Author: | Published: 9 Nov 2000
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Important changes have been taking place in Japan's financial markets since 1996. Known as the Japanese Big Bang, these changes aim to rebuild the Japanese financial markets and recover their competitiveness. Deregulation is the primary purpose of the reforms. Particularly strong emphasis has been placed on encouraging private sector investment into Japan. The tax system has also been changed significantly to reflect the reforms. The following article discusses two of the recent changes to Japanese taxation that affect foreign investors.

Problems with the tax exemption of government bonds interest

Effective September 1 1999, the withholding taxes on Japanese Government Bonds (JGBs) held by non-residents were abolished following the amendment of the Special Measurement Tax Law approved in the Diet at the end of March 1999. The amendment was expected to encourage foreign investors to enter the JGB market and globalize Japanese currency in the long term. Nearly one year has passed since the articles of the amended Special Measurement Tax Law came into effect, and it is evident that the system is not working as contemplated. The underlying problems and the recent move towards the improvement of the system are discussed below.

Two separate systems for administering JGBs

All JGBs are registered in the JGB registry book managed by the Bank of Japan, which acts as the central depository for JGBs. The JGBs are administered under two types of settlement system. One is the Registered Bond System, under which holders of JGBs each register their JGBs directly in the JGB registry book, and transfers of JGBs are executed by registering the new holder's name. The other system is the Book-Entry System, under which holders of JGBs deposit their JGBs with the Bank of Japan through the domestic operating office of the Book-Entry System participants. Most of these participants are financial institutions holding an account for the Book-Entry System directly or indirectly at the Bank of Japan. The transfer of JGBs is settled in the form of entry into the Participant Book (see Diagram 1).

The amendment to the Special Tax Measurement Law

The amendment to the Special Tax Measurement Law brought two significant changes into the tax treatment of interest on JGBs:

  • JGBs held by residents and non-residents under the Registered Bond System are taxable without exception; and
  • JGBs held by non-residents under the Book-Entry System are exempt from withholding taxes.

Taxation of JGBs under the Registered Bond System

Following the amendment, the interest on JGBs under the Registered Bond System will be taxable without exception. The change applies to interest, the calculation period of which starts on or after January 1 2001. This amendment significantly affects JGBs held by Japanese financial institutions under the Registered Bond System, which is at present exempt from withholding taxes. The implication is that the loophole that has been widely used by non-financial institutions (both resident and non-resident) is to be closed, as discussed further below.

Before the amendment, the Special Tax Measurement Law did not specifically stipulate whether, under the Registered Bond System, financial institutions must be the ultimate beneficial holder of JGBs to be exempt from withholding taxes. Such ambiguity enabled non-financial institutions to hold JGBs in the name of Japanese financial institutions and receive tax-free interest on such JGBs. While such ownership of JGBs in the name of financial institutions exposed the ultimate holders of the JGBs to various risks, it has been a commonly used tool for both resident and non-resident JGB holders. Following the amendment, the financial institutions can obtain exempt status only under the Book-Entry System which, unlike the Registered Bond System, does not allow non-financial institutions to hold JGBs in the name of financial institutions.

Tax exemption on JGBs held by non-resident owners

A new provision makes interest on JGBs held by a non-resident under the Book-Entry System exempt from withholding taxes, as long as certain requirements are satisfied. The requirements are contemplated to ensure that the recipient of the JGB interest is a non-resident who is entitled to benefit from the tax exemption, to prevent resident investors from avoiding withholding tax on JGB interest by using the name of a non-resident. The Special Tax Measurement Law requires a double safeguard to confirm status as a non-resident investor:

  • non-resident investors must submit certain documents to certify non-resident status; and
  • the participant must confirm the status.

This exemption has been applied to JGB interest for which the calculation period starts on or after September 1 1999. The requirements for withholding tax exemption are as follows (assuming that the above exemption conditions are satisfied, no Japanese tax would be levied on JGB interest paid to non-resident investors, as long as they do not have a permanent establishment in Japan and the JGB interest is not attributable to their business operated in Japan):

  • tax exemption applies solely to JGBs deposited through the Book-Entry System;
  • non-resident beneficial holders of a JGB should deposit the JGB through a Japanese office of a financial institution participant, who directly or indirectly holds an account for the Book-Entry System at the Bank of Japan (a financial institution participant); and
  • non-resident beneficial holders should follow certain specified procedures.

The specified procedures are:

  • a non-resident investor who purchases a registered JGB is required to submit an application for exemption to the tax office through the Bank of Japan or a domestic (Japan) office of a financial institution participant, when the JGB is initially kept in deposit. The application for exemption should state the purchaser's details, such as name and address, and it should be submitted to the tax office together with an identification document to certify the non-resident status of the purchaser. The domestic (Japan) office of the participant with whom JGBs are deposited shall be required to confirm the bond holder's identification together with the submitted documents; and
  • a non-resident beneficial holder is required to submit a document, which states a holding period for the registered JGB and other necessary information, to the tax office through the domestic office of the financial institution participant on or prior to one day before the interest payment is scheduled to be made.

Consequently, the non-resident customers of global custodians who deposit JGBs indirectly with Japan-based sub-custodians (financial institution participants) are not entitled to the exemption, since the JGBs are not deposited at the Japan office of the global custodians who are qualified as financial institution participants. Japanese sovereignty does not extend to global custodians who are foreign corporations, and the Japanese government cannot enforce procedures to ensure the status of non-resident investors. The Japanese national tax authority is concerned that there will be room for resident investors to use the name of a non-resident when global custodians confirm the non-resident status. The Special Tax Measurement Law places strict emphasis on whether the JGB investors directly deposit the JGB with a financial institution participant, and the financial institution participant must confirm the bond holder's identification together with the submitted documents in its domestic office.

Non-resident JGB holders who are customers of global custodians must satisfy the following requirements to enjoy the tax exemption entitlement:

  • the JGB holder deposits the JGB directly with the global custodian;
  • the custody operation is conducted at the global custodian's Japanese branch or office through which the JGB is deposited in the Book-Entry System;
  • the global custodian's Japanese branch or office should be the financial institution participant and the same JGB is block registered at the Bank of Japan; and
  • the global custodian's Japanese branch or office shall confirm the identity of the JGB holder and maintain the evidence document of identification.

Effect of the changes on non-resident JGB holders and recent developments

These new requirements under the Book-Entry System for non-resident JGB holders to qualify for the withholding tax exemption has become a huge obstacle for holders who conduct transactions only with global custodians. On the other hand, owning JGBs in the name of financial institutions will no longer be allowed after January 2001 when financial institution will not have exempt status under the Registered Bond System. These facts indicate that non-resident JGB holders are likely to become subject to withholding taxes, while they were not under the old system. Ironically, contrary to what was expected, it is even possible that the amendment to the law could keep non-resident investors out of the JGB market.

Responding to vociferous claims from industry, there have been active discussions to redesign the system to simplify the administrative procedures. It was announced in early August by a high level official from the Ministry of Finance that a partial alteration of the system is being seriously considered to make it easier for non-resident investors to get exempt status before January 2001. It was implied that the change would include entitling global custodians to verify and confirm the non-resident status of the JGB holders.

Amendment of the SPC Law and the Investment Trust Law

An amendment to the Law Concerning Liquidation of Specified Assets by a Special Purpose Company and the Law Concerning Securities Investment Trusts and Securities Investment Corporations was voted into law on May 23 2000, and was promulgated as of June 1 2000. (The names of the laws were also changed respectively into the Law Concerning Liquidation of Assets (the SPC Law), and the Law Concerning Investment Trusts and Investment Corporations (the Investment Trust Law).) The purpose of the amendment is to develop the asset liquidation and investment market, through expanding the scope of assets to be liquidated/invested, as well as establishing investor protection rules, for a group investment structure, where investors' funds are pooled and managed together by an expert fund manager.

Specifically, transactions involving real estate securitization have increased rapidly in recent years, mainly due to a desire by Japanese companies to remove assets from their balance sheets, and also because of comparably high yields in the current market. A new investment corporation vehicle, as permitted under the new Investment Trust Law, which will be able to invest directly in real estate properties, is drawing much attention in the market, being called 'J-REIT' after 'REIT', the popular US investment scheme for real estate properties.

The difference between the two laws is that the SPC Law covers the liquidation side of assets (properties), while the Investment Trust Law covers the investment side of assets (money). The following summarizes the principal elements of the amendments to the laws and outlines the tax treatment relating to such changes. Both new laws will be expected to come into effect within six months of the promulgation date of June 1 2000.

Outline of the amendment to the SPC Law

The scope of the definition of assets is expanded to "general property interest". It was previously limited to real estate, designated monetary claims and trust beneficiary certificates.

The establishment procedure is deregulated:

  • the registration system is changed to a filing system;
  • the minimum capital amount is decreased from ¥3,000,000 to ¥100,000; and
  • a specified ownership trust is introduced (which can be used as a bankruptcy remote scheme without using a Cayman SPC).

The SPC will be able to issue various types of instruments, such as non-voting preferred investment certificates, convertible special bonds, special bonds with warrants etc. The SPC can also simply borrow funds for the acquisition of specified assets.

Deregulation regarding the asset liquidation plan is implemented. The plan no longer needs to be included in the SPC's articles of incorporation.

A trust scheme similar to the corporate type SPC is newly implemented, which is named "special purpose trust".

Outline of the amendment to the Investment Trust Law

The scope of the definition of investment is expanded so that not only securities but also real estate are included.

Under the new law, a real estate fund manager is required to acquire a licence for real estate transactions and approval from the construction minister to enter into discretionary transactions.

Investor protection rules are stipulated so that a fund manager is not allowed to enter into transactions with create conflicts of interest, the fund manager must operate in good faith as a professional, and the fund manager must reimburse investors for damages resulting from gross negligence, etc.

An investment corporation can borrow funds or issue debt type instruments.

A trust type scheme can be structured so that a trust company itself could take a role as a fund manager (a non-instruction type of trust).

Tax Treatment

Corporate taxation on the trustee of the specified trust

Following the amendments to the SPC Law and the Investment Trust Law, the Japanese tax system applied to a trust has changed significantly. Under the existing tax law, a trust itself is generally not subject to corporate income tax, based on either the concept that: (i) a trust is treated as a pass-through entity for tax purposes; or (ii) income/expenses attributable to trusted assets do not belong to a trust.

However, under the new tax law, amended to incorporate the changes of the two laws (which will come into effect at the same time as the two laws), a trustee of a "specified trust" (ie, (a) a special purpose trust and (b) an investment trust other than a securities investment trust, excluding a publicly offered trust in Japan (the "specified investment trust")) has an obligation to file and pay corporate income tax based on a taxable income derived from each specified trust. Accordingly, the Corporate Tax Law is changed so that various tax rules applicable to the specified trust (such as the calculation of taxable income and tax liabilities, tax return filing procedures, etc) would be included.

Deduction of dividends/distributions

Dividends/distributions from the SPC or the investment corporation are deductible for the purpose of calculating the taxable income of these entities, as long as certain requirements under the tax law are satisfied (as stipulated under the existing law). This is based on the concept of avoiding double taxation between investors and vehicles, since the SPC and the investment corporation are regarded merely as investment vehicles. Under the new tax law, one requirement is added for the deduction of dividends/distributions – that is, a principal offering of securities (ie preferred investment certificates and special bonds for the SPC and investment units for the investment corporation) should be made within Japan.

As to the specified trust, similar requirements as shown below are newly stipulated for deductions of distributions to avoid double taxation, since the trust itself is subject to corporate tax:

  • filing of the specified trust based on the SPC Law or Investment Trust Law is completed;
  • the specified trust distributes more than 90% of distributable taxable income;
  • the specified trust is not a "family specified trust" at the end of the fiscal year;
  • beneficiary certificates are subscribed to solely by qualified institutional investors (in the case of a specified investment trust);
  • ¥100 million or more beneficiary certificates are publicly offered, or beneficiary certificates are subscribed to by 50 or more investors, or beneficiary certificates are subscribed to solely by qualified institutional investors (in the case of a special purpose trust); and
  • other requirements (such as a principal offering of a beneficiary certificate is made within Japan, etc).

Taxation relating to an acquisition of real estate

As shown below, special tax reductions in connection with an acquisition of real estate are not applied to the investment corporation.

Taxation of investors relating to profit distributions

Resident corporate investors: distributions of profits from the SPC, the investment corporation, the special purpose trust, or the specified investment trust received by resident corporate investors are fully included in the taxable income of the recipient. Dividend exclusion, which is applied to the dividend from normal shares, is not applicable in this case.

Non-resident investors: if the recipient is a non-resident investor, profit distributions are, in general, subject to withholding tax at the rate of 15% or 20% depending on the instrument type. The withholding tax rate may be reduced under the applicable tax treaty.

Showa Ota Ernst & Young

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