Latest and planned rules are mostly useful
In recent years, there have been a number of changes to the Japanese tax system that have had an impact on foreign investment in Japan and Japanese investment overseas. The changes have been mainly positive for investors and, where they have had a detrimental affect, the Japanese government has sometimes made further changes to improve the position for investors.
Since 2003, when Japan and the US signed a new double-tax treaty, Japan has embarked on a programme of updating old tax treaties as well as signing agreements involving countries — particularly in the Middle East — with which it has not previously had tax-related arrangements.
As part of this programme, a new UK-Japan treaty was signed in 2006. This has had a positive impact on UK investors in Japan, since it has reduced (and in some cases removed) withholding tax on dividends and interest paid between the two countries. It has also removed the withholding tax that previously applied to royalties paid by Japanese firms to those in the UK. This has helped resolve a problem that often arose during Japanese tax inspections: tax authorities would argue that a payment to the UK is a royalty and so subject to 10% withholding tax, while taxpayers would argue that it was not a royalty.
In 2005, there were a number of changes to the Japanese tax law that made foreign investors potentially subject to Japanese tax when they invested in Japan through partnerships or other fund vehicles. This was particularly disadvantageous to private equity funds and their investors, since it could subject them to 30%, or even 41%, tax in Japan.
Fortunately, however, a further change was made to the law in 2009 that removed the Japanese tax liability from passive foreign investors who are not actively involved with the management of the fund and who only own a small stake in the total fund.
While the above amendments have been beneficial to UK investors, one downside is that the Japanese tax authorities generally require various documents to be filed to obtain the benefits. This means foreign investors need to provide more information on their activities than has previously been the case. The new tax treaties Japan has entered into have also restricted the firms that are entitled to benefit from the treaty. This has the potential to affect UK groups (and others) who invest in Japan via third-party countries such as the Netherlands.
Another area in which Japan is increasing the documentation requirements is transfer pricing. Taxpayers will be required to provide evidence showing how they have set prices with related parties outside Japan.
Japan will also introduce new tax rules for transactions between wholly owned group firms in Japan. One of these rules will allow assets to be transferred among the group companies in Japan without tax being payable on any gain until a later date. Again, this is positive for foreign groups operating in Japan, since it addresses an issue that often arises, whereby there is a tax cost even though the group has not profited from the transfer in economic terms.
As well as addressing tax issues facing investors in the Japanese market, Tokyo has also implemented changes to assist Japanese firms investing overseas. One of the most significant amendments is the introduction of a foreign dividend exclusion (FDE) system in 2009. Under the old rules, when a Japanese firm received dividends from an overseas subsidiary, the dividends were taxed at approximately 41% in Japan, with credit for tax paid in the foreign subsidiary. This meant there was a significant additional tax cost if Japanese groups wanted to bring overseas profits back to Japan, either to invest here or to pay their shareholders. Under the FDE system, a substantial part of such dividends is exempt from additional Japanese tax when paid back to the Japanese parent.
The new rules mean that there is little or no additional tax cost for Japanese firms remitting overseas profits back to Japan for investment in Japan (or elsewhere), but they also mean that Japanese groups can reduce their overall tax costs by having operations in overseas countries, such as the UK, rather than having them in Japan.
Since the FDE system began last year, the initial focus of Japanese groups has been to bring earnings back to Japan, but it remains to be seen how, in future, the system will impact decisions on where to locate their operations.