2022 tax reform proposals would expand scope of earnings stripping rules to foreign entities
The 2022 tax reform proposals, announced by Japan’s ruling parties on 10 December 2021, are the first such proposals under the Kishida administration, whose objectives are to foster a “positive cycle of growth and distribution” and the “development of new society after COVID-19.” While changes are proposed to various taxes, including corporate tax, personal income tax, consumption tax (Japanese VAT/GST), inheritance tax, gift tax, customs duties, etc., the following are the main tax reform items that would affect corporate tax:
- Revisions to the earnings stripping rules
- Modifications to the CFC rules for insurance companies, etc.
- Revisions to tax credits for salary increases
- Revisions to the disallowance of R&D and certain other tax incentives for large companies
- Revisions to tax incentives for promoting open innovation
- Revisions to the group relief system
- Revisions to the enterprise tax rate for non-small and medium-sized entities
- Special provision for the reduction of book value of shares in subsidiaries
- A two-year transition period (from 1 January 2022 to 31 December 2023) to facilitate the shift to the electronic data retention system, depending on a company’s circumstances.
While the 2022 tax reform proposals do not include specific details, the Japanese government intends to introduce measures related to digital taxation and global minimum taxation.
The most important measure in the proposals that would affect the tax position/status of foreign entities likely are the revisions to the earnings stripping rules. Under the current rules, if net interest expense (i.e., the total amount of interest expense less the total amount of interest income) exceeds 20% of adjusted income, the excess amount is disallowed as a deduction for corporate tax purposes. The rules are applicable to companies incorporated in Japan (i.e., domestic entities) and foreign entities with a permanent establishment (PE) in Japan where Japan-source income is attributable to the PE. Foreign entities without a PE in Japan that earn certain Japan-source income, such as from aircraft leasing or real estate investments, are not subject to the earnings stripping rules.
This would change under the 2022 tax reform proposals. To align the treatment of domestic entities and foreign entities, the scope of the earnings stripping rules for foreign entities would be expanded to include Japan-source income derived by foreign entities that have a PE in Japan when the income is not attributable to a Japanese PE, as well as to Japan-source income earned by foreign entities that do not have a PE in Japan. The following table sets out the current rules and the tax treatment under the proposed changes to the earnings stripping rules:
* For example, rental income from real estate in Japan, income from the provision of personal services, capital gains from the sale of Japan real estate / specific shares in a Japanese company, etc.
It should be noted that the final measures could differ from the 2022 proposals, depending on the outcome of discussions in the parliament, which is expected in March.