In a related article, we explained that when a foreign parent company transfers the shares of its Japanese subsidiary, the transfer may fall within the so-called “25/5 rule” and give rise to Japanese taxation.
>>Japan Capital Gains Tax on Share Sales by Foreign Companies: The 25/5 Rule and Tax Treaties
Cross-border share transfers can also raise a separate — and more complex — Japanese tax issue: the taxation of gains from the transfer of shares in a so-called “real estate-related corporation” , commonly referred to outside Japan as a real estate-rich company, or “REHC.”
This article summarizes the REHC rule, which involves requirements that are somewhat more intricate than those under the 25/5 rule described above.
What Is the REHC Rule?
Under Japanese domestic rules, a non-resident shareholder without a PE in Japan is generally not subject to Japanese tax on capital gains arising from a disposition of shares in a Japanese company, unless a specific exception applies.
One such exception applies where the shares transferred are shares in a REHC. Where the requirements below are satisfied, the gain is treated as Japan-source income, and the non-resident shareholder is subject to Japanese taxation on the gain regardless of whether it has a PE in Japan.
An REHC is, broadly, a Japanese or foreign company that satisfies both of the following requirements:
- Asset test: at any time during the 365-day period ending immediately before the transfer, 50% or more of the company’s gross assets, by fair value, consisted — directly or indirectly — of Japanese real property and/or shares in other real estate-related corporations; and
- Ownership test: as of the day before the start of the fiscal year in which the transfer occurs, the transferor, together with its specially related shareholders, etc., held more than 2% (5% in the case of a listed company) of the company’s total issued shares, and the transferor was one of those specially related shareholders.
The statutory wording is not easy to parse on a first read. In practice, however, the following types of transfers typically fall within its scope, provided Japanese real estate and real estate-related shares account for 50% or more of the underlying assets:
Key Difference from the 25/5 Rule: Indirect Transfers Are Covered
Unlike the 25/5 rule, which applies only to a direct transfer of shares in the Japanese company itself, the REHC rule also captures indirect transfers. For example, a transfer of shares in a foreign holding company whose value is substantially derived from an underlying Japanese real estate-related corporation may likewise fall within the scope of the REHC rule.
Because indirect transfers are within scope, this issue is easier to overlook in cross-border transactions than the 25/5 rule, and it warrants particular attention when structuring a deal involving a Japanese real estate-related business.
Applicable Tax Rates
Where the REHC rule applies, non-resident corporations are subject to Japanese capital gains tax at a rate of approximately 25.59%, and non-resident individuals are subject to tax at a rate of 15.315%, in each case provided they have no PE in Japan.
Override Under an Applicable Tax Treaty
The REHC rule is a rule under Japanese domestic law.
Where an applicable tax treaty provides otherwise, however, the treaty takes priority over domestic law.
Provisions addressing gains from the transfer of shares in real estate-rich companies (sometimes referred to as “real property clauses”) are included in many of Japan’s tax treaties. However, the precise wording, thresholds, and scope of coverage — including whether indirect transfers are addressed — differ from treaty to treaty, and each applicable treaty must therefore be reviewed carefully.
Summary
As described above, when a foreign company transfers shares in a Japanese company, the transfer may fall within the REHC rule and give rise to Japanese taxation, so care is required.
In particular, because the REHC rule also captures indirect transfers, this issue is more easily overlooked than the 25/5 rule.
Although an applicable tax treaty may override the domestic rule and exempt the gain from Japanese taxation, treaty wording varies considerably from country to country. Unless careful attention is paid to how the relevant treaty is worded, whether it can be applied to the specific case, and what procedures are required in order to apply it, unexpected Japanese taxation may result.
In cross-border share transfers involving Japanese real estate or real estate-related businesses, we recommend reviewing the Japanese tax implications at an early stage, from both a domestic law and a tax treaty perspective.
>>Japan Tax Filing for Foreign Parent Companies Selling Shares in a Japanese Subsidiary
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