The taxation of non-listed shares in Japanese Small and Medium-sized Enterprises (SMEs) presents a unique array of challenges, primarily due to their inherent illiquidity and the complexities involved in establishing a "fair market value" (時価 - jika). Unlike publicly traded securities with readily available market prices, transactions involving shares in closely-held Japanese companies require careful navigation of specific tax laws and valuation principles. This article outlines key tax considerations for transfers (sales), inheritance, and gifts of such shares in Japan.

The Cornerstone: Fair Market Value (時価 - Jika) for Tax Purposes

At the heart of most tax issues concerning non-listed shares is the determination of their fair market value. This value serves as the basis for calculating capital gains, gift tax, and inheritance tax.

1. General Principles and Difficulties:
The absence of an active market means that an "objective" FMV is not readily apparent. Japanese tax authorities rely on a set of detailed valuation rules, primarily stipulated in the National Tax Agency's Property Valuation Basic Circulars (財産評価基本通達 - Zaisan Hyōka Kihon Tsūtatsu), especially for inheritance and gift tax purposes. For income tax (on sales) and corporation tax purposes, these valuation principles are often referenced, sometimes with specific adjustments. It is crucial to note that simply using an agreed-upon price between related parties does not guarantee its acceptance by tax authorities if it deviates significantly from what they consider to be the FMV.

2. Corporation Tax Perspective (法人税 - Hōjinzei) on Share Transfers/Valuation:
While there isn't a single, overarching rule for determining FMV for all corporate share transfers, guidance can be found in how tax authorities approach valuation losses on non-listed shares:

• Corporation Tax Basic Circular (CTBC) 9-1-13: This circular suggests that for recognizing valuation losses, the FMV is considered "the price at which they are normally traded, taking into account the per-share net asset value, etc., of the issuing company as of the end of the business year or the closest date thereto."
• CTBC 9-1-14: This circular allows for the use of the Property Valuation Basic Circulars (specifically, rules 178 to 189-7 for non-listed stocks) as a basis for valuation, provided there is no intention of tax avoidance and subject to certain critical adjustments:
  1. Treatment of "Central Family Shareholders": If the acquiring company (or individual related to it) is a "central family shareholder" (中心的同族株主 - chūshinteki dōzoku kabunushi, a specifically defined dominant family shareholder group) of the issuing company, then for valuation purposes, the issuing company is always treated as a "small company" (小会社 - shōgaisha) under the Property Valuation Basic Circulars. This usually implies a heavier reliance on the net asset value method.
  2. Valuation of Underlying Assets: When calculating the net asset value of the issuing company, if it owns land or listed securities, these specific assets must be valued at their own fair market value as of the end of the relevant business year, not necessarily their book values.
  3. No Deduction for Deemed Corporate Tax on Unrealized Gains: In the net asset value calculation for inheritance/gift tax, a deduction for latent corporate tax on unrealized gains of assets is usually allowed (under PVBC 186-2). However, for the purposes of CTBC 9-1-14 (related to valuation for recognizing losses or in certain transfer scenarios), this deduction is typically not permitted.

3. Income Tax Perspective (所得税 - Shotokuzei) on Share Transfers:

• Valuation Principle: Similar to the corporate tax context, the Income Tax Basic Circular (ITBC) 23-35 Kyo-9 (concerning the valuation of rights to acquire shares, but indicative of principles for shares themselves) refers to FMV as the "price at which they are normally traded, taking into account the per-share net asset value, etc., of the issuing company as of the exercise date [of the right] or the closest date thereto."
• Transfers at "Grossly Low Prices" (Income Tax Act, Art. 59): If an individual transfers assets (including shares) to a corporation for a price that is "grossly low" – defined by the Income Tax Law Enforcement Order (Art. 169) as less than 50% of the FMV at the time of transfer – the transaction is deemed for tax purposes to have occurred at FMV. This means the individual seller will be assessed capital gains tax based on this deemed FMV, not the actual low price received.
• Potential for Re-evaluation Even Above 50% FMV (ITBC 59-3): Even if the transfer price to a corporation is 50% or more of FMV, tax authorities reserve the right to re-evaluate the transaction at full FMV if it is deemed to be a transaction designed to unfairly reduce the individual's tax burden, particularly if it falls under the scope of rules allowing the denial of transactions of family corporations (Corporation Tax Act, Art. 157).

Valuation for Inheritance and Gift Tax: The Property Valuation Basic Circulars (PVBC)

When non-listed shares are acquired through inheritance or gift, their valuation is almost exclusively governed by the detailed rules in the Property Valuation Basic Circulars. The primary methods are:

1. Net Asset Value Method (純資産価額方式 - Junshisan Kagaku Hōshiki) (PVBC 185):
This method values the company based on its net assets. The formula is essentially:
(Total assets at tax-basis FMV - Total liabilities at tax-basis FMV - Deemed corporate tax liability on net unrealized gains) / Number of outstanding shares.

• Valuation of Assets: Assets are generally valued according to specific rules within the PVBC. A key point is that land and buildings acquired or constructed by the company within three years prior to the valuation date (e.g., date of death or gift) must be valued at their current FMV, not their historical cost or book value, unless the book value can be shown to approximate FMV.
• 80% Discount: For shareholders (and their related parties) who, after acquiring the shares, hold 50% or less of the company's total voting rights, the per-share net asset value calculated as above can often be discounted by 20% (i.e., valued at 80% of the full NAV).

2. Comparable Company/Industry Method (類似業種比準価額方式 - Ruiji Gyōshu Hijun Kagaku Hōshiki) (PVBC 180):
This method values the non-listed company by comparing it to publicly listed companies in a similar industry. The comparison is based on three key financial metrics:

• Per-share dividend
• Per-share annual profit (earnings)
• Per-share net asset value (book value basis)
  The formula involves weighting these factors and applying adjustments based on the size of the company being valued (classified as large, medium, or small based on total assets, number of employees, and annual revenue). This method is primarily used for larger non-listed companies or as a component in valuing medium-sized ones.

3. Dividend Discount Method (配当還元方式 - Haitō Kangen Hōshiki) (PVBC 188-2):
This method values shares based on the company's historical dividend payments. The formula is:
(Annual dividend per share / 10%) × (Par value per share / ¥50 standard par value).
A minimum deemed annual dividend of ¥2.50 per ¥50 par value is used if the actual dividend is lower than this or if no dividends are paid.

• This method typically produces a significantly lower valuation compared to the NAV or Comparable Company methods.
• Its use is restricted to specific types of shareholders: generally, minority shareholders who are not "family shareholders" (同族株主 - dōzoku kabunushi) and who are not involved in the company's management (i.e., not officers or directors).

Determining Which Valuation Method Applies:
The PVBC provide a complex flowchart to determine which method or combination of methods applies. Key factors include:

• Shareholder's Status: Whether the acquirer is a "family shareholder" (a member of a dominant family group with significant voting power) or a "non-family shareholder" (or a family shareholder with a very small, non-controlling stake who is not an officer).
• Company Size: Classified as large (大会社 - daigaisha), medium (中会社 - chūgaisha), or small (小会社 - shōgaisha) based on its total assets, employee count, and revenue.
  • Large Companies: Primarily valued using the Comparable Company method (though NAV can be chosen by the taxpayer).
  • Small Companies: Primarily valued using the Net Asset Value method (though a blended method incorporating 50% of the Comparable Company value can be chosen).
  • Medium Companies: Valued using a weighted average of the NAV and Comparable Company methods, with the weighting factor (L) depending on the company's specific size metrics.
  • Minority/Passive Shareholders: Often eligible for the Dividend Discount Method, irrespective of company size.

Taxation of Share Transfers (Sales)

1. Capital Gains Tax:
Both individuals and corporations are subject to tax on capital gains arising from the sale of shares. For individuals selling non-listed shares, this is typically a separate tax at a flat rate (around 20.315%, including local inhabitant tax and a special reconstruction surtax).

2. Deemed Dividends (みなし配当 - Minashi Haitō) on Share Buy-Backs by the Issuing Company:
A significant issue arises when an individual shareholder sells their shares back to the issuing company (a treasury stock acquisition).

• General Rule: The portion of the buy-back price that exceeds the company's per-share stated capital, etc., attributable to those shares can be treated as a "deemed dividend." This portion is taxed as dividend income, which for individuals is often aggregated with other income and subject to progressive tax rates, potentially much higher than the flat capital gains tax rate.
• Important Exception for Inherited Shares (みなし譲渡課税特例 - Minashi Jōto Kazei Tokurei): A crucial exception exists: if an heir sells inherited non-listed shares back to the issuing company within a specific period – generally, within 3 years and 10 months from the date of inheritance (specifically, by the day three years have elapsed from the day following the due date for filing the inheritance tax return) – the entire proceeds are treated as capital gains, thus avoiding the potentially harsher deemed dividend taxation (Special Taxation Measures Act, Art. 9-7).
• Addition to Cost Basis for Inherited Shares (取得費加算の特例 - Shutokuhi Kasan no Tokurei): Furthermore, under this exception, a portion of the inheritance tax paid by the heir that is attributable to those shares can be added to their acquisition cost (cost basis) for the purpose of calculating the capital gain, thereby reducing the taxable gain (Special Taxation Measures Act, Art. 39).

3. Circumvention Attempts (迂回取得 - Ukai Shutoku):
Using intermediary entities or complex transaction structures to sell shares indirectly back to the issuing company (or related parties) solely to avoid deemed dividend rules or to transfer shares at non-FMV without triggering gift tax is viewed unfavorably by Japanese tax authorities. Such "indirect acquisition" schemes carry a high risk of being recharacterized as a direct transaction or as tax avoidance, leading to the imposition of the originally intended tax. A Nagoya District Court case on March 22, 1989 (Heisei Gannen), for instance, recharacterized an indirect sale of shares from parents to their child via an unrelated company as a direct gift of buy-back rights from the parents to the child. The general principle is that if a legal form is chosen solely to reduce or eliminate a tax burden without any other overriding economic or business rationality, and its use constitutes an abuse of private autonomy, tax authorities may disregard the form and tax based on the substance (as articulated, for example, in a Shizuoka District Court decision on July 13, 1995 (Heisei 7)).

Business Succession Tax Deferral/Exemption Scheme (事業承継税制 - Jigyō Shōkei Zeisei)

A key consideration in the context of SME share succession is the Business Succession Tax Deferral/Exemption Scheme. This complex scheme aims to alleviate the burden of inheritance tax or gift tax when shares of a qualifying SME are transferred to a successor who continues the business.

• Mechanism: Subject to numerous stringent conditions (related to the company, the donor/deceased, the heir/donee, and post-transfer business operations), the scheme allows for the deferral of payment of 100% of the gift tax or 80% (in some cases 100%) of the inheritance tax attributable to the SME shares. If certain conditions are met over a longer period (e.g., the successor continues to manage the business for a set number of years, maintains employment levels), the deferred tax may eventually be exempted.
• FY2015 Revisions: The PDF references revisions effective from January 1, 2015, which aimed to make the scheme more accessible by, for example, abolishing the METI prior confirmation system for certain aspects, relaxing requirements for what constitutes an "asset management company" (which are generally excluded), abolishing the kinship requirement for successors, and allowing the donor (for gift tax deferral) to remain as a non-representative director. The rules for maintaining employment levels during the deferral period were also made more flexible (e.g., using an average over the period).

This scheme is highly technical and requires meticulous planning and ongoing compliance.

Other Considerations: Payment of Tax in Kind with Shares (物納 - Butsunō)

In rare circumstances where an heir faces extreme difficulty in paying inheritance tax in cash and other suitable assets (like government bonds or real estate) are unavailable for payment in kind, it is theoretically possible to pay inheritance tax using non-listed company shares.

• However, this is very uncommon (only 2 cases were approved in the fiscal year covering April 1, 2012, to March 31, 2013).
• For non-listed shares to be accepted, they must generally not be "inappropriate for management or disposal" (管理処分不適格 - kanri shobun futekikaku). A key requirement is often the removal of any transfer restrictions from the shares, making them freely marketable. The Ministry of Finance guidelines suggest that such shares, once accepted, will be promptly sold by the government, often through competitive bid or by actively encouraging the issuing company or its insiders to repurchase them. This means the shares are unlikely to remain in government hands for long.

Conclusion

The taxation of non-listed shares in Japanese SMEs is a specialized area heavily influenced by context—be it a sale, inheritance, or gift—and by a detailed set of valuation rules primarily found in the Property Valuation Basic Circulars. Determining the fair market value is a recurring challenge and a frequent point of contention with tax authorities. Specific tax relief measures, such as the favorable treatment for sales of inherited shares back to the issuing company or the comprehensive Business Succession Tax Deferral/Exemption Scheme, exist but are subject to strict conditions and require proactive planning. Given the significant financial implications, obtaining expert legal and tax advice is indispensable for SME owners and their families to navigate these complexities effectively, manage potential tax liabilities, and ensure smooth transitions of ownership.