By Masao Yoshimura, Professor of Tax Law at the Graduate School of Law, Hitotsubashi University
Japan’s ruling parties on December 14 released their 2019 tax reform proposal which includes some important items aimed at implementing the OECD/G20 base erosion profit shifting (BEPS) plan recommendations for countering multinational tax avoidance.
Interest deduction limitation rules – BEPS Action 4
Responding to the BEPS final reports, Japan’s 2019 tax reform proposal would strengthen the current interest deduction limitation rules.
Japan already has both thin capitalization and earnings stripping rules; however, both rules apply to only intragroup loans.
Under Japan’s current thin cap rules, both the total and internal debt to equity ratio must not exceed the threshold of 3:1.
The earning stripping rules were introduced in 2012 before the BEPS project was initiated as a backstop to the thin cap rules.
The current threshold for the earnings stripping provisions is set at 50% of adjusted taxable income. Disallowed interest can be carried forward for seven years, a somewhat shorter period than Japan’s net operating loss carryforward period of 9 years.
The 2019 tax reform proposal would expand the scope of the earnings stripping rules to all loans, including third-party loans, and would lower the earnings stripping threshold from 50% to 20%.
If net applicable interest payments exceed 20% of adjusted income in a taxable year, a deduction of the excess amount would be denied. The disallowed interest can be carried forward for seven years in the same manner as the current rules.
Business associations have already expressed their opposition to extending the earning stripping limitation to third-party loans, emphasizing the risk of double taxation. To alleviate these concerns, the 2019 tax reform proposal provides for certain exclusions from the definition of applicable interest payments.
Under the proposal, excludable interest is stipulated as follows:
(1) For corporate bonds issued by the taxpayer and held by dispersed third-party investors,
- If the payment is subject to withholding tax or included in Japan’s taxable income at the level of the recipient, the total amount of the interest paid on the bond would be excluded from the interest limitation.
- In other cases, if the bonds are issued in Japan, 95% of the amount paid would be excluded from the limitation; if the bonds are issued overseas, 25% of the payment would be excluded.
(2) Other types of interest payments are allowed to be excluded from the applicable interest payments only if the payments are subject to Japan’s income tax at the hand of the recipients.
Japan’s 2019 tax reform – transfer pricing revisions
Under the proposal, Japan will provide a definition of “intangibles” according to the BEPS final reports.
Intangibles would be defined as “something which is not a physical asset or a financial asset and whose use or transfer would be compensated had it occurred in a transaction between independent parties in comparable circumstances.”
In addition, the discounted cash flow method suggested by the BEPS final report will be added to the list of transfer pricing methods.
As for hard-to-value intangibles (HTVI), 2019 tax reform will allow tax authorities to assess and determine the transfer price of “specified intangibles” based on the best method taking into consideration ex-post outcomes derived from the transferred HTVI.
However, Japan’s tax authorities will not be able to exercise this power if the assessment of the compensation for the transferred HTVI does not cause deviation by more than 20 percent from the taxpayer’s projected compensation.
Specified intangibles would be defined under the new law as intangibles satisfying all of the following conditions:
- the intangible is unique and has significant value;
- the transfer price would be calculated based on projected future outcomes; and
- the projections are highly uncertain.
Thus, due to the second condition, a taxpayer will risk reassessment with the commensurate-with-income standard only if using the discounted cash flow method because of a lack of comparable transactions.
As the final BEPS report recommends, a taxpayer will be exempt from the newly introduced method if either of the following sets of documents is provided:
(1) (i)Details of the ex-ante projections used at the time of the transfer to determine the pricing arrangements; and
(ii)Reliable evidence that any significant difference between the financial projections and actual outcomes is due to:
- unforeseeable developments or events occurring after the determination of the price that could not have been anticipated by the associated enterprises at the time of the transaction; or
- the playing out of probability of occurrence of foreseeable outcomes at the time of the transaction;
(2) Documentation providing that a commercialization period of five years has passed following the year in which the HTVI first generated unrelated party revenues for the transferee and in which the commercialization period any difference between the financial projections and actual outcomes was not greater than 20% of the projections for that period.
The 2019 tax reform act will be introduced to the Diet and is expected to be passed by March 31.
The revisions would thus apply to fiscal years beginning after April 1, 2020.