The Journal The Authority on Global Business in Japan

Japan’s tax haven rules, also known as controlled foreign cor­poration (CFC) rules, have undergone many changes in recent years. The last major changes were announced in 2017 and took effect for fiscal years beginning on or after April 1, 2018.

Broadly speaking, if a resident of Japan—together with their related parties—controls a company located in a low-tax jurisdiction overseas, Japanese tax law will seek to attribute the taxable income of that company back, either fully or par­tially, to the Japanese shareholder.

A low-tax jurisdiction is one in which the headline corporate tax rate is lower than 20 percent (30 percent for certain types of paper companies, those which are properly registered but are essentially non-operating and have nominal or zero assets). These jurisdictions include the United Kingdom, Ireland, and Singapore, with others potentially being added to the list given the current business climate in which governments compete to attract multinational businesses.

The details of the regulations are too complex for an article of this nature, but the differences in business practices between Japan and other jurisdictions can create unexpected tax consequences.

The rules contain tests of economic activity to exempt otherwise bona fide companies from being subject to full attribution of their income. A company in a low-tax jurisdiction that passes all the tests will only be subject to attribution of certain types of passive income. But even this attempt to limit the scope can lead to unwanted surprises.

Take the United Kingdom, for example. A common structure is to have a holding company oversee a group of subsidiaries, with tax losses being transferred around the group according to the country’s group relief system. A management charge is paid by the subsidiaries to cover the cost of maintaining the holding company. It is common for the directors of this holding company to also be officers of the subsidiaries, and for the office premises to be shared by companies in the group.

Although this is a typical arrangement in the United Kingdom, it can cause companies to fail the test for local management and control as well as the local business test under Japan’s tax haven rules. A company that does not have its own separate directors will fail the local management and control test. And it will fail the local business test if only one company pays the office rent and the others are not charged, or do not use the office space for their own business purposes.

As a result, an otherwise unremarkable structure with bona fide operating companies can cause the full amount of a company’s taxable income to be attributed to the Japanese shareholder.

Also, the treatment of losses through group relief is not speci­fically dealt with in the legislation. It is likely, however, that these losses will be added back and the taxable income—before group relief—will be attributed back to the Japan shareholder.

Finally, it should be noted that the 11 types of passive income subject to inclusion—for companies that meet the economic activities tests—include a final catch-all category labeled “excess residual profits.” It is designed to catch companies that generate large amounts of income from relatively few assets and personnel.

This can create headaches for two reasons:

  • Income that would not otherwise be classified as passive can suddenly fall within the scope for attribution.
  • When calculating starting profits for this category, it is unclear whether Japanese or local accounting rules should be followed.

This grey area makes compliance with already-complex regulations more difficult.

Tax haven rules apply to Japanese resident shareholders, both corporate and individual. If you control an offshore company, you should seek professional advice from your tax advisors to ensure no unexpected consequences are lurking come tax season.

Adrian Castelino-Prabhu is a principal at Grant Thornton specializing in international inheritance/gift taxation for high-net-worth individuals as well as tax advice for corporations looking to enter the Japan market.