Corporate Reorganization Taxation System in Japan

May 20, 2021

Introduction

With the prolonged effects of COVID-19 causing uncertainties for the future, many companies may feel the necessity to review their management strategies. In this context, an increasing number of companies are considering a “corporate reorganization”. Reorganizing can be done internally and externally to expand or reduce the size of the company organization in order to effectively utilize their management resources and help strengthen business.

There are various methods of corporate reorganization, such as mergers, company splits, share exchange, and share transfers. With these methods, there comes a wide variety of laws. Therefore, when considering a corporate reorganization, it is necessary to consider the scheme comprehensively as one would need to consider various laws.

What is the Corporate Reorganization Taxation System?

Introduced in 2001, the corporate reorganization taxation system is a comprehensive tax system that provides a taxation framework for reorganization procedures.

In general, when an asset is transferred, any gains or losses occurring from the asset transfer is taxed. Therefore, when reorganizing, the assets and liabilities to be transferred are in principle, valued at market value and taxed. However, if all reorganizations including mergers and splits, were taxed based on market value, a large amount of tax will be incurred, and the taxation may hinder appropriate reorganization activities.

To address this, a tax system for corporate organizational restructuring has been established. For organizational restructurings that meet certain requirements (tax qualifications), preferential measures are available to ensure that assets and liabilities are taken over at book value, the taxation relationship is maintained, and no taxation occurs.

This corporate reorganization taxation system’s tax qualifications are based on the concept that if there is no substantial change in economic conditions before and after the reorganization, (i.e., if control over the transferred assets is deemed to continue after the reorganization), the recognition of gain or loss on the transfer of the transferred assets should be deferred.

Differentiating Qualified and Non-qualified Reorganization

Whether a reorganization meets the requirements of the Corporate Reorganization Taxation System will affect what taxation measures it will hinder. In other words, in a tax-qualified reorganization, assets and liabilities can be transferred over at their book value, and no taxation will occur. On the other hand, an organizational restructuring that does not meet the tax-qualification requirements (non-qualified organizational restructuring), assets and liabilities are taken over at market value, which results in gain or loss on transfer and subsequent taxation.

Classification	Valuation on Assets and Liabilities to be Transferred	Will there be taxes levied during the transfer?
Qualified Reorganization	Book value	None
Non-qualified Reorganization	Market value	Yes

Requirements for a Tax Qualified Reorganization

The tax-qualification requirements vary depending on the capital relationship between the companies implementing the reorganization. In other words, there are three different kinds of tax-qualified requirements depending on the capital relationship.

① Full controlling interest (100% internal/intragroup reorganization)
② Controlling interest (more than 50% internal/intragroup reorganization)
③ Joint ventures (reorganization between corporations with an equity stake of 50% or less)

As the capital relationship decreases, the number of requirements increases and the judgment regarding the application of the requirements becomes complicating, making it difficult to qualify as a tax-qualified reorganization. The following table summarizes the requirements for tax eligibility in the above three patterns. Here, we can see that more requirements are required for joint ventures, where the capital relationship would be the weakest. All the requirements listed in the table below must be met in order for the reorganization to be considered a qualified reorganization.

Requirements for Qualification	Full Controlling Interest	Controlling Interest	Joint Venture
Retain full control interest relationship	Required
Retain controlling interest relationship		Required
No monetary payments, etc., are made	Required	Required	Required
Movement of major assets and liabilities	Not required	Required	Required
Approximately 80% of employees in reorganizing business will transfer to the other business	Not required	Required	Required
Retain current business after transfer	Not required	Required	Required
Must be relevant to the business	Not required	Not required	Required
More than 80% of issued shares must remain held	Not required	Not required	Required
Business scale is generally within 5 times that of the business, or a specific officer will be appointed	Not required	Not required	Required

Conclusion

In this column, we looked at the Corporate Reorganization Taxation System, and the requirements companies must meet to benefit from it.

The taxation of reorganization has many detailed and complex rules, and can differ greatly among cases, even with small differences in the reorganization procedure, giving it the power to influence the overall reorganization process. In addition, it is important to keep in mind that this is an area that is subject to frequent tax reform.

One must also consider the impact of other important practical issues, such as the limitation on the transfer and use of tax loss carryforwards and the limitation on the inclusion of losses from the transfer of specified assets in deductible expenses.

Although there are various laws that directly target reorganization, it is important for companies to consider the tax ramifications when considering what reorganization scheme they will use. We hope this column will help you understand the outline of the taxation system for organizational restructuring.

Author

Hiroyuki Kawase