Japan releases study group report on international taxation in the digital economy

By Takato Masuda, Nishimura & Asahi, Tokyo

On August 19, the “Study Group on International Taxation in the Digital Economy” assembled by the Ministry of Economy, Trade and Industry of Japan, released its report (in Japanese, the ministry says an English version will be prepared later). The report provides useful insights into how the Japanese business sector views the OECD’s two-pillar solution, a digital services tax and relevant domestic tax laws, such as controlled foreign corporation (CFC) regimes.

Background and membership composition of the study group

The study group consisted of 14 members, comprised of five academics, four tax professionals, and five companies, including Toyota and Sony. In addition, economic organizations, such as Keidanren (Japan Business Federation), and relevant authorities, such as the Ministry of Finance and the Japanese tax agency, also participated as observers. Before releasing the report, six workshops were held, generally every month from March.

According to the press release, the background to the meetings is as follows:

With economic digitalization accelerating, in order for Japan to continue to grow sustainably as an investing nation (i.e., one based on investment overseas and the returns on same), it is important to provide an environment conducive to fair competition between Japanese and foreign companies in domestic and overseas markets, and to examine what approaches to equitable international taxation will contribute to strengthening the competitiveness of Japanese companies and boosting the economy. These matters should all be addressed while taking into account international discussions, particularly those involving the OECD.

With these issues having been identified, the “Study Group on International Taxation in the Digital Economy” has been meeting to discuss them progressively.

As the Ministry of Economy, Trade and Industry is not directly in charge of international tax negotiations or tax reform, it seems that the report intended to materialize the message from the business sector with the involvement of academics and tax experts and to deliver it to those actually in charge of international tax negotiations and tax reform through this study group.

Overview of the report

The report, which is about 30 pages long, is divided into five sections: “Digitalization of the economy and the need for tax system development to enhance overseas investment,” “Recent trends in international taxation,” “Taxation to ensure fair competition in the overseas market,” “Taxation to ensure fair competition in the domestic digital market,” and “Mid- to long-term perspectives on international taxation.”

The first section, “Digitalization of the economy and the need for tax system development to enhance overseas investment,” provides a general introduction. This report proposes to enhance the international competitiveness of Japanese companies by leveling the tax burden between Japanese companies and foreign companies, as well as between traditional companies and digital companies, in both domestic and international markets. It is also focused on a tax system to prevent outflow of value-creating intangible assets and research and development (R&D) centers from Japan while supporting the overseas expansion of Japanese companies.

The report basically assumes that not only are foreign companies currently monopolizing or oligopolizing the domestic digital market, but also that there is a significant disparity in the tax burden between digital companies and other companies by citing, as supporting evidence of such disparity, an analysis published by the European Commission in March 2018 and an article in the Nikkei newspaper in footnotes. In other words, the report does not provide any of its own empirical estimates of the disparity in tax burdens between digital companies and other companies, while stressing that competition is unfairly distorted.

The second section, “Recent trends in international taxation,” briefly summarizes topics such as Japan’s past tax reforms in international taxation, the two-pillar solution to address the tax challenges arising from the digitalization of the economy proposed by the OECD/G20 Inclusive Framework on BEPS, the US 2017 tax reform (known as the Tax Cuts and Jobs Act), and a digital services tax and other unilateral measures.

The third and fourth sections are where the possible Japanese approaches to the OECD’s two pillars are mentioned. The details of these sections will be discussed later in this article.

The fifth section, “Mid- to long-term perspectives on international taxation,” has a small discussion on the acceptability of a destination-based cash flow tax.

Approach to OECD’s pillar two proposal

The report’s third section, “Taxation to ensure fair competition in the overseas market,” examines possible Japanese approaches to the pillar two proposal.

The report gives a generally favorable evaluation of pillar two but points out that that the timing of the introduction of the income inclusion rule in the home countries of foreign firms competing with Japanese firms (e.g., Europe, the US, China, and Korea) should be taken into account before the rule is brought into Japanese law. This is because implementing the rule earlier than these countries could have a negative impact on the competitiveness of Japanese companies in overseas markets. Whether the US will introduce SHIELD (Stopping Harmful Inversions and Ending Low-Tax Developments) is also considered an important factor.

The report further argues that the income inclusion rule should be applied modestly to industries that hold immoveable or physical assets in foreign jurisdictions (e.g., manufacturing industries with local factories), and that transitional rules to exempt companies that expanded overseas before a certain point in time and appropriate carve-outs are necessary. Although not explicitly mentioned, this may have reflected the typical practice of Japanese companies setting up manufacturing facilities in Southeast Asia and other regions to take advantage of tax incentives.

In addition, the report emphasizes the importance of reducing compliance costs and states that all four simplification options suggested in the blueprint should be implemented upon adoption. With regard to the second pillar, the report also points out that the choice of accounting standard should not result in a favorable or unfavorable tax burden.

With respect to the undertaxed payment rule, the report argues that the introduction of this rule in Japan could have an adverse effect on foreign investment in Japan (especially from the financial industry in Singapore), as investment is shifted from Japan to countries that have not introduced the rule. It is implied that, since Japan intends to become an international financial center and to lure investment, there may be policy conflicts in introducing the undertaxed payment rule.

The report also warns that the current situation, where it may be tax-inefficient to hold or accumulate intangible assets in Japan, is a serious problem, and concrete solutions should be explored immediately. The study group’s position that Japan has to be prepared for future tax competition is understandable, because, as is well known, in a press release on July 1, OECD Secretary-General Mathias Cormann explicitly said that “this package does not eliminate tax competition.”

The report further mentions the possibility of simplifying Japan’s CFC regime upon the introduction of the income inclusion rule. This is because, as the mechanisms and effects of the rule and the CFC regime are partially similar, it is desirable to avoid overlap between these two to reduce compliance costs, even though there are differences between this rule and the CFC regime in terms of the exclusion of non-large enterprises (i.e., the 750 million euros threshold) and the policy rationale. Specifically, the report proposes to differentiate between this rule and the CFC regime by limiting the scope of the CFC regime to activities without a business reason other than tax avoidance. However, a more detailed analysis needs to be conducted in the future. Although not so relevant for foreign parties, simplification of the CFC regime is probably the most recent key issue for Japanese taxpayers and tax authorities.

Approach to OECD’s pillar one proposal

The fourth section, “Taxation to ensure fair competition in the domestic digital market,” examines possible Japanese approaches to the pillar one proposal.

The report acknowledges that pillar one shall be implemented to equalize the tax burden between Japanese and foreign companies in the domestic digital market. However, at the same time, the report cautiously notes that it should be carefully examined whether the trend of allocating more to market jurisdictions should be maintained. As Japan’s population continues to decline and it is uncertain whether Japan will remain an attractive market, strengthening the taxing rights of market jurisdictions could be unfavorable in the long run.

In the report, not many pages are spent on the discussion of pillar one. This probably reflects the assumption that pillar two (especially its impact on revision of the CFC regime) seems to be a more important issue for Japanese companies than pillar one, considering that only a few (maybe less than 10) Japanese companies would be affected by the profit allocation under pillar one, while there are a significant number of Japanese companies that are required to submit country-by-country reports and would be subject to pillar two.

The report also mentions technical discussions on tax avoidance by multinational enterprises that take advantage of the special exemption from consumption tax (Japanese VAT) for companies with small sales in the year before last (accordingly, newly established corporations that have no sales in the year before last are exempt from consumption tax for the initial two years). It further discusses the possibility of introducing certain limitations on deductible payments in reference to the US base erosion and anti-abuse tax (BEAT) to deal with cases where multinational enterprises drain profits from their Japanese subsidiaries through royalty payments.

What about a digital services tax?

This report does not directly discuss the possibility of introducing unilateral measures in Japan, such as a digital services tax. Instead, the report just suggests that the current digital services taxes could serve as points of reference when considering how Japan should respond if the implementation of pillar one were to be delayed.

The report states that the failure to agree on a detailed implementation plan for pillar one, or little or no implementation of such plan, would leave unevenness in the competitive environment between Japanese companies and other companies unaddressed, thus Japan needs to prepare an option that will serve as a temporary measure until pillar one is finally implemented in practice. The report then provides a brief list of pros and cons on sales tax (digital services tax), income tax (withholding tax), and consumption tax from the standpoint of a response to a pillar one delay. It also identifies common problems with all these taxes as passing on the tax burden and how to coordinate with the existing corporate income tax.

The report is carefully worded so as not to convey the misleading impression that Japan is willing to introduce unilateral measures at any moment.

—Takato Masuda is an attorney-at-law and associate at Nishimura & Asahi, Tokyo.

All opinions expressed in this article are those of the author and do not represent or reflect the opinions of any entity whatsoever to which the author has been, is now, or will be affiliated.