Tokyo District Court Allows Tax Saving from Share Repurchase
On May 9, 2014, the Tokyo District Court reversed a large tax that had been imposed on a large U.S. multinational’s Japanese holding company (“Japan HoldCo”).
Under the Japanese Corporate Tax Law, if a shareholder returns shares to an issuing company (i.e., the issuing company acquires treasury shares), a portion of the consideration paid to the shareholder is deemed to be a dividend. Further, all or a portion of such deemed dividend will not be considered taxable income (in the case at issue, the entire deemed dividend was not considered taxable income of Japan HoldCo) and will be subtracted for the purpose of calculation of a capital gain or loss. Therefore, if the sale price (paid by the issuing company to the shareholder) and the book value of the transferred shares are equal, the shareholder will incur a capital loss equal to the amount of the deemed dividend resulting from the share transfer to the issuing company.
On April 22, 2002, Japan HoldCo acquired all of the outstanding shares of an affiliated company (“Japan Ltd.”). Thereafter, on December 20, 2002, December 22, 2003, and December 28, 2005, Japan HoldCo sold a portion of Japan Ltd.’s shares back to Japan Ltd. itself and incurred a total capital loss of approximately JPY400 billion. In 2008, Japan HoldCo and its subsidiaries (including Japan Ltd.) adopted a consolidated tax return and set off the JPY400 billion loss against the consolidated group’s revenue. As a result, the amount of corporate tax imposed on Japan HoldCo and its affiliates was reduced by approximately JPY120 billion.
In response to the above transactions and tax filing, the tax authorities denied Japan HoldCo’s recognition of the JPY400 billion loss pursuant to Section 132.1 of the Corporate Tax Law and reimposed taxes of approximately JPY120 billion with penalties and interest. Under Section 132.1 of the Corporate Tax Law, if an act or calculation made by a closely held corporation (including a wholly owned company such as Japan HoldCo) unfairly reduces the amount of corporate tax, the tax authorities may disregard one or more of such acts or calculations and recalculate the amount of corporate tax owed.
In the case at issue, the tax authorities argued that a series of transactions was made for the purpose of tax avoidance and thus unfairly reduced the amount of corporate tax. However, the Tokyo District Court, in ruling against the tax authorities, stated, among other things, that (i) it is difficult to say that the series of transactions did not have any reasonable basis, and (ii) there are several facts that are inconsistent with the tax authorities’ argument.
The tax authorities appealed the judgment, and the case is now being reviewed by the Tokyo High Court.
Note: Due to the 2010 tax reform, if these transactions were to happen today, realization of the JPY400 billion loss would be denied.
Judgment of Tokyo District Court: Application of a General Anti-Avoidance Rule Concerning Reorganization Transactions
On March 18, 2014, the Tokyo District Court affirmed corporate tax assessments against two tax payers: Yahoo Japan Corporation (“Yahoo Japan”), a Tokyo Stock Exchange listed company, and IDC Frontier Inc. (“IDCF”), a wholly owned subsidiary of Yahoo Japan.
The main issue of the Yahoo Japan case was whether, upon a tax-qualified merger, the surviving company (Yahoo Japan) was entitled to utilize net operating losses (“NOLs”) of the acquired company pursuant to Article 57 of the Corporation Tax Act of Japan (“Act”). In Yahoo Japan, while Yahoo Japan formally satisfied the requirements of Article 57, the tax authorities denied Yahoo Japan’s utilization of the NOLs of the acquired company by applying Article 132-2 of the Act, a general anti-avoidance rule. Under Article 132-2, if the corporate tax burden is determined to be unduly decreased due to a reorganization transaction (i.e., it would be unfair for Yahoo Japan to utilize the tax losses of the acquired company after the merger), the Japanese tax authorities are empowered to deny the reorganization transactions (e.g., merger, company split, share exchange, etc.) or the book entries thereof and compute the taxable income or net operating losses as they deem appropriate
The main issue in the IDCF case was whether a company (IDCF) that was newly incorporated as a wholly owned subsidiary of the transferor upon a company split was entitled to recognize goodwill (which is recognized only in the case of a nonqualified company split and is depreciable for five years on a straight line basis) pursuant to Article 62-8 of the Act. In IDCF, the transferor company was scheduled to sell its shares in IDCF upon the completion of company split, and thus the company split did not formally fulfill the requirements of a tax-qualified company split. Accordingly, IDCF recognized goodwill pursuant to Article 62-8 of the Act. Nonetheless, the tax authorities also denied IDCF’s recognition of the goodwill and deduction of depreciation expense for corporate tax purposes by applying Article 132-2 of the Act.
The court held in each case that Article 132-2 of the Act is applicable not only to (i) cases where the reasonableness or economic substance of a reorganization transaction is questionable, but also (ii) cases where acts constituting part of reorganization transactions formally satisfy certain requisite conditions of corporate reorganization taxation (by virtue of which the company can enjoy a decrease of its tax burden). However, the allowance of such a decrease in the tax burden would clearly conflict with the underlying policy of the corporate reorganization taxation system or the relevant provisions. Further, the court concluded in each case that the tax authorities’ denial pursuant to Article 132-2 was legitimate and dismissed Yahoo Japan’s and IDCF’s claim.
These two judgments were the first judgment in which a court applied Article 132-2 of the Act, and the scope of the Article 132-2 was interpreted broadly. Both Yahoo Japan and IDCF appealed the judgments, and the cases are now pending in the Tokyo High Court.
If the decisions of the Tokyo District Court are upheld, the predictability of tax decisions for corporate reorganizations would regress, and tax practitioners would be required to give careful consideration to the risk of denial by the tax authorities pursuant to Article 132-2 of the Act when providing tax advice