July 10, 2006

Tax Consequences of Cross-Border Investment in Japanese Real Estate by Paul Previtera Reprinted from Tax Notes Int’l, July 10, 2006, p. 151

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

Volume 43, Number 2

Special Reports

by Paul Previtera Paul Previtera is an Australian attorney and senior manager, international tax, with Grant Thornton Japan in Tokyo. This article is based on a presentation made at the Australian Embassy in Tokyo on November 30, 2005. In addition to Previtera, the other participants in the discussion are: Paul Banister, partner, Grant Thornton, Brisbane, Australia ([email protected]); Gordon Price, director, Grant Thornton, Auckland, New Zealand ([email protected]); Gary James, partner, Grant Thornton, Hong Kong (gary.james@ gthk.com.hk); Chang-Yong Shin, partner, Daemyung Grant Thornton, Repuplic of Korea ([email protected]); Jay Lo, partner, Grant Thornton, Taiwan ([email protected]); Nitesh Mehta, manager, Grant Thornton, Mumbai, India ([email protected]); Senen Quizon, manager, Punongbayan & Araullo, the Philippines ([email protected]); Kasumi Tsujimura, manager, ASG Tax Corporation, Grant Thornton, Tokyo, Japan (ktsujimura@ gtjapan.com); and Leela Murugasu, manager, Grant Thornton, Perth, Australia (lmurugasu@ gtwa.com.au). Member firms of Grant Thornton International are independently owned and operated. Grant Thornton International is not a worldwide partnership.

A

report released in September 2005 by the Japanese government’s Ministry of Land, Infrastructure, and Transport shows that despite the national averages of residential and commercial land prices falling for the 14th consecutive year, commercial (0.6 percent) and residential (0.5 percent) land values in Tokyo increased for the first time in that period. Wider economic and specific real estate issues (including some property tax law changes in the past 5 to 10 years) are believed to be driving this increase in real estate investment, not only in Tokyo but in other areas of Japan, particularly from offshore investors. In the ski fields of

Tax Notes International

Hokkaido,1 a number of Australian and New Zealand investors are involved in ski resort development with land values increasing by over 300 percent in the region in the last three years. Several factors believed to be responsible for this turnaround in Tokyo land values include: • increasing confidence levels in Japan’s economy, with a rise in demand for inner-city office buildings and condominiums, creating a miniconstruction boom in central Tokyo; • exponential-like growth in real estate securitization — in 2004 almost ¥7.5 trillion worth of real estate was securitized, nearly double that of 2003; • Japanese real estate investment trusts (JREITs) growing considerably since they first appeared in Japan in September 2001, with the JREIT index on the Tokyo Stock Exchange now more than 20 percent higher than its level in December 2003; • business failures from excessive bubble-era investment still offloading their real property assets, ensuring a constant supply of investment quality properties; • interest rates remaining low for a number of years; and • cuts in and suspensions of property taxes in the past few years. This article examines in detail the following issues: • the taxes and related costs upon acquisition of real property located in Japan; • the taxes levied on holding that real property; • the tax consequences of the receipt of income (rental income and capital gain/loss) in a number of structures; and • how various real estate investment structures available to nonresident investors are taxed in Japan and how that income received by resident taxpayers in some countries within the Asia-Pacific region is taxed in those countries.

1 Hokkaido is the northernmost of Japan’s four main islands.

July 10, 2006

•

151

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

Tax Consequences of Cross-Border Investment in Japanese Real Estate

Special Reports

Generally speaking, there are no restrictions on foreign investment in Japanese real estate and, unlike many other countries, there are no restrictions in the manner in which property investors can structure their real property investment. The one requirement, however, for nonresidents of Japan who purchase real estate is, under some conditions, they must file a report with the Japanese government’s Ministry of Treasury. Article 55-3 of Japan’s Foreign Exchange and Foreign Trade Law (FEFTL) provides that a nonresident who has become a party to a capital transaction must report the details of the transaction to the Ministry of Treasury through its agency, the Bank of Japan. Capital transaction2 is defined as being ‘‘acquisition of immovables or rights related thereto existing in Japan by a nonresident.’’ However, a report is not required if the nonresident acquires the property: • for the purchaser or the purchaser’s relatives or employees to reside in; • to use the property to continue conducting a nonprofit business; • for housing a business; or • from another nonresident. If the transaction is for a purpose different from the above (that is, for direct real estate investment purposes), a ‘‘Report Concerning Acquisition of Real Property in Japan or Rights Related Thereto’’ must be submitted. That report must contain information such as (1) the mode of acquisition (whether a purchase, mortgage, or rental); (2) a description of the real estate (land size, building structure, and so forth); (3) location; (4) acquisition date; and (5) acquisition cost.

II. Taxation in Japan (Overview) Japan’s taxation system is similar to that of most countries; income is taxed based on its source and the residence of the taxpayer. Income associated with real property located in Japan satisfies the source rule in Japanese tax law.3 The following are also taken into account by Japan’s tax authorities when calculating the tax liability of a taxpayer investing in real property in Japan: • the taxpayer’s status (that is, resident, nonresident, individual, corporation); and • the nature of the income (rental, capital gain, dividends, partnership distributions, and so forth).

2

FEFTL, article 20(10). Income Tax Law (ITL), article 161.

3

152 • July 10, 2006

In Japan, national, local, and inhabitants taxes are levied on both resident individuals and companies. Companies are also subject to the enterprise tax. A. Corporate Taxpayers The effective tax rate for Japanese companies whose annual income is more than ¥8 million is approximately 42 percent (30 percent national and approximately 12 percent local). Companies with less than ¥8 million income and with paid-in capital of ¥100 million or less are subject to an effective tax rate of approximately 35 percent4 (22 percent national and approximately 12 percent local). Companies are taxed on their worldwide income. The Corporations Tax Law (CTL) provides that the taxable income for a taxable year is computed by subtracting deductible expenses from gross revenues.5 Generally accepted accounting principles are used to determine the amounts of income and loss for tax purposes. Gross revenues can include sales of property, transfers of property with or without compensation, and receipt of property without payment. Expenses include the interest portion of loans to purchase income-producing property, depreciation of some assets, the cost of goods sold, administrative expenses, and losses other than from dealings in the capital of the company.6 Employee compensation is generally deductible as a business expense; however, excessive salaries and retirement payments are excluded. 1. Dividend Income Dividends received by domestic corporations from other domestic companies, less any interest chargeable on those dividends, are fully excluded from gross income in computing the amount of ordinary income.7 However, if a domestic company owns less than 25 percent of the dividend-paying company, 50 percent of the dividends received less any interest chargeable on those dividends is exempt. 2. Blue Tax Returns The standard tax return in Japan is referred to as the white tax return. However, corporate and individual taxpayers can enjoy a number of tax benefits by electing to file what is known as a blue tax return. Some of the benefits for a blue tax return filer include being able to carry forward losses seven

4 Nonresident corporations investing in Japan that don’t have a permanent establishment in Japan are usually subject to only national taxes. For simplicity, any references to the national corporate tax rate in this article will quote the higher rate of 30 percent. 5 CTL, article 22(1). 6 Id., article 22(3). 7 CTL, article 23.

Tax Notes International

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

I. Who Can Invest?

Special Reports

To be granted the right to file a blue tax return, the taxpayer must maintain proper accounts and books15 recording all of the entity’s transactions, as well as submitting the application before the beginning of the tax year.16 B. Individual Taxpayers For Japanese tax purposes, individual taxpayers are classified as either nonresidents or residents. Residents are then categorized as nonpermanent residents or permanent residents for Japanese tax purposes. (For related coverage, see Tax Notes Int’l, Dec. 12, 2005, p. 954.) 1. Permanent Residents Under Japanese law, permanent residents have formed the intention of residing permanently in Japan or have been living in Japan for more than five years.17 Permanent residents are taxed on their worldwide income and subject to national income tax and local taxes. The tax rates are levied at marginal rates, national income tax ranging from 10 percent to 37 percent.18 Local taxes are approximately 10 percent (bringing an effective tax rate for the top marginal taxpayers to 50 percent).

2. Nonpermanent Residents Nonpermanent residents are defined as residents who have not formed the intention of residing permanently in Japan and have resided in Japan for more than one but less than five years.19 Those taxpayers are subject to Japanese income tax on only their Japanese-source income and any offshore income remitted into Japan.20 Dividend income received by residents. Dividend income is included with other ordinary income with credits on any withholding tax paid allowed to minimize double taxation (at the corporate and shareholder levels). However, a credit is not allowed for dividends from TMKs21 and publicly offered trusts under the Special Taxation Measures Law (STML).22 3. Nonresidents Nonresidents never form an intention of residing permanently in Japan and have resided in Japan for less than 12 months. They are generally only subject to Japanese tax in the following cases: • withholding tax on some types of Japanesesource income (that is, rent, dividends, and interest, typically levied at 20 percent under domestic law); • direct taxation of business profits if some nexus requirements are met (that is, the income is attributable to a nonresident’s permanent establishment in Japan); • direct taxation on some income from the use of holding of Japan situs assets (for example, rental income and tokumei kumiai23 income distributions); and • gains from sale of some Japan situs assets (for example, sale of Japanese real estate and sales of Japanese corporate stock by large shareholders).

8

Id., article 57. Special Taxation Measures Law (STML), articles 42-4 to 42-12. 10 CTL, article 130(1). 11 Id., article 130(2). 12 Id., article 131. 13 STML, article 42-5 to article 52-3. 14 Id., article 66-12, article 66-13. 15 CTL, article 126. 16 Id., article 122. For individuals commencing a new business, the application must be filed two months before its commencement; for corporations, three months prior to commencement. 17 From 2007, permanent residents will have resided in Japan for more than 5 years in the previous 10 years. 18 Under recent tax reforms effective from 2007, individual income tax rates have been extended to between 5 percent and 40 percent. 9

Tax Notes International

19 From 2007, nonpermanent residents will be those who have resided in Japan for less than 5 years in the previous 10 years. 20 A nonpermanent resident who paid offshore into an offshore bank account is still subject to Japanese income tax, as under Japan’s source rules the income earned for services rendered in Japan is Japanese-source income and subject to Japanese tax. However, a compensation package so structured may allow the taxpayer to avoid having to pay into Japan’s social security tax system, and if the taxpayer makes trips outside Japan, he may be able to further reduce his exposure to Japanese income tax. 21 That structure is discussed in section X.C. 22 STML, article 9(1). Tax treatment of those vehicles is discussed later in this article. 23 The tax treatment of tokumei kumiai is discussed later in this article.

July 10, 2006

•

153

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

years8 and claim special deductions from income.9 Unlike it can for white tax return filers, the tax office cannot make any corrections to a blue tax return without first investigating the filer’s accounts,10 is required to provide a written explanation of any corrections made to the tax return,11 and may not make any corrections based on estimates.12 Other benefits for blue return filers include the allowance of specially recognized depreciation13 and special periods for loss carryovers.14

Special Reports

Table 1 Type of Tax Acquisition

Tax Base

Tax Rate

Real property acquisition tax

Assessed value*

Consumption tax

Acquisition cost

3% (residential) 3.5% (commercial) 5% (building only)

Holding

Fixed asset tax City planning tax

Assessed value Assessed value

1.4% 0.3%

Rental Income

Corporate taxpayer Corporation tax Enterprise tax Inhabitant tax

Rent income is included in gross income Corporation tax amount

30% (standard rate) 5.0-9.6% 17.3-20.7%

Individual taxpayer Income tax Inhabitant tax

Rent income is included in gross income

10-37% 5-13%

Capital gains (loss) are included in gross income Corporation tax amount

30% (standard rate)

Disposition

Corporate taxpayer Corporation tax Enterprise tax Inhabitant tax Individual taxpayer Income tax Inhabitant tax

Other

Capital gains are separately taxed from other income

Stamp tax Registration and license tax

Amount on contract Value of property

Inheritance and gift taxes

Value of property less deductions

5.0-9.6% 17.3-20.7% 15-30% 5-9% Up to ¥600,000 Land 1% Buildings 2% 10-50%

*For some residential land, the tax base is reduced by one-half of its assessed value (until March 31, 2009).

IV. Real Property Acquisitions On acquisition of Japanese real property, the acquirer is subject to a number of taxes, including the real property acquisition tax (RPAT), registration/license tax, stamp tax, and consumption tax. A. Real Property Acquisition Tax Individuals or corporations who acquire land or who acquire or construct houses located in the prefecture24 during the year are required to pay the real property acquisition tax.25 The RPAT is not levied on transfers of property by inheritance, succession, or as a result of a corporate merger.26

24

Prefecture includes Tokyo. The tax does not apply to transfers of property by inheritance, succession, or as the result of a corporate merger. It is also not levied on property transferred to a trust when there has been no effective change in legal owner. 26 Local Tax Law (LTL), article 73-7. 25

154 • July 10, 2006

The tax basis for the RPAT is the assessed value of the property; however, the tax basis may be reduced for housing lots, newly constructed residences, or residential construction on newly acquired land. The tax is levied at 3 percent (a reduction from the usual 4 percent) for residential property and 3.5 percent for commercial property until March 31, 2009. B. Consumption Tax The consumption tax is a value added tax levied by the national and prefectural governments on the transfer of goods or services in Japan. The tax base is the consideration of the transfer of goods or services, and the tax rate is 5 percent. Transfers of some designated types of property are nontaxable under the Consumption Tax Law. Transfers of land, including superficies, air rights, easements, rights to lease land, and so forth, are not taxed under the Consumption Tax Law; however, transfers of mining rights, quarry rights, and rights to hot springs are taxable. When land (not taxable) and buildings (taxable) are transferred in a single

Tax Notes International

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

III. Taxes on Real Property Investment (As of April 1, 2006)

Special Reports

Type of Document Contracts concerning transfer of real property (including leaseholds)

Amount Stated in the Document More than

But not more than

¥1 million

¥5 million

¥2,000

¥5 million

¥10 million

¥10,000

¥10 million

¥50 million

¥20,000

¥50 million

¥100 million

¥60,000

¥100 million

¥500 million

¥100,000

¥500 million

¥1 billion

¥200,000

¥1 billion

¥5 billion

¥400,000

¥5 billion

¥600,000

transaction, the transfer price allocated between the land and buildings is based on the normal transaction price for each.27 The implications of consumption tax on rental income are discussed in section VII.B.4 below. C. Stamp Tax Table 2 sets out the stamp tax payable by the acquirer of real property on taxable income documents drawn up for the transaction, such as deeds of contracts. The stamp tax is a national tax. D. Registration and License Tax Registration of real estate brings with it the national registration and license tax, as shown in Table 3. If more than one person registers an item, those persons are jointly and severally liable for the tax. The tax base is the market value of real property, and the tax rate varies from 0.1 percent to 3 percent depending on the type of registration. Table 3. Registration and License Tax Registration Items

Amount of Tax

Tax Basis

Tax Rates

Registration of real property*

V. Holding Real Property Two taxes are levied on property held by both individual and corporate taxpayers.28 A. Fixed Asset Tax (FAT) The tax rate is 1.4 percent of the tax base,29 and the liability of the tax lies with the owner of the fixed asset. The tax base is the assessed value of the fixed asset, which is determined and revised every three years. The FAT is levied by a municipality on land, buildings, and other depreciable property and paid the following year.30 B. City Planning Tax (CPT) The city planning tax is levied by a municipality on land or buildings located where a city-planning project under the City Planning Law or the Land Readjustment Law is in effect.31 The taxpayer and the tax base are the same as those for the fixed asset tax. The tax rate varies according to municipality; however, the maximum rate is 0.3 percent, which applies in large cities such as Tokyo, Osaka, Nagoya, and Sapporo. Lower rates apply in smaller cities, with property located in Narita subject to a tax rate of 0.05 percent. The CPT is collected with the fixed asset tax.

Preservation of ownership

assessed value

0.4%

VI. Other Taxes

Acquisition of ownership

as above

3.0%*

Acquisition of real property through inheritance or merger

as above

0.4%

A. Inheritance Tax An heir with a domicile in Japan at the time of the decedent’s death is subject to Japanese inheritance

*The registration and license tax is 1 percent on land and 2 percent on structures.

27

Consumption Tax Law Basic Circular 10-1-5.

Tax Notes International

28 The tax rates are often reduced for trust or special purpose companies holding Japanese real property. 29 LTL, article 350. 30 Id., article 343. 31 Id., article 702.

July 10, 2006

•

155

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

Table 2. Stamp Tax Rates

Special Reports

B. Gift Tax An individual donee who receives property as a gift from another individual is subject to Japanese gift tax on the value of the entire gift if the donee is domiciled in Japan at the time of the gift, regardless of where the property is located. However, a donee not domiciled in Japan is subject to gift tax only on the value of assets located in Japan. Progressive tax rates are used to compute the tax, ranging from 10 percent for taxable amounts not exceeding ¥2 million, to 50 percent for taxable amounts over ¥10 million.

VII. Rental/Dividend Income The tax liability on rental/dividend income for a real property investor varies, depending on whether: • the real property is held in an individual’s or corporation’s name; • the investor has a PE in Japan; and • the investor is a resident or nonresident of Japan. A. Individual Investors For residents of Japan, rental income received from investment property located in Japan is classified as either real estate income32 or business income33 depending on the scale of the leased building and/or whether the investor can deem its investment(s) a business. For example, rental income from a building containing 10 or more apartments or from 5 or more houses is treated as business income.34 That income is grouped with the taxpayer’s other taxable income and subject to tax at the applicable marginal rate.35 Taxpayers with rental/business in-

32

ITL, article 26. 33 Id., article 27. 34 ITL Basic Circular 26-9. 35 Draft legislation before the Japanese Diet, rumored to become law sometime in 2007, involves the classification of rental income for individual investors. Under the draft legislation, rental income will no longer be classified as lease or business income, but treated as miscellaneous income. While the outcome of this is still unclear, it appears taxpayers will lose the ability to deduct depreciation expenses from their assessable income.

156 • July 10, 2006

come are required to file a tax return. In those cases, the taxpayer is able to claim expenses borne in deriving the rental income, such as interest repayments and depreciation on the total acquisition cost. 1. Interest Repayments Interest repayments on loans used to fund the purchase of an income-producing property are deductible, but only in proportion to the building value over the total property value. For example, 60 percent of the interest payments on a loan would be deductible for an individual taxpayer when, at the time of purchase, the value of the building is US $150,000 and the total value of the property is US $250,000. It follows that interest repayments on a loan for the purchase of land only are not deductible. The deductibility of interest expenses is restricted and not allowed when the rental activities generate losses rather than income as those losses can be offset against other income.36

A donee not domiciled in Japan is subject to gift tax only on the value of assets located in Japan. If a loan is obtained against the entire value of the property, the loan is allocated to the building portion first. 2. Nonresident Individual Investors Nonresident individuals who own real estate investments in Japan are required to file a tax return and are taxed at the applicable marginal rate. However, as nonresidents, they are not subject to local taxes (approximately 10 percent from 2007) if their activities do not constitute them having a PE in Japan (see section VII.B.1 below). Rental payments made directly to the nonresident owner are subject to a 20 percent withholding tax; however, that can be credited against the national income tax levied (as a result of filing a tax return). Question 1. What are the consequences of an individual taxpayer resident in your jurisdiction receiving rental income from real property located in Japan? Paul Banister: An Australian tax resident individual is assessable on income derived from all sources, that is, in Australia and globally. Rental

36 The purpose of the rule is to prevent a taxpayer from reducing their taxable income by offsetting a loss from real property leasing against other types of income. This is an exception to article 69 of the ITL under which an offset of a loss from real property leasing, business, and transfer of assets against other income is allowed.

Tax Notes International

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

tax on the entire assets acquired by inheritance or bequest. If the heir does not have a domicile in Japan, only assets in Japan are subject to the inheritance tax. Inheritance tax rates are progressive, beginning at 10 percent for taxable amounts not more than ¥10 million, reaching 50 percent for taxable amounts over ¥300 million. A basic exemption of ¥50 million is granted (plus ¥10 million per heir).

Special Reports

Foreign Investor Individual

Taxed at individual rates (national tax only if no PE)

Direct Ownership

Japanese Real Property

Rent (20% WHT creditable against income tax)

Lease

Tenants

income from Japan will be so assessable, with deductions allowable under Australian rules. Interest is deductible, subject to thin capitalization restrictions (although total interest and related financing costs must exceed A $250,000 before the restrictions apply). Losses caused by interest expense can be offset against income from other sources, including Australian income. Australian resident individuals suffer tax at rates of up to 46.5 percent. Credit is available for Japanese income taxes paid, subject to the tax not exceeding the average rate of tax on income from that source. Gordon Price: New Zealand resident individuals are taxable on the gross rental income less allowable deductions calculated in accordance with New Zealand tax law. Those deductions would include interest regarding borrowings to finance the property in Japan, depreciation at New Zealand depreciation rates (typically 2 percent straight line and 3 percent diminishing value for buildings), repairs and maintenance, and costs or commissions regarding management of the property. The New Zealand individual will receive a credit for Japanese tax paid in respect of that income, but limited to the individual’s overall average rate of New Zealand tax applied to the income from Japan. Losses can be offset against other New Zealand income. Chang-Yong Shin: An individual resident in Korea is taxable on its global income in Korea. The net rental income is calculated by deducting relevant expenses from the gross rental under Korean tax rules. The income tax rate for the individual is progressive, 8 percent through 35 percent. The in-

Tax Notes International

B. Corporate Investors For Japanese domestic corporations, rental income is included in the property owner’s gross income and taxed at the effective tax rate of approximately 42 percent. Interest repayments on loans taken out to finance the purchase of incomegenerating real property are fully deductible, unlike their treatment for individual investors, as discussed in section VII.A.1 above.

July 10, 2006

•

157

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

Nonresident Directly Owning Japanese Real Property

habitant surtax is additionally imposed at the 10 percent rate of the income tax due. The individual may elect one of two methods for relief of taxes paid in Japan regarding the rental income, that is, (1) deduction from the gross rental or (2) credit against the income tax. A foreign tax credit is allowed subject to the maximum Korean income tax liability regarding the foreign-source income. Any unused foreign tax credit due to the annual limit being reached for the year may be carried forward five years. Nitesh Mehta: An individual resident in India is subject to Indian tax on his or her global income. Rental income earned, subject to certain permissible deductions (described hereunder), by an Indian resident from property located in Japan would be subject to tax in India at the applicable individual rate. (Tax rates are progressive, 10 percent through 33.66 percent.) Credit for taxes paid, if any, in Japan regarding such income would be allowed in India subject to the maximum Indian tax liability regarding such income. Senen M. Quizon: An individual classified as a resident taxpayer in the Philippines is subject to tax on his or her worldwide income. Rental income derived by a Philippine resident taxpayer from property located in Japan is treated as income from foreign sources, hence, taxable at progressive rates (5 percent to 32 percent). Japanese taxes paid on the rental income may be credited against Philippine taxes due, but the credit should not exceed the same proportion of the tax against which such credit is taken. Jay Lo: Foreign-source income earned by Taiwanese individuals is not taxable in Taiwan. This includes rental income received from Japan. Corresponding tax paid in Japan therefore cannot be credited against Taiwanese personal income tax. This scenario will change with effect from 2009 when foreign-source income earned by a Taiwanese individual taxpayer will be subject to an alternative minimum tax. Credit against the alternative minimum tax will be available for Japanese taxes paid, subject to the tax not exceeding the alternative minimum tax paid on income from that source. Gary James: Hong Kong imposes its taxes on a territorial basis. Thus, rental income from property located in Japan is not taxable in Hong Kong.

Special Reports

37

CTL, article 139, and ITL, article 162. ITL, article 164(1)(i). 39 Id., article 164(1)(ii). 40 Id., article 164(1)(iii). 38

158 • July 10, 2006

• other Japanese-source income to the extent attributable to the construction activity in Japan. 2. Nonresident Investor: Japanese Company If a nonresident of Japan invests through a domestic company, the effective corporate tax rate of 42 percent applies. Dividends paid to the foreign shareholder are taxed 20 percent withholding unless a beneficial dividend from an applicable tax treaty applies.

Nonresident Investing Through Japanese Company Foreign Shareholder Dividends (WHT 20% unless tax treaty)

Shares

Domestic Company (KK)

Taxed at corp. rate(42%) (national & local taxes)

Ownership

Japanese Real Property

Rent

Lease

Tenants

Question 2. What are the consequences of an individual/corporate taxpayer resident in your jurisdictions receiving dividends from a Japanese company holding Japanese real property? Gary James: Dividend income received is not taxable in Hong Kong. Gordon Price: New Zealand resident individuals will be taxed on the dividend with a tax credit available for any Japanese withholding tax imposed. There is no credit available for underlying corporate Japanese taxes paid. The treatment of New Zealand corporate investors will vary in broad terms according to whether the company owns 10 percent or more of the Japanese company. If not, the dividend will be subject to the imposition of a 33 percent withholding payment that must be paid by the New Zealand company to the New Zealand Tax Department upon receipt, but

Tax Notes International

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

1. Nonresident Investor: PE ‘‘Permanent establishment’’ is defined under Japanese tax law as being a ‘‘fixed place of business,’’ and an entity or activity deemed as a nonresident’s PE in Japan will result in the nonresident’s profits attributable to the PE being taxed by the Japanese authorities at the prevailing corporate tax rate (42 percent). The existence of a PE for nonresident investors creates rental and capital gains income tax as well as withholding tax issues. While many tax treaties follow the ‘‘attributable’’ methods of computing income, Japanese domestic law uses both the ‘‘entire’’ and ‘‘attributable’’ income methods. Under the entire income method of taxing a PE, all domestic-source income is taxed to a PE, whether or not the income is related or attributable to the business or activities of the PE. That is otherwise known as the ‘‘force of attraction.’’ In many countries, tax treaty provisions normally only apply when they are beneficial to a taxpayer. Under Japanese domestic law,37 an applicable tax treaty’s provisions take precedence over domestic law. Therefore, a tax treaty’s PE or source rules has precedence over the force of attraction rule described above. Simply having direct ownership of property in Japan does not create a PE for a foreign investor. The scope of the investor’s activities as a result of its investment determines the risk of the tax authorities deeming a PE exists in Japan. The Corporation Tax Basic Circular 20-2-1 provides that a building for rent is a fixed place of business. If the foreign investors are involved in rental activities, there is a possibility that the building itself will be treated as a PE of the foreign investors. Under Japanese tax law, there are three classifications of PE: a branch PE,38 a construction activity PE,39 and an agency PE.40 A construction activity PE arises when a foreign corporation engages in construction, installation, or similar work, or the supervision of that work, in Japan for longer than one year. A foreign corporation with a construction activity PE in Japan is subject to Japanese corporation tax on its Japanese-source income, in this case, arising from: • leasing real property or rights to real property located in Japan, or income from quarrying rights or mining leases under some Japanese laws; and

Special Reports

In general terms, when the New Zealand company has an interest in the Japanese company of at least 10 percent, then — provided the Japanese company enjoys no specific tax concessions, such as concessions that may reduce Japanese corporation tax payable simply by virtue of the nature of the industry — in effect no withholding payment will be required to be made by the New Zealand company at the time of receipt. However, when the dividend sourced from Japan is eventually distributed to the shareholders in the New Zealand investor company, it will be taxable in full. Nitesh Mehta: A foreign dividend earned by an individual resident in India is taxable at 33.66 percent (maximum rate in case of individual). Likewise, a foreign dividend earned by an Indian corporation is taxable at 33.66 percent. Credit for taxes paid, if any, in Japan regarding such income would be allowed in India subject to the maximum Indian tax liability regarding such income. Paul Banister: Australian resident individuals and trusts must include dividends from a Japanese company in their assessable income. Credit is available for Japanese withholding tax, although the rate is restricted to 15 percent, which is the maximum rate that is permitted to be charged within Japan because of the Australia-Japan tax treaty. An Australian resident company (which has a tax rate of 30 percent) will be taxed in a similar manner as a resident individual on a dividend from a Japanese company if the Australian company owns less than 10 percent of the company. However, if the ownership interest is 10 percent or more, the Australian company will not suffer tax on the dividend (that is, any further tax is deferred until the Australian company distributes to its own shareholders). Chang-Yong Shin: A dividend from a Japanese corporation received by an individual resident in Korea is taxable in Korea. If its sum of income from interest and dividend for a year does not exceed KRW 40 million, the effective income tax rate on the dividend from Japan would be 14 percent (and 10 percent inhabitant surtax of the income tax due would be additionally imposed). Otherwise, the dividend income would be taxed at the applicable marginal income tax rate (up to 35 percent), subject to the minimum tax rate of 14 percent. The tax withheld by Japan (restricted to 15 percent under the Japan-Korea tax treaty) may be credited against the Korean income tax subject to the maximum Korean tax liability in that case.

Tax Notes International

A dividend from a Japanese corporation received by a Korean corporation is taxable in Korea. The corporate income tax rate is progressive, 13 percent and 25 percent (and 10 percent inhabitant surtax is additionally imposed). The tax withheld by Japan (restricted to 5 percent or 15 percent under the Japan-Korea tax treaty) may be credited against the Korean corporate income tax subject to the maximum Korean tax liability regarding the foreignsource income. Any unused foreign tax credit due to the annual limit being reached for the year may be carried forward five years. As an alternative, the Korean corporation may elect to deduct the tax withheld from its gross income. When the Korean corporation directly owns 20 percent or more shares of the Japanese company, the Japanese tax payable by the Japanese company with respect of the profits out of which such dividend is paid is taken into account for the purpose of calculating a foreign tax credit or deduction. Jay Lo: A foreign dividend earned by an individual taxpayer is treated the same as other foreignsource income as explained above, with the changes effective from 2009 also applicable in this case. Senen Quizon: Dividends received by a Philippine resident individual or domestic corporation from a Japanese corporation will be lumped together with other sources of income of the taxpayer subject to the graduated income tax rates of 5 percent to 32 percent for individual recipients, or 35 percent if the recipient is a domestic corporation. Credit for Japanese taxes paid is allowed against Philippine income tax payable subject to limitations. 3. Property Directly Owned by Foreign Corp. If the owner of the real property is a nonresident corporation and does not have a PE in Japan (that is, a real estate management company is responsible for investment and remittance of income to the owner), the local and enterprise taxes are not levied, resulting in an effective corporate tax rate of 30 percent. In those cases, rental income remitted to the nonresident is subject to a withholding rate of 20 percent. That withholding is creditable against the corporate taxes paid. Question 3. What are the consequences of a corporate taxpayer resident in your jurisdiction receiving rental income from property located in Japan? Senen Quizon: A Philippine domestic corporation is subject to tax on its worldwide income. Rental income received by a Philippine domestic corporation from property located in Japan is subject to income tax at the rate of 35 percent based on net income. Japanese taxes paid on the rental income are allowed to be credited against Philippine taxes

July 10, 2006

•

159

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

with a credit for Japanese withholding taxes imposed on the dividend. The net withholding payment is then available to be credited against the tax liability of the New Zealand company’s shareholders upon eventual distribution to them.

Special Reports

Foreign Investor Corporation

National corp. tax rate (30%) (no PE = no local taxes)

Direct Ownership

Japanese Real Property

Rent (20% WHT creditable against corp. tax)

Lease

Tenants

due, but the credit should not exceed the same proportion of the tax against which such credit is taken. Nitesh Mehta: An Indian corporation is subject to Indian tax on its global income. Rental income earned, subject to certain permissible deductions (described hereunder), by an Indian corporation from property located in Japan is subject to tax at 33.66 percent. Credit for taxes paid, if any, in Japan regarding such income would be allowed in India subject to the maximum Indian tax liability regarding such income. Gary James: A Hong Kong company receiving rental income from property located in Japan will not be taxed in Hong Kong because it will be considered to be non-Hong Kong-source income under Hong Kong’s territorial tax system. Gordon Price: The consequences for New Zealand corporations are the same as for individual taxpayers with the exception that profits are taxed at a flat rate of 33 percent. Jay Lo: Taiwanese corporations are taxed in Taiwan on their global income. Accordingly, rental income earned by a Taiwanese corporation from owning property located in Japan is taxable in Taiwan. Credit for taxes paid in Japan regarding such income is allowed in Taiwan subject to the maximum Taiwanese tax liability regarding such income. Paul Banister: As Australian corporate taxpayers are assessable on their worldwide income, rental income from Japan will be so assessable, with deductions allowable under Australian rules. Interest is deductible, subject to thin capitalization restric-

160 • July 10, 2006

tions (although total interest and related financing costs must exceed A $250,000 before the restrictions apply). Losses caused by interest expense can be offset against income from other sources, including Australian income. Australian resident companies suffer tax at a rate of 30 percent. Credit is available for Japanese income taxes paid, subject to the tax not exceeding the average rate of tax on income from that source. Chang-Yong Shin: Rental income from real property in Japan received by a Korean corporation is taxable in Korea. The net income would be calculated under Korean tax rules. The corporate income tax rate is progressive, 13 percent and 25 percent (and 10 percent inhabitant surtax is additionally imposed). The taxes paid in Japan may be credited against the Korean corporate income tax at the maximum Korean tax liability regarding the foreign-source income. The carryforward rules as mentioned above apply in this case. As an alternative, the Korean corporation may elect to deduct the taxes paid from its gross income. 4. Consumption Tax Japan’s consumption tax is a multistep, broadbased VAT levied on most transactions in goods and services in Japan and the receipt of foreign goods from bonded areas in Japan. The tax is assessed at each stage of the manufacturing, wholesale, and retail processes. Deductions for consumption taxes paid at previous stages by businesses result in the consumer bearing the full burden of the consumption tax. A taxable enterprise is required to pay to the tax office the difference of the annual total 5 percent consumption tax on its taxable revenues (output tax) and the annual total 5 percent consumption tax on its domestic purchases and imports of goods (input tax). If it pays more consumption tax than it receives, it is entitled to a refund of the difference. Rental income is subject to 5 percent consumption tax if the property is used for commercial or business purposes and not for residential purposes. If the property is used for residential purposes, the taxpayer is unable to claim the input tax credit of acquisition consumption tax41 as there is no taxable revenue earned for consumption tax purposes. 5. Depreciation When computing rental income for Japanese resident investors, depreciation of buildings is a tax deduction for both individuals and corporations. Acquisition costs of property housing a business or held for the production of income may be recovered as an expense for depreciation over the useful life of

41

This is discussed in section IV.B above.

Tax Notes International

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

Nonresident Corporation Investing In Japanese Real Property Directly

Special Reports

• interest on loans to acquire assets and the interest portion of installment purchase payment. Question 4. Are resident taxpayers in your jurisdiction able to claim expenses connected to the derivation of Japanese-source rental income? Nitesh Mehta: In India income earned from real property is computed under the heading ‘‘income from house property.’’ As per the computation mechanism, the following are the only permissible deductions from house property income: • property tax paid to the local authority; • a deduction of 30 percent of the annual value of the property (that is, actual rent received or receivable on the property or any part of the property that is let out as reduced by taxes levied by the local authority); and • when the property has been acquired, constructed, repaired, renewed, or reconstructed

42

CTL, article 31. CTL — Enforcement Order (CTL-EO), article 54. 44 CTL Basic Circular (CTL-BC), 7-8-1-6. 45 Id. 46 Id., 7-3-3-2. 43

Tax Notes International

with borrowed capital, the amount of interest payable on such capital is allowed as a deduction in computing the income from house property. Regarding property acquired or constructed with borrowed capital, the amount of interest payable for the period before the year in which the property has been acquired or constructed will be allowed as deduction in computing the income from house property in five equal installments beginning with the year of acquisition or construction. Interest payable outside India is allowable as deduction only when the applicable taxes have been withheld/ paid regarding such interest and the person making the payment may be treated as an ‘‘agent’’ of the nonresident. Generally, the person in India from or through whom the nonresident is in receipt of any income, directly or indirectly, is regarded as ‘‘agent’’ of the nonresident. Gary James: As the rental income from property located in Japan is not subject to tax in Hong Kong, there are no deductions available for the relevant expenses. Jay Lo: As Taiwanese individual taxpayers are not taxed on foreign-source income, no such tax deductions are available. Corporate taxpayers, however, are allowed to claim tax deductions such as depreciation, interest, and property management commissions. Paul Banister: Australian resident taxpayers are allowed tax deductions against Japanese income. However, they are restricted by Australian rules. Items such as depreciation, interest, and property management commissions are allowable. Depreciation is generally written off over the effective life of the asset. As noted in an earlier answer, interest is subject to thin capitalization restrictions. Chang-Yong Shin: Korean resident taxpayers may generally elect to deduct depreciation from the gross rental earned from real property in Japan subject to an annual limitation under Korean tax rules. Senen Quizon: A Philippine resident individual engaged in business or domestic corporation may claim deductions for expenses relating to the property being leased in Japan. Items of deductions from gross income include depreciation and interest payment on loans incurred in connection with the business. Depreciation is based on the estimated useful life of the property while interest expense is an allowable deduction under certain conditions and subject to a ceiling. Gordon Price: My response to question 1 applies here. Care should be taken by both New Zealand individuals and companies to ascertain whether interest costs attributable to the purchase of the

July 10, 2006

•

161

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

the property.42 The useful life of a building may vary from 7 to 65 years depending on the structure’s use and type. Acquisition costs of depreciable property include the purchase price and additional costs of obtaining the property, freight and loading expenses, transport insurance fees, purchase commissions, tariffs, and costs of self-constructed assets.43 Costs to demolish structures are included in the acquisition cost if the demolition starts within one year from the time of acquisition.44 Costs associated with property maintenance are treated as a current expense; however, repairs that extend the useful life of the property or increase its value are included in the acquisition cost.45 When the investment property is sold, previously claimed depreciation expenses are factored in to lower the acquisition cost, increasing the capital gain. The following costs are not included in the acquisition price of depreciable assets:46 • taxes such as real estate acquisition tax or registration license tax; • costs of construction of buildings, and so forth, such as planning, surveying, and basic construction costs that become unnecessary due to a change in plans; • penalties for breach of contract to acquire assets; and

Special Reports

The existence of a PE for nonresident investors creates rental and capital gains income tax as well as withholding tax issues. If a New Zealand corporate investor is controlled by a nonresident (shareholding of 50 percent or more), thin capitalization restrictions should be considered. B. Thin Capitalization Rules Japan’s thin capitalization rules are designed to prevent taxpayers from using excessive interest payments on loans to affiliated entities to reduce their Japan income tax liability. The debt-to-equity ratio is 3 to 1. Any interest paid on debt borrowed in excess of that ratio is not deductible for the taxpayer.47 Japan’s thin capitalization rules do not only apply to interest-bearing loan financing from foreign affiliated companies. Recent tax reforms have resulted in loan guarantee fee and securities commission fee arrangements used to circumvent those rules now being captured by the rules. (For related coverage, see Tax Notes Int’l, Jan. 16, 2006, p. 176.)

VIII. Disposition of Real Property Both nonresidents and residents of Japan are liable to capital gains tax on a capital gain derived on the disposal of some assets with the required connection to Japan. An important feature of Japanese tax law is that a capital gain from the disposal of real property is treated differently for individuals than it is for corporations. However, for both individual and corporate taxpayers, gains are recognized on the date of delivery. When the date of delivery is not clearly identified, either of the following days can be deemed to be the date of delivery48: • the date 50 percent or more of the sales price has been received as consideration; or • the date the amplification for the registration of title transfer is filed.

Notwithstanding the above, gains can be recognized on the date the sales contract is signed.49 A. Corporate Taxpayers Capital gains arising from the disposition of land, rights to land, or shares in a land holding company are included in gross income and taxed at regular tax rates. For a capital gain from the transfer of real property, the recognition of the gain may be deferred for some transactions. For example, tax-free rollover treatment is allowed in the exchange of like-kind property; however, to qualify for that deferral, both the property transferred and the property acquired must be held for at least one year by the respective parties and be used for the same purpose as before the exchange.50 1. Capital Loss Treatment for Corporations A domestic corporation holding property can offset a capital loss against its other income and can carry forward losses seven years.51 Corporations must file a blue tax return for the year the loss was incurred and continue to file tax returns (either blue or white) for subsequent income years. 2. Land Surtax (Suspended) The land surtax is suspended to stimulate real estate sales in the post-bubble-economy era, effective until December 31, 2008. It is unknown at this stage whether the suspension will be lifted for 2009; however, given the recent increase in market activity, its return at some stage is likely. The surtax is levied on corporations in addition to the usual corporate tax treatment and calculated as follows: • property held for less than five years is subject to 12 percent surtax; and • property held for more than five years is subject to approximately 6 percent surtax. Special rules govern the calculation of the gain on a sale, and deductions for deemed interest expense (6 percent) and administrative expenses (4 percent) of the book value of the land are permitted. Using those deemed expenses results in the basis of the land, for calculating the land surtax, annually increasing by 10 percent on a noncompounded basis. 3. Nonresident Corporate Investors The rate of tax levied on gains made by nonresident corporate investors is the same for resident corporations, except no local taxes are levied if the income is not attributable to a PE in Japan (reducing the effective tax rate from 42 percent to 30

49 47

STML, article 66-5. 48 CTL-BC 2-1-2.

162 • July 10, 2006

Id., 2-1-14. STML, article 37. 51 ITL, article 57. 50

Tax Notes International

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

property in Japan would give rise to exposures to New Zealand nonresident withholding tax or the approved issuer levy on interest payments even though funds may have been borrowed outside New Zealand.

Special Reports

Nonresident With No PE in Japan Sells Japanese Real Property Foreign Investor (Corporation) Direct Ownership

Gain taxed at corp. rate (30% - no local taxes)

Japanese Real Property Payment (gross 10% WHT credit against income tax) Sale

Purchaser

B. Individual Taxpayers Capital gains for individual taxpayers from the disposal of real property are taxed separately from other income at a special rate. Capital gains from real property are classified as either short-term or long-term depending on the length of time the property was held. 1. Long-Term Holding Period Gains Capital gains from real property are classified as long-term when the property is held for more than five years as of January 1 of the year in which the property is disposed. Real property long-term capital gains income is taxed at 20 percent (15 percent national tax and 5 percent local tax). 2. Short-Term Holding Period Gains Gains from the disposition of property held for five years or less are taxed at a rate of 39 percent (30 percent national and 9 percent local). 3. Capital Loss Treatment for Individuals For individual resident taxpayers, losses from the disposition of real property located in Japan can only be offset against gains similar in nature to the loss (that is, from the disposition of real property) and cannot be carried forward. Question 5. How are capital losses from the sale of Japanese property received by a corporation or individual taxpayer resident in your jurisdiction treated?

Tax Notes International

Jay Lo: As income earned by a Taiwanese individual from sources outside Taiwan is not taxable in Taiwan, capital losses from foreign investment have no tax implication for a Taiwanese individual. For corporate taxpayers a capital loss suffered from real property investment in Japan can be claimed as tax deduction for reducing Taiwanese corporate income tax. Nitesh Mehta: Capital losses on the sale of Japanese property by a corporation/individual resident in India are treated either as long-term capital loss (if transferred after 36 months) or as short-term capital loss (if transferred within 36 months). While calculating long-term capital gains/losses, the cost of the acquisition of the asset is multiplied by a prescribed cost inflation index. Long-term capital losses are allowed to be set off against long-term capital gains in the same assessment year; however, if such loss cannot be so set off, they can be carried forward and set off only against long-term capital gains in the subsequent eight assessment years. Short-term capital losses are allowed to be set off against any capital gains in the same assessment year; however, if such losses cannot be so set off, they can be carried forward and set off against any capital gains income in the subsequent eight assessment years. Senen Quizon: In the Philippines, capital losses cannot be deducted from ordinary gains or income. Capital losses can be offset only against and to the extent of capital gains from similar transactions. Gary James: Hong Kong does not levy tax on capital gains. Consequently, there would be no offset for capital losses. Gordon Price: Capital losses are generally not deductible in New Zealand by either corporate or individual taxpayers. When property assets are deemed to be held on revenue account (for example, by virtue of the New Zealand investor being associated with a property trader or developer), real estate held on capital account may nevertheless be taxable, in which case any losses incurred would then be deductible. New Zealand does not impose a capital gains tax as such, although real estate transactions can be taxed by virtue of association with other taxpayers holding such assets on revenue account, or under provisions that arbitrarily tax such gains in various specified circumstances (see answer to question 6 below). Chang-Yong Shin: Capital losses incurred by a Korean individual resident from real property investment in Japan may be set off against capital gains on property in foreign countries for the tax year in which the losses/gains occurred. For a Korean corporate resident, capital gains or capital losses on property are treated as gains or losses under ordinary business, and there is no special tax

July 10, 2006

•

163

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

percent). Withholding tax of 10 percent is levied on the gross income received on the disposition (creditable against the corporate tax paid). If the withholding tax amount is larger than the final tax liability, the excess of the former over the latter can be refunded.

Special Reports

Capital Gains Tax Position for Nonresident Individual Investor Foreign Investor (Individual) 15% CGT (long-term) 30% CGT (short-term)

Direct Ownership

Japanese Real Property Income (10% WHT on gross but creditable against income tax) Sale

Purchaser

Question 6. What are the tax consequences for an individual or corporate taxpayer resident in your jurisdiction receiving capital gain income from the disposition of Japanese real property? Chang-Yong Shin: A Korean individual taxpayer who realizes a capital gain on the sale of real property located in Japan is subject to capital gains tax in Korea as follows:

52 If the withholding tax amount is larger than the final tax liability, the excess of the former over the latter can be refunded.

164 • July 10, 2006

• holding period of less than one year — 50 percent; • holding period of one year or more but less than two years — 40 percent; • holding period of two years or more — progressive, 9 percent through 36 percent. For real property held by the individual resident for three years or more, long-term allowance may be deductible from the capital gains at the rate of 10 percent through 30 percent of capital gains, depending on the holding period. Capital gains on real property realized by a Korean corporation are included in the normal taxable income and subject to the corporate income tax at the applicable marginal tax rate. The inhabitant surtax is additionally imposed at the rate of 10 percent of the individual income tax due or corporate income tax due. Nitesh Mehta: In India the taxation of capital gains from the disposition of real estate is essentially the same for both individuals in the top tax bracket and corporations. For individual taxpayers in the top tax bracket, long-term gains (held for more than three years) are subject to 22.44 percent and short-term gains (held for less than three years) are subject to 33.66 percent. For corporate taxpayers, long-term gains are subject to 22.44 percent and short-term gains are subject to 33.66 percent tax. Credit for taxes paid, if any, in Japan regarding such income would be allowed in India subject to the maximum Indian tax liability regarding such income. Jay Lo: As Taiwan does not tax individuals on foreign-source income (see above), the receipt of capital gain income from the sale of Japanese real estate has no tax consequence in Taiwan. Corporate taxpayers, however, are taxed on their worldwide income, and as such any capital gain earned from the sale of property located in Japan is taxable in Taiwan. Credit for taxes paid, if any, in Japan regarding such income would be allowed in Taiwan subject maximum to the Taiwanese tax liability regarding such income. Paul Banister: An Australian tax resident taxpayer is assessable on capital gains realized on assets acquired since September 19, 1985. The assessable amount is first reduced by any capital losses available for offset. Companies are taxed on the net capital gain at the rate of 30 percent, although relief for the inflation component of the gain is available up to September 30, 1999, if the asset was acquired before that date. Individuals are taxed on the net capital gain at their marginal tax rates (that is, up to 46.5 percent), but with two alternative choices for relief:

Tax Notes International

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

treatment for such gains or losses. Therefore, capital losses on property in Japan incurred by a Korean corporate resident are deductible from its taxable income for the year in which they occur. Paul Banister: Capital losses incurred by an Australian tax resident, whether individual or corporate, are allowed to be set off against current year or future year capital gains, wherever they are generated (that is, domestically or globally). There is no time limit for carryforward. 4. Nonresident Individual Investors The rate of tax levied on gains made by nonresident taxpayers on the disposition of real property located in Japan also depends on whether the property was held for more or less than five years. Gains made on the disposition of property held for more than five years are taxed 15 percent (no 5 percent local tax levied, as for permanent and nonpermanent residents). For property held for less than five years, gains are taxed at 30 percent (again, the local tax of 9 percent is not levied). Withholding tax of 10 percent is levied on the gross income, but is creditable against the capital gains tax.52

Special Reports

• the assessable gain is reduced by the inflation component of the gain up to September 30, 1999, if the asset was acquired before that date. A credit will generally be available for Japanese income taxes paid on the gain, but only to the extent of Australian tax payable. Senen Quizon: Gains on the sale of real property located in Japan, regardless of whether classified as an ordinary asset or capital asset, by individual or corporate taxpayers are subject to graduated income tax rates for individuals from 5 percent to 32 percent and 35 percent (for domestic corporations). For individuals, only 50 percent of capital gains are recognized as subject to income tax if the capital asset has been held for more than 12 months (long-term capital asset transactions). One hundred percent of the capital gains are subject to tax if the capital asset has been held for 12 months or less (short-term capital asset transactions). The holding period is not material and the capital gain is recognized in full in case of corporations. Gary James: Hong Kong does not impose a capital gains tax. Further, as the property is located in Japan, the gain would have a non-Hong Kong source, so that even if the ‘‘gain’’ were to be considered a trading profit for Hong Kong tax purposes, it would be subject to Hong Kong profit tax. Gordon Price: Please refer to my answer to question 5. Capital gains will only be taxed when the investor is associated with a taxpayer holding such assets on revenue account or when specific taxing provisions apply. The two most notable provisions in this regard are those that tax profits arising from rezoning when the property has been owned for less than 10 years and when the assets are realized following large-scale property developments.

IX. Disposal of a Japanese Real Property Holding Company Section VIII of this article looked at the taxation of capital gains made by a nonresident investor on the sale of real property located in Japan. This section looks at the consequences associated with nonresident shareholders in a Japanese real property holding company making a capital gain on the alienation of their interest in the holding company. For residents of a foreign jurisdiction with no tax treaty with Japan, those gains are subject to 15 percent withholding (the local tax of 5 percent not

Tax Notes International

levied).53 However, gains for a foreign investor can be exempt from taxation in Japan if the capital gains article of the applicable tax treaty between Japan and the investor’s jurisdiction exempts taxation on capital gains in the source country.54 Japan’s tax treaty with the Netherlands (to the extent that the investor had not been the resident of the source country for five years before the disposition) also provides similar treatment. A foreign investor can structure real property investments in Japan as follows:

Investor

Netherlands BV

Japanese Corporation

Japanese Real Estate

Under that structure, when the BV sells the Japanese corporation’s shares, the capital gains are exempt from taxation in Japan as provided by article 14 of the Japan-Netherlands tax treaty. Further, the capital gains are exempt from taxation in the Netherlands when the BV shareholder meets

53 Section X.C.2 (capital gains), below, deals with that point. 54 Japan’s tax treaties with Ireland, Italy, Indonesia, Zambia, Switzerland, Spain, the Czech Republic, Germany, Finland, Brazil, Belgium, and Romania contain that exemption.

July 10, 2006

•

165

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

• the assessable gain is discounted by 50 percent if the asset was held for greater than 12 months; or

Special Reports

Depreciation of buildings is a tax deduction for both individuals and corporations. It is recommended the taxpayer have significant commercial reasons for establishing that structure. Japan does not approve of ‘‘treaty shopping’’; the benefit of the tax treaty may be denied if it can be proven the sole purpose of establishing the holding company in the Netherlands was to benefit from the capital gains provision. Question 7. What are the tax implications (that is, CFC rules) of a taxpayer in your jurisdiction setting up an offshore company to hold a Japanese real property company, as described above? Nitesh Mehta: There are no specific CFC rules in India. However, commercial and economic substance should be established to take benefit of the tax treaty provisions. Jay Lo: In the case of individual investors, foreign-source income earned is not taxable in Taiwan. As Taiwan has no CFC rules, therefore, individual investors can benefit from the above scheme. Based on the Netherlands-Taiwan tax treaty, withholding tax on dividend is reduced to 10 percent. In the case of Taiwanese corporate investors, a dividend received from worldwide investment is taxable in Taiwan. Accordingly, dividends distributed from Netherlands BV to Taiwanese corporate investors would be subject to Taiwanese tax. Based on the Netherlands-Taiwan tax treaty, withholding tax on dividends is reduced to 10 percent. Chang-Yong Shin: A Korean resident or a Korean corporation having directly/indirectly 20 percent or more interest in a foreign specially related corporation within a tax haven country or region is subject to Korea’s CFC rules. The undistributed income of the foreign corporation allocable to the Korean investor’s ownership is included in the taxable income of the Korean investor for the year when the 60th day from the year-end of the foreign corporation falls. Criteria for determining the tax haven country are either of (1) tax system to grant 50 percent or more exemption of the earning income depending on industry, corporate type, or income source place, or (2) a minimum effective income tax rate of 15 percent.

166 • July 10, 2006

Gary James: Given Hong Kong’s territorial tax system, there would be no tax implications associated with establishing an offshore company to hold Japanese real estate. Senen Quizon: The capital gains derived by a resident individual or domestic corporation from the disposition of a share in an offshore company are taxable in the Philippines at the 5 percent to 32 percent graduated income tax rates in case of individuals and 35 percent in case of domestic corporations. The gains will be the difference between the selling/transfer price and the acquisition cost or the adjusted cost of the shares. Paul Banister: Australian investors are unlikely to obtain any benefit from this approach. This is due to the foreign income accrual regime (including CFC rules), which, broadly, prevents passive income and capital gains being accumulated within foreign entitles without ongoing Australian tax being paid. The situation may be different if the asset was actively used in a business or the other income of the entity was so extensive that the gain, when combined with other passive income, was less than 5 percent of total income of the Dutch BV. Gordon Price: The BV company’s capital gain will not be taxed under New Zealand’s CFC rules when the shares in the Japanese corporation are held on capital account. If the BV company is liquidated to repatriate the capital gain to New Zealand, no tax is payable upon that repatriation. However, if the amount is distributed as a dividend, it will be subject to a 33 percent dividend withholding payment obligation in the case of a New Zealand corporate shareholder, and in other cases it will be included in the New Zealand resident’s taxable income for the year in question. Consequently, in order that the gain can be distributed tax-free in the course of a liquidation, the BV corporation should be a special purpose vehicle conducting no other business or investment activity.

X. Other Investment Vehicles Under Japanese corporate law, a number of investment vehicles are available to the resident and nonresident real estate investor, ranging from asset securitization vehicles, to special purpose companies, to the recently popular real estate investment trust (REIT). A brief explanation of the three most commonly used vehicles follows. A. Tokumei Kumiai Popular with private real estate funds, a tokumei kumiai (TK) is an agreement between the operator (the owner of the property) and a TK investor who invests in the operator’s business (real property investment). There is no limit to the number of TK investors that can participate. TK investors contribute funds to the business and in return are able to

Tax Notes International

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

the participation exemption in its level of ownership in the Japanese corporation. In those cases, however, a careful examination of the rules governing controlled foreign corporations in the investor’s home jurisdiction is required.

Special Reports

Illustration of Typical TK Structure TK Investor Investment

Offshore Profit/Loss

A TK operator in a TK structure with Japanese resident TK investors generally does not invest in real estate directly but through a trust scheme. This is to avoid the somewhat burdensome registration requirements stipulated under the Real Estate Specified Joint Enterprise Law (RESJEL).56 Interests a resident taxpayer has in such an arrangement constitute securities under Japan’s Securities and Exchange Law (SEL); however, notification or filing requirements for such private funds are not required under the SEL.

Japan TK Contract

Japan KK/TK Operator

Illustration of Typical TK Structure For Japan Resident Investors

Real Estate

TK Investor (Japan resident)

Under a TK arrangement, any rental and capital gain income is included in the operator’s taxable income as it is a corporation paying taxes (42 percent). However, when calculating taxable income, the TK operator is entitled to take a deduction for profits allocated to the TK investors. The Japanese tax consequences for the TK investor relating to income under the TK arrangement will depend on whether the TK investor is a Japan resident, whether the investor is deemed to be an ‘‘active’’ or ‘‘passive’’ investor, and whether the TK operator is a PE of the TK investor. 1. Japanese Resident TK Partner The tokumei kumiai profit/loss allocation is treated as normal taxable income/loss of the TK investor for the particular period in which the income/loss is received. No withholding tax is levied on the actual contributions of TK profit allocations made to Japanese resident partners in a TK arrangement having less than 10 TK investors.55 Profit/loss distributions received by the investor will be aggregated with the taxpayer’s other income and taxed at the applicable marginal rate. An active investor will be able to offset losses against other income; however, a passive investor is prohibited from doing so. An active TK investor is one who plays an active role in the business decisions of the Japan TK operator. (For related coverage, see Tax Notes Int’l, Apr. 17, 2006, p. 253.)

Investment

Profit/Loss TK Contract Japan KK / TK Operator (Beneficiary of Trust Bank)

Trust Bank (owns property)

Property

A TK operator with all its TK investors being nonresidents of Japan at the time the agreement(s) is/are entered into is not required to satisfy the stringent requirements as provided in the RESJEL. 2. Nonresident TK Partner Under Japanese domestic law, TK distributions made to nonresident partners are subject to a flat

55

TK distributions made to TK investors in arrangements with more than 10 TK investors are subject to 20 percent withholding tax, creditable against the investor’s national and local income taxes levied on their assessable income.

Tax Notes International

56 Article 7 of the RESJEL lists the criteria that applicants seeking the license must satisfy.

July 10, 2006

•

167

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

participate in the profits or losses from that operation while having no direct control in the management of the Japanese entity.

Special Reports

3. Nonresident TK Partners With PE in Japan The TK arrangement has in recent times brought with it increased scrutiny from the tax authorities as, with the right structuring, TK distributions to foreign investors can be free from Japanese taxation. As a result, there have been a number of cases in which the tax authorities have successfully challenged TK structures, on the grounds that the TK operator is a PE of the foreign TK investor. (For related coverage, see Tax Notes Int’l, Mar. 20, 2006, p. 961.)

Capital gains from real property are classified as either short-term or long-term. The profit/loss allocation from the TK to a TK investor deemed to have a PE in Japan is treated as normal taxable income/loss of the TK investor for the period in which the accounting period end date of the TK operator falls. The TK investor is required to file a tax return and pay income tax at the applicable marginal rate. When implementing a TK structure, it is imperative that the agreement clearly indicates that the relationship between the parties follows the statutory requirements and gives Japan’s National Tax Agency no scope to challenge it on management or ownership grounds. However, a statutory-sound TK agreement can still be challenged if the National Tax Agency can establish the parties are in sub-

57 Japan’s tax treaties with the following countries contain the ‘‘other income’’ provision, stipulating income not expressly covered in the tax treaty is not taxed in the country where the income is sourced and therefore exempt from Japanese withholding tax: Belgium, the Czech Republic, Denmark, Finland, France, Germany, Hungary, Indonesia, Ireland, Italy, South Korea, Malaysia, the Netherlands, the Philippines, Poland, the Slovak Republic, Russia, Spain, Switzerland, Vietnam, and Zambia. Japan’s current tax treaty with the United Kingdom also contains this provision; however under the new tax treaty to take effect from 2007, such payments to a U.K. TK investor will be dealt with under Japanese domestic law and subject to 20 percent withholding tax. This mirrors Japan’s tax treaty with the United States.

168 • July 10, 2006

stance working together, the TK partner has some control over the TK operator, or the TK operator is acting on behalf of the TK investor. Question 8. How are TK income/loss distributions received by a corporate/individual investor taxed in your jurisdiction? Paul Banister: The treatment of an Australian resident company or individual who invests in a Japanese TK depends on whether the chameleonlike tax hybrid rules apply. Generally, the Australian foreign hybrid rules will apply if the TK investor is taxable on income or is allowed loss offset (that is, if they have a PE in Japan). The consequence is that the ‘‘look-through’’ approach in Japan is repeated in Australia. Losses may be offset against other income, although restrictions apply. If there is no Japanese PE (meaning that the TK investor is taxable on a withholding basis only), the foreign hybrid rules will not apply. This means the TK investor will be taken to have invested into a limited partnership and no losses would be allowable. Any distribution will suffer Australian tax as if a dividend is paid — that is, it is taxed at the applicable rate, with credit permitted for Japanese tax payable. As this type of income is not covered by the treaty, Japanese domestic tax law would apply.58 Gary James: As a result of Hong Kong’s territorial tax system, there would be no Hong Kong taxation consequences. Nitesh Mehta: In India we have a concept of ‘‘association of persons’’ wherein two or more persons join in a common purpose or common action for the purpose of producing income. A TK arrangement could be regarded as an arrangement between an ‘‘association of persons.’’ Profits or losses from such a venture may be regarded as business income and charged to tax accordingly (33.66 percent for corporate taxpayers and individuals who fall in the highest tax bracket). Credit for taxes paid in Japan regarding such income is allowed in India subject to the maximum Indian tax liability regarding such income. Chang-Yong Shin: The Korean National Tax Service appears to believe that TK distributions are categorized as interest under ordinary circumstances. The tax implication on the distribution from TK is the same as discussed in section VII.B.1 above, except for the possibility of the two national tax authorities disputing the appropriate withholding tax rate.

58 TK distributions that are not covered by an applicable tax treaty are subject to 20 percent withholding tax as provided under Japanese domestic tax law.

Tax Notes International

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

withholding tax of 20 percent. This is a final tax, and the nonresident TK partner is not required to file a tax return. However, TK distributions made to a nonresident TK investor of a jurisdiction Japan has a tax treaty with containing the ‘‘other income’’ provision may be exempt from Japanese withholding tax.57 For example, under the JapanNetherlands tax treaty, TK distributions are deemed to fall under article 23, ‘‘other income,’’ and are not subject to Japanese withholding tax.

Special Reports

B. Japanese Real Estate Investment Trust There are two kinds of Japanese Real Estate Investment Trust (JREIT), a trust-type JREIT and a corporation-type JREIT. This article focuses only on the corporation-type JREIT structure, as it is the overwhelmingly preferred structure for real estate investors in Japan. The corporation-type JREIT is treated as a domestic corporation; therefore, it is taxable on its worldwide income at the prevailing corporate tax rate (35 percent to 42 percent as previously discussed). However if the entity meets 11 requirements as stipulated under the Special Taxation Measures Law,59 dividends paid to investors can be treated as a deduction, thereby making the corporation-type JREIT a passthrough entity. Any income of the JREIT remaining after the dividends have been distributed is subject to Japanese corporate tax (42 percent). A JREIT is also entitled to a reduced registration tax for real property of 0.6 percent. The 11 conditions are as follows:

59

STML, article 67-15 lists these requirements.

Tax Notes International

1. The corporation is registered under article 187 of the Investment Corporation Law (ICL).60 2. One of the following conditions is satisfied: • the JREIT issues shares through a public offering to the value of ¥100 million or more61; or • the shares are subscribed to by at least 50 investors or solely by Qualified Institutional Investors62 (QIIs) at the end of the accounting period. 3. The total issued shares are offered mainly in Japan.63 4. The JREIT’s business year does not exceed one year. 5. The JREIT operates in compliance with article 63 of the ICL.64 6. The management of the assets is the responsibility of a licensed ITMC under the Investment Trust Law.65 7. A corporation, as stipulated under the Investment Trust Law, is entrusted to holding the asset(s) under article 198(1) of the ICL.66 8. The JREIT is not deemed to be a family corporation at the end of an accounting year.67 9. The JREIT does not hold 50 percent or more of stocks in another corporation.68 10. The JREIT is permitted to only borrow funds from or issue bonds to QII and not from the JREIT shareholders. 11. At least 90 percent of the JREIT’s net income for tax purposes must be distributed as dividends to the JREIT shareholders.69 1. Dividends Declared by a JREIT Dividends distributed to domestic shareholders of a JREIT are subject to Japanese withholding tax at

60

STML, article 67-15(1)(a). Id., article 67-15(1)(b)(1). 62 Id., article 67-15(1)(b)(2). 63 Id., article 67-15(1)(c). A minimum of 50 percent of shares need to be offered in Japan. 64 Id., article 67-15(2)(a). Violations include the corporation engaging in any business other than asset management, opening additional places of business, or hiring employees. 65 Id., article 67-15(2)(b). 66 Id., article 67-15(2)(c). 67 Id., article 67-15(2)(d). A family corporation is defined under article 2-10 of CTL as being a corporation of which more than 50 percent of its capital is owned by one, two, or three shareholders. 68 Id., article 67-15(2)(f). 69 Id., article 67-15(2)(e). 61

July 10, 2006

•

169

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

Gordon Price: It appears from a New Zealand perspective that this type of investment would be regarded as an investment in a limited partnership and the distribution represents a distribution of partnership profit, in which case both corporate and individual investors would be taxable at the relevant New Zealand tax rate with a credit for Japanese withholding taxes. Senen Quizon: The profit distributed to a Philippine resident individual or domestic corporation will be included as part of gross income subject to graduated income tax rates of 5 percent to 32 percent (if recipient is a resident individual) or 35 percent (if recipient is a corporation). Credit for Japanese taxes paid is allowed against Philippine income tax due subject to limitation. There are no regulations covering the tax treatment of losses from this type of hybrid investment. However, since the transaction is in the nature of participation in a business venture, there seems room to argue that the losses from this activity should also be allowed as deduction for purposes of the Philippine income tax liability of the Philippine investor. Jay Lo: As discussed in earlier answers, Taiwan does not tax foreign-source income earned by individual taxpayers. Corporate taxpayers are taxed on their worldwide income and, as such, TK income is taxable in Taiwan. Credit for taxes paid in Japan regarding such income would be allowed in Taiwan subject to the maximum Taiwanese tax liability regarding such income.

Special Reports

Prop.

Property

custody

Manager

Investment

Investors

Investment Company

Buy/sell

Asset Custody

or

Company

Investment Prop. mgt

Dividends

Investors

Trust Loans

Licensed Asset Management Acquire

Company

Lenders

properties Asset mgt.

Real Properties

a rate of 10 percent.70 For nonresident shareholders, local tax is not included, resulting in their tax liability on dividends being 7 percent.71 For domestic corporation shareholders, the dividends are included in the corporation’s taxable income and a credit on the withholding paid at distribution can be claimed against its corporate tax liability. While Japan tax rules allow domestic investors to exclude dividends from their taxable income for dividends received from a Japanese corporation, those rules do not extend to JREITs. As such, JREIT dividends cannot be excluded from a JREIT shareholder’s taxable income. Question 9. What are the tax consequences of an individual or corporate JREIT shareholder resident in your jurisdiction receiving a dividend?

70 STML, article 9-3. Domestic shareholders are subject to both national (levied at 7 percent) and local (levied at 3 percent) taxes. The national and local tax rates will increase to 15 percent and 5 percent respectively from Apr. 1, 2008, resulting in dividends issued to domestic and nonresident shareholders being subject to 20 percent and 15 percent tax respectively. 71 Id., article 37-12.

170 • July 10, 2006

Paul Banister: Australian resident taxpayers are taxed on income from all sources at their applicable tax rate. Accordingly, a dividend is taxable to all entities. However, a company that owns an interest of at least 10 percent in a Japanese company will not be taxable on the dividend; rather, further tax will be deferred until the Australian company distributes to its shareholders. Nitesh Mehta: My answer to question 2 covers the Indian position. Gordon Price: When dividends are tax deductible in Japan, then the distribution amount will be subject to a 33 percent withholding payment obligation upon receipt by a New Zealand resident company. That withholding will be payable net of any credit for Japanese withholding taxes imposed, and the net withholding payment obligation will be subsequently allowed as a credit against the tax obligations of the shareholders upon eventual distribution. Trustee or beneficiary recipients, or individuals investing in the JREIT, will be taxable at the relevant marginal tax rate with a credit for Japanese withholding tax. When distributions are retained in the trust and not distributed to beneficiaries, a flat rate of 33 percent is payable (after allowance of the Japanese foreign tax credit). Senen Quizon: My answer to question 2 applies for the Philippines position on this.

Tax Notes International

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

JREIT Structure

Special Reports

C. Companies Holding Japanese Real Property for Nonresidents

1. Tax on Dividends Dividends paid by a domestic company to a foreign shareholder are subject to 20 percent withholding tax; however, this may be reduced under an applicable tax treaty. Question 10. How are dividends received by an individual/corporate shareholder in a Japanese company/trust holding real property taxed in your jurisdiction? The responses from all the participants were the same as their answers to question 9, with one exception. In New Zealand, a New Zealand corporate recipient of the dividend is not required to deduct a withholding payment on receipt when the investment is 10 percent or more, the company is fully taxable in Japan without entity or industry specific tax concessions, and the dividends are not deductible for the Japanese payer. 2. Tax on Capital Gains Gains from the transfer of shares in domestic companies or beneficial interests in trusts holding Japanese real estate are reported on a tax return as Japanese-source income subject to tax. The taxable interests are: • shares in a company if 50 percent or more of its total assets consists of real estate located in Japan; or

Foreign Shareholder Shares

• beneficial interests in a specified trust if 50 percent or more of the value of its assets consists of real estate located in Japan.

Domestic Co. / Trust

A capital gain derived from the alienation of those interests is taxed as a sale of shares. A nonresident individual is taxed 15 percent, while a foreign corporation is taxed 30 percent on that gain. The taxpayer in each case is required to file a tax return; however, there is no withholding tax levied. If a relevant income tax treaty provides a tax exemption for a capital gain from the sale of shares, the treaty provision takes precedence.74

Ownership

Japanese Real Property Purchase Price

Purchaser

Question 11. What are the tax consequences to a taxpayer in your jurisdiction making a gain on the sale of its interest in a company/ trust holding Japanese real property? Chang-Yong Shin: Capital gain on sale of interest in a Japanese corporation is subject to the capital gains tax in Korea. The capital gains tax rate on the share in a foreign corporation is 20 percent. If the individual holds 50 percent or more shares in the Japanese real property corporation, the progressive capital gains tax rate (up to 36 percent) is applicable

72

Those capital gains are taxed 10 percent until Dec. 31, 2007; the tax will increase to 20 percent on Jan. 1, 2008. 73 STML, article 37-12.

Tax Notes International

74

Section VIII of this article deals with that issue.

July 10, 2006

•

171

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

Gary James: My response to question 2 also applies in this case. Chang-Yong Shin: My response to question 2 addresses this from a Korean perspective. Jay Lo: My response to question 2 applies to the Taiwanese position here. 2. Sale of JREIT Interest: Domestic Investors Japanese tax is levied on any gain made on the sale of a resident investor’s JREIT interest. Any capital gain made by a Japanese individual taxpayer on such a sale is taxed 10 percent.72 Capital gains recognized by domestic companies are taxed at the corporate tax rate (approximately 42 percent). 3. Sale of JREIT Interest: Nonresident Investors Gains made by nonresident shareholders are not subject to local tax, resulting in their tax liability on capital gains being 7 percent.73 However, a gain made by a nonresident JREIT shareholder is not subject to capital gains tax if the JREIT shareholder’s interest in the JREIT is less than 5 percent.

Special Reports

Jay Lo: For Taiwan, refer to my answer to question 2 above. Gordon Price: If the interest is held on capital account, the sale proceeds will not generally be taxable as New Zealand does not have a capital gains tax as such. However, if the investment is held on revenue account, the resale profit is taxable and a credit allowable regarding any Japanese taxes or withholding taxes. The government has announced that legislation is to be introduced during 2006 that will change the treatment of interests of less than 10 percent with effect from April 1, 2007. In broad terms, 85 percent of any gains will be taxable subject to the availability of rollover relief. Unrealized gains may be taxed over the period of ownership to the extent that the

172 • July 10, 2006

dividend paid regarding the investment is less than 5 percent of the value of the investment. D. Tokutei Mokuteki Kaisha A structure used to securitize some assets such as real estate is the special purpose company vehicle, or Tokutei Mokuteki Kaisha (TMK). There are major taxation advantages with the TMK structure; however, a TMK must satisfy a number of conditions before it can be recognized as such. A TMK is required to set out an asset liquidation plan, identify the assets to be owned when it is established, and liquidate once all the specified assets have been liquidated. The other conditions it must satisfy are described in section X.D.7 below. An election can be made to register the TMK under Japan’s Special Purpose Company (SPC) Law, and the treatment may differ accordingly. For this discussion, the position has been taken that the TMK has been registered under the SPC law. 1. Registration and Transfer of Ownership Taxes Real property purchased in accordance with the asset liquidation plan or investment corporations75 is subject to a registration tax rate of 0.8 percent, and the transfer of ownership on a pledge or mortgage is 0.15 percent. Those rates apply until March 31, 2008. 2. Taxation of the TMK Structure The TMK is a Japanese corporation subject to the normal (approximately 42 percent) rates of Japanese corporate income tax; however, by satisfying conditions under article 67-14 of the STML, the TMK is able to deduct in determining its taxable income dividends declared to equity holders, effectively reducing its corporate tax liability to zero. 3. Dividends Paid to Domestic Corp. Equity Holder Dividends declared by the TMK are subject to Japanese withholding tax at 20 percent whether paid to a domestic corporation or foreign investor. For a domestic corporation, the dividends are included in the corporation’s taxable income and the withholding tax paid can be claimed as a prepayment of the corporation’s tax liability. Those investors are not entitled to exclude TMK dividends from their taxable income.76 4. Dividends Paid to Foreign Investors For dividends paid to foreign investors, the 20 percent withholding tax may be reduced under an

75

Those rates also apply to JREITs (see section X.B). Japanese tax rules allow a domestic corporation to claim a dividend received deduction from dividends received from another Japanese corporation. 76

Tax Notes International

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

upon selling the 50 percent or more shares of outstanding shares. The inhabitant surtax is additionally imposed at the rate of 10 percent of the capital gains tax due. The capital gain realized by a corporate resident is taxed at the applicable marginal corporate tax rate (up to 25 percent). The taxes paid in Japan may be credited against the Korean tax with limitation or deductible from the taxable gains. Paul Banister: Broadly, my response to question 6 above also applies in this case. However there is relief available to a company selling shares in a foreign company to the extent to which the underlying assets are used in an active business. Gary James: My response to question 6 above also applies in this case. Nitesh Mehta: The Indian tax position on a gain made from the sale of shares in a real estate company differs from that of a gain made on the sale of real property. In the hands of an individual taxpayer, gains from the disposition of shares in a real estate company are taxed at the applicable marginal rate. For longterm holdings (if transfer of shares after 12 months), the tax rate is 22.44 percent (maximum rate), while for short-term holdings (transfer of shares within 12 months) the tax rate is 33.66 percent (maximum rate). For corporate taxpayers, gains made on the sale of shares in a real property company held for more than 12 months (long-term) are taxed at a rate of 22.44 percent and gains made on the sale of shares held for less than 12 months (short-term) are subject to 33.66 percent tax. Credit for taxes paid, if any, in Japan regarding such income would be allowed in India subject to the maximum Indian tax liability regarding such income. While calculating long-term capital gain/loss, cost of acquisition of the asset is multiplied by a prescribed cost inflation index. Senen Quizon: My answer to question 2 above applies in this case.

Special Reports

Foreign Investor 100% Vote

Offshore Japan

Dividends

TMK (Japan) Management Contract

Asset Manager (Japan)

Bonds

Japanese Real Estate Assets

applicable tax treaty with Japan.77 Under most tax treaties entered into with Japan, the maximum dividend withholding tax rate is reduced to a rate ranging from 5 percent to 15 percent, depending on the treaty and the ownership percentage held by the investor.78 Foreign investors are not required to file a tax return. Question 12. How are TMK dividends received by an individual/corporate taxpayer taxed in your jurisdiction?

77

Recent changes to the Japan-U.K. tax treaty, expected to be effective from Jan. 1, 2007, will result in any dividend withholding tax reductions enjoyed under the current treaty not being available when the Japanese company paying the dividend is entitled to deduct the dividend in computing its taxable profits. 78 Under article 10(4) of the new Japan-U.K. tax treaty, a deduction in withholding tax on dividends will not apply when the dividend can be claimed as a deductible expense (as is the case with TMKs).

Tax Notes International

Qualified Institutional Investor (Japan)

Senen Quizon: The Philippines position is explained in my answer to question 2. Paul Banister: The 15 percent limitation under the Australia-Japan tax treaty applies in this case. From an Australian perspective, the manner of imposing the tax on exit means that it is fully creditable resulting in there being only one level of tax — and if the investors have the right entity at home (for example, complying super funds), tax may be limited to that 15 percent. However, if the income is purely passive in nature, the impact of our foreign income accrual rules (including CFCs) would need to be assessed. Gary James: Hong Kong does not levy tax on dividends received. Nitesh Mehta: The Indian position on receipt of dividends from such a vehicle is described in my answer to question 2 above. Jay Lo: My response to question 2 above applies in this case to Taiwan.

July 10, 2006

•

173

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

TMK Structure

Special Reports

The TK arrangement has recently brought with it increased scrutiny from the tax authorities. To qualify for the capital gains tax exemption on any gain made from the sale of their TMK interest, a TMK shareholder must: • have owned less than 25 percent of the total number of shares in the TMK in the three years before the sale; and • alienate less than 5 percent of their TMK interest in the fiscal year of sale. If ‘‘related’’ TMK shareholders own a combined total of more than 25 percent of the TMK’s total number of shares, the capital gains tax exemption on the sale of any amount of their TMK interest does not apply.80 For an individual foreign TMK investor with no PE in Japan who does not satisfy the 25/5 rule

explained above, any gain made on the sale of its TMK interests is subject to only national taxes and taxed at 15 percent. Corporations are subject to the national tax rate of 30 percent (again, local and enterprise taxes are not levied). For foreign investors with a PE in Japan, any gain made by the foreign investor is subject to corporate (national and local) tax of between 34 percent and 42 percent. Question 13. What are the tax consequences of a taxpayer in your jurisdiction making a gain on the sale of its interest in a company/ trust holding Japanese real property? For all jurisdictions, the answers given to question 11 apply here. 7. STML Conditions As mentioned above, a TMK is eligible to deduct dividends declared if the following conditions, as stipulated under the Special Taxation Measures Law,81 are met: • The corporation is registered under article 8(1) of the Asset Liquidation Law. • One of the following is met: — the TMK issues specified bonds in the amount of ¥100 million (or more) through a public offering; — specified bonds are subscribed only by qualified institutional investors (QIIs); — preferred investment certificates are subscribed to by 50 or more investors in a Japanese public offering (that is, primarily offered in Japan); or — preferred investment certificates are subscribed to only by QIIs. • TMK is not a family corporation under Japanese tax law (not applicable to companies that issue bonds to a QII or as required above in a public offering in Japan). • TMK does not own any assets other than the specified assets. • TMK’s fiscal year does not exceed one year. • Loans to TMK, if any, must be from a QII only (never from shareholders of the TMK or affiliates of shareholder). • More than 90 percent of the TMK’s distributable amount for the fiscal year has been distributed as a dividend to equity holders. • 90 percent condition is based on the TMK’s ‘‘distributable amount.’’

79

ITL, article 291(3). ITL — Enforcement Order, article 291(3) provides six degrees of separation between blood relatives and three degrees separating non-blood relatives. 80

174 • July 10, 2006

81

STML, article 67-14.

Tax Notes International

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

Chang-Yong Shin: A dividend from TMK by a Korean resident is taxed in the same manner as discussed in my response to question 2. Gordon Price: When dividends are tax deductible in Japan, the distribution amount will be subject to a 33 percent withholding payment obligation upon receipt by a New Zealand resident company. That withholding will be payable net of any credit for Japanese withholding taxes imposed, and the net withholding payment obligation will be subsequently allowed as a credit against the tax obligations of the shareholders upon eventual distribution. Individuals are taxed on the gross dividend with a credit for withholding taxes imposed by Japan. 5. Sale of TMK Interest: Resident Investors For a Japan individual resident TMK shareholder, any gain on the sale of their TMK equity interest will be taxed at 20 percent. For corporations, the gain will be aggregated with other assessable income and taxed at the corporate rate (42 percent). 6. Sale of TMK Interest: Foreign Investors For a foreign TMK investor with no PE in Japan, any gain made on the sale of its TMK interests will be taxed domestically according to the shareholder’s percentage of ownership of the TMK and the size of its interest sold.79 In some cases, those gains are exempt from capital gains tax.

Special Reports

This article attempts to give the reader a broader understanding of the potential tax issues facing an investor in Japanese real estate as well as an overview of some of the more common structures available. While Japan is rightly regarded as one of the more highly taxed countries in the world, taxation costs associated with real estate investment can be kept to manageable levels with some careful planning. It is, however, essential that prospective investors are aware of nontax factors likely to affect the decisionmaking process. It is advisable that a checklist similar to the following be prepared and discussed before any structure is implemented. • Are the assets/investor protected? • Is this is a long-term or short-term investment?

Tax Notes International

• Is the property manager experienced? • Is there potential for the holding company to go public? • What are the possible exit strategies? • How is the investment being financed? • How many investors are involved? • Are there any estate planning issues that need to be examined? • How liquid is the investment? • Will this affect any retirement planning? Finally, from a cross-border viewpoint, it is imperative that an investor fully understand the tax implications of an investment in Japanese real estate in their home jurisdiction. It is hoped this forum-type article will assist readers, particularly those resident in the Asia-Pacific region, in that regard. ◆

July 10, 2006

•

175

(C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

XI. Conclusion