Corporate taxation

Author: | Published: 5 Jan 2004
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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 taxes

One of the main changes is the elimination of withholding taxes on several categories of income.

Royalty 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 royalty.

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 penalties.

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, Paragraph 4).

Dividend income
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.

Interest income
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.

Author biography

Atsushi Fujieda

Nagashima Ohno & Tsunematsu

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.

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