Financial Sector

October 2004

The Ministry of Finance is considering a tax exemption for shareholders in Japanese firms that have been acquired by foreign companies that use stock swaps to finance their deals, The Nihon Keizai Shimbun learned Monday. With revisions to the Commercial Code set to enable overseas companies to engage in certain stock swap mergers and acquisitions, the review of the taxation system is designed to further promote investment in Japan. The use of company stock to finance M&As between Japanese firms was recognized in a revision to the Code five years ago. In fiscal 2006, the government is expected to begin allowing overseas firms to use their stocks to finance so-called triangle mergers, in which a Japanese target is merged with a local subsidiary of the overseas firm. Under current law, the shareholders of the Japanese target can be compensated only with stock in the acquirer's local subsidiary. The new revisions will allow the foreign company's own stock to be used as compensation. The Legislative Council, an advisory body to the Justice Minister, is also likely to recognize other forms of compensation, including bonds. But since the Japanese tax code was not drafted with international stock swaps in mind, target shareholders involved in such transactions would be deemed for tax purposes to have sold their stake in the domestic target and then acquired stock in the foreign acquirer, thereby creating a tax burden for shareholders. Consequently, even if the Commercial Code is revised to enable foreign companies to make acquisitions, a senior official at a foreign securities firm says that actual acquisitions will be difficult as long as the tax laws do not change. "In concert with the revised Commercial Code, we plan to include measures in the revised fiscal 2006 tax code to be set at the end of next year," says a senior MOF official. Under the measures being considered, target shareholders would not be taxed for receiving stock in the foreign acquirer, but would be assessed a tax when the foreign stock is converted to cash. Whether bonds and other forms of compensation will receive similar treatment will become a focus of discussion. The MOF expects private-sector savings to decline in light of Japan's falling birthrate and aging population. In preparation for the time when domestic savings will no longer be able to meet capital demands, a framework facilitating capital inflows from overseas is needed. Prime Minister Junichiro Koizumi has called for a doubling of foreign investment in Japan over five years. (The Nihon Keizai Shimbun October 19, 2004)

The revision to tax laws to be adopted in tandem with the revised Commercial Code is likely to include a review of deemed dividend taxation, but the details of the proposal remain unclear. Deemed dividends refer to dividends that are not covered by the Commercial Code, but are taxed. In the case of a stock-swap merger or acquisition, the tax code recognizes the equity portion -- including the capital base and profit reserves -- in the target entity as having been returned to the shareholders at the time of the transaction. A deemed dividend tax is assessed against such equity as the surplus reserves, since it would otherwise be used to pay out dividends. Under current tax law, the shareholders of a Japanese target firm compensated with the stock of a foreign acquirer would likely face a deemed dividend tax. Stock-swap M&As that ensure the employment of workers currently receive a special exemption from the deemed dividend tax. Whether M&As involving foreign companies will be granted similar tax breaks is likely to become a topic of discussion. (The Nihon Keizai Shimbun; October 19, 2004)