With the Japanese financial year (April 1 through March 31) over for most Japanese companies, it is a good time for an update on tax developments in the country. The country's financial and many other industries are still facing difficult economic times. Of particular interest are:
the tax issues faced by companies selecting business structuring strategies;
the tax issues faced by companies entering the market and those trying to benefit from restructuring attempts by Japanese domestic companies; and
how the tax legislator and tax authorities are responding to commercial needs.
TAX ISSUES TO CONSIDER WHEN SELECTING BUSINESS-STRUCTURING STRATEGIES
When selling assets in Japan, the vendor usually wants to shield any capital gains from Japanese taxation by using net operating losses or by triggering losses from assets that are disposed of at the same time. But there will be interesting situations where the opposite is true and where the vendor will want to boost after-tax distributable earnings as much as possible (for example, to satisfy a required dividend flow on certain types of shares).
For a buyer, the main aspects would be:
structuring the purchase in order to limit corporate and transactional taxation;
funding (capital, debt or something in between) and the taxation of the funding flows (withholding taxes on dividends – cross-border and interest);
use of intellectual property; and
other non-tax issues including the organization of human resources and IT.
The Japanese corporate income tax at a composite rate of about 42% is still high in an international context. The consumption tax (an indirect tax like value-added taxes (VAT)) stands at a moderate 5%, but transaction taxes, in particular real estate-related, are punitive, adding up to some 9% (although some relief may be available from local governments or through the use of trust certificates). The government's coffers require a lot of tax money and, where government borrowing has never been a problem, this may change now that the rating agencies are looking critically at Japan's position. This is not a climate for tax reductions (though, according to some, it would be a remedy). It is more likely that indirect taxes would increase to levels more akin to those seen in the rest of the world.
Profitable companies in Japan will be faced with high corporate taxes and relatively few options to reduce the effective burden. For many companies, profits are not the issue at present. Such troubled companies can only achieve profitability by selling assets – an issue visible in a wide range of industries. Banks and insurance companies are selling non-performing loans (NPLs) and real estate are seeking joint ventures for certain businesses. Meanwhile industrial companies are selling real estate and divisions while some companies as a whole are sold, either after bankruptcy or because there is no other option.
The major difficulties appear to be in the financial services sector. In the banking industry institutions already having problems generating profits are also struggling to make their payments on preferred shares, issued to the government some years ago. If they fail to make these dividends, they would be de facto nationalized. Also, it is likely that a new round of injections of taxpayers' money into financial institutions will be required to keep them afloat.
The insurance industry remains a major risk area. Continuing negative spreads, combined with low stock market prices, require insurance companies to sell assets, be acquired by a foreign insurance company or risk going under (and being restructured or acquired by another insurer).
For now, the remedy for many financial institutions has been to either restructure under so-called holding companies or to merge businesses. The tax laws have facilitated these structuring options, with the introduction of corporate reorganization and tax consolidation rules. These will be discussed in more detail below. Often, however, this is a mere stay of execution when weak entities are brought together and, without a real merger integration and restructuring process, continue to struggle for survival.
The remaining option is disposal of assets. Even though tax rates are high, the business or asset-selling company can often either use existing net operating losses or create losses on the disposal of certain assets in order to avoid too punitive a tax charge on the disposal. In some cases though, the seller – despite a bad financial situation and the potential of triggering losses – would like to show profit. That would be the case for a financial institution that needs to make payments on its preferred shares. Dividends are only possible legally when there are sufficient distributable reserves, subject to the provisions in the commercial code.
For any acquirer, it is essential to understand the background at the seller's side for the pricing of the transaction as well as for its structuring.
TAX ISSUES TO CONSIDER WHEN ENTERING THE MARKET
Corporate reorganizations
The introduction on April 1 2001 of tax laws accommodating corporate reorganizations in the form of mergers, corporate spin-offs, contributions in kind, and cash contributions followed by asset acquisitions has facilitated a more flexible framework where both legal and tax barriers have been released for those companies that want to restructure.
But while this is a positive step forward, the rules are not simple and still do not solve all issues. Also, because these rules are so new, not much practical experience has been obtained as yet.
The Commercial Code provides the rules for the various reorganizations as follows:
mergers: existing companies are merged into either a newly incorporated company or into an existing company;
corporate spin-offs/divisions: a business can be spun-off and transferred by the transferor company to either a newly incorporated company or to an existing company. The transferee will issue shares either to the transferor (creating a parent-subsidiary structure) or to the shareholders of the transferor company (creating a brother/sister structure). The rules require that a business be transferred. Thus, the assets and liabilities transferred should constitute a business, ie a unit that can independently participate in the economic environment;
contribution in kind: parent contributes assets – including but not solely consisting of cash – to a subsidiary company in exchange for shares. The existing rule whereby a Japanese shareholder contributes the shares of a subsidiary (domestic or foreign) to another Japanese or foreign company continues to be available; and
cash contributions: parent contributes cash in a new company, followed by the acquisition – at book value – by the new subsidiary of assets from the parent.
The Corporate Income Tax Law provides the tax conditions that apply to these reorganization rules.
Qualified mergers are defined as:
group reorganizations where either the merging company owns, directly or indirectly, more than 50% of the shares of the merged company (and specific conditions are met) or more than 50% of both the merging company and the merged company are owned by the same shareholder; and
mergers that are not group reorganizations but are entered into for the purpose of conducting joint business operations (again, specific conditions are met).
Qualified spin-offs/divisions are defined as:
group reorganizations where either the indirect and direct-related ownership between the transferor and transferee company is more than 50% (and specific conditions are met) or more than 50% of both the transferor and transferee company are owned by the same shareholder; and
corporate spin-offs/divisions that are not group reconstructions but are made for the purpose of conducting joint business operations (again, specific conditions must be met).
The conditions to be met depend on the nature of the qualified merger/spin-off and would be very limited. For example, there should be no cash distributions. Also, 100% ownership is not expected to change after the transaction when ownership of the merged company was 100% in the hands of the previous shareholder who fully owned the entities that merged or the company that spun-off a business. However, when ownership is either below 100% in a group reorganization, or joint business operation, the number of conditions increases. Main conditions for a group reorganization would be:
no cash distributions;
the business of the merged company or of the spun-off business is expected to be continued;
at least 80% of the staff of the merged/spun-off company/business is taken over; and
the main assets of the merged/spun-off company/business are taken over.
For a joint business operation, some additional conditions need to be met. Under the old rules, tax-free reorganizations were generally not possible. Under the rules effective April 1 2001, a transfer of assets at fair market value in a corporate restructuring is still a taxable transaction. Yet, when certain conditions are met the transaction will apply for tax exemption.
The most important condition would be a transfer conducted at book value. There is no gain or loss recognition at the time of the reorganization, the assumption behind such treatment being that the economic ownership of the reorganized business does not change and that therefore, deferral of taxation of unrealized gains and losses embedded in the business is justifiable.
The tax legislation disregards the accounting treatment. Regardless of the accounting treatment, if a reorganization is qualified, the transfer of assets and liabilities is conducted at tax book value for tax purposes. If a reorganization is non-qualified, the transfer of assets and liabilities is conducted at fair market value for tax purposes.
There are a number of provisions that specifically apply for tax purposes and are not important for legal and accounting rules. These provisions aim to ensure that mechanically, restructuring steps are taken in the right order from a tax perspective. An example being that, where a transferor company spins-off a business to a sister company (and the sister company issues shares to the shareholders of the transferor), the sister company can directly issue shares to the shareholders of the transferor company for legal and accounting purposes. For tax purposes though, the sister company is deemed to have issued its shares to the transferor, which would have passed those shares on to its shareholders as a reduction of capital. Similar provisions apply for tax purposes in case of a merger.
The new rules have a number of attractive features. For example, the continuing company can use the net-operating losses of a company disappearing in a merger or of a business that is spun-off (under strict conditions). Another improvement is that for legally qualifying corporate spin-offs, a court-appointed appraiser procedure is no longer required. This is a huge improvement and saves not only money but more importantly, time. The procedure used to take at least three months and often longer. This improvement would apply regardless of qualification for tax-free treatment under the tax rules.
But there are downsides as well, in particular when there are transactions in which foreign legal entities are involved as the parent company. As long as the transaction is qualified, foreign-based companies operating in Japan via a subsidiary may benefit from the restructuring within Japan, even though shares would be issued to a foreign-based entity. But, if the transaction does not qualify, a simple share or asset-transfer may become taxable in Japan and the issue of shares to the foreign company could be taxable in Japan as well. This is particularly the case where there is no capital gains tax protection in the double tax treaty, for example, in the UK.
International transactions that are not exempt include a contribution in kind by a foreign shareholder of the shares in one Japanese subsidiary to another Japanese company in exchange for shares. The transaction would be exempt if a Japanese branch office were used to make either a contribution in kind in a Japanese company (the shares of which would become branch assets) or a cash contribution in a Japanese subsidiary followed by an acquisition of Japanese assets at book value from the branch office. Another important downside would appear to be that the tax legislation incorporates a requirement that the transferee company in a corporate spin-off assumes joint liability for the tax obligations of the transferor company. This is also the case in a brother/sister type spin-off. This could be a major issue for a third-party investor interested in participating in the spun-off business.
There are a lot of combinations of transactions possible under these corporate reorganization rules. Of most interest for foreign acquisitive companies in the Japanese market would be how they could either enter the market as a first step or combine their existing Japanese business with a similar target business. This could be in the form of a joint venture in a business that has been restructured either as a group-reorganization or as a joint business operation by an existing Japanese owner. After the restructuring has been completed, the foreign partner could come in with cash, know-how and/or its local Japanese business. This would allow the joint businesses to mature and the originator to either stay involved or select a gradual exit by way of a sale of the shares in the future.
CONSOLIDATED TAX-RETURN FILING
Companies with book years starting on or after April 1 2002, can elect to file a consolidated tax return. Unfortunately, the precise rules and regulations for the consolidated tax-return filing system have not yet been made public. The proposed law is expected to be issued in draft in May 2002 and is expected to be approved in June/July of this year. Once approved, it would have retroactive effect from April 1 2002.
A number of issues have been made clear. Consolidated filing will only be possible (but not mandatory) for companies that are directly or indirectly 100%-owned by a mutual Japanese shareholder. Essentially, only kabushiki kaisha (KK) or yugen kaisha (YK) type companies can participate in a consolidated tax-return filing. Some other legal entities could be included, but these are not commonly used. The participating companies will jointly apply for the consolidated filing treatment by way of an application with the tax authorities. The application needs to be made at least six months prior to the end of the statutory business year.
The authorities have decided that for the initial two book years from April 1 2002, the national tax rate of 30% will be increased to 32% for budgetary reasons. This would apply for parent companies with a capital in excess of Yen 100 million. As the consolidated filing would only apply for national tax, each of the companies included in the consolidated filing would still have to file local and enterprise taxes. It is also known how tax would be settled among companies in the consolidated group. Essentially, profitable companies will pay the tax to the parent company and loss-making companies will receive the corresponding tax amount from the parent company.
One of the major deterrents for entering a joint filing situation is that subsidiaries in the joint filing group will, at the time of joining the group, have to value their assets at fair market value and any excess over book-basis would be subject to tax, prior to the start of the joint filing situation. This taxation of revaluation gains/losses would not apply for:
the parent company;
100% subsidiaries, the shares of which have been owned for five years or more;
100% subsidiaries established through a share transfer or share exchange;
100% subsidiaries that are established by the parent company or by other companies within the joint filing group; or
100% subsidiaries that entered the group at the occasion of a (tax qualifying) merger into one of the joint filing group companies.
The rules for the use of pre-consolidation net operating losses are pretty strict. Only the losses of the parent company can continue to be used. Pre-consolidation losses in the subsidiaries would only be available for use in very special circumstances.
It will be a real numbers game for companies to decide whether or not tax consolidation makes sense, particularly in terms of converting an existing standalone filing basis into a joint filing basis. Tax planning would become possible though, through the use of leveraged local Japanese acquisition companies. The interest incurred could be offset by the business profits generated in the 100% subsidiary. However, it remains to be seen how the revaluation of the acquired company would be taxed, specifically as it would be unclear how any goodwill, arising when the revaluation takes place, would be treated for tax purposes. In particular, when such goodwill would only be recognized for tax purposes (and not for accounting purposes), it is unclear if amortization for tax purposes would be possible. An asset acquisition may still be preferable.
TOKUMEI KUMIAI – CHANGE IN THE TAX TREATMENT
It has been proposed that the tax treatment for tokumei kumiai (TK) profit distributions will be changed from April 1 2002. At present, the precise rules have not been published but elements have become clear from some published materials and from informal discussions with the tax authorities.
The TK partnership structure has been widely used in the area of acquisition of NPLs and real estate but has recently been clouded under tax investigations. For the acquisition structuring of NPLs and real estate, the TK was in the process of being replaced by tokutei mokuteki kaisha (TMKs or special purpose companies) with a main feature that when more than 90% of the distributable profit of the TMK is distributed, such distribution will be tax deductible for corporate income tax purposes. With the change in the rules, the TK may reestablish itself as an important and relatively simple – compared to the TMK – asset acquisition-funding tool.
A TK is a contract establishing a limited partnership between an operator (or general partner), usually a Japanese entity or the Japanese branch of a foreign entity, and one or more investors (limited partners). The investors will only be treated as limited partners as long as they are not involved in the business operated by the operator. Usually, the operator invests only a very small amount whereas the investor(s) commits a substantial investment to the partnership.
Its main feature is that profit distributions from the operator to the investor are effectively tax-deductible for the operator. In cases where the investor is a non-Japanese company, this could reduce the Japanese effective tax rate on the TK profit distribution. Where a TK has 10 or more investors, a 20% withholding tax is already due on profit distributions from the operator. That rule will change to include 20% withholding tax on profit distributions to all TK investors regardless of whether the specific TK has 10 or more investors. The tax will be levied from the gross profit distribution and will be the final tax.
Investors located in certain tax treaty countries may still claim an exemption from this withholding tax, dependent on the tax treaty wording. This would be the case if there were an appropriate 'other income' article in the relevant double tax treaty. Unfortunately, the procedures of how such claims need to be made had not yet been made public at the time this article was written. In addition, invoking this right under the tax treaty is likely to focus the attention of the tax authorities on the particular structure. The Japanese tax authorities have been quite aggressively challenging the use of TKs, especially in cases where no Japanese taxation could be collected from profit distributions to overseas investors. Structuring of transactions using TKs has caused considerable tax audit activity and, it is now assumed, the change of the law. It appears to indicate that, provided the business reasons and economic situation justify it, TK funding could be an option at a cost of 20% withholding tax from the gross profit distributions. Based on the changed law, the TK could become an even more interesting funding mechanism in situations that have, to date, not been considered suitable.
A combination of the acquisition entity (to be included in a consolidated tax filing situation) with group or external debt and with TK funding, may be an effective way to fund an acquisition or restructuring from the perspective of a foreign Japan inbound investor for the following reasons:
the equity-funding component would yield dividend distributions of after-tax profits. Under tax treaties, dividends would usually be subject to withholding taxes at rates of between 0% and 10%;
funding via intra-group loans would give rise to a tax-deductible interest payment (assuming that the 3:1 debt equity ratio has been observed) that is usually subject to 10% withholding tax if paid to tax treaty country residents; and
pre- (Japanese) tax profits distributed on TK funded investments would be subject to 20% withholding tax on a gross basis. The TK funding could be considered a sort of mezzanine financing, more risk than interest but less risk than on capital. A TK should be very carefully structured and be based by commercial considerations. In particular, a high-risk acquisition or a high-risk tranche in an acquisition may be appropriately funded via a TK partnership arrangement.
FINAL COMMENTS
The Japanese economic situation, including restructuring and the clean up of balance sheets, is still very much in development, with domestic companies concentrating on core businesses, both as a strategic choice and as the result of economic hardship. Some companies can no longer survive on their own or at all. Businesses and assets will come on the market, as far as can be predicted, for the foreseeable future. This will give asset and business acquisition opportunities for many domestic and foreign-owned businesses in Japan.
Until not that long ago, few acquisition-structuring options were available for both sellers and acquirers. Fortunately, the legislator is now providing rules that will make restructuring, optimization of the domestic tax position and funding more attractive. These rules may not be perfect as yet, but they are bound to develop over time into more user-friendly tools for transactions and structuring. As all of these rules are new, a balance needs to be found for now to see how the present rules (once they have all been published and become clear in practice) can be optimally used in restructuring and merger and acquisition situations, both for the benefit of the seller and for that of the acquirer.
Shin Nihon Ernst & Young
Hibiya Kokusai Building
20th Floor, 2-2-3
Uchisaiwai-cho Chiyoda-ku, Tokyo 100-0011
Tel: +81 3 3506 2423
Fax: +81 3 3506 2412
