tokyo High Court 1/23/2008 judgment (2007 Gyou-ko No.215) reversed the Tokyo District Court 5/23/2007 judgment (2005 Gyou-U, No.396) by ruling that the taxpayer had a domicile in Japan for the tax year of 1999 and those shares of the foreign company affiliated with Takefuji Corp. gifted during this period to the taxpayer by his father should be subject to gift tax.

The Tokyo high court determined that the taxpayer’s domicile was in Japan in the tax year 1999 mainly for the following reasons: (i) When he came back on and off to Japan during this period, he stayed in the house in which he had lived with his parents prior to his departure; (ii) He was to be a successor to the president of Takefuji Corp., so Japan must have been the most important site for his professional activity even during this period; (iii) His connection with the house in Tokyo which belongs to Takefuji Corp. whose 30% shares is held by him is stronger than that with the hotel-type apartment in HK he stayed during this period; (iv) During this period, almost all of his assets were in Japan; (v) He adjusted his length of stay in Japan and in HK during this period by following his accountant’s advice and he lacked a strong will to make his residence in HK a primary place of his living.

But, as mentioned in the Preface, the supreme court judgment (2011) overruled the above high court judgment. The supreme court ruled that objective facts on whereabouts of a person’s primary place of living determine where his/her domicile is and the taxpayer’s primary place of living during the period in question was in HK. Also, judge Sudo pointed out in his supplementary opinion the followings: (i) The courts have deemed a domicile under civil law to be one and only and, in general, time has not come yet to consider it to be able to exist in more than one place; (ii) Such being the case, there is a limit to the interpretation of the relevant provisions in such a way as it becomes possible to deem the appellant’s domicile during the year in question to have existed in Tokyo; (iii) If that leads to an unreasonable conclusion, what should be done is to take a legislative action.

Alarmed by the appearance of Takefuji case, the government amended in 2002 tax reform Inheritance Tax Act §1-3 and §1-4. Consequently, as the shaded areas (excluding that in italics) in Diagram I-1 shows, even if an inheritor (or a deceased) or a donee (or a donor) is not a resident in Japan at the time of the inheritance or the gift, the inheritor or the donee owes an unlimited liability to inheritance tax or gift tax, provided that he/she is a Japanese national at that time or had a domicile in Japan within the preceding five years.³⁸ But, a case on which Nagoya District Court 3/24/2011 judgment (2008 Gyou-U, No.114) was handed down has revealed that there still remained room for taking advantage of such tax strategies that might make it possible to avoid gift tax in Japan in spite of the fact the abovementioned 2002 tax reform has made it difficult for tax strategies similar to the one utilized in Takefuji case to be successful.

(Diagram I-1: Scope of property subject to inheritance/gift tax)

P12.tif

(Source: Heisei 25Nen Zeiseikaisei no Kaisetsu

(NTA’s Explanations of 2013 Tax Reform) p.577)

In the above Nagoya district court case, the grandparent (domiciled in Japan) of a baby (the taxpayer/plaintiff) born in US of its Japanese parents (domiciled in Japan with a Japanese nationality) entered into a contract in 2004 with a trust in which the taxpayer is a beneficiary, the trust is a trustee, and the trusted property is a US bond, but there was no gift tax return filed by the taxpayer on this gift. NTA, based on the belief that this contract gave rise to gift when it was entered, assessed gift tax on the taxpayer in accordance with ITA §4(1) (prior to its amendment in 2007) which provided to the effect that, when a trust is set up and anyone other than its trustor is a beneficiary of its benefit or part of its benefit, that beneficiary is to be deemed to have acquired from the trustor, at the time of the setup of the trust, the right to have the benefit of the trust.

The Nagoya district court judged that the taxpayer did not acquire the right to the benefit of the trust at the time of its setup mainly for the following reasons: (i) The beneficiary referred to in ITA §4(1) should be interpreted as a person with the right to the benefit of the trust; (ii) The trustee of the trust in question has a discretion in the distribution of the property of the trust; (iii) The trustor has a power to nominate someone other than the taxpayer to be a beneficiary. But this ruling was reversed by the Nagoya High Court 4/3/2013 judgment (2011 Gyou-Ko, No.36) which ruled as follows: (i) The parent of the taxpayer is deemed to have been to US to let it have US nationality and it is to be considered to have a domicile in Japan that is also the primary place of its parents’ living; (ii) Even if the trustor had a discretion of nominating someone else, he did not exercise it at the time of the setup of the trust, making the taxpayer the sole beneficiary of the trust.

NTA won the above case at the high court but the case prompted and led to the revision of Inheritance Tax Act §1-3 and §1-4 in 2014 to extend the coverage of its unlimited liability to inheritance and gift tax to such a case where an inheritor or a donee who acquired property by way of inheritance or gift even if he/she did not have a Japanese nationality or a domicile in Japan at the time of inheritance or gift, provided that the one who transferred the property by way of inheritance or gift had a domicile in Japan at the time of inheritance or gift (See the shaded area with italics in Diagram I-1). On the other hand, as it is to be shown in 2 below, there are some cases bringing home the fact that it is not only Inheritance Tax Act that needs to be reformed to prevent tax base erosion caused by taxpayers’ tax strategies involving outbound transfer of his/her residence, income or assets.

2. Implications for Individual Income Tax

One example of income tax base erosion from a taxpayer’s outbound transfer of his/her residence is found in the Tokyo District Court 9/14/2007 judgment (2006 Gyou-U, No.205). In this case, NTA assessed capital gains tax on the taxpayer/plaintiff for having sold in HK his Japanese company’s shares in 2001 despite the fact that, during that year, he stayed longer days in Singapore than in Japan. NTA determined that he had a domicile in Japan during that year and tried to justify the tax assessment by pointing out the followings: (i) During the year in question, he stayed in Japan almost as long as he stayed in Singapore, and when he stayed in Singapore, he stayed in a hotel-type apartment; (ii) He brought to Singapore only a handful of his property; (iii) During the year, he worked as a trader not only in Singapore but also in Japan; (v) During the year, no relative of him lived in Singapore; (vi) After 3-4 years of temporal stay in Singapore, he came back and resumed his living in Japan.

ITA §2(1)3 defines a resident to be a taxpayer with a domicile in Japan or continue to have a residence in Japan at least for a year, and, as Diagram I-2 shows, it is not so difficult to cease to be a Japanese resident. In the above case, the district court acknowledged that the plaintiff may have transferred his domicile to Singapore in order to avoid capital gains taxation, but determined that it does not change the objective facts about his residency, so his domicile was in Singapore and he did not have a residence in Japan during the relevant tax year. NTA appealed this case to the Tokyo high court and maintained that the Administrative Ruling §2-2 on ITA provides that, if there are facts and circumstances that imply the temporary nature of an individual’s exit from Japan, such individual shall continue to be treated as a person with a residence in Japan,³⁹ so the taxpayer/respondent should be deemed to have had a residence in Japan even in the relevant tax year.

(Diagram I-2: Scope of Income subject to individual income tax)

P14.tif

(Source: http://tokyo-foreigner.jsite.mhlw.go.jp/yokuaru_goshitsumon/kigyou/q_38_a34/q34.html)

But the Tokyo high court 2/28/2008 judgment on the above case was, as mentioned in the Preface, also in favor of the respondent. It ruled that the Administrative Ruling §2-2 on ITA does not apply to the respondent because the respondent’s stay in Japan during the tax year in question was at hotels and sports clubs and they might be regarded as a residence of the respondent during the relevant year but they cannot be deemed to have been possessed by the respondent, so he cannot be deemed, judging from this administrative ruling, to be a Japanese resident during the tax year. Also, the high court explained that the fact that the car he used frequently during this tax year in question when he came on and off back to Japan was parked at the Narita Airport does not mean that his chattel for living was deposited in Japan, which also illustrates the inapplicability of the administrative ruling §2-2 to this case.

The Tax Tribunal 9/10/2009 decision (Collection of Decisions No.78, p.63) is another example connoting the need for reviewing the current countermeasures against income tax base erosion through the cross-border temporal transfer of an individual’s residence. In this case, the taxpayer/applicant who entered into a contract with a company A’s branch in a country B left Japan in Sep. 2004 and came back in June 2006 and became a Japanese resident again. During his absence from Japan, (i) his spouse remained in a house she rented from her company and he stayed there just like before when he occasionally came back to Japan, (ii) he did not terminate his official registration in Japan as a foreigner, (iii) he did not acquire a residence certificate in the country B and there he stayed in a hotel-type apartment, (iv) he sometimes wrote down the address in Japan as his domicile when he stayed in hotels in the country B.

In view of such facts as mentioned above, NTA assessed income tax on the taxpayer for those years of his absence from Japan as a resident in Japan, but the tax tribunal determined that the assessment is void because he cannot be deemed to have been a resident in Japan during those years in question for the following reasons: (i) The house he stayed in during his stay in Japan was rented by his wife and this house cannot be deemed to have been rented to serve as the primary residence for his living; (ii) The fact that his wife’s domicile was in Japan is not a decisive factor in determining the place of his domicile; (iv) Almost all of his chattels that remained in this house in Japan were necessary for the living of his wife as well; (v) Financial assets he kept in Japan during this period of his absence from Japan were basically limited to cash, deposits in the financial institutions, so this fact also lends support to the fact that his primary place of living during those relevant years was not in Japan.

Chapter III

Problems with Corporate Migration

1. Implications of Recent Reform on Company Act and CFC Rule

Just like individuals, corporations may migrate abroad or their subsidiaries can be setup in low tax countries to become nonresidents of Japan and avoid worldwide income taxation in Japan (see Diagram I-3). It is true that, just like many other countries, Japan has CFC rule in the Special Tax Measures Act (STMA) §66-6, but the 2010 Tax Reform, in light of the recent global trend of lowering the CIT rate and the resulting increase in the administrative burden on the part of corporations with respect to their compliance with the CFC rule, has not only narrowed the potential applicability scope of the CFC rule by raising the minimum triggering ratio of shareholdings from the minimum 5% to 10% but also lowered the tax rate that triggers their application from 25% to 20%, which results in the decrease in the relative number of jurisdictions to which the rule becomes applicable.⁴⁰

(Diagram I-3: Scope of CIT and withholding tax on foreign corporations regarding income sourced in Japan)

P17.tif

# CITA is imposed on the shaded area

(Income Attributable to Business in Japan)

(Source : CITA Basic Administrative Rulings, Clause 2(5) (Others) of Chapter 20)

Also noteworthy is the fact that the new Company’s Act introduced in 2006 has made it possible for a domestic company to enter into a cross-border triangular merger and the concomitant change was made in CITA so that no tax accrues and capital gains are deferred in the case of a qualified cross-border triangular merger that meets those requirements laid down under CITA §2 and CITA Administrative Ordinance §4-3.⁴¹ A typical cross-border triangular merger is shown in the Diagram I-4. In this merger, Company B set up in Japan which is 100% subsidiary of foreign Company C merges with domestic Company A. In order to compensate for the shareholders of Company A that disappears through this merger, shares of foreign Company C are given to them.⁴²

(Diagram I-4: Cross-border triangular merger)

P18.tif

Now that CITA §2-3 provides that a domestic corporation must be registered in Japan, a headquarter of a domestic company cannot be in a foreign country. But a qualified cross-border triangular merger case has opened up a venue for a domestic company to transfer practically its tax residence from Japan to abroad without paying CIT on its liquidation income or incurring capital gains tax on its assets and shares transferred in the process of the merger. On the other hand, such treatment may also give rise to a possibility of tax base erosion and the loss of an opportunity on the part of NTA to tax deferred capital gains. In order to prevent the possibility of Japan’s tax base being eroded through certain types of cross-border triangular merger, measures have been taken to disallow in some cases the deferral of capital gains taxation.

Among those measures that help prevent tax base erosion from certain types of cross-border triangular merger, quite noteworthy is anticorporate inversion rule introduced in 2006. In particular, STMA §66-9-2 dictates that in a case where, by means of a cross-border triangular merger, shareholders of a domestic corporation (shareholders in special relationship, e.g. Shareholders D in Diagram I-4) holds, indirectly through a foreign company (a specific foreign company in a low tax country, e.g. Company C in Diagram I-4), 80% or more of the total shares of a domestic company (domestic company in special relationship, e.g. Company B after merged with Company A in Diagram I-4), reserved profit of the specific foreign company should, under certain conditions, be included in the profit or income of the shareholders in special relationship by taking into account its ratio of shareholding.⁴³

But these rules are only applicable to cases that meet following conditions; (i) 80% or more of the shares of the surviving company (domestic company in special relationship) were held by no more than five shareholders and those with special relationship with those shareholders; (ii) the foreign parent company is located in a country with the CIT rate lower than 20% (reduced from 25% by the 2010 tax reform). Furthermore, even if those conditions are met, the rules apply only to those with shareholding ratio representing 10% (increased from 5% by the 2010 tax reform) or more of the total shares of the domestic company in special relationship. Therefore, it is pointed out that this anticorporate inversion rule may not be so comprehensive and it cannot prevent tax base erosion to be caused by big corporations with many shareholders inverting abroad.⁴⁴

2. Implications of Adopting

Foreign Dividend Exemption Method

It is true that lowering the triggering CIT rate of the CFC rule and the anticorporate inversion rule, deferral of capital gains tax on qualified triangular merger, etc. are proactive measures to clear some impediments standing in the way of corporate attempts to diversify forms of their business and they should be valued highly from the perspective of preventing tax statues from unnecessarily obstructing business activities of companies. Judging from such perspective, partial adoption in CITA §23-2 of territorial taxation system with respect to foreign dividend received was also a very important measure. It provides that foreign dividend paid by a foreign subsidiary to its domestic parent company with a shareholding ratio of 25% or more is not to be included in its profit of the domestic parent company for CIT purpose.⁴⁵

CITA §23-2, which represents Japan’s partial move to the territorial taxation method, is expected to encourage foreign subsidiaries’ accumulated earnings to be repatriated to their parent companies in Japan and the wishful scenario is that they are used much for such expenditures as domestic R&D costs in Japan to put a spur on domestic economic activities. But it may also give rise to some effect that might lead to the erosion of tax base. For example, CITA §23-2 lowers a hurdle that used to discourage corporations from choosing a foreign country as the location to set up their subsidiaries in by not restricting any more the application of relief to the economic double taxation on dividend received only to the one received by a parent company from its domestic subsidiary. This may be in line with the tax neutrality principle but it also has a risk of going further than that.⁴⁶

Firstly, now that more equal tax treatment between dividend received from a subsidiary in Japan and that from a subsidiary abroad has been realized by the introduction of CITA §23-2, it is quite likely to incentivize domestic companies to choose foreign countries as places to set up their subsidiaries in or increase their business activities abroad. Secondly, if domestic companies actually become more proactive in increasing or shifting their business abroad, it would more likely than not aggravate transfer pricing (TP) problem. In fact, the high likelihood of the TP problem getting exacerbated further by the move to the territorial taxation method is considered by some in US as a sufficient reason for not adopting it while it was advocated as one of the promising tax reform options by the Report issued in 2005 by the President’s Advisory Panel on Federal Tax Reform.⁴⁷

Chapter IV

Problems with Transfer of Corporate Income and Assets

1. TP Rule and Taxation of Corporate Contribution

TP rule under STMA §66-4 introduced in 1987 is an important provision to prevent tax base erosion from the transfer of income of a domestic corporation to its foreign affiliates.⁴⁸ But it is not the only rule to prevent tax base erosion to be caused by cross-border income shifting. Particularly, CITA §37 provides for the rule of taxation of corporate contribution (i.e., gratuitous provision of assets or economic benefit) and it also helps prevent tax base erosion from domestic and cross-border income shifting.⁴⁹ The idea or rationale underlying this section is that, among expenses of a company, there are some whose relevance to its business is not so apparent, so such expense constituting corporate contribution is only deductible for CIT purposes within a certain threshold to be determined by the amount of its capital and its amount of income for the relevant tax year, even if such corporate contribution that exceeds the threshold has some relevance to its business.⁵⁰

Moreover, it is to be noted that STMA §66-4(3) was introduced in 1991 and it ordains, as Diagram I-5 shows, that corporate contribution is not deductible at all if it is provided to a foreign company. This provision is intended to correct the difference in tax burden that would otherwise result depending on whether a potential TP case is dealt with by STMA §66-4(1) or by CITA §37. It is true that the amount not deductible under CITA §37 is the amount of corporate contribution, which is, in accordance with CITA §37(8),⁵¹ the amount practically gifted or economic benefits gratuitously given out of the difference between the actual price of property and its fair market value. But its application often produces a result identical to the one that results from the application of STMA §66-4 because in many cases the amount practically gifted is deemed the difference between the actual price of property and its fair market value or its arm’s length price (ALP).⁵²

(Diagram I-5: Tax treatment of corporate contribution to domestic and foreign corps.)

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Such being the case, the question of which of these provisions (STMA §66-4(1) and CITA §37) is applicable to a cross-border transaction in question may not be a big issue from the perspective of the amount of tax payable by the concerned domestic company. But the aggregate tax burden of the company and the counterparty of the cross-border transaction in question as a corporate group could differ much depending on which rule is applied in actuality because the application of CITA §37 does not entitle the Japanese government to initiate the mutual agreement procedure which is necessary to make the corresponding adjustment (i.e., concomitant reduction in the amount of tax payable by the counterparty of the transaction in question) to avoid international double taxation.

On the relationship between STMA §66-4(1) or the TP rule and CITA §37, it should be noted that STMA §66-4(4) spells out that, in a case to which STMA §66-4(1) is applied, the difference between the actual price and the ALP shall not be deductible in calculating a company’s income for respective years for CIT purpose unless it comprises such amount to which CITA §37 applies. In light of this provision, some maintain that it is a legal basis for prioritizing the application of CITA §37 over STMA §66-4(1) in cases where their applicability scope could overlap. While it may be open to question if STMA §66-4(4) actually specifies the prioritized application of CITA §37 over STMA §66-4(1) or not, but it is true that there are many potential TP cases to which CITA §37 instead of STMA §66-4(1) is actually applied.

The main reason for the frequent application of CITA §37 to many potential TP cases could be found in Example 25 of NTA’s TP Implementation Manual for Auditors (hereinafter called NTA’s TP Manual).⁵³ As Diagram I-6 shows, this example spells out that, in a case where Company P has not recorded a profit from a transaction with a foreign Affiliate S, there is gratuitous transfer of money, other assets, economic benefit or gratuitous provision of service to financially support this foreign Affiliate S, and the profit to be recorded at Company P is likely to be deemed contribution to be subjected to the treatment under CITA §37 or STMA §66-4(4) unless its application is exempted in accordance with CIT Basic Administrative Ruling 9-4-2 (Interest-free loans, etc. for restructuring subsidiaries, etc.),⁵⁴ while, if it does not constitute corporate contribution by any chance, it shall be looked into to see if it comes under STMA §66-4(1).

(Diagram I-6: NTA’s guidance on application of CITA §37 over STMA §66-4)

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(Source: Example 25 in NTA’s TP Manual)

Some view that NTA seems to prefer the application of CITA §37 over STML §66-4(1) because it could obviate the administrative burden of finding the ALP and the mutual negotiation procedure for solving international double taxation problem that would arise by the application of the TP rule. In fact, it is pointed out that in a case where a Japanese parent company sends its staff to its foreign subsidiary to provide services, and they enter into an agreement by which the subsidiary’s share of salary payment to them is, for the sake of reducing its financial burden, kept at a minimum level, the end result is that CITA §37 instead of STML §66-4(1) is applied to such case to deny the parent company’s deduction of some of its salary expense paid to the staff even if it was pointed out at first by the tax examiner that STML §66-4(1) should be applicable to it.⁵⁵

It is pointed out further that the end result of applying CITA §37 instead of STML §66-4(1) could sometimes be more preferable to some taxpayers as well and those taxpayers often do prefer such end result because the statute of limitation for the application of CITA §37 is 5 years while it is 6 years in the case of STML §66-4(1). It should be that STML §66-4(1) could also be applicable to such a case mentioned above, now that it is a potential TP case and the NTA’s TP Manual also states in §2-9 (Treatment of intragroup provision of service)(1) that, in a case where a domestic company undertakes the managerial, financial and administrative activity for its foreign affiliate, the judgment of whether it constitutes provision of service or not should be made in accordance with a finding on whether the activity in question has economic or commercial value for the foreign affiliate.

The conclusion drawn in the NTA’s TP Manual is that the abovementioned judgment of whether managerial, financial and administrative activity for a foreign affiliate constitutes provision of service or not should be made by confirming whether an unaffiliated company in a situation similar to this foreign affiliate would pay the price if it receives analogous activity from an unaffiliated company, or whether this foreign affiliate would be in a position to undertake this activity for itself if the domestic company does not undertake such activity. But, in actuality, even such explanation does not help much in many cases in drawing a clear line between cases to which CITA §37 should be applied and those to which STML §66-4 (1) should be applied. Consequently, the guideline shown by the abovementioned Example 25 of the NTA’s TP Manual is likely to dictate and CITA §37 is likely to be applied in many potential TP cases.

2. Other Countries’ Practices and Call for Change

In other countries, it is the TP rule that is usually applied to such cases as shown in the examples mentioned in above 1 of this Chapter. For instance, in US Tax Court judgment on Xilinx Inc. and Subsidiaries v. CIR ([2005] 125 T.C. No.4), it was ruled that the stock option provided to the workers in the Irish subsidiary of the US parent company working as the R&D staff should constitute a cost to be shared by both parties, so it is not in accordance with the arm’s length principle (ALP) for the parent company to take on and deduct the entire cost related to the stock option. This judgment was later overturned by the Ninth Circuit Court of Appeals judgment ([2010] 598 F.3d 1191) because it determined that sharing the cost of the stock option in such a case is not a regular practice between independent parties and is not in line with the ALP.⁵⁶ But, even so, it does not change the basic fact that what matters in such a case is whether IRC §482 is applicable or not.⁵⁷

The abovementioned basic fact can also be inferred from IRS’s Internal Revenue Bulletin 2003-44 which states: The current services regulations at §1.482-2(b) provide generally that where one member of a controlled group performs services for the benefit of another member without charge, or at a charge that is not equal to an arm’s length charge, the Commissioner may make appropriate allocations to reflect an arm’s length charge for such services. The determination of the arm’s length charge depends on whether the services transaction is an ‘integral part’ of the business of the renderer or recipient of the services. The current services regulations provide several overlapping quantitative and qualitative tests to determine whether a services transaction is integral. Also, Treasury Regulation §1.482-7(Sharing of costs) provides for the inclusion of the stock-based compensation in the intangible development costs.⁵⁸

It is not that such difference between Japan and US in tax treatment of certain intragroup service is given little notice in Japan. In fact, there have been voices calling for the applicability scope of CITA §37 with respect to cross-border transactions to be narrowed down in practice, so that STMA §66-4(1) would be applied more often in cases where their application could overlap.⁵⁹ But, as mentioned in 1 of this Chapter, the problem is that it is likely that more frequent application of the TP rule would lead to heavier administrative burden on NTA due to the expected increase in difficulty in finding the ALP and in the workload related to the mutual negotiation procedure for international double taxation relief. Even so, there might be some room for reviewing the current treatment or guideline on the applicability relationship between ITA §37 and STMA §66-4(1) in cases where they could overlap, so that a better balance could be struck on their application.

Chapter V

Problems with Timely Grasp of Assets and Their Transfer

1. Problems with Assets Disclosure Rules

There are various causes for tax base erosion, and the most basic cause is the tax authority’s failure in grasping timely transactions, incomes and assets to be taxed. Therefore, it is fundamental, for the purpose of preventing tax base erosion, to find out at least where taxable transactions, incomes and assets are. Even so, it is not always easy to get timely grip on them because taxpayers often make attempts to hide them from the tax authority. Therefore, it is little wonder that getting timely a very good picture of complex tax avoidance schemes and abusive tax strategies through tax audits could be a very difficult task. In view of such difficulty, OECD’s BEPS Action Plan 11 and 12 proposes to consider introducing such rules that oblige taxpayers to disclose them while it is cautioned that sufficient attention should also be paid to the enforcement and compliance cost that such disclosure obligation would entail.

But the problem is that it is not just complex tax avoidance schemes and abusive tax strategies that are hard for NTA to get sufficient and timely grip on. Some simple transactions, income and assets could also slip out of the tax authority’s radar frequently. Particularly, the tax authority’s sufficient and timely grasp of information on taxpayers’ assets located abroad and foreign-sourced income could be difficult in some cases. Such being the case, in Japan the foreign assets reporting rule introduced in 2012 in Chapter 3 (Article 5 and 6) of 1997 Law No.110 for income tax and inheritance tax purpose is expected to be a big step forward in raising NTA’s grasping level of taxpayers’ income and assets abroad. In accordance with this rule, a Japanese individual resident with foreign assets whose aggregate value is more than fifty million yen at any time of a year should submit to NTA a statement showing their details.

Under the foreign assets reporting rule, an incentive for disclosure of those assets located abroad is given to taxpayers by applying a 5% reduced administrative penalty rate for non/underreporting of income or assets if the report filed in accordance with the rule contains pertinent information on a foreign asset that is relevant to such non/underreporting. As for the administrative penalty for the failure to comply appropriately with the reporting rule, 5% extra is added for income tax purpose to the regular rate on non/underreported income or assets, provided that such non/underreported income or assets relates to the foreign asset that was not disclosed in accordance with the reporting obligation. Also, criminal penalty could be applied to the failure in fulfilling the reporting rule if such failure is proved intentional.

Now that the foreign assets reporting rule has been implemented from Jan. 2014, it is not so certain, at this point, how effective the rule could be, but the Diagram I-7 showing details on the foreign assets disclosed by 5,539 reports submitted for the year of 2013 in accordance with the rule may divulge some facts that raise not a little concern. One concern is about the compliance level to the rule. Lack of strict administrative penalty for the noncompliance and a high hurdle to clear to impose criminal penalty on the noncompliance may have a lot to do with its compliance level.⁶⁰ Another concern is about the scope of the taxpayers with reporting obligations. The reporting obligation is imposed only on individual residents with foreign assets whose total value is more than fifty million yen, so there might be some room for them to contrive methods of assets holding so that they could manage to free themselves from the reporting obligation.

(Diagram I-7 : Breakdown of disclosed foreign assets for the tax year of 2013)

(Source: data issued by NTA in July 2012 at www.nta.go.jp/shiraberu/ippanjoho/…/kokugai_faq.pdf)

While it is true that ITA §232 obliges an individual with annual taxable income of more than twenty million yen to submit to NTA a report showing the breakdown of his/her assets (including foreign assets) and their value, but there is no legal penalty on the noncompliance with this obligation, so it is doubtful that its compliance level is satisfactory.⁶¹ Of course, there are some other measures such as the exchange of information provision in tax treaties, Tax Information Exchange Agreement (TIEA) with some tax haven countries, etc. that would supplement the function of the foreign assets reporting rule, but there may be some room for the foreign assets reporting rule to be fortified and some relevant provisions to be amended so as to close some loopholes of the current disclosure rules.

2. Problems with Inter Vivos Gift of Property

Transactions, income and assets do not necessarily have to cross the national border to avoid the tax authority’s detection. As mentioned above, the tax authority’s radar sometimes fails to catch timely even simple domestic transactions. Particularly, timely grasp of inter vivos gifts or transfer of property among family members can be difficult if no action is taken by the transferee to make public the fact of gift or property transfer. If NTA fails to grasp the fact of such gift or property transfer before the statute of limitation on gift tax assessment (in principle six years after the deadline for gift tax return filing) expires,⁶² the tax base could be eroded. NTA tends to prevent this tax base erosion by taking a stance that the acquisition of property through gift had not been completed at the time of the property transfer so that the statute of limitation has not expired when it was detected, while it is usually claimed otherwise by the transferee.

The abovementioned NTA’s view on the timing of the acquisition of property through inter vivos gift has been accepted by many courts that rebuff the taxpayers’ claim that the statute of limitation on gift tax assessment had already been expired when the tax assessment was made. But there are cases like Naha District Court 9/27/2005 judgment (2003 Gyou-U, No.15) in which the abovementioned NTA’s view was not upheld in spite of the fact that the taxpayer did not register officially the change of the ownership of the real estate until Feb. 1990 while it was transferred gratuitously to him in 1966 through a written contract. This judgment implies that the acquisition of a real estate through inter vivos gift could be at the time when the contract of the gratuitous transfer is made while it is true that this case was rather an exception because there was hardly no gift tax levied in Okinawa before it was returned back to Japan in 1972.⁶³

Also in Tax Tribunal 10/30/2000 decision (TAINS Data Code: F0-3-018), it was decided that the statute of limitation on gift tax assessment on the applicant had already been expired by the time of the assessment because the gift in question was made not at the time when, as NTA maintained, the property in question was registered in accordance with the Real Estate Registration Act or the relevant court ruling was handed down,⁶⁴ but at the time when, as the applicant claimed, the written contract on the transfer of this property was entered into. The tax tribunal also mentioned that gift of property made by means of a written contract is, even if the transfer of the property has not been completed, cannot be rescinded in principle, so that, in the case of gift of property by means of a written contract, the time of acquisition of property by gift is in principle when a contract is effected unless there are such special facts as it is prepared as a way to avoid taxation.

As shown above, gift tax might be avoided in some cases by delaying the public disclosure of the transfer of property, so there are lately cases in which documents are prepared at public notary offices concerning gratuitous transfer of real estates but the official registry of the transfer of the real estates in accordance with the Real Estate Registration Act is entered after seven years have passed since then. In these cases, if the time of the acquisition of property through inter vivos gift is deemed to be when notary documents on the property transfer were prepared instead of when the transferees of the property made official entries of the change in ownership of the real estates in question into the land registry,⁶⁵ the statute of limitation is to prevent NTA from assessing gift tax on the gratuitous transfer of the real estates and the donees’ attempts to avoid gift tax are to succeed.

But actual cases show that such attempts are not successful in most cases. One example of such unsuccessful attempts came to the surface in the Kyoto District Court 1/30/2004 judgment (2002 Gyou-U No.17). In this case, at issue was whether or not the taxpayer who inherited a real estate from his deceased parent was right in filing an inheritance tax return in Oct. 1998 without including in it the real estate transferred to him by this parent that had been recorded as the taxpayer’s property at a public notary office on Jun. 1992. NTA claimed that the real estate in question was managed by his parent even after the recording at the notary office of its

Reviews for Tax Strategy Vs. Countermeasures

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