The principle of taxation of the actual income earner is a principle under tax law where, when the person who is considered to be the income earner is merely a nominee and does not obtain the economic benefits substantially and finally, the tax should be borne by the actual recipient of the economic benefits as the income earner under the Income Tax Act without regard to the external name of the income earner.
The taxation system for controlled foreign companies (CFCs) is a system under which the income of a CFC is included in the amount of miscellaneous income in the calculation of a resident’s income to achieve substantial fairness in the tax burden in order to deal with cases where a corporation tries to avoid a tax burden in Japan by retaining income in a company established in a country or region where there is no tax burden or a significantly lower tax burden on the income of the corporation.
Now, in considering the application of the CFC rules, what should be considered when (i) a shareholder of a CFC is only a nominal shareholder and there appears to be a separate beneficial shareholder, or (ii) a CFC is a nominal shareholder of a company, but there appears to be a beneficial shareholder separate from the CFC?
1 Theory of the principle of taxation of the actual earner
Article 12 of the Income Tax Act sets forth the principle of taxation of the actual income earner, providing that “If the person to whom proceeds arising from assets or business seem to be legally attributed is the holder of those proceeds in name alone and has no enjoyment thereof, but someone other than that person does have enjoyment of those proceeds, the proceeds are to be attributed to the person with actual enjoyment thereof, and the provisions of this Act apply.” Article 11 of the Corporation Tax Act similarly establishes the principle of taxation of the actual income earner. The principle of taxation of the actual income earner is said to be a basic guiding principle that has been recognized as an inherent principle in tax law since before the Income Tax Act was clearly stipulated in 1953.
There are two major theories regarding the meaning of taxation of the actual earner: the legal attribution theory and the economic attribution theory. The legal attribution theory holds that if there is a discrepancy between the form and substance of the legal (private law) attribution of taxable property, the attribution should be determined in line with the substance. The economic attribution theory holds that if there is a discrepancy between the legal (private law) attribution and the economic attribution of the taxable property, the attribution of the taxable property should be determined in line with the economic attribution. The legal attribution theory is commonly accepted from the perspective of ensuring legal stability from the taxpayer’s perspective and difficulties in tax administration enforcement.
However, there is a school of thought that posits that the true rights holder in law (in private law) and the person who economically enjoys the economic gain that constitutes the content and substance of the proceeds coincide in most cases in practice.
The legal attribution theory, which is the prevailing theory, would be appropriate. However, even under the legal attribution theory, economic substance may be considered as an indirect fact when judging the legal (private law) attribution of substance.
2 Criteria for determining substance
The current Income Tax Act classifies income into 10 categories (interest income, dividend income, real estate income, employment income, retirement income, forestry income, transfer income, temporary income, miscellaneous income, and business income) according to its source or nature. Such classification can be broadly divided into asset-based income (interest, dividend, real estate, forestry, transfer income, etc.), labor income (salary, retirement income, etc.), and asset-work coupled income (business income). It is then considered useful to organize the factors for determining the attribution of income by type of income. For example, in the case of dividend income, the factors to determine the attribution of income are the contribution of capital for stock acquisition (capital contribution), the management and disposal of dividends, and the management of the trading account.
A court decision on March 15, 2000 of the Osaka High Court (originally issued by the Osaka District Court on July 16, 1999), regarding how the ownership of nominal shares should be determined in a court case concerning inheritance tax, held that, “Although the name of the shares is an important factor in determining the ownership of the shares, it is also an important factor in determining the right to the shares, since it is common for shares to be acquired under the name of another person. In addition, it is also important to consider whether or not the company contributed the funds to purchase the shares, made the decision to buy and sell the shares, and managed and operated the shares to obtain profits from the sale and purchase. The determination of the person to whom the shares belong should be made by comprehensively taking into consideration each of the above factors and the relationship between the nominee and the management and operator.” In addition, a court decision on October 2008 of the Tokyo District Court (the conclusion was upheld by the Tokyo High Court in its April 16, 2009 decision on appeal) held that, “Whether or not property in the name of a person other than the decedent belonged to the decedent at the time of commencement of inheritance is to be determined by comprehensively taking into consideration such factors as the donor of the capital to purchase the property, the status of management and operation of the property, the person to whom the profits arising from the property belong, the relationship between the decedent and the nominee of the property as well as the person managing and operating the property, and how the nominee of the property came to hold the title.” These court decisions, particularly the October 17, 2008 decision of the Tokyo District Court, indicate that, in determining who the beneficial owner of the property is, the following factors should be comprehensively taken into consideration: (1) the donor of the capital to purchase the property, (2) the status of management and operation of the property, (3) the person to whom the profits arising from the property belong, (4) the relationship between the beneficial owner and the nominee/manager and operator of the property, (5) the circumstances under which the nominee came to hold the title.
3 When a shareholder of a CFC is only a nominal shareholder and there is thought to be another substantial shareholder
(1) Nominal shareholders, etc. of CFCs and legal (private law) shareholders, etc.
Under the Act on Special Measures Concerning Taxation, in order to deal with acts reducing or avoiding the Japanese tax burden by using CFCs without substantial activities, an amount equivalent to the income of the CFC is deemed as being the income of the domestic corporation or individual and is added together to tax the domestic corporation or individual (Articles 66-6 and 40-4, etc. of the Act on Special Measures Concerning Taxation; Controlled Foreign Company Rules).
In applying the Controlled Foreign Company Rules, the Controlled Foreign Company Rules is applied to shareholders, etc. under the law (private law), not to shareholders, etc. under the name of the CFC. This is based, on the surface, on the Notes on Table of Contents of Measures Law Notification 66-6-2 , which are notices on Article 66-6 of the Act on Special Measures Concerning Taxation. However, these notices can be interpreted as providing caution that the principle of real income tax should be followed when determining shareholders, etc. of CFCs, given that taxation of real income earners is a basic guiding principle inherent in tax law , and that even in tax laws that do not have explicit provisions such as Article 12 of the Income Tax Act or Article 11 of the Corporation Tax Act, the application of real income tax is affirmed when there is no explicit provision excluding real income tax. Therefore, the statutory basis would be the provisions that establish the principle of real income tax (Article 12 of the Income Tax Act or Article 11 of the Corporation Tax Act). In addition, Article 40-4 of the Act on Special Measures Concerning Taxation does not contain a notice like the one in the Notes on Measures 66-6-2, but, as stated above, based on the provisions that stipulate the principle of taxation of the actual earner (Article 12 of the Income Tax Act or Article 11 of the Corporation Tax Act), it is understood that the Controlled Foreign Company Rules apply to legal (private law) shareholders, not nominal shareholders.
(2) Criteria for determining whether a shareholder, etc. is a shareholder, etc. in name or in law (private law)
With respect to the nature of the aggregation of income under the Controlled Foreign Company Rules, there are two views: one is that it is a system in which the amount equivalent to the taxable retained income is deemed to be distributed to the domestic corporation and taxed, and the other is that it is a system that embodies the principle of taxation of the actual earner and is a special provision regarding the attribution of income with respect to the provision (Article 11 of the Corporation Tax Act) that sets forth the principle of taxation of the actual earner. Dividend income, as mentioned above, is organized as asset-based income.
Since dividend income is income earned based on the legal relationship of shareholder status, the identity of the shareholder (i.e., the donor of the capital used to acquire the shares) is considered to be an important factor in determining dividend income. In addition, the custody of share certificates, receipt and management of dividends, decision-making regarding the purchase and sale of shares, receipt and management of transfer proceeds, and management of trading accounts (if the shares were acquired through a securities company) are also considered to be determining factors. In addition, with reference to the aforementioned court cases concerning inheritance tax, the following factors may be comprehensively considered: (1) the donor of the capital to purchase the property, (2) the status of management and operation of the property, (3) the person to whom the profits arising from the property belong, (4) the relationship between the beneficial owner and the nominee/manager and operator of the property, (5) the circumstances under which the nominee came to hold the title.
However, since most CFCs are so-called “paper companies”, there are some points that cannot function as determining factors such as they are. In the end, whether the shareholders, etc. of a CFC are legal (private law) shareholders, etc. or merely nominal shareholders, etc. must be determined on a case-by-case basis based on the existence and content of a contract between the parties and the circumstances leading up to its conclusion.
4 When a CFC is a nominal shareholder of a company, but the actual shareholders appear to be separate from the CFC
If there is another beneficial owner of certain shares held by a CFC to which the Controlled Foreign Company Rules are applied, is it possible to apply the principle of taxation of the actual income earner and deny attribution to the CFC of any profits or losses arising from the transfer of such shares?
At present, there is no Supreme Court precedent that explicitly determines that the principle of taxation of the actual income earner is applicable to a CFC to which the Controlled Foreign Company Rules is applied. However, in the investigator’s commentary to the Supreme Court’s September 28, 2007 decision, which denied the inclusion of losses of specified CFCs in the amount of deductible expenses of domestic corporations, to the question of “whether the scope of allowing the inclusion of losses of a specified CFC in the amount of losses of a domestic corporation based on the principle of taxation of the actual income earner should be denied even in cases where the losses of a specified CFC are deemed to be substantially attributable to the domestic corporation”, it was explained that “it seems reasonable to conclude that this judgment does not provide any clarification on this issue” (pp. 664-665). Further, in Note 5 of the investigator’s commentary to the Supreme Court’s July 17, 2015 decision, which held that a limited partnership formed under the laws of the State of Delaware, USA, constitutes a foreign corporation under Article 2.1(vii), etc. of the Income Tax Act, it was explained for “special circumstances” in which profits or losses arising from the business of an organizational entity formed with investments from multiple persons that are not attributable to that organizational entity, that “even if the organizational entity is formally conducting a business, it is possible to think of cases where the profits and losses from the business are in substance attributable to its members or a third party (in such cases, the application of Article 12 of the Income Tax Act and Article 11 of the Corporation Tax Act would become an issue)” (p. 370). Based on these explanations, there may be cases where the principle of taxation of the actual income earner is applied to a CFC and the attribution to the CFC of profits or losses arising from the transfer of shares in which the CFC is a nominal shareholder may be denied.
It should be noted that, in applying the principle of taxation of the actual income earner, the only issue is the legal attribution of the taxable property (in this article, shares). In the above precedent of the Supreme Court decision on September 28, 2007, the two parties had agreed that the domestic parent company would bear the losses of the CFC, but the Supreme Court did not recognize the displacement of profits and losses due to such agreement. This means that even if the parties agreed on the attribution of profits and losses separate from the legal attribution of the taxable property, it is not allowed for tax purposes (this does not apply to cases where there is a silent partnership agreement or other legal relationship that is recognized for tax purposes).