www.pwc.com/jp/tax
Japan Tax Update
Background to the potential revision to
the Japanese tax rules for attributing
profits to permanent establishments
Issue 93, October 2013
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The release of the report by the
Ministry of Finance (MOF) with
potential amendments to align the
taxation of branches with the
OECD's authorised approach
represents a fundamental
modification of Japanese tax law;
in line with international tax
trends and the approach of
Japan's major trading partners.
This article explores the
contextual background to the
report, the rationale for any
change and where it may lead.
This article is published together
with our technical newsletter on
MOF's report, as a complementary
analysis.
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In late 2012 MOF announced its intention to change
the existing rules for the attribution of profit to a
permanent establishment (PE). The MOF proposal is
that the authorised OECD approach to the attribution
of profit (AOA) be adopted into the Japanese tax
legislation. As set out in the OECD’s 2010 Report on
the Attribution of Profits to Permanent
Establishments1, the AOA states that “the profits to
be attributed to a PE are the profits that the PE would
have earned at arm's length,… if it were a separate
and independent enterprise…, taking into account the
functions performed, assets used and risks assumed.
That is, the AOA hypothesises the PE as a separate
legal entity and, applying the OECD's Transfer
Pricing Guidelines by analogy, attributes an arm's
length return for the functions performed, assets used
and risks assumed by the PE.
Since that time MOF has expended considerable
energy and resources to canvass taxpayer views on
the proposed changes. In particular, MOF has been
interested to identify the key issues that most concern
taxpayers in relation to the scope and application of
any change in law.
There can be no doubt that this is an extremely
complex area of tax law. To help companies
understand and navigate through the relevant issues,
this article provides some background on the key
issues that are likely to arise and the impact they may
have on taxpayers, regardless of industry and
regardless of whether Japanese or foreign
headquartered.
Part I, ¶8. See:
http://www.oecd.org/ctp/transferpricing/45689524.pdf.
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Japan Tax Update
Current Japanese tax rules for attributing profit to a permanent establishment
Under the current Japanese domestic tax rules for attribution of profit to PEs, all Japan sourced income is
taxable in Japan, regardless of whether it is attributable to the PE or not 2. Japanese tax law further regulates
what is the Japanese sourced income where the business is conducted both in and outside Japan. Except in
certain specific cases, Japan sourced income for a PE is generally calculated as the “portion” of the enterprise’s
business income to be earned by the Japan PE, based on the separate enterprise theory or the degree of the
contribution by the Japan PE3. However, there are no further guidelines as to how this separate enterprise
theory would be applied.
Although deduction of certain costs incurred for the purposes of the business in Japan is permitted by the PE,
this does not include certain expenses arising from dealings with another part of the enterprise to which the PE
belongs. For example, deductibility is denied for interest expenses on funding or on royalty payments from use
of intangible assets provided by head office (or another PE)4.
This position may be mitigated somewhat where there is a treaty in place, insofar as only the income attributable
to the activities of the PE should then be taxable. However, none of Japan’s tax treaties has an impact on the
recognition of dealings between a head office and its PE (or between two PEs of the same enterprise) and
therefore none of them changes the treatment of items such as interest or royalties.
Why should Japan follow the OECD?
Given the complexity of the issues raised by the proposed law change and the scope of existing tax laws that will
need to be amended or rewritten if the AOA is adopted, many taxpayers may wonder whether it is in Japan’s
best interests to follow the OECD on this issue. The size of the task faced by the Japanese legislators can best be
understood by the fact that it took the OECD 10 years to finalise its report on this topic.
The obvious question is therefore whether the introduction of the AOA into the Japanese tax law is really
necessary. Nevertheless, and despite the concerns described above, the answer to this question would appear to
be yes, given Japan’s status as an OECD member. One obligation of membership is that Japan is in principle
required to ensure that its laws are consistent with OECD principles as far as possible. This is particularly the
case when, as now, the Chairman of the OECD’s Committee on Fiscal Affairs is Japanese5.
In addition, as other OECD member countries begin to incorporate the AOA into their own domestic legislation,
and as the OECD Model Tax Treaty and its Commentary are updated to reflect the AOA principles, increasing
gaps in interpretation of treaty provisions and in expectations between Japan and its treaty partners will arise if
Japanese domestic law is not also updated.
Moreover, the difficulties Japan may face around drafting and implementing legislation on an issue as complex
as the attribution of profit to PEs should be somewhat mitigated by the significant body of work that already
exists on this topic. This includes both work attributable to the efforts of the OECD in its collective capacity, as
well as experience derived from the actions of individual member states (e.g., Australia), which have already
implemented or are considering to implement the AOA themselves. It also includes a large volume of research
and commentary written by both academics and professional advisers within the industry, who have followed
the OECD’s work over the course of many years. As a result, Japan benefits from extensive thought leadership
and available knowledge in relation to the issues that need to be considered when making a significant change of
this nature.
Finally, bringing Japan’s domestic legislation in alignment with what is increasingly seen as the international
standard may improve Japan’s attractiveness as a place of operation in Asia for multinationals. As will be
explained in subsequent articles, the current domestic legislation can result in a need to use tax treaties or other
additional structuring to achieve an end similar to what is currently achievable in Singapore or Hong Kong, key
financial hub competitors of Japan in the region.
On balance therefore, the Japanese government’s intention to pursue this legislative change would appear to be
a positive step forward.
Article 141-1 of the Corporate Tax Act and Article 176(1)-7 of the Corporate Tax Act Enforcement Order.
Article 176(1)-7 of Corporate Tax Act Enforcement Order.
4 In practice an exception is made to permit the deductibility of interest payments by bank branches (i.e., PEs) in Japan, however this is not
legislated and is only permitted up to the amount of LIBOR.
5 Mr. Masatsugu Asakawa.
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What is the scope of the proposed law change?
Reaching this conclusion is the easiest part of the implementation process. The breadth and scope of the existing
laws that may need to be amended to fully reflect the principles of the AOA are significant. They cover not only
the obvious issues such as the definition of domestic source income and the rules for attributing profit, but also
include areas such as transfer pricing, withholding taxation, thin capitalisation, the taxation of certain incomes
earned by offshore parties even without a PE, earnings stripping and foreign tax credits.
There also remain issues for which the OECD provides different alternatives, i.e., identifying the most suitable
approach to the allocation of capital to the PE. For these, the Japanese government will first be required to
analyse the available options and select their preferred position(s) before drafting and implementation work can
even be started.
As part of this introduction to the AOA, the discussion below provides further background on a selection of these
topics.
Applicability of transfer pricing
The application of transfer pricing rules to determine the profit to be attributed to PEs based on the functionally
separate entity approach is the underlying principle of the AOA. Consistent with this, the generally accepted
position in discussions around the AOA is that transfer pricing rules will be applied by analogy, including the
transfer pricing rules governing documentation.
At first glance it would appear that transfer pricing is one area where there is already sufficient and clear
guidance that may be easily adapted for the purposes of applying the AOA. The Japanese transfer pricing rules,
similar to those in many other jurisdictions, provide detailed guidance on (i) methodologies for determining
arm’s length pricing and (ii) documentation that should be maintained by the taxpayer in order to support the
conclusions reached through application of those methodologies.
The fact is however, that application of the transfer pricing rules by analogy may require some additional
legislative amendment. This is because a subsidiary-to-subsidiary transaction physically exists, in contrast to a
dealing between a PE and its head office (or other PE). As a result, additional guidance will need to be provided
as to the standard to be met in order for a dealing to be recognised before the transfer pricing rules can be
applied by analogy for the purposes of profit attribution. This will be particularly important if inadequate
documentation by the taxpayer is sufficient cause for the Japanese tax authorities to invoke taxation by
presumption in the case of an attribution of profit to a PE (just as it is cause under the Japanese transfer pricing
rules for transactions between separate legal entities).
Foreign tax credits
Where income earned by a PE in Japan under the AOA is subject to taxation in another country, a question
arises as to whether that PE should be able to take a foreign tax credit in Japan. For example, take the case
where a US multinational enterprise earns income from a third country, say Korea, and that income is subject to
withholding tax in Korea. If a portion of that income is allocated to a Japanese PE of the US head office, that
income will be subject to double taxation (withholding tax in Korea and income tax in Japan).
Even if foreign tax credits will be available to a Japanese PE in such cases, it does not mean that a foreign tax
credit will be provided where the withholding taxation is imposed by the jurisdiction of the head office, i.e., the
US in the above example. That is, if the Japanese PE earns income from activities carried on in the US, which is
subject to withholding tax in the US, the position may well be taken that the obligation is on the head office
jurisdiction to provide the foreign tax credit to avoid double taxation. A similar issue may arise if the income
earned by the Japanese PE is subject to corporate income tax in the jurisdiction of the head office.
While it is relatively simple to understand the exclusion in the latter case – similarly, no foreign tax credit would
be available to a Japanese subsidiary of a multinational in such situations – it is more difficult in the former.
That is, if a Japanese subsidiary of a multinational earned income from business activities in the parent
jurisdiction, which was subject to withholding tax in that jurisdiction, in contrast that Japanese subsidiary
would generally be entitled to a foreign tax credit in Japan.
The treatment of foreign tax credits for foreign PEs of Japanese headquartered companies raises different
questions, such as how to apply the definition of foreign source income.
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Japan Tax Update
Allocation of capital
In order to determine the arm’s length interest expenses that should be borne by a PE, it is necessary to consider
the amount of capital that should be allocated to it. Although three methods are proposed by the OECD, it is
likely that any future Japanese legislation will focus on two of these, namely:
(i) a capital allocation approach, i.e., where the enterprise’s actual capital is allocated in accordance with the
attribution of assets and risks, thus leading to attribution of an amount of capital to the PE6; and
(ii) the thin capitalisation approach, i.e., where the PE is allocated the same amount of capital as would an
independent enterprise carrying on the same or similar activities under the same or similar conditions as
the PE7.
Practical difficulties exist with both these approaches. For the former, the obvious method is to allocate capital
based on the amount of assets borne by the PE out of the corporation’s total assets. However, not all
corporations will track assets, particularly financial assets in the banking context (i.e., risk-weighted assets), to
this level. The OECD also illustrates an example where the assets of the PE are of a different class or character
than those of the enterprise as a whole8. In such cases, a purely mathematical calculation of capital using an
allocation formula may over or understate the capital of the PE, depending on whether its assets carry more or
less risk than those of the rest of the enterprise.
In contrast under the thin capitalisation approach, there is the opposite concern that it will over or understate
the capital of the enterprise as a whole9. This is because the capital held by independent enterprises in different
jurisdictions will be impacted by local market conditions or the local regulatory environment. In any case, given
the conservative nature of the thin capitalisation approach in Japan, taxpayers in the financial services industry
may be unlikely to adopt this option.
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Finally, while there is a large amount of guidance from the OECD and other industry sources on the profit
attribution issue for financial institutions, guidance for taxpayers in other industries is far more limited10.
Although some of the most difficult questions raised by this topic are indeed related specifically to financial
institutions, such as the allocation of capital within a bank, this does not avoid the need for careful consideration
of the impact of these new rules on other taxpayers.
With this background in mind, a rewrite of the Japanese legislation is likely to be more prescriptive than the
OECD and other guidance in this area if it is to be comprehensive. Indeed, given that many OECD member
countries are still only in the process of considering implementation of the AOA and have yet to take any
legislative steps, the Japanese government may well be at the forefront of decision-making around some of these
uncertainties.
Implementation of the AOA
Determining the scope and drafting the contents of the proposed legislation requires a significant amount of
theoretical analysis. As outlined above however, there is existing thought leadership available to guide the
Japanese government in this area, even if it is primarily focused on financial institutions.
Once drafted however, more practical considerations will arise. For example, will the law be effective
immediately, or will there be a phased approach to implementation? This will be particularly relevant where the
attribution of profit to the PE requires data that may not yet be available in the taxpayer’s information or
accounting systems, such as may be necessary for allocating capital.
Similarly, consideration will need to be given to the training and education of tax examiners in Japan in relation
to application of the new rules. Considering the degree of the change from the current domestic rules, there is
potential for much confusion in future investigations if training is not undertaken adequately and within a
reasonable timeframe following the enactment of the new law.
OECD’s 2010 Report on the Attribution of Profits to Permanent Establishments, Part I, ¶¶121-128.
OECD’s 2010 Report on the Attribution of Profits to Permanent Establishments, Part I, ¶¶129-134.
8 OECD’s 2010 Report on the Attribution of Profits to Permanent Establishments, Part I, ¶124.
9 OECD’s 2010 Report on the Attribution of Profits to Permanent Establishments, Part I, ¶134.
10 Although see Attributing profits to a dependent agent permanent establishment, Australian Taxation Office at
http://www.transferpricing.com/pdf/Australia_PE.pdf for one example.
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Japan Tax Update
The impact of the law change on Japan’s treaty network will also need to be addressed. First, how should Japan
itself interpret the relationship between the new domestic law and existing treaties, drafted as they were under
the pre-AOA framework? At the same time, it will also be incumbent on the Japanese tax authorities to continue
to monitor the implementation of the AOA by other governments, both within and without the OECD. Where
another government has also implemented the AOA in its domestic rules, how should the provisions of the
existing treaty with that counterparty be (re-)interpreted? On the other hand, where key trading partners have
not yet (or do not intend to) implement the AOA, the potential impact on treaty negotiations with those
jurisdictions will need to be carefully considered.
Conclusion
Through the discussion above it is hoped that taxpayers will obtain an overview of the likely scope and impact of
the proposed law change, and as a result will begin to consider and to prepare themselves for the introduction of
the amended legislation as it pertains to them. As highlighted in this article, areas of particular focus for
taxpayers going forward should be on beginning to document dealings for recognition purposes, and on
considering what arm’s length pricing might look like for those dealings that are identified. In addition, as the
proposal from the Japanese government becomes more defined in the coming months, it will be important for
taxpayers to continue to monitor its impact on these and other issues.
Nevertheless, and as described above, the Japanese government’s intention to pursue this legislative change is a
positive step forward for taxpayers. It will ensure that Japan remains aligned with global best practices in this
area, as well as minimising the possibility of differences in interpretation of profit attribution principles between
Japan and other OECD member countries, many of whom still remain among Japan’s largest trading partners.
For more information, please consult your tax representative or contact any of the
following members listed below:
Zeirishi-Hojin PricewaterhouseCoopers
Kasumigaseki Bldg. 15F, 2-5, Kasumigaseki 3-chome, Chiyoda-ku, Tokyo 100-6015
Telephone: 81-3-5251-2400, http://www.pwc.com/jp/tax
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Partner
Yoko Kawasaki
81-3-5251-2450
[email protected]
Marc Lim
81-3-5251-2867
[email protected]
Akemi Kito
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81-3-5251-2944
[email protected]
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Partner
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Partner
Ryann Thomas
81-3-5251-2356
[email protected]
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Naoki Hayakawa
81-3-5251-6714
[email protected]
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