On November 6 2003 the US and Japanese governments signed
the new Income Tax Treaty, substantially changing the previous
treaty that was signed in March 1971.
Around 30 years after the old treaty was signed, the OECD
Model Tax Convention on Income and on Capital has been amended
and the Japanese government has updated many income tax
treaties. In addition, the economic relationship between the US
and Japan has grown much stronger and increasingly
interdependent. The old treaty did not reflect this and an
update was necessary.
Eliminating or reducing withholding
One of the main changes is the elimination of withholding
taxes on several categories of income.
Under the new treaty, withholding taxes on all royalty
income — subject to 10% withholding tax under Article
14, Paragraph 2 of the present treaty — have been
eliminated (Article 12, Paragraph 1). This change is likely to
contribute to the increase in the transfer of technologies
between Japan and the US. According to a November 2003 report
by the Patent Office of Japan, Japanese corporations received
royalties of around ¥209 billion ($1.9 billion) in 2001
from the US for patent and trade mark licences. In the same
year, according to the report, the Japanese corporations paid
corresponding royalties of around ¥274 billion to the US.
Eliminating withholding taxes on such a large amount of
royalties should substantially increase licensing transactions
between the two countries.
However, because the new treaty gives such benefits to
residents of the US and Japan, a resident of a third country
may abuse the new treaty. To cope with this, the new treaty has
incorporated a provision that prevents a third-country
resident, through using a resident of the US or Japan, from
enjoying the tax treaty benefit of the elimination of the
withholding taxes (Article 12, Paragraph 5).
When a royalty paid by a Japanese corporation to its US
affiliated company exceeds an arm's length royalty, under
Article 14, Paragraph 5 of the old treaty the reduced treaty
rate of 10% was applicable only to such amount of the arm's
length royalty. After that, "the excess payment may be taxed by
each contracting state according to its own law, including the
provisions of this convention where applicable." In Japan there
was an argument that that provision's purpose was to cope with
a situation in which a taxpayer charges a royalty as well as
another category of income which may not enjoy any
treaty-reduced rate, on the pretext of royalty as a whole.
Accordingly, when a taxpayer genuinely charges royalty as a
whole, even if the transfer pricing adjustment is made, the
excess portion should still be considered royalty and the
reduced 10% rate should still be applicable to the excess
But in one tax audit the Tokyo Regional Tax Bureau rejected
that argument and applied the Japanese domestic withholding tax
rate of 20% to the excess of the royalties paid by a
US-controlled Japanese corporation to its US affiliated
corporation over the arm's length royalty. Based on the tax
authority's position, when a US-controlled Japanese corporation
is subject to a transfer pricing adjustment it is also required
to pay the withholding tax in deficiency applicable to the
excess royalty. This is the difference between 20% (the
domestic withholding tax rate) of the royalty and 10% (the
reduced treaty rate), as well as certain applicable
Under the new treaty, the rate of the withholding tax
applicable to the excess of the royalty over the arm's length
amount has been reduced to 5% at the maximum (Article 12,
The new treaty also eliminates withholding taxes
applicable to certain dividend payments. Under Article 10,
Paragraph 3(a) and certain provisions of Article 22, for
example, when a Japanese corporation whose shares are listed on
a domestic stock exchange has owned a majority of the voting
stock of its US subsidiary, for 12 months ending on the date on
which entitlement to the dividends is determined, then no such
dividends shall be subject to any US withholding tax.
The new treaty reduces withholding tax rates applicable to
dividends other than these withholding-tax-eliminated
situations. Under the old treaty (Article 12, Paragraph
(2)(b)), when a recipient corporation satisfied certain
prescribed requirements, including owning at least 10% of the
voting shares of the paying corporation, the withholding tax
rate of 10% was applicable to such dividend payments, and 15%
was applicable in other cases (Paragraph (2)(a)). The new
treaty reduces such withholding tax rates to 5% and 10%
respectively (Artcile 10, Paragraph 2 (a)(b)).
The new treaty incorporates a new article (Article 22) to
set forth certain limitations on qualifications for a resident
enjoying tax treaty benefits.
Under the old treaty, the rate of withholding tax
imposed by Japan or the US on interest derived from sources
within the country by a resident of the US or Japan
respectively, did not exceed 10% (Article 13, Paragraph 4).
Under the new treaty, such interest beneficially owned by a
bank (including an investment bank), an insurance company or a
registered securities dealer, who is a resident of Japan or the
US, is subject to no withholding tax imposed by the US or Japan
(Article 11, Paragraph 3).
As with royalty payments, under the new treaty the interest
in excess of an arm's length interest is subject to a maximum
withholding tax of 5% of the gross amount of the excess
(Article 11, Paragraph 8).
According to publicly available data for 2001 collected by
the Bank of Japan, direct investment income (which mainly
consists of dividends and interest) received by Japanese
corporations from their US affiliated companies (whose 10% or
more shares are owned by the Japanese corporations) was around
¥748.9 billion. The amount Japanese corporations paid to
their US affiliated companies (which own 10% or more shares of
the Japanese corporations) was around ¥268.5 billion.
The elimination (and reduction) of withholding taxes on
dividends and interest will substantially impact cash flow of
many corporations in the US and Japan.
Transfer pricing provisions
The new treaty has newly incorporated provisions concerning
transfer pricing, one of the most important tax issues between
Japan and the US.
Firstly, in principle no transfer pricing adjustment will
now be made unless the transfer pricing examination starts
within seven years from the end of the relevant taxable year of
a corporation (Article 9, Paragraph 3). Under the Japanese
transfer pricing regulations, the statute of limitation for the
transfer pricing adjustment by the tax authorities shall be
limited to six years (seven years in the case of a fraud case).
Accordingly, the purpose of the new provision is to limit the
power of the US Internal Revenue Service to conduct
examinations of Japanese-controlled US corporations for the
transfer pricing adjustments.
Secondly, Article 25 of the new treaty, providing for the
competent authority procedures, clearly states that the
competent authorities of the two countries may agree on advance
pricing arrangements (Article 25, Paragraph 3(d)). This
provision confirms the current practice. Many advance-pricing
agreements have already been discussed and entered into and
such bilateral advance pricing arrangements have contributed to
the avoidance of transfer pricing disputes.
Finally, Paragraph 3 of the exchange note of the new treaty
emphasizes the importance of a common understanding of the
principles to be applied in resolving transfer pricing cases to
avoid double taxation. Both countries have agreed to use the
OECD Guidelines regarding common principles as follows:
"The contracting states shall undertake to conduct transfer
pricing examinations of enterprises and evaluate applications
for advance pricing arrangements in accordance with the
Transfer Pricing Guidelines for Multinational Enterprises and
Tax Administrations of the Organization for Economic
Cooperation and Development (OECD Transfer Pricing Guidelines),
which reflect the international consensus with respect to these
issues. The domestic transfer pricing rules, including the
transfer pricing methods, of each contracting state may be
applied in resolving transfer pricing cases under the
convention only to the extent that they are consistent with the
OECD Transfer Pricing Guidelines."
The agreement by both governments to conduct the
examinations and evaluate advance pricing arrangements in
accordance with the OECD Guidelines may have a lot of influence
over transfer pricing practices in both countries.
Effective date of new treaty
The new treaty will come into effect on the date of the
exchange of instruments of ratification (Article 30). According
to a Japanese news report, the government plans to submit the
new treaty and the relevant bills for the enforcement to the
Diet (the Congress) for ratification early next year.
If the exchange of instruments of ratification takes place
before April 1 2004, for withholding taxes, the new treaty
shall apply to relevant payments on or after July 1 2004. For
income tax, the new treaty shall apply to any taxable year
beginning on or after January 1 2005.
Atsushi Fujieda is a partner of Nagashima Ohno &
Tsunematsu. He has been with the firm since 1982, but worked
for Paul Hastings Janofsky & Walker in Los Angeles in 1987
and for Covington & Burling in Washington DC in 1988.
Fujieda specializes in international taxes, in particular,
transfer pricing disputes, M&A, joint ventures and
licensing. He provided testimony at the US Internal Revenue
Service public hearings on proposed and temporary transfer
pricing regulations in August 1992 and August 1993.
Fujieda has lectured on international tax law at
Seinan-Gakuin University. He holds an LLB from Tokyo University
(1980), an LLM from the University of California, Los Angeles
(1987), and was admitted to the New York Bar in 1988.
Nagashima Ohno & Tsunematsu
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