Under the 2020 Tax Reform Act, the currently effective ‘consolidated tax regime’ would be abolished and replaced with a new regime of group relief (‘group tax relief’). The new regime will be effective for tax years beginning on or after 1 April 2022. Measures to transition from the current consolidated tax regime will be introduced.
Similar to the consolidated tax regime, the group tax relief shall be applied by filing an application form to the Commissioner of the National Tax Agency (NTA) in advance. As a transition from the consolidated tax system to the group tax relief system, unless the consolidated tax group files an advance notice not to apply the group tax relief system to the NTA, the group will be treated to apply the group tax relief system for tax years beginning on or after 1 April 2022.
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 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.
As anti-tax avoidance measures, 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. Further, built-in gain or loss of assets owned by subsidiaries will be realised under certain circumstances prior to beginning the consolidated filing or joining the consolidated group.
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 tax relief regime
The 2020 Tax Reform Act introduced a group tax relief regime to replace the current consolidated tax regime from tax years beginning on or after 1 April 2022. The basic rules of group tax relief would be largely similar to those of the consolidated tax system. Similar to the consolidated tax system, (i) the applicable member corporations are 100% subsidiaries owned by a Japanese parent, (ii) the application is optional by the advance filing to the NTA, (iii) local tax is not subject to the group tax relief, (iv) built-in gain or loss of assets owned by a group corporation will be realised under certain circumstances prior to beginning or joining the group tax relief system, (v) tax losses of a group corporation can be carried forward into a group tax relief system if certain conditions are met, but may only be offset against its own taxable income, (vi) the basis of a subsidiary is adjusted when it becomes no longer a member corporation of the group tax relief, and (vii) gains or losses from the intra-group transfer of certain assets are deferred.
Major difference from the rules of the consolidated tax system are: (i) the parent corporation and each subsidiary would file their own (blue form) corporate tax returns through the e-tax system, (ii) the parent corporation would be allowed to deduct losses carried forward up to its own income amount in the same manner as its subsidiaries (only the tax losses carried from the consolidated years, the parent can deduct its losses regardless of its income amount), and (iii) in principle, other members of the group will not be required to file an amended return if one member of the group files such an amended return.
Under the group tax relief, current loss of the member corporations will be allocated to the group corporations on a pro-rated basis. To reduce the administrative burden on group corporations, however, most of the income calculation or tax credit will be made on a stand-alone basis (e.g. donation expense and entertainment expense deduction, income tax credit, incentive tax credit). On the other hand, the research and development (R&D) tax credit and foreign tax credit will be calculated on a group-wide basis, and the creditable amount will be allocated to member corporations based on the respective corporate tax liabilities.
Some tax treatment is slightly modified from the rules under the consolidated tax regime. For example, in applying the dividend income exclusion from foreign subsidiaries, a qualified subsidiary will be judged on a group-wide basis, while the amount of dividend income exclusion will be calculated on a stand-alone basis. With regard to the earning stripping rule, the interest amount threshold of JPY 20 million will be judged on a group-wide basis, while the amount of disallowed interest deduction will be calculated on a stand-alone basis. Tax benefits for SMEs will be applied by the same rules under the group taxation regime, however, for certain tax incentive benefits, stricter rules may be applied.
Further, there will be changes to the way various items are calculated, where a company enters or exits from the group, or where group tax relief is commenced or terminated. The rules for built-in gain or loss realisation will be aligned to the rules for tax qualified reorganisation.
Since each member corporation files corporate tax returns for both national tax and local tax purposes, tax audit will be conducted on an individual entity basis (under the consolidated tax system, only the parent corporation is subject to the national tax audit).
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 or group tax relief regime, the group taxation regime automatically applies to group companies.
By the introduction of the group tax relief regime, under which a member corporation will file corporate tax returns on an individual entity basis, the group tax regime was also reviewed by the 2020 Tax Reform Act to be aligned with the group tax relief regime. The amendments will apply from tax years beginning on or after 1 April 2022.
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.
Under the 2020 Tax Reform Act, certain tax treatments, including the dividend income exclusion, bad debts allowance, and special deduction limitation upon transferring assets, were reviewed from a group-wide basis perspective.
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 tax day of the ultimate parent||Applicable for tax 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 tax 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 Act, 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 tax 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 tax years of foreign subsidiaries starting on or after 1 April 2018.
Under the 2019 Tax Reform Act, 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 applies 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 Act, 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 Act 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))|
Under the income based aggregation rules, certain ‘passive’ categories of income will be subject to income aggregation. ‘Passive’ income includes interest income, however, certain types of income are excluded. Under the 2020 Tax Reform Act, interest received from suppliers to which the CFC provided financing will be excluded from the scope of income. This amendment applies to tax years beginning on or after 1 April 2020.
New rule for basis in affiliated subsidiary
Under the 2020 Tax Reform Act, new rules to reduce basis in an affiliated subsidiary (i.e. a subsidiary with which the parent has a more than 50% control relationship as of the date of the dividend resolution) upon the receipt of dividends from that subsidiary were introduced. Under the new rule, where a Japanese parent receives from an affiliated subsidiary dividends that exceed in the aggregate 10% of the book value of the shares of that subsidiary in a given year, the parent must reduce its basis in the shares of the subsidiary by the amount of the dividends subject to the dividend income exclusion. This rule is designed to prevent the parent from reducing any capital gain arising on a subsequent transfer of such subsidiary’s shares by first receiving dividends from the subsidiary.
Exceptions to the above general rule will apply where: (i) Japanese corporations or residents have owned 90% or more of the shares of the affiliated subsidiary from which the dividends are received since that subsidiary’s establishment, (ii) the total annual amount of dividends received is less than the net increase in the retained earnings of the subsidiary since the year in which the 50% control relationship arose, (iii) the total annual amount of dividends received is JPY 20 million or less, or (iv) the parent receives the dividends on or after ten years from the date that the 50% control relationship arose.
The new rules apply to the tax years beginning on or after 1 April 2020.