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Asia Focus

Tax developments challenge
Japanese taxpayers
Eiki Kawakami of Kojima Law Offices looks back at a busy few months for the Japanese tax system. Politics anddisputes have been keeping taxpayers busier than ever with a number of important decisions making many think
twice about how they structure their work.

The Democratic Party of Japan suffered acrushing defeat in the House ofCouncilors Election on July 11 2010.
During the election campaign, particularly
when the campaign was heating up towards
the end of June, Prime Minister Naoto Kan(member of the Democratic Party of Japan),
who returned from the G8 meeting held inToronto, abruptly proposed to double theconsumption tax rate from 5% to 10% andreduce the corporate tax rate to 25%.
Although it was apparent that Japan must
adopt these tax measures to meet the fiscal
challenges faced by the country, such as promoting economic growth and restoring government finances, his approval ratings
declined as soon as he began campaigning.
As a result, the ruling party suffered a crushing defeat in the election. Judging from thesentiment of the people, it seems that Kan’s
proposals were considered handouts to large
corporations at the expense of the generalpublic.
The Japanese corporate tax rate of 41% issignificantly higher than tax rates in othercountries. Since the opportunity to reduce
the tax rate effectively vanished in the wakeof the election defeat, tax directors of multinational companies will likely continue theirefforts to minimise their effective tax rate inJapan. Amid the political developments
described above, two significant tax disputes
were recently reported and are summarisedbelow.

Yahoo JapanThe taxpayer in this dispute was Yahoo Japan.
Softbank, a leading telecommunications
company, held 40.95% of Yahoo Japan’s outstanding shares and Yahoo Inc. (the US parent of Yahoo Japan) held 34.79% of theoutstanding shares.
In February 2009 Yahoo Japan purchasedfrom Softbank 100% of the outstanding
shares in a subsidiary of Softbank which
operated a data centre. Then, Yahoo Japan
took over the subsidiary’s business operations by merging the purchased subsidiary
into Yahoo Japan. Through the merger,YahooJapan acquired the purchased subsidiary’s tax
loss carry-forward which amounted to ¥21billion ($230 million). However, the Japanese

September 2010

tax authorities found that Yahoo Japan could
not acquire the tax loss carry-forward andissued a Tax Reassessment Notice on June 30
2010.
By virtue of the 2001 tax reforms whichchanged the tax rules relating to mergers andother reorganisations, the tax loss carry-forward of a predecessor company in a merger
can be acquired by the merged company,
provided that a transaction will not fall foul of
the anti-tax avoidance provisions that the law
specifically prescribes for the succession of atax loss carry-forward in a merger. There are
two requirements to acquire the tax loss
carry-forward in a merger. Firstly, the merger
must create synergy. Secondly, certain members of management of the predecessor company must be retained as members of themanagement of the merged company.
Yahoo Japan maintained that both
requirements were met because the purposeof the merger was to utilise the data center
capabilities of the purchased subsidiary forYahoo Japan’s cloud computing business. andthat the president of Yahoo Japan had also
been a vice president of the purchased subsidiary since 2007.
However, the tax authorities asserted thatfor the first requirement, Softbank’s cash
funding needs was an essential reason for thetransfer of shares. Further, the tax authorities
asserted that it would not be possible to treat
the merger as a transaction that was conducted proactively to meet a business necessity. For the second requirement, although
the tax authorities stated that the requirement might be fulfilled in form, they foundthat the requirement was not fulfilled in substance. The tax authorities also stated that in
the determination of the price of the shares ofthe purchase subsidiary, the expectedamount of tax savings that Yahoo Japan
would be able to obtain by the acquisition of
the tax loss carry-forward was factored into
the price of the shares.
This dispute indicates that the tax authorities are not reluctant to take the concept of
substance over form and apply it broadly intheir determination of whether the two
requirements have been met. However, as it
seems likely that the case will be appealed
through the courts, time will tell whether

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such a broad application of the concept of
substance over form is warranted.

IBM Japan
The taxpayer in this dispute was IBM Japan.
The tax authorities recently issued a Tax
Reassessment Notice on the grounds that thecompany’s reported taxable income in 2008
(and in subsequent years) was understatedby ¥400 billion ($4.4 billion). The structure of
the transaction is described below:
1) The seller owns 10 shares issued by thetarget (all of the outstanding shares of thetarget);2) The target has capital of 100 and retained
earnings of 900;3) The seller will sell the 10 shares of the target to the buyer and the sale price of the
10 shares will be equal to the sum of thecapital and retained earnings, such as
1000. The sales price per share will therefore be 100; The seller’s cost basis of theshares is equal to the capital of the targetor 100. Therefore, the seller will recognisea taxable gain of 900 in the sale of theshares. Since the appreciation of theshares has been created by the earnings ofthe target, there would be double taxationon the earnings such as the taxation on
the target on its earned profits and taxation on the sale of the target’s shares;
4) After acquiring the shares of the target,
the buyer will have the target buybacknine shares that were originally owned by
the target (the target will pay 900 to thebuyer and acquire nine treasury shares).
For tax purposes, the 900 that the buyer
will receive will be deemed to consist of adividend distribution of 810 and consideration of 90 for the transfer of the shares.
The dividend distribution is exemptedfrom taxation as it is paid out from profitsthat have already been taxed. For the consideration of 90 for the transfer of theshares, the corresponding cost of theshares is allowed to be offset. Therefore
the buyer is allowed to report a taxable
loss of 810. (The taxable loss of 810 should
be regarded as the recovery of the 90%
portion of the double taxation notedabove);5) If the buyer is a holding company and|1

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does not have taxable profit, the buyer andtarget can file consolidated tax returns. By
doing so, it becomes possible to offset thetaxable loss of 810 against the taxable
profits of the target.
Presumably, the structure described aboveis the structure that IBM implemented whichis the focus of the Tax Reassessment Notice.
This means that the target is IBM Japan (anoperating company in Japan), the seller isIBM Corporation (the parent company ofIBM Japan in New York), and the buyer is IBM
AP Holdings (a holding company establishedin Japan by IBM Corporation).
It should be noted that because the structure implemented would ordinarily cause
taxes to be imposed at an initial stage, theimplementation of the structure would usually not generate any tax savings. However, if
the seller is a qualified resident of the US forthe purposes of the double tax treaty
between Japan and the US, the above-mentioned Japanese taxation of the capital gain of900 will be exempt from Japanese taxation
and would create significant tax savings inJapan.

2010 Tax Reforms
For Japanese tax reforms in 2010, what ismost interesting is that certain sections of thetax law (and related regulations which arerelevant to the above-mentioned taxable lossof 810) were reformed. As a result, undersimilar circumstances, the tax deduction of
the loss of 810 will no longer be allowed
when the new law takes effect on October 12010.
The new law provides that: if a domestic
corporation transfers shares to the corporation that issued the shares and if the transferor and transferee are wholly-owned affiliates
within a corporate group, any gain or loss
realised by the transfer will not be recognised
for tax purposes; and if a domestic corporation acquires shares intending to subsequently have the shares acquired as thetreasury shares of the corporation that issued
such shares and if the shares are acquired asa treasury share by the corporation whichissued the shares, the tax exemption of thedividend distribution received will not apply.
Given the nature of these reforms, itwould seem that the tax deduction of losses(as was done in the IBM structure mentionedabove) were in compliance with applicable
tax laws and regulations then in effect.
However, the tax authorities seem to be taking the position that general principles ofanti-tax avoidance will apply even before a
specific anti-tax avoidance rule is enacted.

Tax litigation
In the field of tax litigation, on December 3
2009, the Supreme Court rendered a significant judgment involving the constitutional

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Asia Focus
Eiki Kawakami
Kojima Law Offices
Gobancho Kataoka Bldg 4F., Gobancho 2-7,Chiyoda-ku, Tokyo 102-0076 Japan
Tel: +81-3-3222-1401
Fax: +81-3-3222-1405
Email: e-kawakami@kojimalaw.jp
Website: www.kojimalaw.jp
Eiki Kawakami is the head of Kojima Law Offices’ tax practice. He has 30 years of experience providing local andinternational tax advice, and specialises in developing tax
strategies for international clients to maximise efficiencies
in their Japanese operations.
Previously he was a tax partner first with Arthur Andersen
Worldwide Organisation and then with KPMG Japan. He
moved to Kojima Law Offices in November 2007.
He built the leading and fastest growing independent tax
firm in Japan. Kojima Law Offices has been named byInternational Tax Review as the 2009 Japan Tax Firm of theYear and also has been listed as a leading tax firm in WorldTax 2010.
He has served clients in a variety of industries including theautomotive, pharmaceutical, healthcare, software, technology, engineering, retail, financial services, hotel operations and leasing sectors. His primary advisory capabilities
involve tax issues associated with inbound investment
structures, cross-border financing, M&As, reorganisations,
equity compensation and tax litigation support.

principle that no taxes can be assessed without a law requiring such assessment. The
court case concerned a dispute over whether
or not a tax payment to the government in
Guernsey qualified as a foreign tax payment
under the Japanese controlled-foreign company (CFC) rules. The tax laws in Guernsey
allow a taxpayer to choose the tax rate which
would apply to a taxpayer and a captive
insurance company in Guernsey that is amember of a Japan-based corporate group.
The company selected the tax rate of 25.5%
which was slightly higher than the thresholdtax rate of 25% under the Japanese CFCrules.
Although the tax authorities asserted thata payment in Guernsey would not qualify as
a foreign tax payment under Japanese tax
laws, the Supreme Court held that the payment constituted the payment of a tax
because it satisfied the requirements of apayment of tax established in previous court
precedents. Further the Supreme Court
found that it was a foreign corporate tax as it
satisfied the requirements of the foreign corporate tax prescribed in the corporate income
tax law. Consequently, the taxpayer prevailed.
In the lower court, the tax authorities
pointed out that “when a legislator legislates,
the legislator will envision certain situations

www.internationaltaxreview.com(which will be covered by such legislation),
but will not be able to envision every situation (that should be covered by legislation).
Therefore, it is inevitable that written laws
will become general and abstract”. The tax
authorities also asserted that, “a court must
assume the authority and responsibility toestablish concrete rules applicable to a dispute based on such general and abstract laws
in order to settle disputes.”, and therefore,“when a court interprets a law, the interpretation should inevitably include the functionof creating law”. This assertion by the tax
authorities seemed to be the authorities’basisof the above-mentioned tax reassessment
directed against Yahoo Japan.
The tax authorities also asserted that“some may argue that tax avoidance can beprevented by legislation. However, in thearea of international tax avoidance, legislation based on prior experience has limitationsin preventing tax avoidance and thus we cannot solely rely on the legislature to solve tax
avoidance problems and maintain the principle of equal taxation”. This assertion by thetax authorities seemed to be the authorities’basis of the above-mentioned tax reassessment on IBM Japan. However, the Supreme
Court rejected these assertions, at least in theGuernsey case.

September 2010