Progress is good, but further improvements needed
On 16 December 2010, the Japanese government published the 2011 tax reform proposals. They include changes designed to promote the country as a principal Asian financial market. Below I explain the key tax reform proposals that affect the banking sector, and examine further changes that might be introduced to achieve these aims. The tax reform suggestions followed a period of lobbying by industry groups, including the International Bankers Association (IBA) and various chambers of commerce. The proposals designed to encourage foreign investment in Japan’s financial and securities market include the following:
Dividends and capital gains from listed stock
Reduced withholding tax rates currently apply to dividends, while reduced tax rates apply to capital gains from listed stocks (7% for national tax and 3% for local tax). These reduced rates were due to expire on 31 December 2011, but have been extended for two years.
For foreign firms and non-resident individuals receiving qualifying dividends, this means a withholding tax rate of 7% (as local taxes should not apply). The extension should encourage foreign investors to continue to “buy Japan” in the capital markets, a trend that has been very clear in the progress made by the Nikkei 225 stock exchange average this year.
The proposals provide a tax exemption for interest and lending fees received by foreign financial institutions in respect of securities lending (limited to lending with cash or securities put up as collateral) satisfying certain conditions, including a term of six months or less. Applicable securities include book-entry local and corporate bonds and listed stocks.
This helps bring Japan in line with other major financial centres in respect of the taxation of securities lending, and should encourage this important activity.
Measures to attract foreign investors requiring Sharia law-compliant financial instruments were proposed. Distributions received by foreign investors in respect of quasi-bond beneficial interests (equity-type bonds) will be exempt from tax. This is a welcome proposal that seeks to provide tax benefits similar to those available for book-entry bonds. Further measures the FSA should consider for future reform include
PE taxable income
One significant tax disadvantage for foreign financial institutions operating in Japan is the method of profit attribution to a branch or “permanent establishment” (PE) in Japan. Currently, under Japanese domestic tax law, when a foreign firm has a PE in Japan, all the foreign firm’s Japan-source income is taxable in Japan—not just the income attributable to the PE itself—although it may be possible to reduce the amount to the attributable income under an applicable tax treaty.
Although the FSA supported a change to domestic tax law to restrict taxable income of a PE to that attributable to it, the proposals made no changes to these rules and foreign investors will need to continue to lobby for change in this area.
Currently, there is limited scope for the offsetting of tax profits and losses between different types of financial products, specifically for individual tax payers. This discourages foreign investors from diversifying their portfolio of investments, and may be an area for future tax reform if the government is to demonstrate its continuing commitment to foreign investment.
While the press has focused largely on the headline-grabbing reduction in the effective rate of corporate income tax, there were some significant reforms aimed at encouraging foreign investment in Japanese capital markets. Although certain lobbied-for changes were not included in the final proposals, the changes introduced do indicate that business and commercial groups, such as the IBA, are being heard and the government is pursuing a plan to further foreign investment. The FSA and lobbying groups should be congratulated for progress to date, while continuing to work towards further tax reform in this area.