Executive summary

Japan's coalition leading parties released the 2022 tax reform outline (the Outline) on 10 December 2021. Based on the Outline, a tax reform bill (the Bill) will be prepared and submitted to the Diet,¹ and is expected to be enacted by the end of March 2022.

This Alert summarizes the key provisions in the Outline that are relevant to multinational corporate taxpayers.

Detailed discussion

Increased employee compensation credit

To achieve an appropriate distribution of wealth to the society and stimulate Japan's economy, the existing increased employee compensation credit will be refined to encourage businesses to provide company-wide pay raises. Currently, if the compensation paid to newly hired employees in the current year increases by 2% or more as compared to compensation paid to newly hired employees in the previous year, the compensation paid to newly hired employees in the current year is eligible for a 15% to 20% tax credit subject to certain conditions.

The Outline proposes that if the total compensation paid to specified employees² in the current year beginning between 1 April 2022 and 31 March 2024 increases by 3% or more as compared to total compensation paid to specified employees in the previous year, the excess of the current year's compensation over the previous year's compensation is eligible for a 15% to 30%³ tax credit (capped at 20% of corporate income tax payable).

In this regard, the Outline also provides that:

• Companies with common capital of JPY1 billion (approximately US$9 million) or more and full-time employees of 1,000 or more must notify the Ministry of Economy, Trade and Industry that the company has disclosed online their pay raise policy, customer relationship policy, etc. to be eligible for this regime.
• This regime will not be available in the year of incorporation of a company.
• Certain small and medium-sized enterprises (SMEs) are eligible for lower thresholds and more beneficial credits.⁴
• A similar regime is applicable for local enterprise tax.

Conditions for certain tax incentives

In order to claim certain tax incentives such as the research and development (R&D) tax credit, companies (except for certain SMEs) must satisfy either of the following conditions (unless the current year's taxable income is less than the previous year's taxable income):

• Total compensation paid to specified employees in the current year is more than that in the previous year.
• Domestic investment in depreciable assets is more than 30% of depreciation expense.

Post the 2022 tax reform, for companies with common capital of JPY1 billion or more and full-time employees of 1,000 or more, which reported taxable income in the previous year, the first condition will be further restricted such that total compensation paid to specified employees in the current year must increase by 0.5% or more for fiscal years beginning between 1 April 2022 and 31 March 2023, and by 1% or more thereafter, respectively, as compared to the previous year.

Domestic dividend withholding tax

Under the existing law, dividends paid by a Japanese company to another Japanese company are subject to withholding tax at a rate of 20.42% even though such withholding taxes are typically fully creditable or refundable for the dividend recipient. Such domestic dividend withholding tax will be eliminated for dividends to be paid on or after 1 October 2023 if the dividends are paid to a Japanese company by the following Japanese companies:

• A 100% group company
• A company where the dividend recipient directly owns greater than one-third of such company as on the dividend record date

Distributions out of capital surplus

Distributions out of capital surplus are bifurcated into: (i) deemed dividends; and (ii) return of capital in accordance with the formula stipulated under the Japanese tax law. The 2022 tax reform will amend the formula such that the amount of such return of capital will be capped at the amount of the capital surplus that is debited for accounting/legal purposes with respect to the distributions. This change is to reflect the recent Supreme Court decision on such distributions.⁵

For companies that issue different classes of shares, the amount of such return of capital will be calculated based on the particular class of shares associated with the distributions.

Low-value depreciable assets

Under the existing law, depreciable assets with an acquisition cost below JPY100,000 (approximately US$909) can be deductible on acquisition, and depreciable assets with an acquisition cost below JPY200,000 (approximately US$1,818) can be deductible over three years. The 2022 tax reform will exclude assets that are used for rental purposes (unless such rental activity is part of the company's primary business) from accessing this provision, and hence such assets will need to be depreciated over their useful life.

Open innovation tax incentive

The existing open innovation tax incentive, which provides a deduction equivalent to 25% of the eligible investment in qualified venture companies, will continue to be available with the following amendments:

• The venture company must have been in existence for less than 15 years (currently, 10 years) if it is loss making and its R&D expenditures comprise 10% or more of its gross revenue.
• The expected investment period condition (which, if not satisfied, might cause a tax recapture, for example, if the investment in the venture company is disposed of) will be revised to three years (currently, five years).

Tax basis adjustment under the group profit and loss sharing regime

Japan's existing tax consolidation regime will automatically transition to the group profit and loss sharing regime, as introduced under the 2020 tax reform, for fiscal years beginning on or after 1 April 2022. The 2022 tax reform will revise, among others, the tax basis adjustment rule under the group profit and loss sharing regime as provided below:

• Under the current rule, when a group company ceases to be part of the group (e.g., stock of the group company is sold to a third party), the tax basis in the group company is adjusted to the tax book value of the net assets of the group company. Accordingly, the shareholder of the group company may lose the opportunity to claim a deduction for part of the original acquisition cost of the group company.⁶
• Under the new rule, in addition to the current rule, an amount equivalent to the goodwill⁷ of the group company can be added to its tax basis, subject to certain documentation requirements.⁸

The new rule also applies to group companies that commenced or joined the existing tax consolidation regime and will transition to the group profit and loss sharing regime.

Tax deferral for government subsidy

The existing law provides a tax deferral regime for certain income such as government subsidies in connection with qualified asset acquisitions. The 2022 tax reform will clarify the implications of the deferral when the subsidy is granted after the acquisition of the assets.

Earnings-stripping rule

Under the existing law, a deduction for certain net interest expenses is restricted to 20% of the adjusted taxable income. For foreign companies, this rule is currently applicable only in relation to domestic source income attributed to the foreign company's permanent establishment (PE). The 2022 tax reform will expand the scope of domestic source income subject to the earnings-stripping rule to: (1) domestic source income of foreign companies with a PE, but not attributable to the PE; and (2) domestic source income of foreign companies without a PE.

Japanese consumption tax (JCT) qualified invoice system

The new JCT qualified invoice system will come into effect from 1 October 2023, and JCT taxpayers will be required to register as a qualified invoice issuer to be able to provide a qualified invoice, enabling buyers to claim a credit for input JCT.

The 2022 tax reform will amend, among others, the registration process as provided below:

• Currently, an exception allows an exempt taxpayer to register as a qualified invoice issuer in the middle of a taxable period and become a qualified invoice issuer from the registration date, but only for the taxable period that includes 1 October 2023. The 2022 tax reform will expand the applicability of this exception to taxable periods that include any day between 1 October 2023 and 30 September 2029.
• If the expanded exception applies, the qualified invoice issuer cannot revert to an exempt taxpayer for the following taxable periods until the taxable period that includes the day two years after the registration date.
• The tax authority will be entitled to reject the registration application by foreign businesses, or revoke the registration of foreign businesses, which are required to assign a tax representative in Japan in accordance with General Law of National Taxes, but are not compliant with such requirement.

Base Erosion and Profit Shifting (BEPS) 2.0

The Outline clarifies that Japan strongly supports the OECD⁹/G20¹⁰ Inclusive Framework on the BEPS Two-Pillar solution agreed internationally in October 2021 to address the tax challenges arising from the digitalization of the economy. The Outline also indicates that the Japanese Government will continue to contribute to the discussion and will ensure that the new rules come into effect in accordance with the agreement, while balancing the potential incremental burden for taxpayers and any existing relevant rules.

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

Ernst & Young Tax Co., Tokyo

• Koichi Sekiya | koichi.sekiya@jp.ey.com

Ernst & Young LLP (United States), Japanese Tax Desk, New York

• Ryuta Tosaki | ryuta.tosaki1@ey.com
• Keiho Kotono | keiho.kotono1@ey.com

Ernst & Young LLP (United States), Asia Pacific Business Group, New York

• Chris Finnerty | chris.finnerty1@ey.com
• Gagan Malik | gagan.malik2@ey.com
• Bee-Khun Yap | bee-khun.yap@ey.com
• Dhara Sampat | dhara.sampat2@ey.com

Ernst & Young LLP (United States), Asia Pacific Business Group, Chicago

• Pongpat Kitsanayothin | pongpat.kitsanayothin@ey.com

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ENDNOTES

¹ Japanese bicameral legislature.

² Employees who are paid monthly throughout the current year and previous year, subject to certain conditions.

³ Generally, a 15% tax credit is available, but if the current year's compensation increases by 4% or more as compared to the previous year, an additional 10% tax credit is granted, and if certain educational expenditure increases by 20% or more as compared to the previous year, an additional 5% tax credit is given, subject to certain compliance requirement.

⁴ If the total compensation paid to specified employees in the current year increases by 1.5% or more as compared to total compensation paid to specified employees in the previous year, the excess of the current year's compensation over the previous year's is eligible for a 15% to 40% tax credit (capped at 20% of corporate income tax payable).

⁵ The Supreme Court, on 11 March 2021, held that the enforcement order which allows the return of capital to exceed the capital surplus that is debited for accounting/legal purposes was beyond the anticipated tax consequences under the relevant tax law - Supreme Court website.

⁶ In particular, for instance, where the group company was acquired from outside of the group at a substantial premium price/value.

⁷ Goodwill is, broadly speaking, defined as an excess of the fair market value (e.g., purchase price) over the net asset value of the company, as determined in a similar way that goodwill is calculated when a company is absorbed into another company via a non-tax qualified merger.

⁸ The new rule does not apply if the group company is subject to mark-to-market on the basis that the company's main business is not expected to continue to operate.

⁹ Organisation for Economic Co-operation and Development.

¹⁰ Group of 20.