Japan's Controlled Foreign Corporation (CFC) Rules: When Are Foreign Subsidiary Profits Taxed in Japan?

Japanese Attorney at Law - Bengoshi L.L.

• 7 min read

For Japanese multinational corporations, the ability to defer home-country taxation on profits earned by their foreign subsidiaries has long been a feature of international tax planning. However, to prevent the abuse of this deferral principle, particularly through the accumulation of profits in low-tax jurisdictions, Japan, like many other countries, has implemented Controlled Foreign Corporation (CFC) rules. These rules, also known as anti-tax haven measures (タックス・ヘイブン対策税制 - takkusu heibun taisaku zeisei), can attribute certain undistributed income of foreign subsidiaries directly to their Japanese shareholders, subjecting it to current taxation in Japan. Understanding the scope, mechanics, and exceptions of Japan's CFC rules is vital for any Japanese enterprise with overseas operations.

1. Purpose and Evolution of Japan's CFC Legislation

Japan's CFC rules were first introduced in its Act on Special Measures Concerning Taxation (租税特別措置法 - Sozei Tokubetsu Sochi Hō, hereinafter "ASMT") in 1978. The initial primary objective was to curb tax avoidance by Japanese shareholders (both individuals and corporations) who might otherwise allow profits to accumulate in subsidiaries established in countries with significantly lower tax rates, thereby "unduly reducing" their Japanese tax burden by not receiving dividends.

Over the years, the underlying rationale and the specifics of the rules have evolved. While the initial focus was on the non-distribution of profits from low-tax countries, amendments, particularly in 2010 and more recently, have shifted the emphasis. The system now also targets the erosion of the Japanese tax base by addressing the artificial shifting of highly mobile, passive-type income to low-tax environments, even if the foreign subsidiary has some active business operations. The legislative intent has broadened from merely countering the deferral of dividend taxation to more directly protecting Japan's taxable income base from being eroded by certain international structures.

2. Identifying a "Specified Foreign Subsidiary" (特定外国子会社等 - Tokutei Gaikoku Kogaisha Tō)

For Japan's CFC rules to apply, the foreign entity must first be classified as a "Specified Foreign Subsidiary, etc." This involves a two-pronged test:

A. "Foreign Related Company" (外国関係会社 - Gaikoku Kankei Kaisha) Status:
A foreign corporation qualifies as a foreign related company if more than 50% of its total issued shares (or voting power, or value under certain circumstances) is owned, directly or indirectly, by Japanese residents, Japanese domestic corporations, and/or specially-related non-resident individuals or entities (ASMT Art. 66-6, para. 2, item 1). This establishes the necessary control link by Japanese interests.

B. Location in a Low-Tax Jurisdiction (The "Trigger Tax Rate"):
The foreign related company must have its head or principal office in a country or territory where the effective tax rate on its income is significantly lower than in Japan. This is determined by a "trigger tax rate."

  • Historically, this rate was set at 25% or less.
  • It was lowered to 20% or less by the 2010 tax reforms.
  • The 2015 tax reforms further refined this, setting the threshold at less than 20% (ASMT Art. 66-6, para. 1; Cabinet Order for ASMT Art. 39-14, para. 1).
    If the effective tax rate paid by the foreign related company in its country of residence on its income is below this 20% threshold, it is generally considered to be in a low-tax jurisdiction for the purposes of these rules, thus becoming a "Specified Foreign Subsidiary, etc." (CFC).

3. Japanese Shareholders Subject to CFC Rules

Once a foreign entity is identified as a CFC, its undistributed income may be attributed to certain Japanese shareholders. The rules generally apply to:

  • Japanese domestic corporations, and
  • Japanese resident individuals,
    who, along with their related parties, own 10% or more of the shares (or capital contribution) of the CFC, either directly or indirectly (ASMT Art. 66-6, para. 1). This 10% ownership threshold has seen changes; it was once 5% but was revised back to 10% in 2010. The rationale for such a threshold is often linked to the shareholder having sufficient influence over the foreign company's distribution policy.

4. The General Mechanism: Current Taxation of Attributed Income

If a Japanese shareholder meets the ownership threshold in a CFC, and the CFC does not qualify for an active business exemption (discussed below), a portion of the CFC's "applicable retained earnings" (適用対象金額 - tekiyō taishō kingaku) is attributed to the Japanese shareholder. This attributed amount, calculated based on the shareholder's direct and indirect ownership percentage, is then treated as current income of the Japanese shareholder and included in their taxable income for that business year (ASMT Art. 66-6, para. 1). This effectively eliminates the tax deferral benefit for the attributed portion of the CFC's income.

5. The Active Business Exemption (適用除外基準 - Tekiyo Jogai Kijun)

Recognizing that not all operations in low-tax jurisdictions are for tax avoidance, Japan's CFC rules provide a crucial "active business exemption." If a CFC meets all the following criteria, its entire income (subject to the passive income rules discussed next) is generally exempt from current attribution to its Japanese shareholders (ASMT Art. 66-6, para. 3):

  1. Business Standard (事業基準 - jigyō kijun): The CFC's principal business must not be the holding of shares or debt securities, the licensing of industrial property rights or copyrights, or the leasing of vessels or aircraft. However, there are exceptions for certain types of holding companies, such as "business holding companies" (事業持株会社) or "logistics holding companies" (物流統括会社), which were introduced by the 2010 reforms to accommodate legitimate group structuring.
  2. Substance Standard (実体基準 - jittai kijun): The CFC must have a fixed place of business (e.g., office, factory, retail store) in its country of residence that is necessary for conducting its principal business. This tests for physical presence and operational infrastructure.
  3. Management and Control Standard (管理支配基準 - kanri shihai kijun): The CFC must locally manage, control, and operate its business itself in its country of residence. This looks for genuine local decision-making and operational autonomy.
  4. Local Business/Non-Related Party Standard (所在地国基準・非関連者基準): Depending on the nature of the CFC's principal business (e.g., wholesale, manufacturing, banking, insurance), it must satisfy either:
    • A "local business" test (e.g., conducting its business primarily within its country of residence), OR
    • A "non-related party" test (e.g., conducting its business primarily with unrelated parties).

The application of these active business exemption criteria has been a frequent subject of tax disputes and litigation in Japan. Courts have examined various factual scenarios, including structures where Japanese companies used Hong Kong subsidiaries for processing arrangements (rairyō kakō - 来料加工) in mainland China. These cases often turned on whether the Hong Kong subsidiary had sufficient substance and local management, or whether its primary business qualified for the exemption (e.g., Tokyo High Court, August 30, 2011; Tokyo District Court, July 20, 2012). Other cases have scrutinized the business purpose, physical presence, and local management aspects in different contexts (e.g., Tokyo High Court, May 27, 1991; Nagoya District Court, September 4, 2014).

6. Partial Inclusion for "Specified Income" (Passive Income)

A significant feature, strengthened by the 2010 reforms, is that even if a CFC meets the active business exemption criteria, certain types of its passive or "asset-management-type" income (特定所得 - tokutei shotoku) are still subject to current attribution to its 10%-or-more Japanese shareholders (ASMT Art. 66-6, para. 4).

This "partial inclusion rule" targets income streams that are considered highly mobile and easily shifted to low-tax jurisdictions for tax avoidance purposes, regardless of the CFC's broader active business. The types of "specified income" subject to this rule include:

  • Dividends (excluding certain intra-group dividends).
  • Interest income.
  • Gains from the sale of shares or debt securities (portfolio investments).
  • Royalties for the use of intellectual property rights or copyrights.
  • Rental income from the leasing of vessels or aircraft.

The rationale is that there is often less economic justification for earning such passive income in a low-tax CFC compared to active business profits derived from genuine local operations.

7. Relief from Double Taxation on Attributed and Distributed Income

To prevent the same income from being taxed multiple times, Japan's CFC rules incorporate relief mechanisms:

  • Credit for Underlying Foreign Corporate Taxes: When a CFC's income is attributed to a Japanese shareholder and taxed in Japan, any foreign corporate income tax paid by the CFC on that attributed income is generally allowed as a foreign tax credit against the Japanese shareholder's tax liability arising from the attribution (ASMT Art. 66-7).
  • Exclusion of Actual Dividends: When income that has already been taxed to a Japanese shareholder under the CFC rules is subsequently distributed as an actual dividend by the CFC, that dividend is generally excluded from the Japanese shareholder's taxable income up to the amount previously attributed and taxed. This exclusion applies to dividends paid out of profits attributed within the preceding 10 years (ASMT Art. 66-8). This prevents economic double taxation at the shareholder level (once on attribution, again on distribution).
    However, there is no specific provision to adjust for potential double taxation if the CFC itself has Japanese domestic source income that is taxed in Japan and also contributes to the retained earnings subject to CFC attribution (as noted in a Tokyo District Court case, June 27, 2014).

8. Interaction with Tax Treaties and Other Anti-Avoidance Rules

  • Compatibility with Tax Treaties: The Japanese Supreme Court has consistently held that Japan's CFC rules are generally compatible with its tax treaties. The prevailing view is that CFC rules impose tax on the Japanese shareholder for its deemed income arising from its controlling interest in the CFC, rather than taxing the CFC itself on its business profits in a manner that would violate the business profits article of a treaty (e.g., Supreme Court, October 29, 2009, Glaxo SmithKline case, involving the CFC rules for individuals, but the principle is broadly applicable).
  • Corporate Inversion Countermeasures: Japan has also introduced specific anti-corporate inversion rules (ASMT Art. 40-7 et seq. for individuals, Art. 66-9-2 et seq. for corporations). These rules target situations where Japanese shareholders restructure their holdings in a domestic Japanese corporation such that they hold these shares indirectly through a foreign corporation established in a low-tax jurisdiction, effectively "inverting" the corporate structure to shift profits offshore.
  • Relationship with Transfer Pricing Rules: CFC rules and transfer pricing rules are distinct but complementary anti-avoidance measures. Transfer pricing rules (discussed in Chapter 9 of the referenced book) address the mispricing of transactions between related parties to shift profits. CFC rules, on the other hand, primarily address the deferral of tax on income already accumulated in low-tax foreign subsidiaries. While transfer pricing adjustments might reduce the profits accumulated in a CFC, CFC rules can still apply to any remaining low-taxed retained earnings that are not covered by the active business exemption.

Conclusion

Japan's CFC rules represent a complex but critical component of its international tax system, aimed at preventing the erosion of its tax base through the use of low-tax foreign subsidiaries. The rules achieve this by selectively eliminating tax deferral on certain types of income accumulated in such entities. For Japanese corporations with international operations, navigating these rules requires a careful assessment of the status of their foreign subsidiaries (control and effective tax rate), the nature of the subsidiaries' activities (to determine eligibility for the active business exemption), and the character of the income they earn. The distinction between active business income and targeted passive income is particularly important. Given the detailed criteria and the potential for significant tax implications, thorough planning and professional advice are essential when structuring and managing overseas investments.