Tax & Transfer Pricing
Tokyo

Newsletter
20 December 2016

Japan 2017 Tax Reform Proposal
Introduction
On December 8, 2016, the ruling parties and the government issued the 2017
tax reform proposal ("Proposal"). This newsletter focuses on key proposed
tax revisions set out in the Proposal, including significant changes to Japan's
CFC rules, the introduction of a tax-free corporate spin off regime, and otherchanges that may be relevant to Japanese and non-Japanese multinational
enterprises doing business in Japan. It is expected that the tax reform bill will
be submitted at the next ordinary session of the Diet, scheduled to take placesome time in late January, and passed in late March 2017.

Major Proposed Changes:
I.

Changes to Japan's CFC Rules

II.

Introduction of Tax Free Corporate Spin-Off Method

III. Changes to Japan's Corporate Reorganization Regime
1. Treatment of "Cash Out" Squeeze Out Transactions
2. Application of Corporate Reorganization Rules to Transactions thatare not Corporate Reorganizations
3. Recognition of Revaluation Gain under Tax Consolidation Rules andin Taxable Share Exchanges
IV. Changes to Gift/Inheritance Tax Rules

I. Changes to Japan's CFC Rules
Key points
κThe new rules are scheduled to apply with respect to fiscal years
of foreign subsidiaries beginning on or after April 1, 2018.

κ

The current framework, which categorizes a foreign subsidiary
based on its effective tax rate (trigger tax rate = 20%), will basicallyremain as is; the Proposal did not include a reduction of the trigger
tax rate in response the UK's reduced corporate tax rate.*κ

Under the current rules, a foreign subsidiary with an effective tax
rate of at least 20% is exempt from application of Japan's CFC
rules in any case. Under the Proposal, a foreign subsidiary with
an effective tax rate of 20% or more (located in such places as the
Netherlands, Belgium, Switzerland, Luxemburg, etc.) would be
captured by the rules, unless the subsidiary satisfies certain
substance requirements. Certain offshore holding companies thus
may be subject to concurrent taxation under the new rules,
although foreign subsidiaries with an effective tax rate of 30% ormore would continue to be exempt.

κ

The Proposal significantly expands the scope of taxable passive
income of a foreign subsidiary with an effective tax rate of lessthan 20% but which is exempt from full taxation due to the "active
business exemption". Nonetheless, interest income on qualified
intra-group loans will be excluded from the scope of taxable
passive income.

κThe definition of a "foreign subsidiary" will be changed to exclude
foreign corporations with a 50% or less ownership interest in each
entity in the chain. For instance, a foreign subsidiary that is owned
exactly 50% by a Japanese corporation and 50% by a nonJapanese corporation would be outside the scope CFC rules
under the Proposal (under the current rules, such subsidiary may
be caught by the rules if the non-Japanese corporation has
Japanese shareholders).

κ

While the Proposal expands the scope of potential taxation under
the CFC rules, several exceptions are introduced as well. The
language of many of the requirements of these exceptions is notclear, however; for example, requirements to "engage in all
activities that are normally required to conduct the business in an
appropriate manner", to be "actively involved in manufacturing
activity by performing significant functions" in the "ordinary courseof business" are not defined. These ambiguities could lead togreat uncertainty, depending on how the final tax reform bill isdrafted.

*The current UK corporate income tax rate of 20% (as of Dec 2016) isscheduled to be reduced to 19% in April 2017, and possibly reduced to 17%
after 2020.

2 Japan 2017 Tax Reform Proposal  20 December 2016

Proposed Changes
1.

Overview

The changes to the Japan's CFC rules in the Proposal are reported to be asymbol of the Japanese government’s efforts to respond to the BEPS final
report. In fact, the idea of strengthening Japan's CFC rules has been
attracting significant media coverage since July 2016. These changes, thebiggest since the current classification of taxable foreign subsidiaries basedon effective tax rates was introduced in 1992, would widely affect all
Japanese multinational enterprises with subsidiaries located outside of Japan.
Japanese multinational enterprises may need to analyze the ramifications of
the changes to their specific businesses and structures and, if necessary,
undertake strategic restructuring prior to the proposed effective date of the
new rule (April 1, 2018).

(A) Current Regime
Under the current regime, a foreign subsidiary is classified in one of two
categories based on the effective tax rate test, which looks to whether thesubsidiary is taxed at an effective tax rate of less than 20% or not. If theforeign subsidiary is taxed at an effective rate of less than 20%, it is further
tested to determine whether it can satisfy the "active business" exemption. If
it qualifies, one next looks at whether the subsidiary has taxable passive
income or not. The basic framework can be illustrated as follows:

Current Japanese CFC Rule Regime(Threshold)
Effective Corporate Tax Rate Active Income(ETR) of a foreign sub

Passive income

Fully Exempt(with no conditions)
Trigger Tax RateETR 20%Conditionally Exempt(when the corporation satisfies the“active business exemption”)

Taxable CFC
IncomeSource: Baker McKenzie (Tokyo)(B) New Rule
The Proposal would create one additional group under the CFC rules. The
three categories would be (i) a foreign subsidiary with an effective tax rate ofat least 20%, but less than 30%, (ii) a foreign subsidiary with an effective tax
rate of less than 20%, and (iii) a foreign subsidiary with an effective tax rateof at least 30%. The Proposal also significantly expands the scope of taxable
passive income and creates a new concept, "extraordinary excess profit".
Income in the "extraordinary excess profit" category would be taxed
immediately, regardless of whether such excess profit was derived from anactive business or not. The new framework can be illustrated as follows:
3 Japan 2017 Tax Reform Proposal  20 December 2016

(Threshold)
Effective Corporate Tax
Rate(ETR) of a foreign sub

New Japanese CFC Rule Regime
Active Income

Passive income

Fully Exempt(with no conditions)
ETR 30%New
Category

Conditionally Exempt(when the corporation satisfies the “certain substanceETR 20%Conditionally Exempt(when thecorporation satisfies
the “active businessexemption”)

Extraordinary
Excess Profit

Taxable CFC Income

Expansion of the Scope of
Taxable Passive Income

Source：Baker McKenzie (Tokyo)

We analyze each significant change under the Proposal in greater detailbelow.

2.

**New Concept ** Full Inclusion of Income of a Foreign
Subsidiary with an Effective Tax Rate of 20% to 30%

Under currently effective CFC rules, the "effective tax rate of less than 20%"threshold is significant; as long as a foreign subsidiary has an effective tax
rate of 20% or more, the foreign subsidiary is not "caught" by the rules. ManyJapanese multinational enterprises likely considered this threshold inchoosing a jurisdiction in which to set up an offshore holding/financecompany. Some jurisdictions appear to have maintained their headline tax
rates at 20% with Japan's CFC rules in mind, in an effort to attract Japanese
corporate investment.
Under the Proposal, a foreign subsidiary with an effective tax rate of at least
20%, but less than 30%, would be subject to concurrent taxation at the parent
level under Japan's CFC rules unless all of following conditions are satisfied.
If all of the following conditions are satisfied, the Japanese company can
avoid the CFC rule's requirement to concurrently include subsidiaries'
passive income, as discussed in greater detail below.

(A) Main or Head Office of the Subsidiary is Not Located in a
"blacklisted" Jurisdiction (i.e., One Designated by the
Ministry of Finance)
The Proposal indicates that that when a subsidiary is established certain
jurisdictions that the Ministry of Finance "designates", the subsidiary will per
se be caught by the CFC Rules. Specifically, jurisdictions on this "blacklist"
would be ones that are not cooperative with Japan with respect to tax related
information exchange. The Proposal does not specify which jurisdictions will
4 Japan 2017 Tax Reform Proposal  20 December 2016

be on the list. If a foreign subsidiary is located in such a jurisdiction, however,it will be subject to Japan's CFC rules regardless of its substance.

(B) Company is Not a "Cash Box Company"
A foreign subsidiary would be considered a "cash box company" if its ratio of"passive investment assets" to total assets is greater than 50%, and its ratioof "passive income" to total assets is greater than 30%. A foreign subsidiaryfailing this test would be subject to the full income inclusion rule, even if it
engages in an active business. The formulas for the determination are assummarized below. (Note that different formulas apply with respect to"licensed offshore finance subsidiaries".)①

Passive investment asset test
(total of securities, loan receivables, intangible assets and otherassets generating passive income) / total assets > 50%②

Passive income test
Passive income (interest, dividends, gains from the sale of securities,
royalties on intangible assets etc. / total assets > 30%

Interest income on qualified intra-group loans and dividend income received
from another subsidiary (in which the first subsidiary has at least a 25%
ownership interest) will be excluded from the scope of passive income.
Portfolio investments would not normally create a 30% return on assets;
therefore, there would be very limited circumstances in which a foreignsubsidiary would satisfy both tests. A foreign subsidiary that might typicallybe categorized as a "cash box company" would be (i) an intangible asset
holding company, or (ii) a company seeking capital gains from minority
investment (i.e., venture capital).

(C) Company is Not a "Mailbox Company"
A foreign subsidiary satisfying either of following two conditions would not betreated as a "mailbox company".
① The subsidiary has an office, factory or other fixed place of business("Fixed Place Test").
②

The company administers, controls and operates its business by itself
in its place of incorporation ("Control and Administration Test").

The above are two of several conditions that must be satisfied in connection
with the active business exemption under the current CFC rules.
Interestingly, as opposed to the active business exemption requirements (fora foreign subsidiary with an effective tax rate of less than 20%) where all of
the conditions must be satisfied, the Proposal provides that satisfaction ofeither of the above two conditions would enable a foreign subsidiary with aneffective tax rate of 20% or more, but less than 30%, to qualify for the
exemption. It is generally believed that the Fixed Place Test requires theobjective existence of a fixed place (e.g., a rental office). Perhaps because
the analysis is relatively straightforward, the Fixed Place Test has not been
an area for dispute; rather, the Control and Administration Test is consideredmore difficult to satisfy.

5 Japan 2017 Tax Reform Proposal  20 December 2016

The Control and Administration Test poses certain practical difficulties. For
example, it is not clear to what extent a parent may be involved in mattersconcerning the foreign subsidiary's operations, such that the subsidiary would
still satisfy the Control and Administration Test. The prevailing interpretationis that if the parent (or other group entity) merely authorizes and makes final
decisions regarding the actions of the foreign subsidiary pursuant to internal
decision making procedures, this in and of itself should not cause the Control
and Administration Test to be failed. If, however, the parent is actively
involved in negotiations with local customers, credit management, or taking
or making purchase orders, or in other matters that are necessary inconnection with the foreign subsidiary’s ordinary course of business, theControl and Administration Test may be considered to be failed. The biggest
factor in proving satisfaction of the Control and Administration Test would
seem to be the number of directors and employees the foreign subsidiary
actually has in the local country.
Historically, Japanese multinational enterprises have tended to set up
offshore holding / finance companies with limited substance, located injurisdictions with a headline tax rate of at least 20% (e.g., the Netherlands).
The companies would then engage local service providers to act as local
directors, so as to satisfy local corporate law requirements (e.g., requirementof having at least one local director). Assuming that the Proposal takes effectas drafted, it is very likely that offshore holding / finance companies with no"real" directors or employees would trigger taxation under Japan's CFC rules,
unless they satisfied the Fixed Place Test. Even if the new rule captures suchoffshore holding /finance companies, however, dividend income paid byanother corporation in which such offshore/finance company has at least a
25% ownership would be excluded from taxable CFC income. Thus, adverse
consequences would be limited to cases in which such offshore holding /finance company had made portfolio investments using surplus cash, or
engaged in non-qualified intra-group financing activities.
The flow chart below illustrates the process of determining whether acompany falls under the new CFC rule category (effective tax rate of 20% to30%).
CFC Judgment Flow for a foreign subsidiary with an effective tax rate of at least 20%,
but less than 30%
Subsidiary is
located in a
"blacklisted"jurisdiction

NO

Cash box company(Passive
investment asset
test & Passive
income test)

YES

YES

NO

Mail Box Company NO(Control and
Administration
Test)

Fully Exempt fromJapanese CFC(No partial inclusion)

YES

Subject to CFC Taxation(Dividend paid by another sub in which such offshore/finance company has atleast a 25% ownership would be excluded from taxable CFC income)Source: Baker McKenzie

Under the current rules, the effective tax rate of a foreign subsidiary is tested
on a year-by-year basis, and carryforward losses are only allowed if theyarise in a fiscal year in which the company has an effective tax rate of 20% ormore. As a result, an arguably unreasonable consequence arises under the
6 Japan 2017 Tax Reform Proposal  20 December 2016

current CFC rules where a foreign subsidiary suffers losses in a fiscal year inwhich its effective tax rate is 20% or more, but cannot use such NOLs tooffset taxable income in a year in which the effective tax rate goes below
20%. Although not explicitly dealt with in the Proposal, the issue may go
away due to the creation of the new category (i.e., the effective tax rate of
20% to 30%).
Under current rules, the Japanese parent of a foreign subsidiary may need tobear extra administrative burdens every year in order to determine whether
the CFC rule applies to a foreign subsidiary located in a jurisdiction with aheadline tax rate of at least 20%. We believe such additional administrative
action can be a good opportunity for a tax group at the Japanese company's
headquarter to control the tax costs of the group on a worldwide basis, and tobuild a better internal governance structure from a tax perspective.

3.

Expansion of Scope of Partial inclusion (Article 66-6(4) of
the Special Tax Measures Act)The biggest adverse impact of the Proposal to Japanese headquarteredcompany may be the expansion of the scope of partial inclusion of "passive
income". The Proposal provides the following changes.
Current Scope

Proposed Changes
Exclusion

Scope of taxable
income①

Interest, Originally
Issued Discount ofbonds.

Any interest①②③

Interest income
from qualified intragroup finance.
Interest income of aforeign subsidiarylicensed to conduct
a lending businessunder the local law.
Interest on bankdeposits derived in
the ordinary courseof business.

②

Dividends paid by
a company inwhich theownership
percentage is lessthan 10%.

Any dividend

Dividends paid bycompany with a lessthan 25% ownership.
10% ownership
requirement continues toapply to companies in oil& gas industry,③

New category

Securities lending

None

④

Capital gains
derived from thesale of shares(less than 10%
ownership) andbonds

Capital gain derived
from the sale of any
security

Capital gain derived
from the sale of shares(less than 25%
ownership)

7 Japan 2017 Tax Reform Proposal  20 December 2016

Current Scope

Proposed Changes
Scope of taxable
incomeExclusion⑤

New category

Income fromderivative transactions

Derivative transactions
for hedging purposes
Income from derivativetransactions of a foreignsubsidiary licensed to
conduct a futures tradingbusiness under the locallaw.

⑥

New category

Foreign exchange
gains or losses

Foreign exchange gainor loss arising in theordinary course ofbusiness.

⑦

New category

Any other financial
income (e.g., income
paid by collective
investment fund,revaluation gain of
securities for sale)⑧

Lease of ships
and aircraft

Lease of any tangible
property

Lease of tangible
property used in thehome jurisdiction
Lease of tangible
property which qualifies
under certain substancerequirements⑨

Royalties on
intellectual
property

Royalties on any
intangible asset

Any intangible asset
developed by thecompany itself
Any intangible asset
used by the company in
its own business⑩

New category

Capital gains derived
from the sale ofintangible assets

Any intangible asset
developed by thecompany itself
Any intangible asset
used by the company in
its own business⑪

New category

Extraordinary excess
profitCertain exclusions (asdescribed below)

In general, the scope of taxable passive income will be expanded in all
income categories, and new income categories will be created. Notablechanges include the following.

(A) Interest Income from Qualified Intra-Group Finance
Activities
A foreign subsidiary with an effective tax rate of less than 20%, but which
qualifies for the active business exemption, may frequently use its surplus
8 Japan 2017 Tax Reform Proposal  20 December 2016

cash to provide loans to other group company, or may function as an active
finance company. Excluding interest income arising from qualified intragroup financing from the scope of taxable passive income is welcomed, so as
to support the competitiveness of Japanese multinational enterprises.
In order to qualify for the exception, however, "directors or employees of aforeign subsidiary must perform, in a jurisdiction where the head office issituated, all activities that are normally required for conducting a lending
business in an appropriate manner". Among other things, it seems to beparticularly difficult to draw a clear line regarding what is meant by conducting
a lending business "in an appropriate manner", and what specifically is meantby "all activities that are normally required" for such business. This creates apractical difficulty, this since these requirements must be satisfied in order forthe exclusion to apply.
Since the wording of the Proposal refers to "interest", rather than "interestand the like", intra-group guarantee fees may be outside the scope of taxable
passive income for purposes of the law, if the tax bill is submitted to the Diet
using exactly the same language as the Proposal.

(B) Interest Income on Bank Deposits and Exchange Gain
Arising in the Ordinary Course of Business
The Proposal does not clarify what the "ordinary course of business" meansin this context. If not clarified in the actual tax reform bill, great uncertainty
will remain for both tax payers and the authorities regarding what constitutes"the ordinary course of business" for purposes of the law.

(C) Extraordinary Excess Profit
Under this provision, the extraordinary profit of a foreign subsidiary would betaxed even if the foreign subsidiary engaged in an active business. The
Proposal provides the following formula for computing "extraordinary excess
profit".
Taxable extraordinary excess profit = (income of a foreign subsidiary other taxable passive income) - (total assets + accumulated depreciation
expense + labor costs) x 50%

9 Japan 2017 Tax Reform Proposal  20 December 2016

While the details remain to be seen, one would expect that traditional
manufacturing activities would not likely generate "extraordinary excess
profit" under the above formulate, since it would be necessary for theactivities to earn at least a 50% return on assets.
Because Japan's CFC rules apply on a year-by-year basis, however, there
could be cases in which a company, especially those operating businesses
with high volatility, to generate extraordinary excess profit in a single fiscal
year. We believe the following are cases in which a company might generate
extraordinary excess profits.
Example 1: Business Requires Minimal Capital Expenditure, but Has
Valuable Intangible Assets.
Where a company’s business model involves creating valuable intangible
assets using operating expenses such as R&D expense, but the company
has low cost of goods sold, it may generate extra ordinary excess profit.
Examples of areas in which this might occur would be pharmaceuticals andsoftware, since these businesses tend not to require the use of a large
amount of capital expenditures. This may particularly be the case if a
subsidiary outsources R&D to another company, resulting in the subsidiary
incurring lower labor costs.
Example 2: Company Does Not have Its Own Factory, or Company
Largely Outsources Manufacturing
A company with a highly recognized brand that sells products it does notitself manufacture may also generate extraordinary excess profit, if the only
"labor cost" added to total asset costs is its own. This is because such a
company would tend to generate a higher return on assets. Companies that
10 Japan 2017 Tax Reform Proposal  20 December 2016

might fall into this category would include those that sell luxury goods,
premium foods, or premium beverages.
One of the tax authority's assumptions in enacting this provision may be thatJapan parent companies have contributed to the development of valuable
brands. If the tax authorities can confirm, however, that a Japanese parent
contributed to the development of its foreign subsidiary's valuable intangible
assets, arguably the authorities should address the issue through Japan'stransfer pricing rules, rather than through the CFC rules. And in thealternative, if the Japan parent did not contribute to the development ofvaluable intangibles possessed by, for example, a subsidiary that theJapanese multinational enterprise acquired, there is no rationale for Japan totax extraordinary excess profits generated by that foreign subsidiary.
Example 3: Sale of Business, or Real Property Used in Business
Under the CFC rules currently in effect, gain derived by a foreign subsidiaryfrom the sale of an active business, or from the sale of real property used insuch active business, should not be subject to concurrent taxation underJapan's CFC rules due to the active business exemption. Depending on thetiming of measurement of the total assets, however, the above formula maylead to extraordinary excess profit in the fiscal year in which the sale took
place.
Keeping in mind the three examples set out above, it will be important toconsider the wording of the final tax reform bill, as inclusion of the proposed
extraordinary excess profit provision could lead to various issues, as
described above.

(D) Computation of Taxable Passive Income and Loss
Carryforward
Under the Proposal, taxable passive income will be classified into one of thefollowing two groups, and computed separately as follows.
Income Categories

Computation Method

Group 1(each income
categorycannot be
negative)

Interest, dividends,
stock lending, royalties,
leases of tangible
assets, andextraordinary excess
profit.

The total of these income
categories.

Group 2(each income
category canbe negative,
and can beused to offset
one other)Gain on the sale ofsecurities, income fromderivative transactions,foreign exchange gains
or losses, other financial
income, gain on the saleof intangible assets.

κκ

The total of these income
categories (if the total is aloss, it cannot be used tooffset income of Group 1)
Losses of Group 2 incurred
within the preceding 7
years can be used to offset
income of Group 2 in thecurrent year.

Under currently effective CFC rules, the amount of taxable passive income islimited to the net income of the foreign subsidiary. This limitation may be
11 Japan 2017 Tax Reform Proposal  20 December 2016

abolished under the Proposal, however, such that passive income can betaxed even if the foreign subsidiary as a whole is generating losses.

4.

Partial Inclusion for a Licensed Financial Subsidiary (NewRule)

A special rule applies to a foreign subsidiary engaging in a financial
instrument business or insurance business pursuant to applicable local law if
directors and employees of which perform, in the jurisdiction in which thehead office is situated, all activities that are normally required for conducting
the business in an appropriate manner (a "Licensed Financial Subsidiary").
The scope and method of computation of taxable passive income of a
Licensed Financial Subsidiary is as follows.
Income Categories

Computation Method

Group 1

Income fromextraordinary
overcapitalization.

No detailed method ofcomputation is provided.
Losses cannot be used to offset
other income category or be
carried forward.

Group 2(i) Lease of tangible
assets

Losses cannot be used to offset
other income categories or be
carried forward.

(ii) Royalties(iii) Extraordinary excess
profits
Group 3Gain on sale ofintangible assets

Losses can be used to offset
income of Group 2. Losses ofGroup 3 incurred within
preceding 7 years can be used
to offset income of Group 3 inthe current year.

The Proposal further provides that "taxable income" is limited to the greaterof (i) income of Group 1, or (ii) aggregation of Groups 2 and 3. To the extent
the Licensed Financial Subsidiary does not have income of Group 2 and 3(which may largely be the case) , no taxable passive income will arise as longas it does not have income from extraordinary overcapitalization. Note that
the Proposal is silent as to what constitutes "extraordinary overcapitalization".

5.

Calculation of Indirect Ownership (Article 66-6 (2) of theSpecial Measures Tax Act)

Under the currently effective CFC rules, the "indirect ownership percentage"is derived by multiplying each ownership interest down the chain to a tested
foreign corporation. Therefore, a foreign corporation owned jointly(50%/50%) by a Japanese corporation and a non-Japanese corporation
could still be regarded as a foreign subsidiary subject to Japan's CFC rules if
the foreign counterpart has Japanese shareholders. Under the Proposal,

12 Japan 2017 Tax Reform Proposal  20 December 2016

however, indirect ownership is only counted if there is a more than 50%
ownership in each level down the chain to a tested foreign corporation.
Further, the Proposal includes an amendment under which a foreign
corporation would be subject to Japan's CFC rules if the Japanese parent (orits foreign subsidiary) has a right to claim the entire amount of the proceedsof a liquidation of the foreign corporation. Further analysis should be
conducted when the language of the draft tax reform bill is finalized, as the
final amendment may lead to an increase in the scope of the "effective
control" principle.

6.

Changes to Active Business Exemption (Article 66-6 (3) of
the Special Measures Tax Act)

Under the current CFC rules, a foreign subsidiary that satisfies all theconditions of the "active business" exemption is excluded from the scope ofJapan's CFC rules, even if the subsidiary's effective tax rate is less than 20%.
The Proposal provides certain changes to the active business exemption,
including the following.
Current rule

New rule

Business test

Leasing of aircrafts
and ships does notsatisfy the businesstest under any
circumstances.

Leasing of aircrafts and ships
may satisfy the business test
if certain substancerequirements are satisfied.

Fixed place test /Control andadministration
test

If a significant portionof the foreignsubsidiary's functions
are outsourced toanother person, thecontrol andadministration test
may not be satisfied.

A foreign subsidiary that is
engaged in an insurance
business and that has a local
license will still qualify for thecontrol and administration test
even if it outsources functions
to another person (subject tosatisfaction of other applicablerequirements).

Head office test
(requires that theprime business ofa foreignsubsidiary be
conducted in acountry in which
the head office islocated)If the foreignsubsidiary outsourcesa large part of the
manufacturing process
is to another person ina different jurisdiction(e.g., toll
manufacturing), thehead office test may
not be satisfied, since
the manufacturing
activity is viewed ashaving been
conducted outside of
the jurisdiction of thehead office.

A foreign subsidiary that
outsources its manufacturing
process may still satisfy thehead office test if thesubsidiary is regarded as
playing a significant role in the
manufacturing process.

Back to top

13 Japan 2017 Tax Reform Proposal  20 December 2016

II. Introduction of Tax Free Corporate Spin-Off Method
Key changes
κ

The Proposal introduces a tax-free spin off method. One of therequirements for tax free treatment will be that the controllingshareholders do not exit before or after the corporate spin-off. It
remains to be seen whether the "non controlling shareholders"requirement applies to a spin-off followed by a tax-qualified merger
or share exchange. A split-off (i.e., where shares in Spin Co aredelivered in exchange of its own shares) appears to remain
outside the scope Japan's tax-free transaction regime.

κAfter the new law takes effect, it may not be possible tointentionally structure a minority squeeze out as a non-tax qualified
reorganization (which may, in certain cases, be more favorable toa taxpayer in the context of a series of transactions than a tax
qualified (or tax-deferred) reorganization), by using cash
consideration in the squeeze-out related reorganization.

κIn an acquisition of a publicly listed company followed by a certain
type of squeeze out transaction, it will no longer be necessary torecognize revaluation gain upon entering into a tax consolidated
group.

κThe new rules may resolve a long standing issue regarding
recognition of revaluation gain with respect to "self-createdgoodwill" at the election of or entry into a tax consolidation.

The Ministry of Economy, Trade and Industry requested that the government
introduce tax deferral measures to facilitate more flexibility in corporate
reorganizations, such as by allowing taxpayers to undergo "spin-off"transactions. The Proposal responds to this request and sets out proposedchanges to the corporate tax law that would allow spin-off transactions thatsatisfy certain requirements to be tax free. The Proposal also sets out
several other important changes to the corporate reorganization rules. In thissection, we discuss notable changes to the corporate reorganization rules.

1.

Introduction of Tax-Free Spin-Off Regime

The Proposal provides for two kinds of tax-free spin-offs, each subject to a
separate set of conditions. The tax-free spin-off rules should come into effectwith respect to corporate splits or in-kind distributions that takes place on orafter April 1, 2017.

14 Japan 2017 Tax Reform Proposal  20 December 2016

Vertical Corporate Split(transfer of business to
SpinCo followed by a
distribution of shares in
SpinCo to its
shareholders)

In-Kind Distribution of
Shares in Subsidiary

Transaction

Transfer of business to
SpinCo followed by a
distribution of shares in
SpinCo to its
shareholders
proportionally.

Distribution of shares in awholly owned subsidiary to
its shareholders
proportionally.

Control Test

ParentCo must not have a controlling shareholder
before a spin-off, and SpinCo cannot be expected tohave a controlling shareholders after the spin-off.

Asset Test

The major assets andliabilities of Parent Co
used in a spin-offbusiness must betransferred to SpinCo.

None

Employee
Retention Test

Approximately morethan 80% of theemployees engaged in
the spun-off businessmust be expected to be
employed by SpinCo

Approximately more than
80% of the employees of
SpinCo must be expected
to be retained after the spinoff.

Business
Continuity Test

The spun-off business must be expected to be
conducted by SpinCo continuously after the spin off.

Director Test

A director or employee
of Parent Co must
become a "designateddirector" of SpinCo.

All of the "designateddirectors" of SpinCo may
not resign as a result of thespin-off.

A key requirement for a tax free spin-off is that there is no "controllingshareholder" prior to the spin-off. This is a new concept; the existing
corporate reorganization rules provide for tax-free treatment primarily if thereis "control" between the parties involved. Because of this, the new ruleappears to be intended to apply to a spin-off transaction conducted by alisted company.
Key Point 1: SpinCo Must Not be Controlled by Any Person
In the USA, where corporate spin-offs are not uncommon, corporations do
not appear to conduct straight spin-offs (i.e., spinning off only a certain
business) alone; rather corporations usually couple the spin-off with anacquisition of the SpinCo by another company. Such a transaction iscommonly referred to as Reverse Morris Trust ("RMT").
The tax-free spin off included in the Proposal does not seem to extend to a
RMT-type spin off, since SpinCo must not be expected to be controlled byany person after the spin off. In considering the existing corporate
reorganization rules, however, it seems possible that this restriction would not
15 Japan 2017 Tax Reform Proposal  20 December 2016

be violated if SpinCo were merged into another person by way of a taxqualified merger.
Key Point 2: Rules Do Not Contemplate Tax Free "Split-Off"
Corporations in the U.S. will often undertake a split off transaction (i.e.,
corporation delivers shares of SpinCo to its shareholders in exchange for its
own shares), and/or give shareholders the right not to exchange shares,
rather than to undertake a spin-off transaction, so as to avoid dilution of thecompany's share price. It appears that this type of transaction is not included
as a type of tax free transaction under the Proposal.
Key Point 3: Non-Tax Issues
As discussed above, the tax-free spin off rules appear designed to facilitate
spin-offs by listed companies. The Japanese stock exchange's listing rules
may also need to be amended in order to allow the shares of SpinCo to belisted immediately after the transfer of the spun-off business by Parent Co.
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III. Changes to Japan's Corporate Reorganization
Regime1. Treatment of "Cash Out" Squeeze Out Transactions
The Proposal amends the taxable corporate reorganization rules by allowing
a certain corporate reorganization such as merger or share exchange to be
used to squeeze out minority shareholders even if "cash" is delivered to theminority shareholders. Under the current rules, if cash is delivered to minority
shareholders, the squeeze out transaction is automatically treated as ataxable corporate reorganization. A taxable transaction may under certain
circumstances be more favorable to the taxpayer than a tax-freereorganization, because the taxpayer can obtain a basis step up etc. Under
the new rules, however, delivering cash to minority shareholders will be
disregarded if the corporation acquiring the Target already owns 2/3 of thetotal issued shares of the Target prior to the squeeze out transaction. The
transaction will thus likely be treated as a tax-free merger or share exchange
under the new rule.
The new rule will apply to transactions conducted on or after October 1, 2017.

2.

Application of Corporate Reorganization Rules toTransactions that are Not Corporate Reorganizations

Under the current rules, certain minority squeeze out transactions are notconsidered corporate reorganizations if the taxpayer uses transactions otherthan those that are part of the corporate reorganization rules under theCompanies Act; for example, the rules call for mandatory share repurchasesby the company and a mandatory right of large shareholders to acquire
shares from minority shareholders. Such minority squeeze out transactions
would lead to recognition of revaluation gain if the acquirer is a member of a

16 Japan 2017 Tax Reform Proposal  20 December 2016

tax consolidated group because the transaction would not be considered anacquisition by way of a tax-free reorganization.
Under the new rules, it is expected that such squeeze out transactions canbe treated as a tax-free corporate reorganization, and would be excluded
from the scope of revaluation gain rules under the tax consolidation rules.
The new rule will apply to transactions conducted on or after October 1, 2017.

3.

Recognition of Revaluation Gain under Tax Consolidation
Rules and in Taxable Share Exchanges

Under the current rules, when a corporation elects tax consolidation, or adomestic corporation either enters into an existing tax consolidated group or
undertakes a taxable share exchange, built in gain or loss of certain assets
owned by the tax consolidated subsidiary or a corporation entering into an
existing tax consolidation group or a corporation acquired by way of taxable
exchange must be recognized and taxed immediately. A long standing issue
in practice has been whether goodwill is subject to this revaluation rule.
Under the Proposal, any asset which has a tax basis of less than JPY 10
million will be excluded from the scope of assets that must be revalued;
therefore, the need for revaluation will not only be relaxed for goodwill, but for
any off-balance sheet intangible assets that are clearly within the scope ofrevaluation under the current rule, including patents and trademarks.
The new rule would apply to transactions conducted on or after October 1,
2017.
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17 Japan 2017 Tax Reform Proposal  20 December 2016

IV. Changes to Gift/Inheritance Tax Rules
The proposals include revisions to Japan's gift and inheritance tax rules
which, if incorporated as proposed, will increase complexity of the current
regime, and change the scope of foreign and Japanese persons potentiallysubject to the tax.

1.

Overview of Proposed Rules

The new rules introduce new categories of residents for inheritance / gift tax
purposes; specifically, a "short-term visitor" and a foreigner with a "temporary
address".
The proposed rules can be summarized as follows:
Currently has Address in Does Not Currently Have Address
Japan

In Japan

HEIR / GIFT

Japanese Citizen

RECIPIENT"Temporary

DECEDENT /Address" *1

GIFT DONOR

Had anNo

Address in

Address

Not a

Japan atin JapanJapanese

Sometimeat

Citizenin the Last

Anytime

10 Yearsin the Last
10 Years

Currently
Has Japan"Temporary

Address

Address" *1

D/F

D/F

D/F

D/F

D/F

D/F

D onlyD/F

D onlyD only

D/F

D/F

D/F

D/F

D/F

D/F

D onlyD/F

D onlyD onlyD/F

D onlyD/F

Had an Address
in Japan at
Does Not

Sometime in the

Currently

Last 10 Years

Have an"Short-Term

Address inVisitor" *2

Japan

No Address inJapan at Anytime

D onlyin Last 10 Years

D = Domestic (Japan-situs) assets

F = Foreign (non-Japan-situs) assets*1 A foreigner with a "Temporary Address" is one who is in Japan on aworking visa (not a PR or spousal visa) and has lived in Japan for a totalof 10 or fewer years out of the last 15 up to the date of the inheritance.
*2 A "Short-Term Visitor" is a non-Japanese national who resided in Japanfor a total of 10 or fewer years out of the last 15 up to the date of theinheritance.

18 Japan 2017 Tax Reform Proposal  20 December 2016

For further information
please contact

2. Changes From Previous Rules(A). Thresholds Changed from Five Years to Ten Years
Under the previous rules, the relevant thresholds for changes in tax treatment
were having had an address in Japan at any time in the last five years; thethreshold has been raised to any time in the last ten years.

Edwin T. WhatleyPartner+81 3 6271 9458
Edwin.Whatley@bakermckenzie.com

Ryutaro Oka
Partner+81 3 6271 9474
Ryutaro.Oka@bakermckenzie.com

Shinichi Kobayashi
Partner+81 3 6271 9467
Shinichi.Kobayashi@bakermckenzie.com

Howard Weitzman
Counsel+81 3 6271 9724
Howard.Weitzman@bakermckenzie.com

Koji Oshima
Economist+81 3 6271 9546
Koji.Oshima@bakermckenzie.com(B). Introduction of "Short-Term Visitor" and Foreigner with a"Temporary Address"
The proposal introduces two new categories of short term residents, who
would be taxed only on assets located in Japan upon an inheritance or gift,rather than on worldwide income. This would be an improvement from thecurrent rules, which make no distinction between "short-term visitors" orforeigners with a "temporary address" and other residents of Japan, whose
worldwide assets are subject to taxation in the event of an inheritance.

(C). Heirs of Long-Term Foreign Residents Subject to Tax on
Residents' Worldwide Assets Even After Individual has LeftJapan
Under the proposed rules, where a foreigner other than one who is a "shortterm visitor" - meaning a non-Japanese national who has resided in Japan fora total of 10 or fewer years out of the last 15 - who has resided in Japan at
any time in the last 10 years dies, his or her heirs are subject to Japanese
inheritance tax on the decedent's worldwide assets. Put another way, aforeigner who has resided in Japan, regardless of visa-type, for more than 10
out of the last 15 dies, even if the foreigner has expatriated, his or her heirs
will be caught by this provision.
The provisions as drafted in the proposal, would appear to capture within thescope of worldwide inheritance taxation, a non-Japanese national who has
expatriated from Japan, who dies within five-years of his or expatriation. For
example, assume Mr. X, a US national, lived in Japan from 2003 - 2018. In
January 2018, Mr. X expatriates from Japan to live in the US. According to
the new provision, Mr. X's heirs would be subject to Japanese inheritance tax
on Mr. X's worldwide assets if Mr. X resided in Japan at any time in theprevious 10 years. Thus, under these rules, Mr. X's heirs would be subject toJapanese inheritance tax on Mr. X's assets if Mr. X passes away at any time
up to 2018. This 10 year rule does not apply, however, to a "short-term
visitor" of Japan. Although the wording of the current tax proposal is not
crystal clear, this would appear to mean that if Mr. X passes away afterJanuary 2023, his heirs1 would only be subject to Japanese inheritance tax
on Mr. X's Japan-situs assets. This is because after January 2023, Mr. X
should be considered a "short-term visitor" of Japan, as he would haveresided in Japan for less than 10 out of the 15 years up to his passing. As ashort-term visitor, his heirs should only be subject to Japanese inheritancetax on Mr. X's Japan-situs assets.

1

The example in this paragraph assumes that Mr. X's heirs are themselves either
non-Japanese nationals, or if they are Japanese nationals, that they have not resided
in Japan at anytime in the last 10 years.

19 Japan 2017 Tax Reform Proposal  20 December 2016

3.

Conclusions

As noted at the outset, the new rules appear to be a "mixed bag" for foreign
nationals residing in Japan.
On the positive side, the introduction of new "short-term" residency and"temporary address" rules, allow a non-Japanese national, who may be inJapan temporarily in connection with, for example, a work-related transfer, topotentially escape from the net of Japanese inheritance taxes on worldwide
assets. This change, if adopted as proposed, will hopefully make it easier forforeign and Japanese corporations to entice talented foreign personnel totransfer to Japan.
On the negative side, the new rule appears to capture current long-term
residents within the net of Japanese inheritance taxation on worldwide assets,
for five years after such persons have completely expatriated from Japan.
This change was unexpected, and appears inconsistent with international
standards. Whether the government consents to rolling back this tax
proposal remains to be seen, and we will provide another update as soon as
there are developments.
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20 Japan 2017 Tax Reform Proposal  20 December 2016