The economic activity tests: even if a companymeets all of them, the analysis is not over.If there is passive income, only that portion is included. This ispartial CFC inclusion.It is.

What is a partially covered foreign related company?

Article 66-6(2)(vi) of the Act on Special Measures Concerning Taxation.

A partially covered company foreign related companies　means a foreign related company satisfying all requirements in item (iii)(a) through (c),excluding a foreign related companyspecified foreign subsidiary company falling within the specified excluded category.That is the definition.

A company meeting all the economic activity tests is a partially covered foreign related company.Meeting the tests does not mean there is nothing more to check;it is precisely because it meets them that it enters this category.

Twelve categories of “specified income amounts” are included

These are listed in Article 66-6(8) of the Special Measures Act.The items run from (i) through (xi), but item (vii-2) makes twelve categories in total.

Each item has its own exclusions.These are central in practice.

Main exclusions

Item (i), dividends: dividends from holdings of at least 25% are excluded

The provision excludes dividends from a corporation whereownership is at least 25%and the other requirements prescribed by Cabinet Order are met.However, the parenthesis removes from that exclusion “dividends of surplus and similar distributions prescribed by Cabinet Order as deductible in calculating that corporation's income.”Dividends deductible by the payer do not benefit from the exclusion.

Also,for certain companies whose principal business is fossil fuel extraction, foreign corporation the threshold is 10% or moreunder subitem (b).The threshold cannot uniformly be described as 25%.

Item (ii), interest received: three exclusions

(Excluding interest ondeposits or savings arising in the ordinary course of the company's business,（……）the amount of that interest,andinterest on loans made by a partially covered foreign related company principally engaged in money lending,limited to one that, under the laws of its head-office jurisdiction,has a license, registration, or similar authorization to conduct money lending as a business,and whose, in that jurisdiction,officers or employeesperform all tasks ordinarily considered necessary to properly conductthe money-lending business,as well as interest on loans made by such a company,and other interest prescribed by Cabinet Order.These amounts are excluded.)

The money-lending exclusion has two cumulative conditions:local licensing or registration,andand officers or employees performing all the relevant tasks.Meeting only one is insufficient.

Item (iv), securities transfers: excluded if ownership is at least 25% immediately before transfer

(Excluding consideration for transfers of shares or similar interests in another corporation where the partially covered foreign related company's holding, as a proportion of the total number or amount of issued shares and similar interests, isat least twenty-five percent immediately before the transfer.Consideration for those share transfers is excluded.)

The testing time is “immediately before the transfer.”It is not year-end or after the transfer. Gains on selling subsidiary shares are not always subject to partial inclusion.

Items (v) and (vi): ordinary gains and losses of operating companies are excluded

The exclusion in item (vi), foreign exchange gains and losses, is particularly significant in practice.

（The business conducted,excluding businesses engaging in transactions prescribed by Cabinet Order,in its ordinary course,gains or losses arisingare excluded.。）

Foreign exchange gains and losses ordinarily arising from imports and exports do not fall within specified income in the first place.

The derivative exclusion under item (v) hasthree categories,, whichall delegated to Ministry of Finance Order.(1) Derivative transactions conducted to reduce losses listed in the items of Article 61-6(1) of the Corporation Tax Act,as prescribed by Ministry of Finance Order,meaning hedges; (2)in accordance with the laws of the head-office jurisdiction,derivative transactions by a partially covered foreign related company conducting activities equivalent to those in Article 2(22) of the Commodity Derivatives Transaction Act as a business, whose officers or employees perform all relevant tasks,as prescribed by Ministry of Finance Order;those derivative transactions; and (3)other derivative transactions prescribed by Ministry of Finance Order.These are the three categories.It is not enough simply to call a transaction a hedge; it must meet the Ministry of Finance Order's requirements.

Item (viii), fixed asset leasing: three exclusions

• Leasing of fixed assetsused primarily in the head-office jurisdiction,with the following excluded from this category:real estate and rights over real estate,which are treated separately
• Real estate located in the head-office jurisdictionor rights over such real estate, leased to others
• Leasing by a company that, in its head-office jurisdiction,officers or employeeshas officers or employees performing all tasks ordinarily considered necessary to properly conduct fixed asset leasing,the money-lending business,and meets the other requirements prescribed by Cabinet Order

Movable property is classified by where it is used; real estate by where it is located.The first parenthesis excludes real estate because the second exclusion covers it separately.

Items (ix) and (x), intangible assets: results of the company's own R&D are excluded

Royalties and transfer consideration relating tothe results of the company's own research and development are excluded, as are other amounts prescribed by Cabinet Order.Royalties from purchased or transferred intellectual property are generally subject to inclusion.

Calculating the amount subject to partial application: treatment differs by item

Article 66-6(9) of the Special Measures Act.This is where errors most often occur.

For each fiscal year of the partially covered foreign related company, the amounts listed initems (i) through (iii), (viii), (ix), and (xi)of that paragraph aresummed,and combined with the amount based on the total underitems (iv) through (vii-2) and (x)for that fiscal year,with any negative total treated as zero,after adjustments, as prescribed by Cabinet Order, for negative totals arising in fiscal years beginning within the prescribed period before the current fiscal year,seven yearsrelating to items (iv) through (vii-2) and (x).The two amounts are added together.

There are two groups.

Groups A and B cannot be offset against each other.A transfer loss in Group B does not offset dividends or interest in Group A. A negative Group B amountis carried forward within Group B for seven years.That is the structure.

Three exemptions

Article 66-6(12) of the Special Measures Act.Meeting any one exempts the company from partial inclusion.

(i) For each fiscal year, the tax burden ratio isIf the tax burden ratiomust beat least twenty percent.This satisfies the first exemption.

(ii) For each fiscal year,the amount subject to partial application the amount subject to application.or the amount subject to partial application for financial subsidiaries and similar entities is¥20 million or less.This satisfies the first exemption.

(iii) The proportion of the amount subject to partial application for the fiscal year in the amount prescribed by Cabinet Order as equivalent to income based on that year's financial statements isfive percent or less.This satisfies the first exemption.

Item (ii) is an amount threshold, ¥20 million or less, and item (iii) is a percentage threshold, 5% or less.Even where the tax burden ratio is below 20%, these two exemptions often remove the company from inclusion.

AndIf paragraph (12)(ii) or (iii) applies, the return attachment obligation is also removedunder the parenthesis in paragraph (14)(i), which uses the term“partially covered foreign related company exempt from attachment.”」）。However, paragraph (15) imposes a retention obligation.No attachment requirement does not mean no need to prepare documents.

Separate rules for foreign financial subsidiaries and similar entities

Item (vii) defines“foreign financial subsidiaries and similar entities”as partially covered foreign related companies conducting banking, business equivalent to Type I financial instruments business, or insurance, whose officers or employees perform all relevant tasks, and similar qualifying entities. For them, rather than paragraph (8),paragraphs (10) and (11)provide separate calculations. Paragraph (11) uses the larger of “the amount under paragraph (10)(i)” and “the total under paragraph (10)(ii), (iii), and (v), plus the adjusted amount under item (iv).”The larger amountis used.

Points that require care in practice

• Can income be included even after all economic activity tests are met?Meeting them is precisely what makes the company a partially covered foreign related company.
• Are all dividends included?Dividends from holdings of at least 25%, or at least 10% for certain fossil fuel companies, are excluded.
• What about interest on intragroup loans?Check both the money-lending license or registration condition and the condition concerning performance of all relevant tasks.
• Can securities transfer losses offset dividends?No. They carry forward for seven years within Group B.
• We sold subsidiary shares.If ownership was at least 25% immediately before the transfer, the consideration is excluded from item (iv).
• Are foreign exchange gains and losses on imports and exports included?Under the parenthesis in item (vi), those arising in the ordinary course of business are excluded.
• Is there a small-amount exemption?Yes: ¥20 million or less under paragraph (12)(ii), or 5% or less under item (iii).
• If attachments are unnecessary, are documents unnecessary too?The retention obligation under paragraph (15) remains.

Partial inclusion is difficult because meeting the tests is not the end of the analysis.If a foreign subsidiary has dividends, interest, property rent, or royalties, begin by totaling those amounts. If you are concerned about its revenue composition, consult us with a breakdown of the latest year's income and expenses.

Legal basis

• Article 66-6(2)(vi) of the Act on Special Measures Concerning Taxation (Partially Covered Foreign Related Companies), and paragraph (2)(vii) (Foreign Financial Subsidiaries and Similar Entities)
• Article 66-6(8), each item, of the Act on Special Measures Concerning Taxation (Specified Income Amounts), and paragraph (9) (Amount Subject to Partial Application)
• Article 66-6(10) and (11) of the Act on Special Measures Concerning Taxation (Calculations for Foreign Financial Subsidiaries and Similar Entities)
• Article 66-6(12), each item, of the Act on Special Measures Concerning Taxation (Exemptions from Partial Inclusion)
• Article 66-6(14)(i) of the Act on Special Measures Concerning Taxation (Attachments to Final Returns), and paragraph (15) (Retention Obligation)

This article does not cover Cabinet Order details of the exclusions, the items in paragraphs (10) and (11) concerning foreign financial subsidiaries and similar entities, or details of insurance-related item (vii-2). Individual calculations require review of revenue breakdowns and contract terms.