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The Protocol amending the Japan–U.S. Income Tax Treaty finally came into effect on August 30, 2019 by the exchange of ratifications, after almost six years from when the Protocol was signed by both governments on January 24, 2013. While Japan ratified the Protocol in June 2013, it was only ratified by the U.S. on July 17, 2019.
This is the first revision in 15 years since a comprehensive revision was conducted in 2004 (hereinafter, the Japan–U.S. Income Tax Treaty as revised in 2004 is referred to as the “Former Treaty” and the Japan–U.S. Income Tax Treaty as revised in 2019 is referred to as the “Amended Treaty”; collectively, the “Treaty”).
The Protocol does not provide for a comprehensive amendment of the Former Treaty but rather a partial amendment.
Some major amendments made by the Protocol include:
- the expansion of the scope of dividends and interest that are exempted from taxation by the country in which the payer of the dividends and interest has residence;
- the introduction of mandatory arbitration in certain cases under the Article on mutual agreement procedures (MAP) (Article 25); and
- the expansion of the scope of the Article on mutual assistance in the collection of taxes to cover delinquent tax claims in general (Article 27).
Expansion of Tax Exemptions Granted by Source Country for Investment Income (Dividends and Interest)
In accordance with the Protocol, the scope of the tax exemptions on dividends and interest granted by a Source Country (i.e., in this case, the country in which the payer of the dividends and interest has residence) has been expanded. In addition, stricter limits have been placed on the tax rates that can be imposed by a Source Country, as described below.
Under the Former Treaty, certain limits were placed on the tax rate that could be imposed by a Source Country on dividends (Article 10, Paragraphs 2 and 3 of the Former Treaty). There were three tiers of tax rates that applied, depending on certain conditions being met:
(i) if the beneficiary of the dividends held more than 50% of the voting shares of the corporate entity paying the dividends and the holding period was 12 months or more, the dividends would be exempted from tax in the Source Country;
(ii) if the beneficiary of the dividends owned 10% or more of the voting shares of the corporate entity paying the dividends, in principle the tax rate that could be imposed by the Source Country was limited to 5%; and
(iii) the tax rates mentioned in (i) and (ii) above applied only to dividends paid between corporations. In all other cases, the tax rate that could be imposed by the Source Country was limited to 10%.
Under the Protocol, the threshold requirements that have to be met in order for the dividends to qualify for the tax exemption in (i) above have been relaxed such that the dividends would be eligible for the exemption if the beneficiary holds 50% or more of the voting shares of the corporate entity paying the dividend and where the holding period is six months or more (Article 10, Paragraph 3 Item (a) of the Amended Treaty).
Under the Former Treaty, interest was subject to tax by a Source Country provided that such taxation did not exceed 10% of the gross amount of the interest in principle (Article 11, Paragraph 2 of the Former Treaty). However, certain categories of interest were exempted from tax. For example, in cases where the beneficiary of the interest fell under certain categories of financial institution, such as banks, insurance companies or registered securities dealers, such interest would be tax exempt (Article 11, Paragraph 3 of the Former Treaty).
Under the Protocol, interest is exempt from tax in the Source Country, in principle (Article 11, Paragraph 1 of the Amended Treaty). However, the exemption does not apply to contingent interest which may be taxed by the Source Country at a rate not exceeding 10%. Contingent interest is, in short, interest that is calculated by reference to, inter alia, income, sales, receipts, changes in the value of property or dividend payments made by a debtor or its affiliate (Article 11, Paragraph 2 Item (a) of the Amended Treaty).
Introduction of Arbitration System in Mutual Agreement Procedure
Article 25 of the Former Treaty sets out the provisions relating to the MAP between the competent authorities of both contracting states.
Under the Former Treaty, a person who considers that the actions of one or both of the contracting states result or will result for him/her in taxation not in accordance with the provisions of the Treaty may present the case to the competent authority of the contracting state of which he/she is a resident. The aforesaid competent authority is then obligated to endeavor to resolve the case by mutual agreement with the competent authority of the other contracting state, if the objection appears to it to be justified and if it is not itself able to arrive at a satisfactory solution. Any agreement reached shall be implemented notwithstanding any time limits or other procedural limitations in the domestic law of the contracting states (Article 25, Paragraphs 1 and 2 of the Former Treaty).
Under the Protocol, in addition to the above provisions, new provisions have been added which provide that in situations where both competent authorities are unable to settle the case within two years by mutual agreement, the case shall be resolved through arbitration (Article 25, Paragraphs 5 to 7 of the Amended Treaty). The determination of the arbitration panel shall constitute a resolution by mutual agreement between the competent authorities of the entire case based on Article 25 and shall be binding on both contracting states, unless the presenter of the case does not accept the determination. The resolution resulting from such determination of the arbitration panel shall be implemented notwithstanding any time limits or procedural limitations in the law of the contracting states (Article 25, Paragraph 7 Item (e) of the Amended Treaty).
It should be noted that any matters concerning an advance pricing agreement may also be resolved through arbitration (Article 25, Paragraph 7 Item (d) of the Amended Treaty) and that the “baseball arbitration method” (or “last best offer method”) has been adopted (Article 14, Paragraph 3 Item (i) of the Protocol).
It is expected that large transfer pricing cases will be resolved through arbitration.
Expansion of Mutual Assistance in Collecting Taxes
Under the Former Treaty, the system for contracting states to lend assistance to each other in the collection of taxes was previously limited to cases of abuse of the Treaty only, but the scope of this system has been expanded under the Amended Treaty to apply to delinquent tax claims in general (Article 27, Paragraphs 2 to 4 of the Amended Treaty).
The types of tax in Japan which are subject to this system are income tax, corporate tax, special income tax for reconstruction, consumption tax, inheritance tax, and gift tax.
Although Japan and the U.S. have signed the Convention on Mutual Administrative Assistance in Tax Matters, the U.S. has reserved the right not to provide tax collection assistance or assistance in serving documents (except the service of documents by mail). Accordingly, it is expected that the expansion of mutual assistance in collecting taxes under the Amended Treaty will play an important role in tax practice.
The Protocol came into effect on August 30, 2019, and applies to withholding taxes in respect of amounts paid or credited on or after November 1, 2019. For all other taxes, the Protocol applies to taxable years beginning on or after January 1, 2020.
The amendment to Article 25 regarding the introduction of mandatory arbitration under the MAP applies to cases that are under consideration by the competent authorities on August 30, 2019, and to cases that come under consideration after that date.
The amendments regarding information exchange and mutual assistance in the collection of taxes have effect from August 30, 2019, regardless of the tax year of the case or tax claim.
Scope of Agent-Type Permanent Establishment
Based on the fact that the scope of agent-type permanent establishments (PEs) under the Organization for Economic Co-operation and Development (OECD) Model Tax Convention was expanded based on the BEPS Project’s final report (Action 7 Preventing the Artificial Avoidance of Permanent Establishment Status), the scope of agent-type PEs under Japanese law was similarly revised during a tax reform conducted in Japan in 2018 (see Article 2, Item 12–19 (c) of Corporation Tax Act, Article 4–4, Paragraph 7 of Order for the Enforcement of the Corporation Tax Act). As a result, commissionaires/commission agents now fall under the scope of agent-type PEs under Japanese domestic tax law.
On the other hand, Article 5, Paragraph 6 of the Amended Treaty states that “An enterprise shall not be deemed to have a permanent establishment in a Contracting State merely because it carries on business in that Contracting State through a …general commission agent …of an independent status…” At first glance, it may seem like a general commission agent constitutes an agent-type PE under the Treaty. However, the actions of a commission agent are not legally binding on the enterprise it is acting for, and accordingly a commission agent is not considered to be an agent-type PE under the Amended Treaty irrespective of its independence. The position under Japanese domestic tax law would therefore appear to conflict with the position under the Amended Treaty.
In this regard, the procedure for resolving the above conflict is set out in Article 2, Item 12-19 of Japan’s Corporation Tax Act, which states that with regard to the definition of “permanent establishment”:
“… in the case where a treaty for the avoidance of double taxation or prevention from tax evasion concluded by Japan contains any provisions which define the scope of permanent establishments that are different from the following permanent establishments, permanent establishments shall be those specified as a permanent establishment under such treaty (limited to permanent establishments located in Japan) for a foreign corporation to which such treaty applies.”
In other words, where a tax treaty concluded between Japan and another country contains a definition of “permanent establishment” which differs from the definitions under the relevant domestic tax acts of Japan and such other country, the definition under the tax treaty will prevail. Therefore, in the above case, the definition under the Amended Treaty takes precedence, and a commission agent is not included in the scope of an agent PE.
BEPS Multilateral Instrument
The Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI) entered into force on January 1, 2019 for Japan, based on Japan’s deposition of the instrument of acceptance with the OECD in 2018. As the number of MLI signatory countries and areas has been increasing, the MLI now applies to the tax treaties between Japan and 26 other countries and areas as of July 22, 2020. However, the U.S. has not signed the MLI and the MLI is therefore not applicable to the Treaty.
For a long time, the tax treaty between Japan and the U.S. has been regarded as a very important tax treaty from the perspective of Japanese tax treaty policy, which affects the contents of tax treaties with other countries to be signed by Japan. However, as the U.S.’s tax treaty policy is that it does not intend to sign the MLI, which significantly deviates from Japan’s tax treaty policy which is to participate in the MLI, there is a possibility that the importance of the U.S. tax treaty from a Japanese tax treaty policy perspective may decrease in the future as the MLI signatory countries and areas increase.
Akira Tanaka is a Partner and Yoshiko Nakamura is an Associate with Anderson Mōri & Tomotsune.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.