Tax

May 2002

METI will request the Ministry of Finance and other ministries to ease the tax burden on investment funds that acquire unprofitable divisions spun off by large corporations. The measure entails permitting investment funds to assume the accumulated deficit of a money-losing business acquired from another company. METI aims to put such a rule into effect in fiscal 2003, as part of a plan to encourage corporate acquisitions by investment funds and other entities. The plan is based on recommendations by a subcommittee to the ministry's Industrial Structural Council. The ministry plans to incorporate the plan into a bill to strengthen the Law on Special Measures for Industrial Revitalization, which expires next March 31. It will likely submit the bill to an extraordinary Diet session for autumn. Investment funds would set up a bridge company to be merged with ailing subsidiaries or divisions of large corporations. The new firm would be permitted to take on that subsidiary's or division's deficit. Currently, tax authorities do not permit a profit-making company to assume the deficit of another firm, fearing such a move may be made to evade taxes. (May 27, the Nihon Keizai Shimbun)

A private research group has proposed that tax levies be based on two distinct types of income, one work-based earnings and the other income garnered from financial and real estate holdings. The idea is to develop ways to stem capital flight while mitigating the risk faced by savers in an increasingly globalizing market environment. The group of business leaders and private economists proposes that income from financial instruments and properties be taxed at a flat rate that is low relative to work-related income tax rates, which go up progressively as assessed income increases. The proposal is modeled on systems adopted by a number of Scandinavian countries in the 1990s, and takes account of the fact that the Japanese way of taxing personal income is increasingly out of step with recent developments in sophisticated cross-border investment techniques. In one example of the confusing nature of Japan's tax regime, income from financial instruments is subdivided into interest income, dividends, capital gains and sundry items. All of these subcategories are subject to unique levies such as at-source withholding, category-specific self-assessment, and taxation on consolidated income. A growing number of financial products designed to minimize an individual's tax burden through juggling these formulas has become available. Financial and property assets can also be easily transferred to tax havens overseas. These loopholes make it difficult for the government to collect all the tax it would otherwise be due and contribute to unfairness in the tax system, as those with the most resources are the most likely to escape paying full taxes. Taxing income from financial and property assets at a single flat rate would increase the amount collected and reduce unfairness. Proponents of a flat rate suggest that it would also discourage individuals from moving assets overseas, if it were set sufficiently low. Those in favor of such a system also claim that it would encourage individuals to invest in financial instruments. Individuals might well be more willing to take risks, if allowed to charge losses against other income or carry it forward into subsequent years, the authors of the proposal believe. This view provides vigor to the domestic capital market. Such a change to Japan's tax system could be the beginning of a shift in the basic emphasis of the country's economic policy from savings to investment. (May 24, the Nihon Keizai Shimbun)

Hideyuki Aizawa, who heads the influential Research Commission on the Tax System set up by the Liberal Democratic Party, suggested that a limited set of changes to the tax system may be put in place by the end of this fiscal year as part of an effort to stimulate the economy. Some of the tax reforms planned for next fiscal year should be front-loaded and set for passage at an extraordinary Diet session this autumn. He also hinted at tax cuts worth several hundred billion yen aimed at fostering corporate R&D and spurring development in other key areas. The government would not have to raise the 30 trillion Yen government bond issuance ceiling, were taxes cut by the end of this fiscal year in the areas of intra-family asset transfers for the purpose of buying a home, R&D investment and real estate trading. Some top government officials and LDP lawmakers have expressed support for the idea of lowering levies in these areas to boost the economy. On a change scheduled for implementation in January 2003 that would oblige those with capital gains from stock trading and other sources to file a tax return instead of opting to have gains withheld for tax purposes, Aizawa reiterated his view that this is likely to discourage investment. He is afraid that such a change would drive individual investors away from the stock market. The LDP tax commission chief also stressed his intention of reexamining the securities taxation system for possible changes. In the tax reform scheduled for next fiscal year, expansion of the tax base in the areas of income and corporate taxes along with a review of tax rates and integration of inheritance and gift taxes will form the core. The possible introduction of a system whereby the size of a corporation, as indicated by such things as gross profit margin and staff numbers, is taken into account when setting tax levies has met with opposition from small and midsize firms. An increasing number of local governments have been studying the possibility of imposing levies of this kind with a view to offsetting declining local corporate tax revenue. (May 22, the Nihon Keizai Shimbun)

The interim tax reform scheme approved by the Council on Economic and Fiscal Policy has been seriously undermined by the Ministry of Finance. The blueprint was devised by four private-sector members of the council, including Jiro Ushio, chairman of Ushio Inc., and Hiroshi Okuda, chairman of Toyota Motor Corp. A 3-way battle is likely to heat up among the council, the Finance Ministry and the government's Tax Commission in the period before mid-June, when the council is expected to finalize a basic tax reform program. During the council's deliberations, the draft blueprint was amended at the last moment in two areas. One concerns the financing of tax cuts. The key economic council had maintained that a portion of the funds saved through cutting expenditures should be allocated for that purpose, with some members even calling for a change in tax rates. This part, however, was completely removed from the submitted document. Opposition from the MOF was behind the move, as it thinks changing the tax rates could undermine the government's fiscal health. The other part regards the relaxation of progressive rates for income and residential taxes. On this matter, the council would conduct a comprehensive review of the tax rate structure based on three principles: simplicity, width and lightness. The tax code would be simplified through reforms that widen the tax base as well as lighten the tax burden by lowering rates. The submitted blueprint only says that the council will review the tax structure "in earnest." On the issue of expanding the tax base, there are no major differences among the three government entities. However, they have different views on tax rates. The council seeks a further easing of rates, aiming to revitalize spending by individual consumers and companies. The Ministry of Finance opposes this idea. (May 22, the Nihon Keizai Shimbun)

The set of recommendations put together by a panel of corporate executives and academics proposes that the tax code be used aggressively as a way to help Japan get out of its protracted economic slump and regain global competitiveness. The panel says that if corporations cannot earn profits, then they must lower their compensation to employees, which impedes consumption. Since corporations are the source of economic activity, tax code changes should aim at boosting the competitiveness of corporations. The panel calls for lowering corporate taxes. Japan's effective corporate tax rate, which includes how much taxes businesses actually pay to both the central and local governments, stands at 40.87%, which the Ministry of Finance claims is on a par with rates among major industrialized nations. Although the effective corporate tax rate stands at 40.75% in the U.S., many point out that in the U.S., much more is deducted from income, lowering the tax burden. European and Asian nations are moving to lower effective corporate tax rates. The rate stands at 30% in the U.K., while Germany reduced the effective rate to about 38% from fiscal 2001. The rates stand below 30% in East Asian countries. At a time when corporations can select which countries to invest in, nations have strategically reduced taxation on businesses. Consequently, Japan can no longer claim that its corporate tax rate is the same as other industrialized countries'. Behind the panel's proposals is the view that Japanese companies will lose competitiveness if no effort is made, and that Japan will not be able to draw investment from overseas unless it makes efforts to lower tax rates ahead of other nations. The proposals also call for creating a tax code designed to promote capital investment. In the U.S., companies can make use of accelerated depreciation, a method that allows them to recognize higher amounts of depreciation on machinery and equipment in earlier years. Accelerated depreciation encourages businesses to engage in capital investment since it enables them to deduct larger amounts of expenses from taxable income at earlier stages of investment, making capital spending easier. In Japan, accelerated depreciation is allowed only partially. Because the country is in a period of industrial transformation, investment is riskier, and the panel hopes accelerated depreciation will be adopted more widely for companies to be more willing to take risks. In the ongoing tax reform debate, there are growing calls for the quick introduction of tax incentives for investment. Some suggest allowing firms in the information technology sector to depreciate the full amounts of machinery and equipment in the years when investments are made, as technological progress in the sector cuts equipment life spans. The Council on Economic and Fiscal Policy has already started studying investment tax incentives. The panel's recommendations also call for providing tax breaks for R&D activities. Currently, businesses are not granted tax breaks unless they increase R&D expenses. In the U.S., a certain percentage of R&D expenses is tax-deductible once those expenses are over a certain level. The panel envisions overhauling the existing corporate tax code to better fit structural changes in the Japanese economy. Its proposals include abolishing special tax privileges granted to existing corporations and reviewing the relatively low tax rates applied to public corporations as well as small and midsize businesses. (May 21, the Nihon Keizai Shimbun)

A draft reform plan compiled by members of a key economic council headed by Prime Minister Koizumi highlights the wide gulf on tax reform separating the council from the Ministry of Finance and the government's Tax Commission. Backed by the four private-sector members of the Council on Economic and Fiscal Policy, the plan focuses on strengthening the competitiveness of the Japanese economy by lowering individual income tax rates, creating tax breaks for business investment, and other measures to lighten the tax burden. In contrast, the MOF and the Tax Commission are more concerned about the impact on government finances of a downward trend in tax revenue, a problem that is being called "the hollowing-out of the tax base." Toshiro Muto, administrative vice-Minister of Finance, outlined the MOF's position, stressing that Japan's corporate tax rates and the progressive structure of income tax rates are already equal to the levels of other major industrialized nations. The two sides, in essence, do not even agree on the underlying ideology of tax reform. The government hopes to hammer out a basic tax reform plan by mid-June, in time for the Group of Eight summit to be held in Kananaskis, Canada. But the chances are high that the political battle between the council and the MOF will continue right up to the last moment, political analysts say. The gap between the council and the MOF is particularly wide in regard to how to finance the tax cuts required to lighten the tax burden. The draft plan from the private-sector members of the council calls for using the resources freed up by expenditure cuts at the central and local government level. The basic idea is to take advantage of a fiscal reform dividend, which would eliminate the need to rely on government bond issuance to finance tax cuts. The MOF opposes that any funds freed up by expenditure curbs should be channeled to meet redemptions of maturing government debt. Even Finance Minister Shiokawa, a figure who supports the idea of using tax reform to revitalize the economy, stresses the importance of maintaining revenue neutrality, raising taxes in future years to balance tax cuts now. The council's draft plan calls for the adoption of incentives to support corporate investment in information technology and R&D. If the debate hits an impasse on how to finance tax cuts, it is possible that the actual size of tax cuts and the concrete methods of implementing them will be left out of the tax reform blueprint to be outlined next month. (May 21, the Nihon Keizai Shimbun)

The described below are extracts of tax reform proposals by a panel of private-sector experts. A) Reform Needed To Revitalize Private Sector. Tax reform is essential in Japan's effort to structurally revamp its economy. Although individuals and private companies should take the initiative in revitalizing the economy, business activity in Japan has remained very much under the thumb of the government for a long time. This has prolonged the nation's economic doldrums and caused its competitiveness on international markets to decline. If the Japanese economy is to revive, the tax system must be reformed in a manner that will make maximum use of the resources of individuals and companies. To achieve this, we must aim for smaller government by further deregulating the economy and devising more efficient fiscal spending. First, any attempt to reform the tax system should consider globalization trends. Unless Japan's tax code is adapted to the international norm, domestic manufacturers will continue to shift production to overseas, thereby leading to the hollowing-out of Japan's manufacturing base and a sharp fall in tax revenues. To enhance the competitiveness of Japanese companies, cooperate taxes must be reduced. For this purpose, the tax burden must be shifted from producers to dealers and consumers. Second, policymakers should also deal with the rapid aging of the population.　They should devise tax measures making it easier for seniors and women to work, and should promote labor productivity with a view to making up for the shrinking working population. It is also necessary to achieve equity between senior citizens and younger generations, the latter of whom shoulder far heavier tax burdens. Third, the tax code should be simplified to make it more comprehensible for taxpayers, thereby gaining their trust. Policy initiatives to achieve such an objective include the flattening of the progressive income tax rate, a review of various deductions now applicable to personal income and the simplification of taxes on financial transactions. There should also be an end to legal loopholes that allow some businesses to pay less than their fair share of the consumption tax. Any effort to reform the tax system is inseparable from measures regarding the allocation of tax revenues. In the short term, the government should fight any waste in using taxpayers' money, while offering tax breaks for corporate capital investments and R&D, which will likely generate immediate benefits. While the tax rates should be lowered, the tax base must be expanded. Over the longer run, the government must draw up a program to boost tax revenues and reduce spending, aiming to curb its snowballing deficit. It is desirable that the Council on Economic and Fiscal Policy is responsible for ironing out the basic details of such a program and that the government Tax Commission flesh them out with further specifics, thereby achieving a clear division of labor. B) Creation Of Incentives Priority. To date, the keyword for Japan's tax policymakers has been "Impartiality, neutrality and simplicity." But from now on, emphasis should be placed on the creation of incentives for players in the economy to revive the nation's industry. The focus, therefore, should be shifted from the equitable distribution of income to the creation of a system offering equal opportunities and rewarding hard work. Profit made through financial transactions, for example, should be considered as a reward for taking risk rather than gains resulting from idle pursuits. A taxpayer ID number should also be introduced to help expand the tax base, which is expected to reduce the cost burden for the overall taxpaying population. To energize business activities, the preferential fixed-asset tax treatment now granted to farms and small residential land should be ended. A uniform standard should be applied for the tax, regardless of how a given property is being used. Such a measure should create incentives for putting real estate to more profitable use. The tax code should be simplified to prevent any arbitrary action on the part of tax authorities and make tax payments easier. If the government manages to introduce an online tax payment system at an early date, it will prompt company employees to personally submit their tax returns, which will raise more awareness among taxpayers about tax issues. This, in turn, would put more pressure on the government not to waste taxpayers' money. C) Specific Tax Change Proposals. 1. Income tax reform. The curve of the current progressive income tax rate, which rises sharply once taxpayers enter the middle-income bracket, should be moderated. Meanwhile, Japan's tax base, which is far narrower than those of other major industrialized countries, should be expanded so that a lower tax rate could be applied to a wider sector of the overall population. At present, income tax accounts for a mere 5% of salaries of all income-earners because of deductions for spouses and other dependents. Spousal deductions, however, tend to penalize a spouse for finding a job and deny the economy potential workers. Deductions for dependents other than children, therefore, need to be revamped. Preferential tax treatment for retirement benefits should also end in order to encourage labor mobility. 2. Dual income tax for wages, financial gains. Meanwhile, a uniform tax rate must be levied on interest/dividend income and stock capital gains, as international capital transactions are increasing and such financial activity grows diverse and complex. These financial gains, as well as income from real estate, should be taxed separately from wages. If a uniform, relatively low tax rate is applied to profit made from a whole range of financial instruments, it will help eliminate disparities in taxes on different kinds of financial transactions. A uniform rate will also prevent market participants from trying to avoid taxes through arbitrage trades, as well as curbing flight of capital abroad. Profit arising from financial transactions or real estate should be considered as a reward for taking risks. If taxpayers were allowed to offset profit with losses and carry forward losses to deduct from the following year's gains, investment risks would be reduced, thereby stimulating transactions. The current arrangement that allows taxpayers to partially subtract losses on real estate from earned income should be abolished with a view to preventing tax evasion. 3. Coping with international competition. Reduction of the corporate tax is essential to revitalize business activity. Corporate tax rates in many countries are trending downward amid globalization of corporate activity. Japan's tax rate, including local levies, stands at a little more than 40% and is higher than the average of countries belonging to the Organization for Economic Corporation and Development. The Japanese rate is especially high when compared with rates in the rest of East Asia and constitutes a serious disadvantage in attracting corporate investment to Japan. Local taxes account for some 10% of overall tax levies, demonstrating local governments' heavy dependence on companies for tax revenue. But local authorities' heavy reliance on corporate taxes has become a major cause for a serious tax revenue gap among localities. So any debate on reform of local taxes must be accompanied by a review of corporate taxes. As competition among countries to attract corporate investment heats up, governments must beat other nations in reducing corporate taxes for improving economic competitiveness. On the other hand, existing corporate tax breaks should be abolished in order to expand the tax base. Measures must be devised to encourage companies to take risks despite growing economic uncertainty. Firms should be allowed to take advantage of accelerated depreciation in order to stimulate investment in new facilities. Tax deductions should be applied to a wider range of R&D fields. Companies should also be allowed to carry forward losses over a longer period. A loss carryback, another tax abatement measure, which is currently suspended, should be utilized. While it is vital for companies to prioritize resource allocation, legislation aimed at promoting regrouping of business operations will not benefit firms much if the tax system hampers such activity. Thus the 2% surcharge for companies using consolidated taxation should be abolished at an early stage. Tax breaks for smaller firms and government-affiliated nonprofit organizations should also be ended. The disparity between tax and accounting laws and the Commercial Code must be rectified in order to prevent the tax system from distorting accounting procedures. 4. Tax incentives for entrepreneurs. People should be encouraged more to start new businesses if the economy is to revive. To this end, individual investors in start-up companies, or "angels," should be entitled to bigger tax deductions to make up for the high risk of their investment.　Given the fact that a growing number of foreign investors are conducting their activities through limited liability companies, which exempt them from the corporate tax, Japan should adopt such measures to prepare a level playing field for both domestic and foreign investors. A corporation is just one vehicle for utilizing capital efficiently. As the number of business entities without corporate status increases, it is becoming increasingly difficult to maintain the current tax system, which relies heavily on the ability of corporations to pay taxes. Over the long run, it will be desirable for the corporate tax to be considered more or less the same as the tax on shareholders' income. The corporate tax should be lowered to the level of the rate on capital gains. 5. Inheritance, gift tax reforms. Under the current system, a maximum rate of 70% is levied on inherited assets worth 2 billion Yen or more. But overall revenues from the tax are not particularly high because a wide variety of deductions and other tax abatement measures are available. A reasonable tax levy should be worked out for a larger number of people in order to promote government support of senior citizens. In order to prevent people from avoiding the inheritance tax, the amount of assets parents can give as gifts to their children each year has been strictly limited. If a single tax is levied on the aggregate of gifts made while the parents are alive, that will allow taxpayers to avail themselves of the tax break applying to the inheritance tax before inheritance. Although any such measure could help stimulate investment by encouraging the transfer of assets from older to younger generations, certain exceptions should be made for a trust fund set up with inherited money for a disabled person. 6. Tax deduction for donations. The operation of a public service tends to become inefficient and often fails to meet diverse needs of recipients. In order to improve such services without increasing fiscal spending too much, the government must rely on donations from the private sector. Therefore, more generous tax breaks should be granted to individuals and corporations willing to spend their money for public benefit. (May 20, the Nihon Keizai Shimbun)

To give the economy a sustained boost by encouraging an early transfer of wealth from the elderly to younger generations, the government's Tax Commission agreed to unify gift and inheritance taxes. The basic proposal calls for taxing inheritances and gifts received over a set period of time prior to the death of the donor as a cumulative total, while lowering the unified rate of taxation. Japan's current tax system imposes a relatively high tax rate on gifts to prevent pre-death transfers of wealth aimed at circumventing inheritance taxes. The progressive rates for both gift and inheritance taxation go as high as 70%. While unifying gift and inheritance taxation would expand the taxable base for inheritances, it would also allow gift recipients to take advantage of the much larger exclusion that applies to inheritance taxation. Gift taxation carries a basic exemption of only 1.1 million Yen, compared with a basic exemption of 50 million Yen, plus 10 million Yen for each legally designated heir for inheritances. In principle, a unified structure would ensure that there is no difference in the tax consequences of gifts and inheritances. The ultimate aim is to facilitate the transfer of some of the huge stores of financial wealth built up by the elderly in Japan to younger generations for consumption or investment to benefit the broader economy. Tax Commission Chairman Hiromitsu Ishi suggested that the period of cumulative taxation could bundle inheritances with gifts going back around 10 prior years, essentially the length of time that the tax authorities are able to store records. Ishi also indicated, however, that unifying gift and inheritance taxation may require the introduction of taxpayer identification numbers for administration purposes. The mention of the politically sensitive topic of identification numbers potentially opens the door to debate over privacy protection and other issues. The consensus of analysts is that winning final approval for unified gift and inheritance taxation will be a lengthy political process. In the meantime, calls would intensify for raising the gift tax exclusion and other measures designed to lighten the gift tax burden. (May 15, the Nihon Keizai Shimbun)

Calls are already growing within business circles and the ruling Liberal Democratic Party to eliminate surcharges imposed on companies that take advantage of a group taxation system to be introduced in fiscal 2002. After Cabinet approval, the government plans to submit to the Diet bills aimed at introducing the consolidated corporate tax system. Designed to facilitate corporate reorganization and encourage new investments, the system is already proving to be unpopular, since companies that resort to group taxation will be slapped with 2% surtaxes for the first two years. The consolidated tax system will allow a corporation to offset profits at one group firm by losses at another, helping the parent company to reduce taxable income. By introducing the system, the government hopes to encourage businesses to embark on bold reorganization and make new investments. However, the number of companies embracing the consolidated tax would be small due to the 2% surtax that the government decided to levy to secure tax revenue. Nippon Light Metal Co. plans to adopt consolidated taxation from the current fiscal year through March 2003, hoping to reduce groupwide tax payments. NTT DoCoMo Inc. will make eight regional units wholly owned subsidiaries on Oct. 1 to introduce group taxation. Nippon Telegraph and Telephone Corp. and Hitachi Ltd., which have loss-generating group firms, also announced plans to adopt group taxation from the current fiscal year. NEC Corp. and Fujitsu Ltd. are considering a similar move. Both companies reported the largest losses since their founding for fiscal 2001. Although consolidated taxation is considered a boon for companies suffering from poor earnings, companies may not necessarily see their tax burdens decrease due to the 2% surtax. Mitsubishi Heavy Industries Ltd. Said that consolidated taxation would increase the company's tax burden, while a Fuji Photo Film Co. argues that the firm can see no merit in the system as long as the surtax is in place. In addition, Mitsubishi Electric Corp. and Ito-Yokado Co. decided not to adopt group taxation. Toyota Motor Corp., Honda Motor Co., Sony Corp. and Matsushita Electric Industrial Co. remain cautious about the introduction. Unless the proportion of groupwide losses to groupwide profits stands at 6.25% or higher, companies would shoulder the heavier tax burden under consolidated taxation than under current, non-consolidated taxation because of the surcharge. On April 11, Finance Minister Shiokawa met with Takashi Imai, chairman of the Japan Federation of Economic Organizations (Keidanren), who is adamantly opposed to the surtax. Despite the disagreements, Shiokawa managed to obtain a promise of Imai's cooperation in getting the Diet to approve the bills. Conceding that the surtax is discouraging companies from adopting group taxation, Shiokawa expressed a willingness to review the surtax in the near future. (May 9, the Nihon Keizai Shimbun)

Tax reform needs to support innovative firms. Behind the economy's prolonged stagnation is a structural problem, as industry cannot flexibly adapt to the fluid business environment. Private businesses should play the leading role in changing this scenario. The government needs to eliminate factors that hamper corporate initiative and support companies, such as venture businesses, facing new challenges head on. The major tools to accomplish these goals are tax system reform and policies to promote competition and deregulation. Debate on tax reform should focus on what measures could boost the vitality of private firms and also make Japan a more attractive arena for business operations. From this standpoint, Japan's corporate taxation system has many problems, which need to be addressed. A consolidated corporate tax system, which goes into effect this fiscal year, aims to help businesses flexibly restructure. Many experts welcome the plan as a way to invigorate the private sector. However, the government has seriously weakened the move by deciding to impose a 2% surcharge on corporate income for companies that adopt group taxation for offsetting a likely decline in tax revenues. The extra levy has forced many companies to give up plans to use the system. The government should withdraw the additional levy to prove its determination to the public for pressing forward with tax reform to support corporate efforts to be more competitive. The government also should introduce more tax incentives to encourage businesses to innovate, a key factor in promoting long-term economic growth. Some tax breaks already exist to promote investment in R&D, but few companies have taken advantage of them in recent years, since they are not qualified for such breaks to slash investment due to sagging earnings. The tax authorities should consider a U.S.-style system that makes businesses eligible for tax incentives for R&D investment if the ratio of R&D spending to sales is high. Tax breaks to support venture capitalists in investing in start-ups should also be expanded. The Ministry of Finance asserts that corporate tax rates in Japan are on a par with international levels, as they have been lowered to take into account developments in other countries. In fact, many countries still continue to cut tax rates on corporate revenue. But compare the 40%, including local tax, imposed on Japanese firms, with Hong Kong's 16% and Singapore's 24.5%. There is still room left for further cuts in corporate tax rates. (May 2, the Nihon Keizai Shimbun)