Japan: Supreme Court affirms rule of law in Japanese taxation

September 11, 2011

Gary Thomas of White & Case reports on litigation that made clear that the Japanese tax authorities must have a legal basis for making an assessment and not rely on a tax avoidance argument

On February 18 2011, the Japanese Supreme Court issued an important decision which affirmed the principle of the rule of law in Japanese taxation.

To comprehend the importance (and limitations) of the Supreme Court's recent decision, it is necessary first to understand the constitutional, legislative, and enforcement background against which this decision arose.

Article 30 of the Japanese Constitution states that: "(t)he people shall be liable to taxation as provided for by law," while Article 84 provides that "(n)o new taxes shall be imposed or existing ones modified except by law or under such conditions as the law may prescribe."

However, tax law and enforcement in Japan historically have been characterised by laws and orders setting forth the basic rules in relatively simple form, circulars issued by the commissioner of the National Tax Agency to instruct tax examiners how to interpret those rules when necessary, and, in the absence of more detailed criteria, often expansive interpretations of the tax legislation and circulars based upon the tax authorities' own perceptions of pertinent facts.

While Japanese tax legislation itself has the virtue of being relatively uncomplicated as compared with some other countries' tax laws, this has led to the tax authorities exercising considerable enforcement discretion.

The case leading to the recent Supreme Court decision involved the Japanese gift tax, which imposes high rates of tax on gifts received by donees domiciled in Japan. However, if a donee does not have his domicile in Japan (and the gifted assets are not considered to be located in Japan), the Japanese gift tax would not apply.

The donee was a Japanese individual and son of wealthy parents who owned Takefuji, a substantial Japanese consumer finance company. The donee had moved his domicile to Hong Kong from mid-1997, received from his parents in late December 1999 a gift of shares in a Netherlands company (treated as assets located outside Japan) which held the shares of the consumer finance company, and then moved his domicile back from Hong Kong in December 2000. He monitored his time within Japan during this period based upon advice from tax specialists. Japanese tax auditors closely examined the facts concerning his contacts with and activities in Japan and in Hong Kong before, during and after the date of the gift. They concluded both that objective factors supported their position that the donee had failed to transfer his domicile from Japan to Hong Kong and that subjective factors, in particular, his intention to avoid the Japanese gift tax, justified the imposition of the tax. As a result, an assessment of about ¥116 billion ($204 million) plus penalties was issued in March 2005.

In its decision in May 2007, the Tokyo District Court considered the definition of domicile and noted that this term is not defined in the tax law itself, with the result that the definition for tax purposes had to be borrowed from the Japanese Civil Code. Based on the concept of domicile under the Civil Code, the court focused on objective factors, such as the period of time the donee spent, and his actual activities conducted, in both Hong Kong and Japan up to the time of the gift. The court concluded that he had indeed transferred his domicile to Hong Kong before the date of the gift and, as a result, the Japanese gift tax did not apply.

The government appealed to the Tokyo High Court, which in a January 2008 decision focused more on the donee's alleged tax avoidance motives and reversed the Tokyo District Court decision.

The donee subsequently appealed to the Supreme Court. The Second Petty Bench of the Supreme Court decided unanimously in favour of the donee (now, appellant) based upon its reading of the definition of the Civil Code concept of domicile, which it pointed out is the pre-condition for taxation based upon the gift tax. In rejecting the High Court's reasoning focused on tax avoidance motives, the Supreme Court held that unless there are special reasons for a contrary interpretation, the term domicile means the centre of livelihood, in other words, the centre of a person's livelihood where he has the deepest contacts in his life and that it is appropriate to determine whether a specific place is a person's domicile according to whether he had objectively created the substance of a centre of livelihood.

In regard to this case, the court concluded that the objective factors indicated the appellant had established his domicile in Hong Kong by the time of the gift and held that, even if there were tax avoidance motives, this did not eliminate the "objective" substance of his livelihood. The court stated that, if it is considered to be inappropriate to allow the avoidance of the gift tax due to such a long-term absence from Japan, this must be dealt with through legislation because there are limits to interpretation of the law, while also noting that tax reforms implemented in 2005 already had contained necessary measures to deal with this issue. Consequently, the court reversed the High Court and held in favour of the appellant.

Importantly Justice Sudo, the senior judge of the Second Petty Bench, wrote an extensive supplemental opinion in which he not only reiterated the court's holdings but referred directly to articles 30 and 84 of the Japanese Constitution underlying the rule of law in taxation. In particular, he noted that Article 84 requires that the pre-conditions for taxation be set forth in the law and asserted that these pre-conditions be clearly stated and then strictly interpreted. He argued that it is not acceptable to impose taxes easily by denying tax avoidance through special legal interpretations or special recognition of facts, such as expansive interpretations, interpretations by analogy, or application of abuse of rights theories, even if no clear basis for taxation was found.

While many in Japan have heralded this decision as a significant victory for the rule of law, it is not clear what impact it will have on tax enforcement or the tax legislative process.

From a narrow perspective, the decision admonishes the tax authorities to have a clear basis in law before imposing an assessment and not to rely on a tax avoidance motive. However, Japanese tax law includes a number of anti-avoidance rules designed to enable the tax authorities to address specific concerns, including, for example, the substantial income earner rule, the corporate donation rules and provisions permitting the tax authorities to reject acts or computations of so-called family companies, companies engaged in corporate reorganisations, or consolidated corporations, if there is been an unreasonable reduction in corporate taxes. The application of these rules has been upheld in the past and undoubtedly the tax authorities will continue to apply them. Consequently, taxpayers should exercise due care in their planning.

This decision also may encourage the Japanese tax authorities to seek more effective legislation to deal with perceived tax avoidance abuses, possibly including a general anti-avoidance clause designed to satisfy rule of law concerns.

Akira Akamatsu

White & Case

Marunouchi Trust Tower Main

26th Floor 1-8-3 Marunouchi

Chiyoda-ku, Tokyo 100-0005

Japan

Tel: + 81 3 6384 3125

Fax: + 81 3 6384 3300

Email: aakamatsu@whitecase.com

Website: www.whitecase.com

Akira Akamatsu is a White & Case partner specialising in international taxation. Before joining the firm, Akira served at the National Tax Agency (NTA) National Office and the Tokyo Regional Taxation Bureau from 1975 to 1990. His position, before joining White & Case, was NTA International Examination Section Chief.

Akira is registered as a Japanese zeirishi (licensed tax attorney). His practice is focused specifically on transfer pricing taxation, taxation of permanent establishments, cross-border M&A, anti-tax haven regulations (Japanese controlled-foreign-corporation regulations), foreign tax credits, and tax treaty interpretation. He is mainly involved in consulting and managing tax examinations, tax disputes, competent authority consultations under tax treaties and advance pricing agreements (APAs).

Akira has lectured both in Japan and overseas. He is also widely published and his articles have appeared in major Japanese and international tax journals. He was also honoured with a special award from the Japanese Tax Institute for his book "International Tax Principles and Japanese International Tax Law" (Zeimu Kenkyukai, 2001). His other works include Kokusai Kazeino Jitsumuto Riron-Global Economy and Tax Laws [Theory and Practice of International Taxation-Global Economy and Tax Laws] (Zeimu Kenkyukai, 2009, Second Edition). He also co-authored Chiteki Zaisan Zeimu Senryaku [Intellectual Property Taxation Strategies] (Zeimu Keiri Kyokai, 2007).

Akira has also authored various articles concerning international taxation; and he is co-author of the BNA portfolio on Japanese transfer pricing.

He can appear in the National Tax Tribunal and is a member of the Tokyo Zeirishikai (Licensed Tax Attorneys Association). He is a doctor of law from Hitotsubashi University, Tokyo in 2000.

He speaks English and Japanese, and is a Japanese citizen.

Gary Thomas

White & Case

Marunouchi Trust Tower Main

26th Floor 1-8-3 Marunouchi

Chiyoda-ku, Tokyo 100-0005

Japan

Tel: + 81 3 6384 3190

Fax: + 81 3 6384 3300

Email: gthomas@tokyo.whitecase.com

Website: www.whitecase.com

Gary Thomas is head of the firm's global tax practice. He concentrates on international tax planning and tax controversies. He is registered as a Japanese zeirishi (licensed tax attorney), fully qualified to practise before the National Tax Agency (NTA) and the National Tax Tribunal, the only US tax lawyer with such qualifications. He has worked in Japan for more than 25 years and is fluent in spoken and written Japanese. Gary is also a member of the California Bar and is registered in Japan as a gaikokuho jimu bengoshi.

Tetsuya Bessho

Ernst & Young Shinnihon Tax

Atsushi Fujieda

Nagashima Ohno & Tsunematsu

Yushi Hegawa

Nagashima Ohno & Tsunematsu

Akihiro Hironaka

Nishimura & Asahi

Naoki Idei

Kojima Law Offices – Taxand

Kaori Itano

Artisan Tax Advisors