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Japan adopts earnings stripping rules

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As part of the 2012 Tax Reform, Japan adopted earnings-stripping provisions under which a corporation's deduction for net interest expense paid to a related party will be limited to 50% of adjusted income effective for tax years beginning on or after April 1 2013.

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Michael Shikuma


Takeo Mizutani

A related party is any: (i) person with whom the corporation has a 50% of more equity relationship; (ii) person with whom the corporation has a de-facto controlling or controlled relationship; or (iii) third party lender which is financially guaranteed by a person in (i) or (ii). Net interest is the difference between the interest paid to related parties and any interest income which corresponds to such interest paid. Interest paid to related parties includes interest and interest in the form of lease payments or guarantee payments, but excludes back-to-back repo interest and interest paid to a related party lender which is subject to Japan corporation tax. Corresponding interest income includes a pro rata portion of interest income and interest in the form of lease payments received based on the ratio of interest from related parties to total gross interest income, but excludes interest income from resident related parties, domestic corporations, and nonresidents and foreign corporations with a permanent establishment in Japan.

Adjusted income is taxable income to which is added back (or subtracted) net interest expense, depreciation expense, excluded dividend income, and extraordinary loss (or income).

Net interest expense which exceeds 50% of adjusted income is not deductible, but may be carried forward for up to seven years and deducted in such future tax year up to the 50% threshold computed for that tax year. In addition, the unused carryforward amount of a disappearing corporation in a tax qualified merger, or 100% subsidiary in a liquidation, is transferred to the surviving, or parent corporation.

The limitation does not apply if net interest expense for the tax year is ¥10 million ($125,000) or less, or if interest paid to related parties (after deducting back-to-back repo interest, but before deducting corresponding interest income from third parties or nonresidents) is 50% or less of the total interest expense (excluding interest paid to related parties which is subject to corporation tax).

In the case of a corporation which is part of a consolidated group tax filing, the excess of the corporation's net interest (excluding interest of other consolidated group members) over 50% of the adjusted consolidated income, is not deductible.

Where the thin capitalisation interest limitations apply (when the debt-to-equity ratio exceeds 3:1), the deductible interest expense is the lower of the limit under either the thin capitalisation or these earnings stripping rules. If the corporation is subject to the anti-tax haven (controlled foreign corporation) rule, the nondeductible interest paid to the tax haven company (the corporation's foreign subsidiary) is reduced to the extent that the corporation is subject to current tax on the interest income of the tax haven company.

Michael H Shikuma (mshikuma@mofo.com) & Takeo Mizutani (tmizutani@mofo.com)

Morrison & Foerster

Tel:+ 81 3 3214 6522

Website: www.mofo.com

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