Controlled Foreign Company (CFC) rules（A tax haven: rules attribute to a domestic corporation income from foreign related companies in which it holds interests, including companies lacking substance. The economic activity tests are the collective name for four requirements determining whether a company is a subject foreign related company: Business test・Substance Test and Management and Control Test・Unrelated-party test or the country-of-location test. These continue, under a new name, the former exemption criteria.

A foreign related company, including a foreign corporation in which domestic corporations and other relevant persons hold more than 50%, is subject to company-level attribution if it is a specified foreign subsidiary company or subject foreign related company. The overall distinction is covered elsewhere; this article focuses on the economic activity tests for the latter.

The Logic: Meet All Tests to Be Excluded; Fail Any One and Attribution Applies

Article 66-6(2)(iii) defines a subject foreign related company as a foreign related company failing any of the following requirements, excluding specified foreign related companies. Thus, the requirements in sub-items (a), (b), and (c)must all be met to avoid classification as a subject foreign related companyand company-level attribution. Conversely,failure of any one requirement means the company is a subject foreign related company and subject to company-level attribution. Correctly reading the direction of the statutory negative is the most important point.

Three Statutory Sub-Items, but Four Tests in Practice

The statute divides the requirements into (a), (b), and (c). They are commonly called four tests because sub-item (b) combines two requirements in one sentence.

• (a) Business Test: The principal business must not be holding shares or bonds, licensing industrial property or similar rights, or leasing ships or aircraft. Exceptions satisfying the test include qualifying regional headquarters companies, holding companies qualifying as foreign financial subsidiaries, and aircraft leasing where officers or employees perform all ordinarily necessary leasing activities in the head-office country and other requirements are met.
• (b) Substance Test / Management and Control Test: The company must have the office, store, factory, or other fixed facilities necessary for its principal business in its head-office country (for regional headquarters companies, headquarters functions; for financial subsidiaries, prescribed management functions), and must itself manage, control, and operate the business there. Two tests appear in one sentence.
• (c) Unrelated-Party Test or Country-of-Location Test: If the principal business is wholesale, banking, trust, financial instruments, insurance, water transport, air transport, or property leasing principally involving aircraft, business must be conducted mainly with unrelated parties. Other businesses must operate mainly in the head-office country. The applicable test is determined by the principal business; it is not elective.

Specified Foreign Related Company Status Takes Priority

The definition of subject foreign related company excludes specified foreign related companies. Thus, even if all four economic activity tests are met, specified-company status takes priority and company-level attribution applies. Paragraph (2), item (ii), lists four types: (a) companies meeting none of conditions (1)–(5) concerning facilities, local management and control, etc. (paper companies); (b) companies with high passive-income ratios (cash boxes); (c) companies meeting the specified insurance-premium requirements involving unrelated persons; and (d) companies headquartered in countries or regions designated by the Minister of Finance.

Relief Despite Failing the Tests: Exemption Based on the Tax Burden Ratio

Even a subject foreign related company is exempt from company-level attribution under paragraph (1) if its If the tax burden ratio is at least 20%, under paragraph (7), or at least 27% for a specified foreign related company. The economic activity tests and the tax burden exemption are separate stages of analysis.

Conversely, passing all four tests does not eliminate every attribution risk. A company can still be a partially subject foreign related company under partial CFC inclusion. covering only passive income such as dividends, interest, and royalties (paragraph (8) onward; details elsewhere).

Practical Points

The tax authorities may request documents needed to determine compliance with sub-items (a)–(c). Failure to provide them within the specified period creates a presumption that the requirements are not met and the company is a subject foreign related company (paragraph (4)). Many detailed criteria concerning facilities, actual management and control, and unrelated-party transaction ratios are delegated to Cabinet Order. Those Order provisions are outside this article's scope.

Legal basis

Article 66-6 of the Act on Special Measures Concerning Taxation: paragraph (1); paragraph (2), items (i), (ii)(a)–(d), (iii)(a)–(c); paragraph (4); paragraph (7), items (i) and (ii); and paragraph (8) (partial attribution, existence only)