Selling Shares in a Japanese Company with Foreign Subsidiaries (e.g., China, India): What are the Japanese and Potential Foreign Tax Implications?

Japanese Attorney at Law - Bengoshi L.L.

• 8 min read

I. Introduction: The Complex Tax Web of Selling Shares in a Japanese Company with Overseas Operations

When shares in a Japanese company are sold, the immediate tax concern is typically the Japanese capital gains tax implications for the seller. However, if the Japanese company itself holds significant subsidiaries or assets in foreign jurisdictions, particularly in countries like China or India, the transaction can trigger a second layer of complex tax considerations: foreign taxes arising from the indirect transfer of those underlying foreign assets. This dual-layer tax exposure requires careful navigation by both sellers and buyers.

This article explores the primary Japanese tax consequences of selling shares in a Japanese company and then delves into the increasingly pertinent issue of potential foreign tax liabilities, focusing on the indirect transfer tax rules in jurisdictions like China and India. Understanding these multifaceted implications is crucial for structuring deals, conducting due diligence, and accurately assessing the net financial outcome of such a sale.

II. Japanese Tax Implications on the Sale of Shares in a Japanese Company

The Japanese tax treatment of gains from the sale of shares in a Japanese company primarily depends on the seller's tax residency and status.

A. Seller is a Japanese Resident Individual

For an individual resident in Japan, capital gains from the sale of shares are generally classified as "income from the transfer of shares" (kabushiki-to ni kakaru jōto shotoku-tō - 株式等に係る譲渡所得等). This income is subject to separate taxation (i.e., not aggregated with other income like employment income) at a total flat rate of 20.315%. This rate comprises 15% national income tax, 5% local inhabitants tax, and a 0.315% special reconstruction income surtax (15% × 2.1%).

B. Seller is a Japanese Corporation

If a Japanese corporation sells shares in another Japanese company, the capital gains (or losses) are generally treated as ordinary corporate income (or expenses). These gains are aggregated with the corporation's other profits and losses for the fiscal year and are subject to the standard Japanese corporate income tax rates. There are no special reduced rates for capital gains from share sales for corporate sellers.

  • Consumption Tax: The transfer of shares is a non-taxable transaction for Japanese Consumption Tax (JCT) purposes.
  • Stamp Duty: Generally, a share transfer agreement itself is not a taxable document for Japanese stamp duty purposes. However, if a separate receipt for the sales proceeds is issued, that receipt may be subject to stamp duty depending on the amount.

C. Seller is a Non-Resident Individual or Foreign Corporation

For a non-resident individual or a foreign corporation selling shares in a Japanese company, the Japanese tax implications are more nuanced:

  • No Permanent Establishment (PE) in Japan: If the foreign seller does not have a PE in Japan, capital gains from the sale of shares in a Japanese company are generally not subject to Japanese tax. However, there are important exceptions where Japanese taxation can still apply:
    1. "Real Estate Holding Company" Shares (不動産関連法人株式 - fudōsan kanren hōjin kabushiki): If the Japanese company's assets consist predominantly of real estate located in Japan (e.g., more than 50% of its total asset value is derived from Japanese real property) and the seller (along with related parties) meets certain ownership thresholds, the capital gains can be taxable in Japan. The holding period and percentage of shares sold are also relevant.
    2. "Transfer of Shares Similar to a Business Transfer" (事業譲渡類似株式の譲渡 - jigyō jōto ruiji kabushiki no jōto): If a foreign shareholder (together with related parties) sells a significant stake (e.g., 25% or more held within the last three years, and 5% or more sold in the current year) in a Japanese company in a manner that resembles the transfer of a business, the gains may be subject to Japanese tax.
    3. Shares "Accumulated for Manipulative Trading" (買集め株式 - kaishime kabushiki): Gains from selling shares that were acquired for market manipulation purposes.
  • With a Permanent Establishment (PE) in Japan: If the foreign seller has a PE in Japan and the shares sold are effectively connected with that PE (e.g., they are assets of the PE's business), then the capital gains are generally subject to Japanese corporate (or individual) income tax as part of the PE's income.

III. The Lurking Giant: Potential Foreign Tax Implications via Indirect Transfer Rules

The sale of shares in a Japanese company that, in turn, owns valuable subsidiaries or assets in other countries can attract the attention of foreign tax authorities under what are known as "indirect transfer" tax rules.

A. The Concept of Indirect Transfer Taxation

Several countries, with China and India being prominent examples, have implemented tax rules designed to capture capital gains realized from the transfer of shares in an offshore entity (like a Japanese holding company in this context) if that offshore entity's value is substantially derived from assets or underlying businesses located within their jurisdiction. The rationale is that even though the direct sale is of foreign shares, the economic substance is a transfer of value linked to domestic assets.

B. Case Study: China's Indirect Transfer Rules

China has been at the forefront of developing and enforcing indirect transfer tax rules. Key aspects include:

  • Regulatory Framework: Initially guided by notices like Bulletin 698 (Guo Shui Han [2009] No. 698), China's rules were significantly formalized and expanded by Public Announcement [2015] No. 7 of the State Administration of Taxation (SAT) and subsequent guidance.
  • Key Triggers: These rules typically apply if an offshore transfer of shares in an intermediate holding company (which could be the Japanese company being sold, if its value is mainly from Chinese subsidiaries) is found to lack a "reasonable business purpose" (gōriteki jigyō mokuteki - 合理的事業目的) and is structured to avoid Chinese enterprise income tax.
  • Recharacterization Risk: Chinese tax authorities may disregard the intermediate holding structure and recharacterize the transaction as a direct transfer of the underlying Chinese equity or assets. The seller of the offshore shares would then be assessed Chinese tax on the deemed capital gain.
  • Factors for "Reasonable Business Purpose": Announcement [2015] No. 7 provides several factors to consider, including the equity value of the foreign intermediate holding company relative to its assets, its functions and risks, the tax situation of the indirect transfer, and the impact of tax treaties. Certain safe harbors exist, such as if the transaction falls under a qualifying group reorganization or if the shares are traded on a public stock exchange.
  • Reporting Obligations: Both the seller and, in some cases, the buyer may have reporting obligations to the Chinese tax authorities.
  • Tax Treaty Impact: China often interprets its tax treaties to permit taxation of such indirect transfers, potentially under capital gains articles (if the underlying assets are predominantly immovable property in China) or "other income" articles, arguing that the gain is sourced in China. This interpretation can sometimes be contentious.

C. Case Study: India's Indirect Transfer Rules

India also has robust provisions for taxing indirect transfers:

  • Legislative Basis: India introduced retrospective amendments to its Income Tax Act, 1961, to tax indirect transfers, notably in response to the Supreme Court's ruling in the Vodafone case (Vodafone International Holdings BV v. Union of India, January 20, 2012), which had initially ruled against such taxation.
  • Core Principle: If shares of a foreign company derive their value, directly or indirectly, substantially from assets located in India, any capital gains arising from the transfer of those foreign shares can be taxable in India.
  • "Substantial Value": Specific thresholds are defined (e.g., if the value of Indian assets exceeds a certain amount and represents at least 50% of the value of all assets owned by the foreign company).
  • Withholding Tax by Purchaser: A significant feature of India's rules is the potential obligation on the purchaser of the offshore shares to withhold Indian tax from the sale consideration payable to the seller, if the purchaser is aware or should be aware that the transaction involves an indirect transfer of Indian assets. This can create a direct compliance burden and risk for buyers, even if they are non-Indian.

The approach taken by China and India reflects a broader global trend where countries are becoming more assertive in taxing gains from indirect transfers of assets located within their borders. The OECD/G20 BEPS Project, particularly Action 6 (Preventing Treaty Abuse), has also influenced this area by recommending measures to counter treaty abuse, which can be relevant to structures used to achieve indirect transfers.

IV. Navigating the Risks: Due Diligence and Structuring Considerations

Both sellers and buyers involved in the sale of shares of a Japanese company with significant foreign operations must be vigilant.

A. For the Seller:

  • Multi-jurisdictional Tax Due Diligence: Before the sale, conduct thorough due diligence on potential indirect transfer tax liabilities in all countries where significant subsidiaries or assets are located.
  • Assess "Reasonable Business Purpose": Evaluate the commercial rationale for existing holding structures, especially if they involve low-tax jurisdictions.
  • Valuation: Understand how the value of the Japanese company's shares is attributable to its various foreign underlying assets.
  • Reporting Obligations: Be aware of and comply with any reporting or disclosure requirements in the relevant foreign jurisdictions.
  • Impact on Net Proceeds: Factor potential foreign taxes into the expected after-tax proceeds from the sale.

B. For the Buyer (of the Japanese company's shares):

  • Acquisition Due Diligence: Investigate the Japanese target company's foreign subsidiary structure and assess any potential inherited or contingent indirect transfer tax risks.
  • Purchaser Withholding Obligations: Crucially, determine if the acquisition could trigger a withholding tax obligation for the buyer under the laws of countries like India.
  • Contractual Protections: Seek appropriate representations, warranties, and indemnities from the seller in the Share Purchase Agreement (SPA) to cover potential pre-closing foreign tax liabilities, including indirect transfer taxes. Price adjustments could also be considered.

C. Role of Representations & Warranties and Indemnities in SPAs:

  • Sellers should be asked to represent and warrant compliance with all applicable tax laws in jurisdictions where the Japanese company and its subsidiaries operate.
  • Specific indemnities covering pre-closing tax liabilities, explicitly including potential indirect transfer taxes triggered by the sale transaction itself, are highly advisable. The scope, duration, and cap of such indemnities are key negotiation points.

V. Interaction with Japanese Foreign Tax Credit System

If a Japanese corporate seller is subject to tax in a foreign country on gains deemed to arise from an indirect transfer (e.g., China taxes the Japanese seller on the sale of its Japanese shares because the Japanese company holds a valuable Chinese subsidiary), the question arises whether this foreign tax can be credited against Japanese corporate income tax.

  • General Principles: Japan provides a foreign tax credit (FTC) system to mitigate international double taxation. However, for a foreign tax to be creditable, it must generally be a tax on the Japanese corporation's income, and there are limitations on the amount of credit that can be claimed (based on the proportion of foreign source income to worldwide income, calculated under Japanese tax rules).
  • Challenges:
    • Nature of the Foreign Tax: The foreign tax must be recognized by Japanese tax authorities as a creditable corporate income tax.
    • Source of Income: Japan's rules for determining the source of capital gains might differ from those of the foreign country imposing the indirect transfer tax. If Japan considers the gain to be Japanese-sourced, it may limit or deny the FTC.
    • Treaty Provisions: The relevant tax treaty (if any) between Japan and the foreign country might contain provisions on double taxation relief that could affect FTC eligibility. If the foreign tax is imposed in a manner inconsistent with a tax treaty, its creditability in Japan could be questioned.

This area can be complex, and obtaining an FTC for foreign indirect transfer taxes is not always straightforward.

VI. Conclusion

Selling shares in a Japanese company that has a significant international footprint involves navigating more than just Japanese domestic capital gains tax. The assertive stance of countries like China and India on taxing indirect transfers of assets within their borders adds a critical layer of potential foreign tax risk and complexity.

For both sellers and buyers, comprehensive multi-jurisdictional tax due diligence is indispensable. This includes understanding the value drivers of the Japanese target, the tax laws of the countries where its subsidiaries operate, and the potential interplay of various tax treaties. Clear contractual provisions, including robust tax representations, warranties, and indemnities, are crucial for allocating these often substantial risks. Proactive planning and expert tax advice from specialists familiar with both Japanese and relevant foreign tax laws are key to successfully managing these complex transactions.