May 2019
Under the Japanese corporate tax law, earnings stripping rules have been introduced with the aim of preventing tax avoidance by limiting the deductibility of interest paid to related parties where it is disproportionate to income. The rules apply both to Japanese subsidiaries and branches of foreign companies. Under the 2019 tax reform, pursuant to the BEPS initiatives and the recommendations by the BEPS Action 4 final report, the earning stripping rules will be amended by reducing the current 50% of adjusted taxable income to 20% in computing interest expense disallowance. This revision will generally strengthen the current rules.
The earnings stripping rules were introduced for fiscal years commencing on or after 1 April 2013, and under the current rules if net interest expense (the total amount of interest expense less the total amount of interest income) to related parties exceeds 50% of adjusted income, the excess portion is disallowed.
Disallowed interest expense can be carried forward for 7 years (the 2019 tax reform does not affect this).
(1) Scope of interest expense
Under the current rules, net interest expense includes interest paid to foreign related parties only (interest paid to third parties is not included).
However, under the 2019 tax reform, net interest expense is calculated as follows:
Net interest expense = (A) - (B)
It does not matter whether interest expense is paid to related parties or unrelated parties. Also, interest included in the Japanese taxable income of the recipient is excluded from the above net interest expense.
(2) Adjusted income
The adjusted income is computed based on income before deduction of interest, taxes and depreciation/amortisation expenses (EBITDA). Currently, non-taxable domestic and foreign dividend income is included in the calculation of adjusted income; however, under the tax reform for fiscal year 2019, non-taxable domestic and foreign dividend income will be excluded from the calculation of adjusted income.
In addition to the above, the calculation of adjusted income for operators of silent partnerships (Tokumei-Kumiai, TK) will be newly provided.
(3) Deduction limit
Under the current tax law, the disallowed interest expense is calculated as follows:
“Net interest expense to related parties” – “Adjusted income x 50%”
In this regard, under the new rules, the deductible amount of net interest expense (including net interest expense to non-related parties) will be limited to 20% of the adjusted income for the current fiscal year.
(4) De Minimis Rules
Under the new rules, the earnings stripping rules do not apply if:
A) Net interest expense does not exceed JPY 20 million (raised from the current JPY 10 million); or
B) The ratio of group net interest expense to group adjusted income is 20% or less (newly established group basis exemption criteria)
|
|
Current rules |
Revision |
|---|---|---|
|
1. Scope of interest expense |
Related parties net interest expense |
Net interest expense (including third party interest expense) |
|
2. Adjusted income |
Non-taxable domestic and foreign dividend income is included |
Non-taxable domestic and foreign dividend income is not included |
|
3. Deduction limit |
50% of the adjusted income |
20% of the adjusted income |
|
4. De Minimis Rules |
・Net interest expense of JPY 10M or less ・Total interest expense paid to related parties is 50% or less than the total interest expense paid |
・Net interest expense of JPY 20M or less ・Total ratio of group net interest expense to group adjusted income is 20% or less |
The thin capitalisation rule restricts the deductibility of interest payable by a resident subsidiary to its overseas controlling shareholders. The debt/equity ratio as a safe harbour is 3:1, i.e. if the debt from the overseas controlling shareholders exceeds the ratio, interest expense calculated on the excess debt is treated as a non-deductible expense for Japanese corporate tax purposes.
If both the earnings stripping rules and the thin capitalisation rules are applicable in a fiscal year, only the larger of the disallowed amounts under either will be applied. However, even if the non-deductible amount of the earnings stripping rules is larger, when the earnings stripping rules are not applied as the above-mentioned “De Minimis Rules” are satisfied, the thin capitalisation rules will be applied.
The above revision will be applied to tax years beginning on or after 1 April 2020.
Since the scope of interest expense will be expanded and also the deduction limit will lower by this revision, companies that are not affected under the current rules may need to consider the impact of this revision.
In addition, it is necessary to pay attention to the fact that the deduction limit will be reduced at a holding company that mainly receives dividends from subsidiaries.
Kenichiro Kishi
kishi@bdotax.jp
Risa Kuribayashi
kuribayashi@bdotax.jp