When calculating taxes for a Japanese branch of a foreign corporation, the first step is not just confirming "how much profit is in the Japanese branch's books." It is determined to what extent that profit is attributable to the Japanese branch for tax purposes. The 2014 tax reform placed this concept at the center of domestic law. Today, new corporate tax rules apply to business years beginning on or after April 1, 2016. It is necessary to check each company's applicable start year and prepare the branch's profit calculations and internal documentation.

This paper explains how the recent amendments affect profit calculations for foreign corporate branch offices in Japan and Japanese corporate branch offices overseas, focusing primarily on amendments to corporate tax.

Application of the corporate tax applies to business years beginning on or after April 2016.

As a general rule, the new corporate tax system takes effect today, applying to business years beginning on or after April 1, 2016. For companies with a March fiscal year-end, the business year from April 2016 to March 2017 is the first. For companies with a December fiscal year-end, it is normally the year beginning in January 2017. Business years that began prior to April 1, 2016, are generally subject to the pre-amendment rules, even if they span across this implementation threshold. Let us examine them separately: the promulgation and enforcement of the amended law itself, and the fiscal year in which it becomes applicable to each company.

National Tax Agency'sOverview of the Amendment (October 2015)explains the application timing of corporate tax and the main revision contents. This application timing is from the Ministry of FinanceReference materials related to the FY 2014 amendmentis shown. For personal income tax, there is a separate division starting from the 2017 tax year onward.

The comprehensive tax system is not a system that taxes the worldwide income of foreign corporations.

The term "worldwide income taxation system" used in explanations of pre-amendment domestic law is often misunderstood as meaning that "if there is a branch in Japan, the foreign corporation's worldwide profits are taxed." What becomes an issue for a typical foreign corporation with a Japanese branch is a mechanism that incorporates Japanese domestic source income into the scope of tax returns, regardless of whether it is attributable to the branch. It does not mean that worldwide income is unconditionally incorporated.

For example, consider a case where a foreign corporation has a Japanese branch, and its overseas headquarters receives interest from Japan without going through the Japanese branch. Under the domestic law prior to the amendment, the structure captured both the operating profit of the branch and domestic-source income unrelated to the branch together. However, the attribution principle may already apply due to tax treaties. This amendment represents a shift in domestic law toward considering "the relationship with Japan" and "attribution to the Japanese branch" separately.Explanation of the Financial Services Agency's FY2014 Amendment OutlineAlso, it addresses the differences between the comprehensive principle under domestic law and the attribution principle under tax treaties.

If it belongs to the Japanese branch, income generated in a third country is also subject to taxation.

Under the revised attribution principle, the Japanese branch is treated as if it were an independent company, and the income it ought to earn is calculated. As a result, while domestic-source income unrelated to the branch is excluded from the branch's income, income earned by the Japanese branch's business from a third country may be included in Japan's taxable income.

For example, suppose there is Country A where the overseas head office is located, Japan where the Japanese branch is located, and Country B where a business partner is located. If the business with the partner in Country B is actually managed by the Japanese branch, and the assets and risks necessary for that business also belong to the Japanese branch, the mere fact that the payment originates from Country B does not mean it is exempt from taxation in Japan. In this sense, the transition to the authorized OECD approach cannot be described as a simple reduction of the tax base.

In the amendment, to address cases where such third-country income is also taxed in the third country, a foreign tax credit mechanism pertaining to the Japanese PEs of foreign corporations was also established. It is necessary to read the mechanism for incorporating income and the mechanism for adjusting double taxation together.

What changes with AOA is how in-house profits are allocated

AOA is an acronym for the OECD-approved approach. In accordance with the approach of Article 7 of the 2010 OECD Model Tax Convention, income is attributed to a PE based on the functions it performs, the assets it uses, and the risks it assumes. This does not mean that a Japanese branch becomes a separate legal entity. To calculate the tax amount, it considers what profit an independent enterprise would have earned.

When it comes to product sales, clues include who selects the suppliers, determines the sales terms, and manages the risks of inventory and bad debts. A conclusion cannot be reached solely based on the fact that the head office name is written on the contract, or that sales were recorded at the Japanese branch. It is necessary to trace the decision-making and actual business operations.

Even between head offices and branch offices of the same corporation, tax law sometimes recognizes internal transactions, such as the transfer of goods or the provision of services. The consideration for such transactions cannot simply be an arbitrary figure decided internally; instead, it must be determined based on the arm's length price principle. However, not all internal fund transfers or expense allocations constitute such internal transactions. There are different treatments, such as head office expense allocations.

Furthermore, a mechanism will apply to calculate the capital required if the Japanese branch is considered an independent entity and to restrict the deductibility of interest expenses corresponding to that capital. Simply recording funds from the head office as borrowings does not necessarily mean the entire amount of interest can be treated as an expense. For financial institutions, obtaining the data necessary for capital calculation is also a preparatory item.

It also relates to overseas branches of Japanese companies.

This amendment is not just an issue for foreign-affiliated companies. When Japanese companies have overseas branches, it also involves grasping foreign-source income used in calculating the foreign tax credit. A system has been established to capture income attributable to foreign PEs and to take into account internal transactions with the head office.Outline of the 2014 Amended BillThen, we can review the taxation of foreign corporations and the foreign tax credit as related amendments.

When the profits of an overseas branch increase, that same amount cannot necessarily be used as-is as foreign-source income in Japanese tax calculations. We will verify which assumptions are shared and where there are discrepancies regarding the figures used in the local tax return, the branch's management accounting, and Japan's foreign tax credit. Furthermore, an increase in taxes paid abroad does not mean that the full amount can always be credited in Japan.

What managers check is whether the account books and the reality of the work are connected.

For example, suppose a Japanese branch is described as "a hub that only provides sales support," but in reality, the person in charge on the Japanese side determines prices, inventory, and whether or not to execute transactions. In this case, unless the discrepancy between the description and reality is resolved first, no matter how precisely profit margins are compared, the starting point will remain uncertain.

The documents to be reviewed include the organization chart, job authority, contract execution procedures, asset management status, communications between the head office and branches, and the basis for expense allocation. Since internal transactions do not necessarily have contracts like external transactions do, the amendment requires the creation and presentation of documents demonstrating attribution or internal transactions. At the start of the fiscal year to which the new system applies, we would like to check how well we can explain things using current ledgers and materials, and share any missing information with the head office.

Note that the contents of tax treaties vary by country, and the 2010 revision of the OECD Model Tax Convention does not automatically amend treaties with individual countries. Even for companies that already apply the attribution principle under a tax treaty, it is necessary to review the impact on internal transactions, documentation, and other matters. Based on the domestic laws for the relevant fiscal year and the applicable tax treaties, the presence of a PE and the attributable income will be examined in turn.

Reference: Kenta Kobayashi, KPMG Tax CorporationImpact of the revision of taxation principles for foreign corporations(KPMG Insight Vol. 8, September 2014, pp. 31–45).