Japan - Taxation of cross-border M&A | KPMG | GLOBAL

Japan - Taxation of cross-border mergers and acquisitions

Japan - Taxation of cross-border M&A

This report provides insight into tax issues that need to be considered when considering mergers and acquisitions (M&A) in Japan.

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Introduction

This report provides insight into tax issues that need to be considered when considering mergers and acquisitions (M&A) in Japan.

Recent developments

Japan has been reducing corporate income tax rates for the last few years. The effective corporate tax rate has dropped to about 30 percent. To make up for the lost tax revenues, various countermeasures have been introduced, including a limitation on the amount of tax-deductible losses carried forward in a year.

In addition, the consumption tax rate rose to 8 percent (from 5 percent) on 1 April 2014 and is scheduled to increase to 10 percent on 1 October 2019.

Asset purchase or share purchase

The following sections discuss issues that need to be considered from a Japanese tax perspective when considering a purchase of either assets or shares. The advantages and disadvantages of each alternative are summarized at the end of this report.

Purchase of assets

In an asset deal, the selling entity realizes a gain or loss in the amount of the difference between the sale price and the tax book value of the assets sold, and the assets have a new base cost in the buyer’s hands.

Purchase price

For tax purposes, in an asset deal, the purchase price is among individual assets based on their market values. In a purchase of a business, the excess of the purchase price over the total of the values allocated to each individual asset is treated as goodwill for tax purposes. Any excess of the total of values of the individual assets over the purchase price is negative goodwill for tax purposes.

Goodwill

For tax purposes, goodwill recognized in a purchase of business should be amortized over 5 years (20 percent of the base cost annually). The amortization is deductible. Negative goodwill should also be amortized over 5 years (20 percent of the base cost annually), and the amortization should be treated as taxable. Unlike the depreciation of tangible assets or the amortization of intangible assets explained later in this report, the amortization of goodwill or negative goodwill recognized in a purchase of business for tax purposes is not affected by the accounting treatment.

Depreciation

Generally, a company may select either the straight-line or declining-balance method to compute the depreciation of each class of tangible assets. The default depreciation method for most assets is the declining balance method. For buildings and certain leased assets, the straight-line method must be used. Intangible assets also must be amortized using the straight-line method.

The depreciation and amortization allowable for tax purposes is computed based on the statutory useful lives of the assets provided in a Ministry of Finance ordinance. For second-hand assets, shorter useful lives could be applied.

The depreciation or amortization must be recorded in the statutory books of account to claim a tax deduction. The amount of depreciation or amortization exceeding the allowable limit for tax purposes must be added back to the profits in calculating taxable income. If the book depreciation or amortization amount is less than the allowable amount for tax purposes, no adjustment is required, and the asset’s useful life is effectively extended for tax purposes.

Tax attributes

Tax losses and other tax attributes are not transferred to the buyer in an asset deal.

Value added tax

Japanese consumption tax, similar to valued added tax (VAT), is levied on a sale or lease of an asset and supply of service in Japan. The current consumption tax rate is 8 percent. Certain transactions are specifically excluded, such as sales of land and securities. A sale of business in Japan is treated as a sale of individual assets for consumption tax purposes and should be subject to consumption tax, depending on the type of asset transferred. A sale of goodwill in Japan is taxable for consumption tax purposes.

When the consumption tax rate rises to 10 percent (from 8 percent) on 10 October 2019, a multiple tax rate system will be introduced, applying a reduced rate of 8 percent to sales of Food/beverages (excluding alcoholic beverages) and certain newspapers under subscription contracts.

Transfer taxes

Stamp duty is levied on business transfer agreements, with the stamp duty determined according to the value stated in the agreement. The maximum amount of stamp duty is 600,000 Japanese yen (JPY).

If real estate is transferred in a business transfer, registration tax and real estate acquisition tax are levied.These taxes are subject to a number of temporary reductions and reliefs, and the tax rates differ depending on the type of acquiring entity (e.g. trust, special-purpose vehicle). Where the acquiring entity is an ordinary corporation, registration tax is levied in principle at 2 percent of the property’s appraised value. For land, the tax rate is reduced to 1.5 percent until 31 March 2019.

Real estate acquisition tax is levied at 4 percent of the appraised value of the property. This rate is reduced to 3 percent until 31 March 2018 for land and residential buildings. Further, when land is acquired by 31 March 2018, its tax base is reduced by 50 percent.

Purchase of shares

In a share purchase, the buyer does not achieve a step-up of the base cost of the target company’s underlying assets.

Tax indemnities and warranties

In a share purchase, the buyer takes over the target company’s liabilities, including contingent liabilities. In negotiated acquisitions, the buyer usually requests, and the seller provides, indemnities or warranties for any undisclosed tax liabilities of the target company. The extent of the indemnities and warranties is a matter for negotiation. When an acquisition is made by way of a hostile takeover, the nature of the acquisition makes it impossible to seek warranties or indemnities.

Tax losses

Tax losses may be carried forward for 9 years (10 years for losses incurred in fiscal years beginning on or after 1 April 2018).

The deductible amount of tax losses is limited to 55 percent (50 percent for fiscal years beginning on or after 1 April 2018) of taxable income for the fiscal year.

For small and medium-sized companies and tax-qualifying Tokutei Mokuteki Kaisha (TMK) and Toushi Hojin (TH), etc., tax losses are deductible up to the total amount of taxable income for the year.

For Japanese corporate tax purposes, there is no distinction between revenue income and capital income. Restrictions could apply on the carry forward of losses where more than 50 percent of the ownership of a company with unused tax losses changes hands. These restrictions only apply where, within 5 years after the change of ownership, one of several specified events occurs, such as the acquired company ceases its previous business and starts a new business on a significant scale compared to the previous business. Japanese tax law also provides for a tax loss to be carried back for 1 year at the option of the taxpaying company. This provision was suspended as of 1 April 1992, except in certain situations, such as dissolution and for small and medium-sized companies.

Crystallization of tax charges

If the target company belonged to a 100 percent group, deferred gains and losses of the target company relating to transfers of assets to other entities within the 100 percent group crystallize in the target company when the target company leaves the 100 percent group as a result of the acquisition.

Pre-sale dividend

Where the seller is a Japanese corporation, the seller may prefer to receive part of the value as a pre-sale dividend rather than sale proceeds. Capital gains from the sale of shares are subject to corporate tax at approximately 30 percent.

However, domestic dividend income less interest expenses deemed incurred for holding the shares (net dividend income) is exempt from corporate tax, provided the Japanese seller corporation held more than one third of the Japanese target company. A 20 percent exemption applies for shareholdings of 5 percent or less, and a 50 percent exemption applies in all other cases. Domestic dividend income received within a 100 percent group is entirely excluded from taxable income without deducting interest expenses attributable to the dividend.

Transfer taxes

No stamp duty is levied on the transfer of shares. However, if the target issues share certificates for transfer, stamp duty applies to the certificates’ issuance. The amount of stamp duty depends on the stated value of the certificate, to a maximum liability per share certificate of JPY20,000.

Tax clearances

It is not necessary to obtain advance clearance from the tax authorities for acquisitions or disposals of shares. For complex or unusual transactions, the parties may decide to seek a ruling from the tax authorities (generally, verbal) to confirm the proposed tax treatment.

Choice of acquisition vehicle

The following vehicles may be used for an acquisition by a foreign buyer. When establishing an ordinary domestic company (Kabushiki Kaisha or Godo Kaisha), registration tax is charged at 0.7 percent of share capital (not including capital surplus), while establishing a branch of a foreign company is generally subject to registration tax of JPY90,000.

Local holding company

If the buyer wishes to offset financing costs for the acquisition against the Japanese target company’s taxable income, a Japanese holding company may be set up as an acquisition vehicle.The offset would be achieved through either a tax consolidation, which allows an offset of losses of one company against profits of other companies in the same group, or a merger.The tax consolidation system in Japan is explained in the section on ‘Other considerations’ later in this report. For discussion of the tax implications of a merger, see ‘Equity’.

Foreign parent company

If the foreign buyer wishes to offset the financing costs for the acquisition against its own taxable profits, the foreign buyer may choose to acquire the Japanese target company directly. In this case, the Japanese tax implications should be considered for dividends from the target company to the foreign parent company and for capital gains to be realized when the foreign parent company disposes of the target company in the future.

Japanese withholding tax (WHT) is imposed on dividends paid by a Japanese non-listed company to its foreign shareholders at the rate of 20 percent under Japanese domestic law. Reduced rates are available under Japan’s tax treaties. A special reconstruction income tax is imposed on WHT at 2.1 percent from 2013 to 2037, except for cases where the WHT rate is reduced under a tax treaty.

Capital gains from the sale of shares in a Japanese company by a foreign corporate shareholder without a permanent establishment in Japan are subject to Japanese national corporation tax where:

  • the foreign shareholder and its related parties owned 25 percent or more of the outstanding shares at any time during the previous 3 years, including the year of sale, and sold 5 percent or more of the outstanding shares of the Japanese company in a specific accounting period
  • more than 50 percent of the Japanese company’s total property consists of real estate located in Japan on a fair market value basis.

Some of Japan’s tax treaties exempt foreign shareholders from taxation on capital gains in Japan.

Non-resident intermediate holding company

If the foreign parent company could be subject to significant tax in Japan and/or its home country if it directly holds the Japanese target company, an intermediate holding company in another country could be used to take advantage of benefits of tax treaties. However, interposing an intermediate holding company for the sole purpose of enjoying tax treaty benefits could be regarded as treaty shopping and application of the treaty could be disallowed. The Japanese government has recently been updating its tax treaties, and many now contain limitation on benefits (LOB) and principal purpose test (PPT) clauses.

Local branch

A foreign corporation operating in Japan through a branch is liable for corporate income taxes only on the income attributable to the branch, which is calculated in line with the Authorized OECD Approach (AOA). Generally, there is no material difference in the tax treatment of a branch of a foreign corporation and a corporation organized under Japanese law. The methods for computing taxable income, tax-deductible provisions and reserves, limitations on allowable expenses (e.g. entertainment expenses and donations) and corporate income tax rates are the same for both a branch and a corporation.

Joint venture

A joint venture generally is either a Japanese corporation with joint venture partners holding shares in the Japanese corporation or a Nin-i Kumiai (NK, similar to a partnership) with joint venture partners holding interests in the NK. In Japan, an NK is not recognized as a separate taxable entity and the partners are liable for Japanese tax on the basis of their share of profits under an NK agreement and in accordance with their own Japanese tax status.

Choice of acquisition funding

Debt

Interest paid or accrued on debt, including an intercompany loan, generally is deductible for the paying corporation, but there are exceptions, particularly for an intercompany loan from a foreign shareholder or affiliate.

Deductibility of interest

The thin capitalization rule restricts the deductibility of interest payable by a Japanese subsidiary to its overseas controlling shareholders or affiliates. The safe harbor is the debt-to-equity ratio of 3:1. Where loans from the overseas controlling shareholders or affiliates cause the ratio to be exceeded, interest expenses calculated on the excess debt are not deductible for Japanese corporation tax purposes.

Third-party debts may also be subject to the thin capitalization rule, including:

  • back-to-back loans from overseas controlling shareholders through third parties
  • debts from a third party with a guarantee by overseas controlling shareholders
  • debts from a third party provided through bonds borrowed from overseas controlling shareholders as collateral for the debts.

In lieu of the 3:1 ratio, a company may use the debt-to-equity ratio of a comparable Japanese company where a higher ratio is available.

In addition, an earnings-stripping rule aims to prevent tax avoidance by limiting the deductibility of interest paid to related persons where it is disproportionate to income. Under the rule, where ‘net interest payments to related persons’ exceed 50 percent of ‘adjusted taxable income’, the excess interest expense is disallowed and can be carried forward for up to 7 years.

Interest paid to overseas shareholders or affiliates should also be reviewed from a transfer pricing perspective. Withholding tax on debt and methods to reduce or eliminate it Under Japanese tax law, the WHT rate on interest payable to a non-resident is 20 percent. A special reconstruction income tax is imposed on WHT at 2.1 percent from 2013 to 2037, except where the WHT rate is reduced under a tax treaty.

To obtain the reduction of Japanese WHT under a tax treaty, the recipient or their agent should submit an application form for relief from Japanese income tax to the competent authority’s tax office through the payer corporation before the date of payment.

Checklist for debt funding

  • Consider whether interest should be treated as fully deductible from a thin capitalization/earnings stripping perspective.
  • Consider whether interest should be treated as fully deductible from a transfer pricing perspective.
  • The use of bank debt may avoid thin capitalization and transfer pricing problems unless there are back-to-back arrangements or guarantees by a related party.
  • Consider whether the level of profits would enable tax relief for interest payments.
  • WHT of 20 percent (and the special reconstruction income tax imposed on WHT at 2.1 percent from 2013 to 2037) applies on interest payments to foreign entities unless a lower rate applies under a tax treaty. To apply a treaty rate, an application form must be submitted to the tax office before making the payment.

Equity

Dividends paid by an ordinary Japanese company are not deductible. Under domestic law, WHT is imposed on dividends paid by a Japanese company to its foreign shareholders at 20 percent. WHT on dividends from certain listed companies is reduced to 15 percent. Reduced tax rates are available under Japan’s tax treaties — see the table of treaty withholding tax rates at the end of this report.

Bear in mind the special reconstruction income tax imposed on WHT at 2.1 percent from 2013 to 2037, except where the WHT rate is reduced under a tax treaty.

Japanese corporate tax law provides for a specific regime for corporate reorganizations, summarized in the next section.

Tax-qualified versus non-tax-qualified reorganizations

The corporate reorganization regime provides definitions of ‘tax-qualified’ and ‘non-tax-qualified’ reorganizations for the following transactions:

  • corporate division (spin-off and split-off)
  • merger
  • contribution in kind
  • share-for-share-exchange (kabushiki-kokan) or share transfer (kabushiki-iten)
  • squeeze-out
  • dividend in kind
  • share dividend.

Under a tax-qualified reorganization, assets and liabilities are transferred at tax book value (i.e. recognition of gains/ losses is deferred) for tax purposes, while under a non-tax- qualified reorganization, assets and liabilities are transferred at fair market value (i.e. capital gains/losses are realized) unless the reorganization is carried out among a 100 percent control relationship. Where a share-for-share-exchange, share transfer or squeeze-out is carried out as a non-tax-qualified reorganization, built-in gains and losses in assets held by the subsidiaries are crystallized, although assets and liabilities are not transferred and remain in the subsidiary unless the parent company and the subsidiaries had a 100 percent control relationship.

The table below outlines the general conditions required for a tax-qualified merger:

Relationship Conditions

(1) 100 percent control relationship

(a) Only shares in the surviving company are distributed as consideration for the transfer (no-boot requirement — see below).
(b) The 100 percent control relationship is expected to remain.
 
(2) More than 50 percent control relationship
(a) Same as (1)-(a)
(b) The more than 50 percent control relationship is expected to remain.
(c) Approximately 80 percent or more of directors and employees of the merged company are expected to be engaged in the business of the surviving company.
(d) The surviving company is expected to continue to operate the main business of the merged company
(3) 50 percent or less relationship (a) Same as (1)-(a), (2)-(c) and (d)
(b) One of the main businesses of the merged company has a relationship with one of the businesses of the surviving company.
(c) The relative business size (i.e. sales, number of employees, etc.) of the related businesses is not considerably different (within a 1:5 ratio), or at least one of the senior directors from both the merging company and surving is expected to become a senior director of the surviving company after the merger.
(d) Where one of the shareholders of the merged company held more than 50% of the shares in the company before the merger, that shareholder is expected to continue to hold the shares in the surviving company received due to the merger.

Source: KPMG in Japan, 2018

For the no-boot requirement discussed in (1)-(a):

  • In a triangular merger, where shares in the parent company that directly holds 100 percent of the shares in the surviving company are distributed instead of shares in the surviving company, the no boot requirement is satisfied in principle.
  • Where the surviving company held more than two-thirds of the shares in the merged company before the merger, even if minority shareholders receive boot, the no-boot requirement is not jeopardized (the 2/3 exceptional rule).

Pre-reorganization losses

Under a tax-qualified merger, where certain conditions are met, pre-merger losses are transferred from the merged company to the surviving company. Otherwise (i.e. under a non-tax-qualified merger or other tax qualified merger that does not satisfy certain conditions), such losses cannot be transferred.

Where the merger is tax-qualified, pre-merger losses incurred in the surviving company can be used against future profits after the reorganization, where certain requirements are met. There are no such requirements for non-tax-qualified mergers. This rule also applies to pre-reorganization losses incurred in the transferee company in the case of a corporate division and contribution in kind.

A number of rules restrict the use of built-in losses after a reorganization in certain circumstances.

Taxation of shareholders

When the shareholders receive only shares in the transferee company or only shares in the parent company of the transferee company (in triangular reorganizations), capital gains and losses from the transfer of the shares are deferred in principle. In a merger, split-off or share-dividend, where the reorganization is non-tax qualified, the shareholders of the transferor company recognize a deemed receipt of dividends.

Hybrids

Hybrid instruments are deemed to be either shares, which are treated as equity, or debt, which is subject to the accrual rules. The major types of instruments and their treatment for tax purposes are as follows:

Type Treatment
Convertiblebonds Debt, subject to accrual rules
Perpetualdebt Debt, subject to accrual rules
Subordinated debt Debt, subject to accrual rules
Preferenceshares Equity

Source: KPMG in Japan, 2018

Discounted securities

Generally, the issuer of discounted securities obtains a tax deduction for the discount accruing over the life of the securities, while the lender recognizes taxable income accruing over the life of the securities. However, the tax treatment of discounted securities could be different, and each case should be analyzed on its facts.

Deferred settlement

Earn-out arrangements that defer part of the consideration and link its payment to the performance of the acquired business are not uncommon in acquisitions. Generally, the seller recognizes gains as they are realized, but the tax treatment of such a deferred settlement varies case-by-case, and each case should be analyzed on its facts.

Other considerations

Concerns of the seller

The seller’s concerns or preferences about how to structure the deal are affected by various factors, including the seller’s tax position and whether it is an individual or corporation. For example, where the seller is a Japanese resident individual, capital gains from the sale of shares of a Japanese non- listed company are taxed at 20 percent (15 percent income tax and 5 percent inhabitant tax, plus 2.1 percent th special reconstruction income tax imposed on the income tax liability from 2013 to 2037.

Where the Japanese non-listed company in which the Japanese individual holds shares sells assets and distributes the sale proceeds as a dividend to the shareholder, generally, the company is subject to corporate tax at approximately 30 percent on the gains from the sale of assets. The shareholder then is subject to income tax on dividend income distributed out of the company’s after-tax profits at a maximum of approximately 55 percent. In this case, a Japanese individual seller may prefer a share deal to an asset deal. The position is not straightforward, and professional advice should be sought.

Group relief/consolidation
Consolidated tax return filing system

A group of companies may elect to file consolidated tax returns. A group is made up of a Japanese parent company and its 100 percent directly or indirectly owned Japanese subsidiaries. Non-Japanese companies are excluded from the consolidated group. To become a consolidated group, an election needs to be made to the tax office in advance. The tax consolidation system is applicable to national corporation tax only, and each company in a consolidated group is required to file local tax returns individually.

Consolidation allows for the effective offset of losses incurred by one company against profits of other companies in the same group. Consolidated tax losses can be carried forward and offset against future consolidated profits for up to 9 years (10 years for losses incurred in fiscal years beginning on or after 1 April 2018).

In principle, losses incurred by subsidiaries before joining the consolidated group expire on joining, but there are exceptions. Prior losses incurred by certain subsidiaries (e.g. a subsidiary held by the parent for over 5 years) may be utilized by the consolidated group up to the amount of post-consolidation income generated by the subsidiary.

At the time of joining a consolidated group, a subsidiary is required to revalue its assets to fair market value and recognize taxable gains or losses from the revaluation for tax purposes except in certain cases, including where the subsidiary has been held by the parent company for over 5 years.

Group taxation regime

The group taxation regime automatically applies to certain transactions carried out by Japanese companies belonging to a 100 percent group (i.e. a group of companies that have a direct or indirect 100 percent shareholding relationship), including a tax-consolidated group. In principle, the group taxation regime applies only to transactions between Japanese companies in a 100 percent group.

Capital gains/losses arising from a transfer of certain assets (e.g. fixed assets, securities, monetary receivables and deferred charges excluding those whose tax book value just before the transfer is less than JPY10 million) within a 100 percent group are deferred. The deferred capital gains/ losses are realized by the transferor company, for example, where the transferee company transfers the assets to another person or where the transferor or transferee company leaves the 100 percent group.

Donations between companies in a 100 percent group are not taxable income for the recipient company and are a non- deductible expense for the company paying the donation.

Domestic dividends paid between companies in a 100 percent group are fully excluded from taxable income without deduction of associated interest expenses. In the case of dividends in kind paid in a 100 percent group, no capital gains/losses from the transfer of assets are recognized (tax-qualified dividend in kind).

In certain cases, including where a company repurchases its own shares from another company in a 100 percent group or where a company liquidates and distributes its assets to another company in a 100 percent group, the shareholder company does not recognize capital gains/losses on surrendering the shares. Tax losses of the liquidated company may be transferred to its shareholder company on liquidation.

Transfer pricing

Japan’s domestic transfer pricing legislation aims to prevent tax avoidance by companies through transactions with their foreign related companies. Generally, the tax authorities require all intragroup transactions to be carried out in accordance with the arm’s length principle.

By virtue of the 2016 tax reform, a three-tiered approach (local file, master file and country-by-country file) was adopted based on the OECD’s final recommendations under its Action Plan on Base Erosion and Profit Shifting (BEPS).

Foreign investments of a local target company

The Japanese CFC regime was amended under the 2017 tax reform. The new CFC regime applies for fiscal years beginning on or after of a controlled foreign company (CFC), which is a foreign company of which more than 50 percent is held by Japanese residents or a foreign company that has a de facto control relationship with Japanese residents.

Under the new CFC regime, where a Japanese parent company holds at least 10 percent of the shares in a CFC, the Japanese parent company is required to include its proportionate share of the income of the CFC in its taxable income. The scope of income of a CFC to be included depends on the characteristics and the effective tax rate of the CFC:

  • Where a CFC is a ‘specified CFC’ (i.e. a paper company, a cash-box company or a company whose head office is located in a black-list jurisdiction) and the effective tax rate of the CFC is less than 30 percent, the entire income of the CFC is included in taxable income of its Japanese parent company.
  • Where a CFC is not a specified CFC and does not satisfy the economic activity tests and the effective tax rate of the CFC is less than 20 percent, the entire income of the CFC is included in taxable income of its Japanese parent company.
  • Where a CFC is not a specified CFC and satisfies the economic activity tests and the effective tax rate of the CFC is less than 20 percent, only passive income of the CFC is included in taxable income of its Japanese parent company.

Comparison of asset and share purchases

Advantages of asset purchases

  • Goodwill may be recognized and amortized for tax purposes.
  • Fixed assets may be stepped-up and depreciated or amortized for tax purposes (except for land).
  • No previous liabilities of the target company are inherited.
  • Possible to acquire only part of a business.

Disadvantages of asset purchases

  • Capital gains, including those arising from goodwill, are taxable for the seller, so the price could be higher.
  • Real estate acquisition tax and registration tax are imposed.
  • Consumption tax (VAT) arises on certain asset transfers.
  • Benefit of any losses incurred by the target company remains with the seller.

Advantages of share purchases

  • Legal procedures and administration may be simpler, making this more attractive to the seller and thus reducing the price. Buyer may benefit from tax losses of the target company.
  • No consumption tax (VAT) is imposed.
  • Where the seller is non-Japanese, Japanese tax on capital gains from the sale of shares in the Japanese target company could be exempt, depending on Japan’s tax treaty with the country in which the seller is located.
  • Buyer may gain the benefit of existing supply and technology contracts and licenses or permissions.

Disadvantages of share purchases

  • Liable for any claims or previous liabilities of the target company.
  • No deduction is available for the purchase price.
  • Step-up of the target company’s underlying assets is not possible. Amortizable goodwill is not recognized.

KPMG in Japan

Yuichi Komakine
KPMG Tax Corporation
Izumi Garden Tower 6-1
Roppongi 1-Chome
Minato-ku
Tokyo 106-6012
Japan

T: +81 3 6229 8190
E: yuichi.komakine@jp.kpmg.com

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