Consolidated tax regime
Under the consolidated tax regime, a consolidated group can report and pay national corporate income tax on a consolidated basis. A consolidated group may be formed by a Japanese parent company and its 100% owned (directly or indirectly) Japanese subsidiaries. The taxpayer may file an application to elect a consolidated group filing for tax purposes, but the election must include all of the parent's eligible subsidiaries. Once the election is made, the consolidated filing, in principle, cannot be revoked unless there is a specific event, such as an ownership change, that causes the qualifying conditions of a consolidated filing to fail or an application to discontinue the consolidated group has been approved by the Commissioner of the National Tax Agency (NTA).
The taxable income of the consolidated group is computed on a consolidated basis by aggregating the taxable income or losses of each member of the consolidated group followed by the consolidation adjustments. Profits from intra-group transactions, except for transfer of certain assets as defined, should be included in the aggregate taxable income. Gains or losses from the intra-group transfer of certain assets are deferred.
Pre-consolidation tax losses of a subsidiary can be carried forward into a consolidated tax group if certain conditions are met, but may only be offset against taxable income of the subsidiary for the calculation of consolidation income.
The consolidated national corporate income tax liability is determined by applying the corporate income tax rate to the consolidated taxable income and adjusted for consolidated tax credits. The total tax liabilities are allocated back to each member company. The parent company files the consolidated return and pays the national corporate income tax for the group; however, each member company remains jointly and severally liable for the consolidated group’s total national corporate income tax liability.
Local corporate income taxes levied on member companies are paid on a separate company basis, but the amount of local tax payable may be affected because of the consolidated filing.
Group taxation regime
A group taxation regime is applicable to domestic companies that are wholly owned by a domestic company, foreign company, or individual ('group companies'). Unlike the consolidated tax regime, the group taxation regime automatically applies to group companies.
The key points of this regime are summarised as follows:
- The recognition of capital gains or losses from the transfer of certain assets (including the transfer of assets as a result of a non-qualified or taxable merger) between group companies is deferred until the asset is transferred to another group company or a non-group company. The scope of assets is the same as that under the tax consolidation system (i.e. fixed assets, land, securities, monetary receivables, and deferred expenses [excluding securities for trading purposes and assets with a book value of less than JPY 10 million]).
- Where a donation occurs between group companies, there are no tax implications for either the donor or donee (i.e. no deduction for the donor and no taxation for the donee). Note that this treatment is not applied to a group company owned by an individual. This is consistent with the treatment of a donation between members of a consolidated tax group.
- A dividend received from a group company can be fully excluded from taxable income without any reduction for allocable interest expense. This is consistent with the treatment of dividends between members of a consolidated tax group.
A group company that would otherwise qualify as an SME on a stand-alone basis is not eligible for SME benefits (e.g. reduced corporate tax rate, preferable allowable ratios for deductible portion of bad debt provisions, partial deductibility of entertainment expenses, carryback of tax losses) if the SME is owned by a parent company or two or more parent companies of the group that has paid-in capital of JPY 500 million or more.
Where a corporation that is a member of a 100% group is in the process of liquidation and is expected to be dissolved, any loss from the impairment or devaluation of the shares of the liquidating corporation cannot be recognised by the parent company as a tax deductible expense.
If a corporation that is subject to corporation tax sells property to or buys property from a foreign-related person, or provides services or conducts other transactions with a foreign-related person, and consideration is received or paid by the corporation, the transaction is required to be carried out at an arm’s-length price for corporation tax purposes.
A foreign-related person is a foreign corporation that maintains certain special relationships with the subject corporation, such as parent-subsidiary, brother-sister, or substantial control relationship.
The arm’s-length price for the sale or purchase of inventory may be determined using one of the following methods:
- Comparable uncontrolled price method.
- Resale price method.
- Cost plus method.
- Berry Ratio method.
- Other method (i.e. profit split method and transactional net margin method [TNMM]).
The 'most appropriate method' should be applied in order to calculate the arm’s-length price.
An advanced pricing agreement (APA) system is available to confirm the arm’s-length pricing system proposed by a taxpayer. In general, corporations entering into an APA are advised to file a request for mutual agreement procedures (MAP) in order to obtain the agreement of the competent authorities of each country.
In October 2015, the OECD released the final BEPS reporting package with Action 13 relating to transfer pricing and related documentation. Taking into consideration the compliance costs for taxpayers along with increased transparency, the 2016 Japan Tax Reform requires the following documentation in order to adhere with the BEPS project:
|Document||Required information||Submission deadline||Applicability|
|Country-by-Country (CbC) Report||Country revenue, pre-tax income, taxes payable, etc.||Must be e-filed within one year of the last fiscal day of the ultimate parent||Applicable for fiscal year of the ultimate parent entity beginning on or after 1 April 2016|
|Master File||Group company structure, business outline, financial conditions, etc.|
|Local File||Transfer pricing documentation||By due date of tax return, to retain for seven years||Applicable for corporate tax in fiscal years beginning on or after 1 April 2017|
Under the 2019 Tax Reform, the transfer pricing rules were revised to align with BEPS Action 8 and the revised OECD transfer pricing guidelines, including:
- Clarification of the definition of intangibles subject to transfer pricing legislation and introduction of measures for adjusting the transfer pricing of hard to value intangibles (HDVI).
- Introduction of the discounted cash flow (DCF) method as an approved transfer pricing methodology.
- Extension of the current statute of limitations for transfer pricing assessments from six years to seven years.
The above amendments will be applied to tax years beginning on or after 1 April 2020.
Interest paid on debt to controlling foreign shareholders is disallowed to the extent the average balance of debt on which that interest is paid is more than three times the equity of controlling foreign shareholders.
Interest expense deduction limitation (earning stripping rule)
Under the 2019 Tax Reform, the earnings stripping rule was revised to align with BEPS Action 4, including:
- Expansion of the scope of non-deductible interest, which includes interest paid to third parties but excludes interest that is subject to Japanese income tax in the hands of the recipient.
- Lowering of the benchmark fixed ratio from 50% to 20%.
- Starting from taxable income, exempted dividend will no longer be added and WHT claimed as tax credit will be added.
- Lowering of the threshold for application of the new rules.
The above amendments will be applied to tax years beginning on or after 1 April 2020.
The deductible portion of a corporation’s net interest expense to a related party as well as to the third party is restricted to 20% of the adjusted income. The net interest is calculated as interest expense less corresponding interest income. Interest expense does not include (i) interest expenses on specified bonds (issued to limited number of unrelated parties and not in public), (ii) interest payments subject to Japanese taxation or paid to qualifying public service corporations, and (iii) interest on back-to-back repos.
The adjusted income is defined as taxable income, adding back interest expense and depreciation expense, but excluding extraordinary income or loss.
Limitation (de minimis and group basis) on application is (i) net interest expense in a fiscal year is JPY 20 million or less, or (ii) the aggregated net interest expense on a Japanese corporate group basis (where there is more than a 50% capital relationship) is 20% or less of the aggregated adjusted income on the same group basis.
The non-deductible interest incurred in the past seven years will be deductible at up to 20% of the current adjusted taxable income.
Anti-tax haven (controlled foreign company or CFC) rules
Undistributed profits of a foreign subsidiary (i.e. CFC, which is defined as a foreign related corporation [FRC] by the (i) equity ownership test [owned more than 50% by Japanese corporations or residents] or (ii) de fact control test) to which an applicable tax rate is 30% (in case of a shell company) or 20% are included in the Japanese parent company’s taxable income under certain conditions.
In the 2017 Tax Reform, major changes were made considering the BEPS recommendations to shift to a more of an income-based approach (although elements of the entity approach remain). After the amendments, income earned by a CFC is 'aggregated' (i.e. included within Japanese taxable income) in three different ways:
- Entity-based aggregation where all of the income of a CFC is taxable to a Japanese shareholder if (i) the main business of the foreign controlled subsidiary is not 'active' (as defined) and (ii) the foreign tax rate is lower than a 20% 'trigger' rate.
- Entity-based aggregation where all of the income of a CFC is taxable to a Japanese shareholder if (i) the CFC fails certain 'substance' and 'administration and control' tests and is thereby treated as a 'paper company' or 'cash box company' and (ii) the foreign tax rate is lower than a 30% 'trigger' rate.
- Income-based aggregation where even if the entity-based aggregation rules do not create income inclusion on an entity basis the relevant income of a CFC is taxable to a Japanese shareholder if (i) income of the CFC includes certain 'passive' categories of income and (ii) the foreign tax rate is lower than a 20% 'trigger' rate.
A Japanese corporation owning a 10% or more direct or indirect interest in a CFC is required to include its pro-rata share of the taxable retained earnings of the CFC in its gross income under certain circumstances.
A dividend paid by a CFC is not deductible when calculating its undistributed income.
The new rules apply for fiscal years of foreign subsidiaries starting on or after 1 April 2018.
Under the 2019 Tax Reform, the CFC regime was amended, including:
- Narrowing of the definition of 'Paper Company' by excluding specified holding companies, real estate holding companies, and resource development project companies.
- Expansion of the definition of 'Cashbox Company'.
- Relaxation of the threshold for the unrelated entity test (a component of the CFC 'economic activity test') applicable to FRCs primarily engaged in the insurance industry.
- For FRCs under a consolidated tax return system or subject to pass through tax treatment, clarification of (a) the calculation of income for entity-based aggregation, (b) the calculation of the threshold effective tax rate, and (c) the use of foreign tax credits.
- Revision of the scope of passive income aggregation.
Amendment (ii) above will be applied to CFCs with tax years beginning on or after 1 April 2019. The remaining amendments will be applied to CFCs with tax years beginning on or after 1 April 2018 for Japanese parent corporations’ aggregated taxable income for tax years ending on or after 1 April 2019.
Under the 2019 Tax Reform, the following three categories of FRCs are no longer treated as Paper Companies; (i) specified share holding companies (FRCs primarily engaged in the holding of shares of [specified] subsidiaries), (ii) specified real estate holding companies (FRCs primarily engaged in the holding of specified real estate), and (iii) resource development project companies (FRCs primarily engaged in the holding of shares of specified resource development project subsidiaries, providing funding raised from unrelated parties to such subsidiaries, or holding specified real estate related to such projects).
To qualify as one of the exempted FRCs described above (other than category (i), FRCs primarily engaged in the holding of shares of subsidiaries), the FRC should be managed and controlled by a management company and should perform functions essential to the carrying out of the management company’s business.
In addition, the 2019 Tax Reform introduced specific tax treatment to the determination of aggregated income for FRCs applying consolidated tax return filing rules or covered by pass through provisions in the jurisdiction of their head office location. Under the amendments, the aggregated taxable income calculated under the tax law of the FRC, the threshold effective tax rate of the FRC, and the amount of foreign tax credits (applied by the Japanese parent company) are all calculated without applying any consolidated tax return filing rules or pass through provisions. The New Tax Circulars prescribe the use of the principle method or simplified method (described below) for the above calculation, as well as provide guidance regarding the application of optional income tax provisions and foreign tax credits.
|Applied provisions in the local statutes||Aggregated income calculation|
|Principle methods||Simplified methods|
|Consolidated tax filings||Corporate tax filing submitted on a consolidated basis (corporate tax payable is calculated based on the consolidated group’s taxable income and filed by a single entity)||Calculated on a non-consolidated tax filing basis||Approved if the local provisions result in a reasonable calculation of income|
|Pass through provisions||The FRC’s corporate tax income is treated as income of the FRC’s shareholder(s)||Calculated without application of the pass through provision (as if the FRC’s income were not attributable to the FRC’s shareholder(s))|