Japanese Corporate Tax on Outbound Investment: Understanding Tax Deferral and the Foreign Subsidiary Dividend Exemption

When Japanese corporations expand their operations globally, a fundamental strategic decision involves the choice of legal structure for their foreign ventures. Opting to establish a foreign subsidiary, as opposed to operating through a foreign branch, carries distinct Japanese corporate tax implications, particularly concerning the profits earned by these overseas entities. Two key concepts dominate this landscape: tax deferral on unrepatriated profits and the foreign subsidiary dividend exemption system. Understanding these is crucial for grasping how Japan taxes the foreign income of its multinational enterprises.

1. Outbound Investment: Branch vs. Subsidiary - The Initial Tax Divide

Before delving into the specifics of subsidiary taxation, it's useful to briefly contrast it with a foreign branch structure from the perspective of a Japanese parent company:

• Foreign Branch: If a Japanese domestic corporation operates abroad through a branch, that branch is considered an integral part of the Japanese corporation. Consequently, the profits (and losses) generated by the foreign branch are immediately included in the Japanese parent company's worldwide taxable income for Japanese corporate tax purposes. Relief from double taxation on the branch's income taxed in the foreign country is typically provided through Japan's foreign tax credit system.
• Foreign Subsidiary: When a Japanese corporation establishes a subsidiary in a foreign country (e.g., incorporates a local company under the laws of that country), this subsidiary is generally treated as a separate legal and taxable entity distinct from its Japanese parent. This separation is the basis for the principle of tax deferral.

2. The Principle of Tax Deferral (課税繰延 - Kazei Kurinobe)

For Japanese corporate tax purposes, profits earned by a foreign subsidiary are generally not immediately taxed in the hands of the Japanese parent company as long as those profits are retained within the foreign subsidiary and not distributed. This is known as tax deferral.

The rationale is that the foreign subsidiary, being a separate legal entity and a non-resident of Japan from Japan's perspective, is primarily subject to tax in its own country of residence on its earnings. Japanese tax on those earnings at the parent level is deferred until the profits are repatriated to Japan, typically in the form of dividends. This deferral principle has been a longstanding feature of many international tax systems, allowing profits to be reinvested and accumulated offshore without triggering immediate home country taxation for the parent.

This differs significantly from a branch structure, where the absence of a separate legal entity means profits are taxed in Japan as they are earned by the branch. The choice between these structures can, therefore, be influenced by whether a Japanese company anticipates initial losses (which a branch structure might allow to be offset against domestic profits) or sustained profits that it wishes to reinvest abroad without immediate Japanese taxation.

3. The Shift to a Dividend Exemption System (外国子会社配当益金不算入制度)

While deferral applies to retained earnings, the crucial question becomes how profits are taxed when they are repatriated from the foreign subsidiary to the Japanese parent, usually as dividends.

Prior to the 2009 tax reforms, Japan employed an indirect foreign tax credit system for such dividends. Under this system, the Japanese parent would include the dividend received in its taxable income and could then claim a credit not only for any foreign withholding tax on the dividend but also for a portion of the underlying foreign corporate income tax paid by the subsidiary on the profits from which the dividend was paid.

However, the 2009 tax reforms brought about a fundamental change, largely replacing the indirect foreign tax credit mechanism with a foreign subsidiary dividend exemption system (外国子会社配当益金不算入制度 - gaikoku kogaisha haitō ekikin fusannyū seido), governed by Article 23-2 of the Corporation Tax Act.

The primary policy objectives behind this shift included:

• Reducing the tax burden on repatriated foreign earnings, thereby encouraging Japanese companies to bring profits back to Japan for domestic investment or distribution to their own shareholders.
• Simplifying the system compared to the complexities of the indirect foreign tax credit calculation.
• Aligning Japan's system more closely with the participation exemption systems prevalent in many other developed countries, thus enhancing the international competitiveness of Japanese multinational corporations.

4. Mechanics of the Foreign Subsidiary Dividend Exemption

Under the current system, 95% of dividends received by a Japanese domestic corporation from a qualifying foreign subsidiary are excluded from the parent company's taxable income in Japan. The remaining 5% of the dividend is effectively kept within the taxable income base. This 5% inclusion is notionally intended to cover a portion of the expenses incurred by the Japanese parent company that might be associated with earning the (otherwise exempt) foreign dividend income, acting as a simplified deemed expense disallowance.

Eligibility Requirements for a "Qualifying Foreign Subsidiary"

For a dividend to qualify for this 95% exemption, it must be received from a "foreign subsidiary" (外国子会社 - gaikoku kogaisha) that meets specific criteria:

• Shareholding Threshold: The Japanese domestic corporation must generally own 25% or more of the total issued shares (or capital contribution) of the foreign subsidiary. This ownership can be determined by either the number of shares or the value of the shares/capital held.
• Holding Period: The Japanese parent must have held the qualifying shareholding for a continuous period of at least six months immediately prior to the date on which the obligation to pay the dividend becomes fixed (i.e., the dividend determination date).
• Other Conditions: Additional detailed requirements may be stipulated by Cabinet Order.

It is important to note that the 25% shareholding threshold can be modified by applicable tax treaties. Some of Japan's tax treaties may reduce this threshold for the purpose of applying certain treaty benefits related to intercompany dividends, potentially to 10% or another figure, if the treaty explicitly links to or influences the conditions for domestic dividend exemption. For instance, the Japan-U.S. tax treaty, in its provisions for eliminating withholding tax on certain intercompany dividends, refers to ownership percentages that might interact with these domestic rules.

Treatment of Foreign Withholding Taxes on Exempt Dividends

A crucial consequence of the dividend exemption system is the treatment of foreign withholding taxes levied by the subsidiary's country of residence on the dividend payment:

• If the dividend received by the Japanese parent qualifies for the 95% exemption, any foreign withholding tax imposed on that dividend is generally neither creditable nor deductible for Japanese corporate tax purposes (Corporation Tax Act Art. 69, para. 1, referring to exclusions from creditable foreign taxes in Cabinet Order Art. 142-2, item 7, no. 3; and Corporation Tax Act Art. 39-2 for non-deductibility).
  Since the dividend income itself is largely exempt from Japanese tax, allowing a credit or deduction for foreign taxes on that exempt income would be inconsistent with the system's design.

Anti-Hybrid Mismatch Rule

To address international tax avoidance schemes involving hybrid financial instruments or entities, a significant amendment was introduced effective from 2015. If a dividend received from a foreign subsidiary is deductible for corporate income tax purposes in the subsidiary's country of residence (e.g., payments on certain types of hybrid instruments that are treated as debt in the subsidiary's country but equity in Japan), such "deductible dividends" are excluded from the scope of the Japanese dividend exemption system (Corporation Tax Act Art. 23-2, para. 2, as amended). This rule aims to prevent situations where a payment is deducted in the payer's jurisdiction and exempt in the recipient's jurisdiction, leading to double non-taxation.

5. Impact of the Dividend Exemption on Corporate Behavior

The shift from an indirect credit system to a dividend exemption system has had noticeable effects on the tax planning and behavior of Japanese multinational corporations:

• Reduced "Lock-Out" Effect: The exemption system generally reduces the Japanese tax cost of repatriating foreign profits. This mitigates the "lock-out" effect where companies might otherwise prefer to keep profits offshore to avoid further home country taxation upon distribution.
• Increased Focus on Foreign Tax Efficiency: Since the underlying foreign corporate tax paid by the subsidiary and the withholding tax on the dividend are no longer creditable against Japanese tax when the dividend is exempt, Japanese parent companies have a stronger incentive to actively manage and minimize the effective tax rates their foreign subsidiaries face in their host countries, as well as any withholding taxes on profit distributions. Every dollar of foreign tax saved directly enhances the overall after-tax return from the foreign operation when profits are repatriated under the exemption system.

6. Scope: Exemption Primarily for Dividends

It is essential to remember that this 95% exemption system is specifically for dividends received from qualifying foreign subsidiaries. Other forms of income or returns from foreign subsidiaries, such as:

• Interest received on loans to a foreign subsidiary,
• Royalties received for the use of intellectual property by a foreign subsidiary, or
• Capital gains realized from the sale of shares in a foreign subsidiary,
  are generally fully taxable to the Japanese parent company. For these types of income, if foreign taxes (e.g., withholding tax on interest/royalties, or capital gains tax in the foreign country) are paid, the Japanese parent can typically claim a foreign tax credit, subject to the standard rules and limitations. Some countries do offer "participation exemptions" that also cover capital gains on subsidiary shares, but Japan's primary system for subsidiary profits focuses on exempting distributed dividends.

Conclusion

For Japanese corporations investing overseas through subsidiaries, the interplay of tax deferral on retained earnings and the 95% dividend exemption on repatriated profits forms the cornerstone of Japan's current approach to mitigating international double taxation on active foreign business income. This system, adopted in 2009, represents a significant move towards territoriality for active subsidiary earnings distributed as dividends. It aims to enhance the competitiveness of Japanese multinationals by simplifying the tax treatment of foreign dividends and encouraging the repatriation of funds. However, it also places a greater onus on these corporations to efficiently manage their foreign tax burdens, as these are no longer generally creditable against Japanese tax when the associated dividend income is exempt. Understanding these rules, including the specific eligibility criteria and the treatment of related foreign taxes, is vital for effective international tax management by Japanese enterprises.