NAViS Topics

Earnings Stripping Rules

If the income tax rate in the jurisdiction of a subsidiary is much higher than its parent company’s, you may prefer a loan to equity finance from the perspective of tax because interest is tax deductible. One of the tax rules to prevent excessive tax avoidance behavior is earning stripping rules.

Overview   

If the income tax rate in the jurisdiction of a subsidiary is much higher than its parent company’s, you may prefer a loan to equity finance from the perspective of tax because interest is tax deductible. (For more details, please read our Quick Review on Thin Capitalization Rules)  One of the tax rules to prevent excessive tax avoidance behavior is earning stripping rules. 

The earning stripping rules will disallow deductions of the excess interest expense paid or payable to the related persons if the relevant interests exceed 50% of income. Borrowings from third parties will be included if the loans are back-to-back loans or guaranteed by the foreign controlling shareholder

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Who are related persons?   

Compared to the Thin Capitalization Rules, overseas subsidiary of the company is included in related person (condition (2) and (5) below).
A related person is defined as a foreign corporation or nonresident individual that (1) directly or indirectly owns 50% or more shareholding in the company, or (2) is directly or indirectly owned 50% or more shareholding in the company, or (3) is a foreign corporation in which 50% or more shareholding is owned by the same shareholder which directly or indirectly owns 50% or more shareholding in the company, or (4) has the power to control the company, or (5) is a foreign corporation which the company has the power to control.

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Carry forward:   

While in the thin capitalization rules the nondeductible interests are denied permanently, in the earnings stripping rules they will be carried forward over the next 7 years, and if the current interest payable to the related persons is less than 50% of income, interests carried forward can be deducted up to the limit.

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De Minimis tax rule:   

A company will be exempted if you meet either of the following conditions.

• Interest payments to related persons is JPY10 million or less.

• Interest payments to related persons is 50% of total interest payments or less.

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Double taxation – thin capitalization rules:   

If both the thin capitalization rules and the earning stripping rules are applicable, the one which denies larger amount of interest is applicable to avoid double taxation. Taxwise, the earning stripping rules are preferential for taxpayers as there is no carry forward system in the thin capitalization rules.