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By Brian Yap
Japanese railway operators and pharmaceutical companies are among the multinational firms that are highly concerned by the country’s forthcoming proposal to limit net interest deductions.
The changes—part of the OECD’s base erosion and profit shifting (BEPS) rules to counter corporate tax avoidance—would mean companies that historically relied heavily on debt will no longer be able to write off interest payments to the same extent, creating higher tax burdens.
To avoid high domestic taxation, multinational companies often use interest deductions in friendly tax regimes to lower their corporate tax bills.
If Japan incorporates the Organization for Economic Cooperation and Development’s plans, fixed-ratio rules would also include net interest paid to third parties like banks, tax advisers said. Currently, these only apply to interest paid to overseas companies and affiliates.
The Ministry of Finance hasn’t yet released a formal version, but it is likely to do so in the fiscal year 2019 tax reform package, said Hiroshi Makuuchi, the manager of tax policy Keidanren, a Japan business federation.
“Railway operators and land developers are very concerned. Pharmaceutical companies, which have been active in M&A transactions, are very concerned that they could be under the scope of the new rules,” Makuuchi said. He added that the new rules would “heavily” discourage outbound M&A transactions, damaging the competitiveness of Japanese companies.
The ruling party’s fiscal year 2017 and 2018 tax reform outlines the review of earnings stripping rules. “It remains to be seen whether their revision will be included in the fiscal 2019 tax reform outline,” a Ministry of Finance spokesman told Bloomberg Tax Aug. 15.
Japan currently restricts the deductibility of interest paid to overseas parties to 50 percent of adjusted taxable profits. The government would likely reduce that cap to 30 percent under the new regime, practitioners said.
Japan’s financial sector and leasing companies, which are highly leveraged because they deal in heavy equipment and aircrafts, would be some of the sectors likely to be most affected, Jonathan Stuart-Smith, a partner at EY in Tokyo, told Bloomberg Tax Aug. 9. The change would also impact real-estate companies, which traditioanlly depend on debt, Stuart-Smith said.
Japanese financial institutions, as well as companies like automakers, regularly issue bonds on U.S., U.K., and European markets to get foreign currencies, Kei Sasaki, an international and domestic tax partner at Anderson Mori & Tomotsune in Tokyo, told Bloomberg Tax Aug. 10. BEPS Action 4, which deals with interest deductions, would make deducting interest paid to foreign bondholders much more difficult, Sasaki said.
“If the deduction of interest paid to foreign entities isn’t allowed, the payer will become less competitive since such deduction currently decreases tax liabilities of Japanese companies,” he said.
The fixed-ratio rules could deter Japanese companies and foreign multinationals from engaging in merger and acquisition transactions, Stuart-Smith said. Japan’s pharmaceutical industry is most active in takeovers, and the high-value deals require borrowing large amounts of money, Stuart-Smith said.
In a typical Japanese-led M&A transaction—where a special purpose vehicle (SPV) borrows money from syndicated banks under a leveraged buyout—the SPV will merge with the target company after acquiring 100 percent of its shares. An SPV is an entity created for a specific purpose, like the acquisition of assets.
In this case, the merged company won’t have to worry about the new rules, considering its sufficient EBITDA (earnings before interest, taxes, depreciation and amortization) derived from the ex-target’s business to offset the interest, said Hiroyuki Kurihara, tax disputes associate at Mori Hamada & Matsumoto in Tokyo. The SPV and the target sometimes don’t merge, because doing so would require the merged company to obtain a new license, Kurihara said.
“The fact that the SPV doesn’t have any real business, as it only receives upstream loans or dividends from the target, would make it very difficult for the SPV to avoid the new rules, assuming that the new rules generally applies on an entity-by-entity basis,” Kurihara said.
Highly leveraged companies may need to review their capital structure and consider whether they should convert some debt to equity, minimizing additional tax on interest payments, Stuart-Smith said.
“Equity could be more favorable as dividend payments are generally non-deductible, so the cross-border treatment of equity would often be symmetrical,” Stuart-Smith said.
But a debt-to-equity conversion exercise may not be easy.
In the case of 100 percent intra-group financing within Japan, a debt-to-equity swap is generally not considered a taxable transaction. But it is a taxable event when it involves external debt, Kurihara said.
Makuuchi suggested a bit of caution.
“What we should do first is to assess if there are really ‘material’ BEPS risks in Japan. If there is no such risk, we do not have to fully incorporate the BEPS rule,” he said.
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