1. Introduction
In some Japanese companies, they have a large amount of borrowings from their foreign parent companies and book interest payments as expenses, which are deductible expenses in computing corporation tax. Those companies should be careful about Japanese tax law such as “Thin Capitalization Rules” and “Earnings Stripping Rules”. In this column, we would like to mention two tax rules to restrict interest payments to foreign parent companies.

2. What is “Thin Capitalization Rule”?
If the average balance of indebtedness pertaining to the indebtedness to the foreign parent company concerning the subsidiary exceeds an amount equivalent to three times as much as the amount of capital share of foreign parent company in accounting period, an amount corresponding to the exceeding part out of the amount of interests on indebtedness paid by domestic corporation to foreign parent company shall not be deductible as expenses in computing corporation tax.
The calculation of the above excess amount is as follows:

(NOTE)
In principle, the average balance of indebtedness is calculated as below:

               The average            The amount of capital
               balance of        －      share of foreign       ✕ 3
               indebtedness              parent company

3. The purpose of “Thin Capitalization Rules”
When the subsidiary in Japan raises funds from the parent company in a foreign country, the followings are typical methods:
 
A) Capital investment from the parent company
B) Loan from the parent company

In case of A) above, a Japanese subsidiary will pay dividend to a foreign parent company, whereas in case of B) above, the Japanese subsidiary will pay interest to the foreign parent company.  In computing the corporate tax, the dividend is not deductible expenses, but interest on loan is in principle deductible expenses.  So the Japanese subsidiary can reduce taxable income intentionally by increasing loan from the foreign parent company instead of capital investment.

Therefore, "Thin Capitalization Rule" was introduced in 1992 to avoid the intentional tax reduction of excess interest payment.

4. What is “Japanese Earnings Stripping Rules”?
If the amount of net interest (NOTE 1) to related persons (e.g. corporations having a special relation such as the relation with the corporation that either corporation directly or indirectly holds 50 percent or more of the total of issued stocks, etc.) for the accounting period exceeds the amount of equivalent to 50 percent of an adjusted income amount (NOTE 2), the amount of the exceeding part shall not be included in gross expense in computing taxable income.

(NOTE 1)
Amount of net interest = Total amount of paid interest - Total amount of received interest

(NOTE 2)
Adjusted income amount = Taxable income + Net interest to related persons + Depreciation + The amount of exclusion of dividends received from gross revenue + The amount of bad debt loss

The above rules shall not be applied in either of the following cases:

i) The corporation’s total amount of interest paid to related persons≦10 million yen, or
ii) The corporation’s total amount of interest paid to related persons≦50 percent of the total of amounts of interest paid by the corporation

5. The purpose of “Japanese Earnings Stripping Rules”
The interest payment is deductible as expense in calculating taxable income.  So some Japanese companies intentionally increase borrowings from their foreign parent companies and book excessive interest in financial period, which will reduce corporation tax without affecting the whole income and expense of related parties.

Therefore, in the FY2012 tax reform, “Japanese earnings stripping rules” were introduced with a view to preventing tax avoidance by excessive interest payment.

6. Conclusion
In relation to tax restriction of excess interest paid to foreign parent companies, we mentioned Japanese tax rules of "Thin Capitalization Rules" and “Earnings Stripping Rules” this time.

Please note that this article is only prepared for the purpose of introducing general contents and no professional advices included.  Therefore, please don’t make any judgment based on this article without an individual advice from any professionals.

If you have any further questions, please feel free to contact us.

●　Website of Ministry of Finance Japan <http://www.mof.go.jp/index.htm>
●　Zeimukenkyukai(2014)  “FY2014 Zeimu index

　　 (『平成26年度版　税務インデックス』)” Zeimukenkyukai
●　Y. Gomi and T. Honjo (2014) “2014 CORPORATION TAX ACT of Japan”

　　<http://www.sozeishiryokan.or.jp/corporation_tax/corporation_tax2014e.html>