The Tokyo High Court recently revoked the original administrative disposition of the National Tax Agency (hereinafter, the Tax Agency) regarding the tax treatment by Kokusai Kogyo Kanri Co., Ltd., a Japanese company (formerly Kokusai Kogyo Co., Ltd.; hereinafter, Kokusai Kogyo), of funds received from its U.S. subsidiary. With respect to the funds of $644,000,000 (JPY 51.2 billion) received from the U.S. subsidiary, Kokusai Kogyo filed its tax return under the following categories:
- $544,000,000 (JPY 43.2 billion), the source of which is retained earnings of the subsidiary; and
- $100,000,000 (JPY 7.9 billion), the source of which is capital surplus.
Japanese tax law treats the funds transferred from a foreign subsidiary to its parent (in Japan), differently according to its source (i.e. whether the source is retained earnings or capital surplus). When a Japanese corporation receives funds from its foreign subsidiary, the source of which is retained earnings (in this case, such funds will be called a dividend), 95% of such funds (dividend) will be allowed not to be calculated into gross revenue (in other words, allowed to be excluded from gross revenue to be qualified as tax free).
This rule is designed to avoid double taxation in Japan and a foreign country. However, in 2014, the Tax Agency claimed that this treatment was wrong and made a disposition of correction. Kokusai Kogyo sought the revocation of the disposition of correction by the Tax Agency at the Tokyo District Court. The Tokyo High Court affirmed the assertions by Kokusai Kogyo and dismissed the argument from the Tax Agency, saying that “in the Corporation Tax Act, there is a general principle distinguishing the capital contributed by the shareholders and the profit gained by the corporations” and therefore, “funds transferred from a subsidiary, the source of which is retained earnings, and funds transferred from a subsidiary, the source of which is capital surplus, should be treated to be independent.” The Tax Agency further appealed to Japan’s Supreme Court, on June 11, 2019.
This Tokyo High Court’s ruling will have a material impact on the future practice of tax planning in M&A transactions and will influence future corporate dividend/capital return policies.