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February 2004
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New U.S.-Japan Tax Treaty
On November 6, 2003, a
new tax treaty was signed by the United States and Japanese
authorities. The treaty is
expected to be ratified by the U.S. Senate and Japanese Diet by April 2004
and will be effective as early as July 2004. This treaty will replace a
treaty that is now more than 30 years old.
The new treaty
completely eliminates source-country withholding taxes on certain income,
including:
·
all royalty income;
·
certain interest income, including interest income
earned by financial institutions; and
·
dividend income paid to parent companies with a
controlling interest in the paying company.
However, the new treaty
contains anti-conduit provisions that may deny the benefit of the
withholding exemption where a back-to-back payment to a third party is
involved.
Following is a summary
of some of the most significant provisions of the new
treaty.
Royalties
The new treaty
eliminates the withholding on royalties. The current treaty permits a tax
of 10 percent. This change
will eliminate the need for offshore intangible holding companies that had
been a popular way to avoid Japanese withholding tax. However, under the new treaty,
royalties which are in turn paid to a third party outside of Japan that
would not be eligible for similar treaty benefits under the new treaty
would lose the benefit of the exemption.
The new treaty provides
that withholding in respect of the amount of a payment that is in excess
of an arm’s-length amount is limited to 5 percent. Similar provisions are contained
in the interest and the other income provisions.
Interest
The current treaty
permits the U.S. and Japanese to impose withholding tax at the rate of 10
percent. There are, however,
several instances where no withholding is required. These include interest earned (or
guaranteed, insured, or indirectly financed) by central banks and the
Export-Import Banks of Japan and the U.S. The new treaty expands the
exceptions that are available to include interest owned by banks,
insurance companies, securities dealers, and other enterprises, provided
that in the three taxable years preceding the taxable year in which the
interest is paid, the enterprise derives more than 50 percent of its
liabilities from the issuance of bonds in the financial markets or from
taking deposits at interest, and more than 50 percent of the assets of the
enterprise consist of debt-claims of unrelated persons. The new treaty also exempts
interest on account receivables related to sales of equipment or
merchandise, as well as interest that is beneficially-owned by pension
funds. Again, the new treaty
provides an exception in the case of back-to-back interest payments and
caps the rate of withholding at 5 percent in the case of excessive
payments.
Dividends
Under the new treaty,
the taxation of dividends has changed. Under the current treaty,
dividends paid to a U.S. person are subject to a 10 or 15 percent rate of
Japanese withholding taxation depending on the percentage of shares in the
Japanese company paying the dividends that is held by a U.S.
investor. The 10 percent
withholding rate applies where 10 percent or more of the voting stock is
owned by a U.S. investor.
Other dividends will generally be subject to a 15 percent rate of
withholding. In each case
below, the treaty rates will not be available where the arrangement is
considered to be part of a back-to-back arrangement involving a non-treaty
beneficiary.
Dividends
Paid by a YK
Under the new treaty,
dividends of the corporation are subject to 10 percent withholding rate,
where less than 10 percent of the voting stock is owned by the dividend
recipient. The rate is 5
percent where 10 percent or more of the voting stock is owned by the
recipient. Dividends paid by
a YK (Yugen Kaisha) will
not be subject to withholding taxation where the U.S. corporation owns 50
percent or more of the voting stock, and certain other conditions are
met. These other conditions
are that: (1) the payor is a publicly-owned company; (2) the dividends are
derived in connection with, or incidental to, an active trade or business
in which the recipient is actively engaged and which is substantial in
relation to the trade or business of the payor in its jurisdiction of
residence (Japan), and certain base erosion limitations have been met by
the payor; or (3) the recipient has received a discretionary
ruling.
Dividends
Paid by a TMK
The new, lower dividend
taxation rules do not apply if the company paying the dividend is able to
deduct the dividend as it is in the case of a TMK (Tokutei Mokuteki Kaisha). In such case, the dividend is
subject to a 10 percent withholding rate, provided that no more than 50
percent of the TMK’s assets consist, directly or indirectly, of real
property situated in Japan.
Where more than 50 percent of the assets of such company consist,
directly or indirectly, of real property situated in Japan, the 10 percent
rate shall apply only: if (1) the owner is an individual or a pension fund
having no more than a 10 percent interest in the company paying the
dividend; (2) the company paying the dividend is publicly-traded and the
owner of the dividend owns no more than 5 percent of any class of
interest in the company; or (3) the owner of the dividend owns no more
than 10 percent of the interests in the company and the company is
diversified.
Dividends which are not
eligible for protection under the new treaty will be subject to
withholding at the domestic rate of 20 percent. This will be an increase from the
10 percent rate that is applicable under the current
treaty.
Distributions PURSUANT
TO A TK RELATIONSHIP
The protocol to the new
treaty provides that Japan may impose tax at source, in accordance with
its domestic law, on distributions to non-Japanese investors that are made
by a person pursuant to a silent partnership (Tokumei Kumiai or TK) contract. TK distributions are subject to a
20 percent withholding rate on all profits.
Impact of Ownership Through Limited
Liability Companies and Limited Partnerships
The new treaty contains
special provisions applicable to entities which are considered “fiscally
transparent” by the United States or Japan. These provisions potentially apply
to amounts received by limited liability companies or partnerships, or
comparable foreign entities, which are not subject to taxation, but whose
members or partners are subject to taxation with respect to the income of
the entity. The purpose of
these provisions is to ensure that treaty benefits are available only to
entities which are taxable in the relevant jurisdiction. In general,
amounts which are received by such an entity (such as a single member
limited liability company) that are not taxable in the United States at
the entity level will be ineligible for treaty benefits even though the
entity might be treated differently for Japanese tax purposes. Instead, the members or partners
are eligible for treaty benefits if they otherwise satisfy the applicable
requirements.
Inclusion of an Other Income
Clause
Under the
so-called Business Profits article of both the current and new treaty,
items of income that are associated with a trade or business are not
taxable in the absence of a permanent establishment in the other
country. Both the current and
new treaty contain such a provision.
Unlike most other treaties, however, the current treaty does not
contain a so-called “other income clause.” Under such a provision, the right
to tax items not specified in the treaty is reserved to the jurisdiction
of the taxpayer’s residence.
The new treaty contains such a provision. This provision prevents the U.S.
or Japan from taxing income that is not protected under the Business
Profits article. This could
apply, for instance, in the case of certain rental income. However, the new treaty provides
an exception to the lower rates of withholding in the case of back-to-back
payments, and limits the rate of withholding on excessive payments to 5
percent.
Associated Enterprises (Transfer
Pricing)
As does the current
treaty, the new treaty permits the reallocation of amounts among related
parties. The diplomatic notes
accompanying the new treaty provide that associated adjustments may be
made only to the extent that they are consistent with the OECD transfer
pricing guidelines. In
addition, they may only be made if the examination is begun within 7 years
of the close of the year for which the transfer pricing adjustment is
proposed. While this
provision will have little effect in the U.S. due to the 3-year statute of
limitations, it appears to impose constraints on the Japanese tax
authorities.
Limitation on Benefits
Article
The current treaty has
no anti-treaty shopping provision.
In keeping with the present U.S. negotiating position which began
with the Dutch treaty that was negotiated in the early 1990s, Article 22
of the new treaty contains such a provision. As a result, non-treaty countries
will be precluded from setting up a U.S. or Japanese entity to gain access
to the relatively favorable rates of taxation on payment
flows.
Effective
Date
The effective date of
the new treaty will depend on when it is ratified. For taxes other than
withholding taxes, the new treaty will apply generally as of January 1 of
the year after its entry into force.
For withholding taxes, if ratified before April 1, 2004, the new
treaty applies to amounts paid on or after July 1, 2004. If ratified on or after April 1,
2004, the new treaty applies to amounts paid on or after January 1,
2005.
Finally, taxpayers may
elect to delay the effective date of the provisions of the new treaty by 1
year, provided application of the entire treaty is deferred for the
same 1-year period.
Contact Us
For more information on the above
article, please contact:
Peter
Connors
pconnors@orrick.com
For more information on
Orrick in Tokyo, please contact any of our lawyers listed
below:
News from Tokyo is one of many Orrick
publications designed to provide our clients and contacts with information
they can use to more effectively manage their businesses and access
Orrick's expertise. Please contact John Hodder at jhodder@orrick.com for
information on our other publications.
The contents of this publication are for
informational purposes only and are not meant nor should be construed to
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publishing process.
Copyright © Orrick, Herrington & Sutcliffe
LLP 2004
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