Japan’s CFC tax reform: new wine into old bottles?

by Professor Masao Yoshimura, Hitotsubashi University

Japan’s ruling coalition on December 8 released a proposal to revise the controlled foreign company (CFC) rules as a part of its 2017 tax reform plan.

The proposal, designed to be in line with the OECD/G20 base erosion profit shifting (BEPS) report under Action 3, basically maintains Japan’s current hybrid approach regarding CFCs but introduces additional rules to crack down on shell companies and cash boxes.

The government intends to draft a tax reform bill based on the plan and submit it to the Diet in January 2018.

Current CFC rules

Japan introduced CFC rules in 1978. At first, Japan adopted an entity approach to counter tax avoidance using subsidiaries in tax havens. In 2010, a new set of rules was introduced based on a transactional approach.

Current law provides a definition of CFC control based on a legal test. The rules apply to Japanese residents who own, directly or indirectly, 10% or more of the voting stock of a foreign corporation more than 50% of whose voting stock is owned or controlled, directly or indirectly, by those residents.

The rules provide for a low-tax threshold; only CFCs whose effective tax rate is less than 20% are subject to CFC taxation.

Moreover, the law adds an exemption from entity-based inclusion. A CFC is excluded from full-inclusion if it meets a main business test (non-disqualifying business test), a substance test, a management and control test, and a non-related transaction test or home country activity test.

Even if a CFC is excluded from full-inclusion, however, listed passive income streams earned by the CFC are includable in the CFC’s Japanese shareholders’ taxable income.

Japan’s proposed CFC revisions

With the reform, Japan would maintain a hybrid approach under which certain CFCs that satisfy an exemption requirement are excluded from full inclusion, but some income earned by those CFCs is still subject to CFC taxation.

First, the proposal would introduce an economic control rule or de facto control rule in addition to the current legal control test.

Unfortunately, the plan has not made the new test sufficiently clear; instead, it provides an example where a foreign corporation is regarded as a CFC in a situation where a Japanese resident has the right to claim substantially all of the residual assets of the foreign corporation.

Second, in response to the Panama leaks, Japan will also introduce rules to counter tax avoidance that operate as both anti-BEPS measures and as “defensive measures” in response to non-cooperative jurisdictions.

These new rules address shell companies, cash boxes, and companies situated in blacklisted jurisdictions, putting such arrangements into the scope of full-inclusion CFCs.

Finally, the current low-tax threshold will be repealed and two sets of tax rate exemptions will be introduced. The first exemption, applicable to the new rules, exempts CFCs with an effective tax rate of 30% or greater; the second exemption, applicable to the current rules, is set at tax rates of 20% and above.

Therefore, there is no actual difference between the low-tax threshold and the tax rate exemption in terms of conventional rules. Large businesses that were concerned about the repeal or lowering of the low-tax threshold should be relieved to see the details of the new plan.

Aircraft leasing

Aircraft leasing has been added to the list of disqualifying businesses for purposes of determining whether a CFC is excluded from full-inclusion.

If a CFC that has a main business of aircraft leasing has an effective tax rate of less than 20%, the CFC is subject to full-inclusion without exception. As Ireland has become a leading center for aircraft leasing, some banks and trading companies have pointed out that the current CFC rules could lead to over-inclusion and damaging competitiveness of Japanese leasing companies.

The plan excludes certain aircraft leasing that has economic substance from being considered disqualifying businesses. If any officer or employee of an aircraft leasing CFCs is engaged entirely in ordinary and necessary activities for aircraft leasing in their home country, the CFC will satisfy the main business test.

The plan also revises the categories of passive income subject to the transactional approach based on the BEPS final report. The extent of CFC inclusion will be expanded.

If the Diet passes the proposed bill, the revised CFC rules will be applicable to taxable year beginning on or after April 1, 2018.