Executive summary

On 16 October 2018,¹ representatives of Japan and Spain signed a revised income tax treaty (Revised Treaty) and protocol (Protocol) which will replace the existing 1974 treaty.

The Revised Treaty is aimed at further promoting investment and economic activities between Japan and Spain. It eliminates barriers for cross-border collaboration and offers various opportunities for both countries. The revisions are also meant to align the Revised Treaty with the current Organisation for Economic Co-operation and Development (OECD) Model Convention as well as with the recommendations in the OECD's final reports in its Action Plan on Base Erosion and Profit Shifting (2015 BEPS Reports).

Significant provisions in the Revised Treaty are:

• Introduction of a fiscally transparent entity/arrangement concept
• Tie-breaker rule for a treaty residency determination of non-individual dual resident persons
• Expanded scope of permanent establishment
• Adoption of the Authorized OECD Approach (the AOA) in Article 7, Business Profits
• Full exemption of withholding tax on dividend, interest and royalties
• Exemption on source country capital gain taxation on share dispositions
• Incorporation of mandatory arbitration
• Limitation on benefits and principal purpose tests for the entitlement of benefits

The Revised Treaty and Protocol will enter into force 30 days following the exchange of ratification instruments. The provisions of the Revised Treaty and Protocol will become effective as of 1 January of the year following entry into force.

This Alert summarizes the key provisions of the Revised Treaty and Protocol.

Detailed discussion

Fiscally transparent entity/arrangement concept (Article 1)

Paragraph 2 of Article 1 states that income derived by or through an entity or arrangement that is treated as wholly or partly fiscally transparent under the tax law of either Contracting State would be considered to be income of a resident of a Contracting State but only to the extent that: (1) the income is treated, for purposes of taxation by that Contracting State, as the income of a resident of that Contracting State; and (2) the entity or arrangement is established under the law of either Contracting State or of a third jurisdiction which has an agreement containing exchange of information provisions and treats the entity or the arrangement as fiscally transparent.

Tie-breaker rule for non-individual dual resident persons (Article 4)

Paragraph 3 of Article 4 provides that, in cases where a person other than an individual is a dual resident, the competent authorities of the two Contracting States will seek a determination by mutual agreement of the country of residence based on the place of the head or main office, the place of effective management, the place of incorporation or otherwise constituted and any other relevant factors. In the absence of such agreement, such person will not be entitled to any relief under the Revised Treaty.

Permanent establishment (PE) (Article 5)

Reflecting the recommendation in the 2015 BEPS Report on Action 7, the PE definition is expanded by adding:

• The anti-fragmentation rule. The exceptions to a PE definition (Paragraph 4 of Article 7) do not apply to a place of business that would otherwise constitute a PE where the activities carried on at that place and other activities of the same enterprise or of closely related enterprises exercised at that place or at another place in the same State constitute complementary functions that are part of a cohesive business operation. However, at least one of the places where these activities are exercised must constitute a PE or, if that is not the case, the overall activity resulting from the combination of the relevant activities must go beyond what is merely preparatory or auxiliary.
• An enterprise is deemed to have a PE if a person acting in a Contracting State on behalf of the enterprise habitually concludes certain contracts, or habitually plays the principal role leading to the conclusion of those contracts that are routinely concluded without material modification by the enterprise.

Business income (Article 7)

The Revised Treaty's taxation on business income attributable to a PE is in line with Article 7 of the AOA. Under the provision, business income attributable to the PE will be calculated based on the arm's-length principle as if the PE were a separate and independent enterprise from its head office.

Dividends (Article 10)

The following three withholding tax rates are provided:

• A full exemption applies on dividends if the beneficial owner of the dividends is either a company that has owned directly or indirectly at least 10% of the voting power of the company paying the dividends for at least twelve months or a pension fund.
• A 10% rate applies on dividends which are deductible from the taxable income of the company paying the dividends.
• A 5% rate applies in all other cases.

Interest (Article 11)

The Revised Treaty provides a full exemption on interest other than the following:

• Interest that is determined by reference to receipts, sales, income, profits or other cash flow of the debtor or a related person, to any change in the value of any property of the debtor or a related person or to any dividend, partnership distribution or similar payment made by the debtor or a related person, or any other interest similar to such interest. In this case, a 10% rate applies.

Royalties (Article 12)

The Revised Treaty provides exclusive resident country taxation on royalties.

Capital gains (Article 13)

The Revised Treaty grants a full exemption on gain from disposition of shares. However, the exemption does not apply to shares of a company deriving at least 50% of the value directly or indirectly from immovable property at any time during the 365-day period preceding the transfer.

Silent partnership (Article 20)

The Revised Treaty grants the taxing rights to Japan for income and gains derived by a silent partnership (Tokumei Kumiai) or another similar contract.

Mandatory arbitration (Article 24)

Paragraph 5 of Article 24 of the Revised Treaty explicitly provides for mandatory arbitration proceedings, in which the cases not being resolved between the tax authorities of the Contracting States within two years will be resolved pursuant to decisions made by third-party arbitrators if the taxpayer requests.

Entitlement to benefits (Article 28)

Article 28 of the Revised Treaty introduces the provisions that set forth the criteria that would determine whether a person is considered as a qualified person (as defined in Paragraph 2 of Article 28) or satisfies any other specified objective tests to be entitled to the benefits (dividends, interest and royalties) in the Revised Treaty. The objective tests are based on characteristics such as legal structure, ownership, or activities reflecting a link between the person and the residence state.

The competent authority may still grant benefits to a resident of a Contracting State even if the resident fails to be a qualified person or satisfy one of the objective tests.

Paragraph 8 of Article 28 of the Revised Treaty provides the anti-abuse rule for PEs situated in a third jurisdiction. A benefit under the Revised Treaty will generally be denied if income arising from a Contracting State is attributable to a PE in a third-country jurisdiction, the other Contracting State does not impose tax on the income attributable to the PE in the third-country jurisdiction and the tax imposed on the income by jurisdiction(s) other than the two Contracting States is less than 60% of the tax, which would have been imposed if the PE existed in the other Contracting State.

Paragraph 9 of Article 28 of the Revised Treaty provides that a benefit under the Revised Treaty will be denied if obtaining the benefit under the treaty is one of the principle purposes of any arrangement or transaction that would result directly or indirectly in that benefit.

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ENDNOTES

¹ 17 October 2018 in Japan.

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CONTACTS

For additional information with respect to this Alert, please contact the following:

Ernst & Young Tax Co., Tokyo

• Jonathan Stuart-Smith
  jonathan.stuart-smith@jp.ey.com

Ernst & Young LLP, Japanese Tax Desk, New York

• Hiroaki Ito
  hiroaki.ito1@ey.com

Ernst & Young LLP, Asia Pacific Business Group, New York

• Chris Finnerty
  chris.finnerty1@ey.com
• Kaz Parsch
  kazuyo.parsch@ey.com
• Bee-Khun Yap
  bee-khun.yap@ey.com

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ATTACHMENT

PDF version of Tax Alert 2018-2115