On May 9, 2014, the Tokyo District Court reversed a large tax that had been imposed on a large U.S. multinational’s Japanese holding company (“Japan HoldCo”).

Under the Japanese Corporate Tax Law, if a shareholder returns shares to an issuing company (i.e., the issuing company acquires treasury shares), a portion of the consideration paid to the shareholder is deemed to be a dividend. Further, all or a portion of such deemed dividend will not be considered taxable income (in the case at issue, the entire deemed dividend was not considered taxable income of Japan HoldCo) and will be subtracted for the purpose of calculation of a capital gain or loss. Therefore, if the sale price (paid by the issuing company to the shareholder) and the book value of the transferred shares are equal, the shareholder will incur a capital loss equal to the amount of the deemed dividend resulting from the share transfer to the issuing company.

On April 22, 2002, Japan HoldCo acquired all of the outstanding shares of an affiliated company (“Japan Ltd.”). Thereafter, on December 20, 2002, December 22, 2003, and December 28, 2005, Japan HoldCo sold a portion of Japan Ltd.’s shares back to Japan Ltd. itself and incurred a total capital loss of approximately JPY400 billion. In 2008, Japan HoldCo and its subsidiaries (including Japan Ltd.) adopted a consolidated tax return and set off the JPY400 billion loss against the consolidated group’s revenue. As a result, the amount of corporate tax imposed on Japan HoldCo and its affiliates was reduced by approximately JPY120 billion.

In response to the above transactions and tax filing, the tax authorities denied Japan HoldCo’s recognition of the JPY400 billion loss pursuant to Section 132.1 of the Corporate Tax Law and reimposed taxes of approximately JPY120 billion with penalties and interest. Under Section 132.1 of the Corporate Tax Law, if an act or calculation made by a closely held corporation (including a wholly owned company such as Japan HoldCo) unfairly reduces the amount of corporate tax, the tax authorities may disregard one or more of such acts or calculations and recalculate the amount of corporate tax owed.

In the case at issue, the tax authorities argued that a series of transactions was made for the purpose of tax avoidance and thus unfairly reduced the amount of corporate tax. However, the Tokyo District Court, in ruling against the tax authorities, stated, among other things, that (i) it is difficult to say that the series of transactions did not have any reasonable basis, and (ii) there are several facts that are inconsistent with the tax authorities’ argument.

The tax authorities appealed the judgment, and the case is now being reviewed by the Tokyo High Court.

Note: Due to the 2010 tax reform, if these transactions were to happen today, realization of the JPY400 billion loss would be denied.