(C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. SM , 8 September 2003, p. 891 Tax Notes Int’l Tax by Yo Ota and Takashi Tezuka

Reprinted from

Tax Treatment for Spin-Offs Under ax notes Japan’s Revised Revitalization Law

international t Iran: Mohammad Tavakkol, Maliyat Journal, College of Economic Affairs, Tehran content. party third or domain public any in copyright claim not does Analysts Tax reserved. rights All 2003. Analysts Tax (C) Ireland: Kevin McLoughlin, Ernst & Young, San Jose TAX NOTES INTERNATIONAL Isle of Man: Richard Vanderplank, Cains Advocates & Notaries, Douglas Copyright 2003, Tax Analysts Israel: Joel Lubell, Teva Pharmaceutical Industries, Ltd., Petach Tikva; Doron Herman, S. Friedman & Co. ISSN 1048-3306 Advocates & Notaries, Tel-Aviv Italy: Alessandro Adelchi Rossi and Luigi Perin, George R. Funaro & Co., P.C., New York; Gianluca Queiroli, Cambridge, Massachusetts Executive Editor: Cathy Phillips Japan: Gary Thomas, White & Case, Tokyo; Shimon Takagi, White & Case, Tokyo Jersey: J. Paul Frith, Ernst & Young, St. Helier Managing Editor: Maryam Enayat Kazakhstan: Robert M. Ames and Erlan B. 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Tax Treatments for Spin-Offs Under Japan’s Revised Revitalization Law

by Yo Ota and Takashi Tezuka

correspondingly amended to make this spin-off structure tax-advantageous, leaving it unclear Yo Ota and Takashi Tezuka are with Nishimura whether this spin-off will be used as expected. & Partners in Tokyo. I. Spin-Offs In the United States, there are three ways to ac- ffective 9 April 2003, the Law on Special Mea- complish a corporate division in which a single Esures for Industrial Revitalization1 was corporation divides into two or more entities: amended to make the distribution of dividends spin-off, split-off, and split-up. more flexible. This amendment made it clear that a corporation may distribute to its shareholders not only cash dividends, but also shares of its sub- sidiaries, removing the legal barriers to “spin-off” Spin-off transactions (a form of corporate divestiture re- sulting in a subsidiary of a company becoming its sibling company)2 in Japan. However, as was the case with new merger and acquisitions measures adopted under the revised Industrial Revitaliza- P Shareholders tion Law (the Revised IRL),3 the tax law was not

Sstock

1Adopted in 1999, the Industrial Revitalization Law was drafted by the Ministry of Economy, Trade, and Industry for the purpose of enhancing productivity and growth and revitalizing PCo industry in Japan. Among other things, it provides for the relax- ation of certain restrictions against mergers and acquisitions found in the Commercial Code of Japan. 2Black’s Law Dictionary 1409 (7th ed. 1999). 3For a discussion of tax consequences of the new M&A mea- sures adopted under the Industrial Revitalization Law, see Ota SCo and Tanigawa, “Japan’s New M&A Measures Open Door for Tax Benefits,” Tax Notes Int’l, 2 June 2003, p. 887, 2003 WTD 105-8, or Doc 2003-13359 (7 original pages).

Tax Notes International 8 September 2003 • 891 Practitioners’ Corner

In a spin-off, the distributing corporation dis- In this article, we will highlight only the

tributes stock of a controlled corporation (a sub- spin-off method, which will be presumed to be the (C) Tax Analysts 2003. All rights reserved. does not claim copyright in any public domain or third party content. sidiary) to its shareholders. This subsidiary may reorganization method most frequently used in either be a newly created or existing corporation. the United States. The shareholders generally receive a pro rata The U.S. type spin-off is similar to share splits share of the controlled corporation’s stock, and do in Japan insofar as shareholders receive stock not transfer anything in return for this stock. without surrendering anything in return. How- In a split-off, the distributing corporation dis- ever, in share splits, the Commercial Code of tributes stock of a controlled corporation to its Japan (the Commercial Code) has generally been shareholders, and the shareholders receive stock construed to prohibit a corporation from issuing in the controlled corporation in return for some of anything besides its own stock to its shareholders. their stock in the distributing corporation. Therefore, to achieve the same corporate struc- ture accomplished by the U.S. type spin-off, Japa- nese share splits are not helpful. Split-off If a Japanese corporation is allowed to distrib- ute the shares in its controlled corporation to its shareholders as a dividend, the U.S. type spin-off may be achieved through such type of dividend, be- P Shareholders cause shareholders need not surrender anything in return for receiving any “dividend” by definition. Pstock The Commercial Code, however, does not explicitly state the form in which dividends could be paid to in return Sstock shareholders. Therefore, whether the spin-off for S stock transaction was possible or not is solely a matter of interpretation, and no prevailing opinion has PCo emerged as to whether a more liberal interpreta- tion should be adopted. This has been the main cause for uncertainty regarding the availability of the spin-off under the Commercial Code.4 As a result of this Japanese system, it was widely SCo understood that the U.S. type spin-offs could not be directly accomplished in Japan. Rather, in order to achieve in Japan the same corporate structure fol- lowing the U.S. type spin-off, it was necessary to dis- In a split-up, the corporation transfers all of its tribute the subsidiary’s stock in consideration of the assets to two or more new corporations (controlled cancellation of part of the parent’s stock and concur- corporations) in return for stock. Then the stock is rently to carry out a capital reduction. That is to say, distributed to the shareholders of the parent in practice, the U.S. type spin-off was unable to be corporation in return for all of the parent stock. implemented in Japan, and only the U.S. type split-off may be implemented through capital re- duction with the payment of the subsidiary’s stock Split-up to the shareholders. One notable actual case in which this method was used in Japan involved the Japanese com- pany Chugai Pharmaceutical Co., Ltd. (Chugai). P Shareholders In September 2002 Chugai split off its wholly owned subsidiary, the U.S. company Gen-Probe

Pstock S1+S2 stock

PCo 4As a practical matter, even before the Industrial Revitaliza- tion Law was amended, some of scholars and practitioners had argued that the U.S. type spin-off was legally possible through the method of the distribution of shares in subsidiary as divi- dends. However, Japan’s Ministry of Justice, which controls the commercial registry, has traditionally maintained the position S1 Co S2 Co that the distribution of dividends in kind (including the distribu- tion of shares in a subsidiary as dividends) is prohibited and only cash dividends are allowed under the Commercial Code.

892 • 8 September 2003 Tax Notes International Practitioners’ Corner

Incorporated (Gen-Probe), by reducing capital the articles of incorporation of the subsidiary re-

and capital reserve and allotting shares of quire the approval of the board of directors for the (C) Tax Analysts 2003. All rights reserved. does not claim copyright in any public domain or third party content. Gen-Probe common stock to each Chugai share- transfer of shares and the shares of that subsidiary holder.5 However, this U.S. type split-off required may not be distributed in connection with the the execution of burdensome procedures under spin-off. Still another requirement for the use of the Commercial Code, such as creditor protection this newly admitted spin-off scheme provides that procedures.6 The Industrial Revitalization Law the distributing company must be audited by an in- was amended to simplify those procedures. dependent outside auditor. Note that the value of The Revised IRL now provides that a corpora- the subsidiary’s shares to be distributed may not tion, upon the resolution of its board of directors,7 exceed surplus available for dividends, as the new can distribute dividends to its shareholders not amendment does not create an exception to the div- only in the form of cash, but also in the form of idend restrictions under the Commercial Code. If shares of a subsidiary of which the distributing all of the foregoing requirements can be met, the corporation holds two-thirds or more of the voting U.S. type spin-off now becomes clearly lawful for a power. The shares of the subsidiary can be distrib- Japanese corporation. uted as dividends anytime and as many times as needed during the fiscal year of the distributing II. Tax Consequences company as long as that distribution complies with Although explicitly permitted under the Re- the guidelines set forth in plans authorized and ap- vised IRL, the U.S. type spin-off in Japan will nev- proved by all ministers of relevant governmental ertheless cause significant tax implications under authorities.8,9 The amendments also provide that Japanese tax laws, as explained in detail below. To better illustrate the negative tax treatment afforded the newly admitted spin-offs under the Japanese tax law, it would be useful to first out- 5In this case, technically speaking, each Chugai shareholder surrendered nothing in return for receiving the shares in line the tax treatment under the U.S. Internal Gen-Probe, because Chugai was not, under the Commercial Code, Revenue Code (IRC) for purposes of comparison. required to cancel any Chugai stock of shareholders as a result of First, in the United States, if the distribution of a its reduction of capital and capital reserve. However, it can be considered from the theoretical viewpoint that each Chugai subsidiary’s shares meets the requirements under shareholder lost the theoretical equity value in his/her stock (as a IRC section 355,10 the shareholders receiving the result of the reduction of capital and capital reserve in Chugai) in subsidiary’s shares will report no gain or loss under return for receiving the shares in Gen-Probe. Therefore, the section 355(a), contrary to the treatment afforded Chugai case resembles the U.S. type split-off rather than the U.S. type spin-off. ordinary cash dividends that are taxable to share- 6Another way to achieve the same corporate structure follow- holders under IRC section 301. Further, a company ing the U.S. type spin-off is to use the corporate demerger steps distributing shares of a controlled subsidiary in a under the Commercial Code. However, this method also requires transaction meeting the requirements of IRC sec- that burdensome procedures such as creditor protection be used. tion 355 generally will recognize no gain or loss for 7In order for a Japanese corporation to pay cash dividends to tax purposes upon the distribution, contrary to the its shareholders, the approval of a majority of voting shares at the treatment afforded an ordinary distribution of as- ordinary shareholders’ meeting is required. Note that, although this newly admitted spin-off scheme under the Revised IRL is modeled after the legal system for the payment of dividends un- der the Commercial Code, it liberalizes the above procedural re- quirement for ordinary cash dividends. 8 The Industrial Revitalization Law, as amended, applies only 10The statutory requirements under IRC section 355 can be to certain revitalization plans that must be authorized and ap- summarized as follows: (i) the distributing company must distrib- proved by all ministers of relevant governmental authorities. ute solely shares or securities of a company that it controls imme- There are three kinds of Authorized Plans: a self-restructuring diately before the distribution (“control” here means the plan, a co-restructuring plan, and a business transfer and restart ownership of shares possessing at least 80 percent of the total plan. The distributing company must first obtain one of the three combined voting power of all classes of shares entitled to vote and Authorized Plans before executing a statutory spin-off. For prac- at least 80 percent of the total number of shares of all other tical matters such as how to obtain this authorization and ap- classes of shares of the corporation. See IRC section 368(c)) (con- proval, see Ota and Tanigawa, supra note 3. For those interested trol requirement); (ii) the distributing company must distribute in the Industrial Revitalization Law, see Ministry of Economy, all of the shares and securities in the controlled company held be- Trade, and Industry, Outline of the Revised Industrial Revital- fore the distribution (distribution requirement); (iii) both the dis- ization Law (the Law on Special Measures for Industrial Revital- tributing and controlled company must be engaged immediately ization) (28 April 2003; accessed 15 August 2003) http://www. after the distribution in the active conduct of trade or business meti.go.jp/english/policy/index_other.html. (active trade or business requirement); (iv) the distribution was 9Note that if the distributing company ends up holding less not used principally as a device to distribute earnings and profits than two-thirds of the subsidiary’s voting power by distribution, of the distributing company, the controlled company, or both (de- such distribution is no longer available, as the distributing com- vice requirement). There are other nonstatutory, judicial require- pany must hold two-thirds or more of the subsidiary’s voting ments, such as business purpose test, continuity of business power at the time immediately before the distribution. enterprise, and continuity of interest.

Tax Notes International 8 September 2003 • 893 Practitioners’ Corner sets that would ordinarily be taxable to the distrib- However, the Revised IRL provides for rather

uting company under IRC section 311. In short, in modest “first aid measures” to ease the negative (C) Tax Analysts 2003. All rights reserved. does not claim copyright in any public domain or third party content. the United States, a spin-off is tax-free so long as tax consequences of the Japanese spin-off. The Re- the spin-off meets the IRC’s statutory requirements vised IRL provides that the distributing company as well as certain judicial requirements. may pay out cash to its shareholders, together Unlike the tax preferential treatment under with the shares in its subsidiary, in an amount the IRC, current Japanese tax laws do not make equal to the tax to be paid by those shareholders. spin-offs tax beneficial. First, the distributing In addition, as the distribution of the subsidiary’s company will be subject to capital gains tax in con- shares are classified as “dividends” under both nection with any unrealized capital gains on the the Revised IRL and the Japanese tax laws, the transferred subsidiary’s shares.11 In other words, shareholders receiving shares are entitled to an for tax purposes, no nonrecognition treatment ex- income tax credit for the dividend14 when they file ists regarding a company’s distribution of the their tax returns. shares in its subsidiary,even if that distribution is permitted under the Revised IRL. As for the III. Conclusion shareholders receiving the subsidiary’s shares The rationale for tax-free nonrecognition treat- from the distributing company, they will also be ment for the U.S. type spin-offs under the U.S. IRC subject to income tax at the standard uniform is that spin-offs can be viewed as a mere change in rate12 through withholding tax to be withheld by form of the company.15 This rationale is equally ap- the distributing company. plicable to the newly admitted spin-offs under the In short, despite the promulgation of the Re- Revised IRL in Japan, if the spin-off is properly vised IRL, Japan has not introduced any counter- used. Therefore, it is widely expected that Japan’s part to U.S. IRC section 355 or other similar Ministry of Finance and Ministry of Economy, arrangement. Consequently, the tax burden con- Trade, and Industry will cooperate to assure tinues to be a significant impediment to the imple- spin-offs afford appropriate tax advantages. Other- mentation of the U.S. type spin-off transactions in wise, this newly permitted spin-off under the Re- Japan.13 vised IRL would not be employed as expected. Without a corresponding change in the tax law, it would be practically impossible in Japan to imple- ment daring spin-offs such as AT&T’s spin-off of Lu- 11The current tax rate consists of 30 percent of national corpo- cent Technologies Inc. in 1996, and it may have an rate income tax and a progressive tax rate starting from 5.6 per- adverse effect on the progress of structural reforms cent of local enterprise tax. The effective tax rate amounts to in Japan.16 ✦ approximately 40 percent. 12For corporate shareholders, the current effective tax rate is approximately 40 percent, including local tax. Note that for cor- porate shareholders, all or part of dividends received will be ex- cluded from their taxable income. (This special treatment for corporate shareholders is a counterpart of the corporate share- holder dividends-received deduction under IRC section 243.) For individual shareholders, generally speaking, the tax rate is 20 percent for unlisted shares. No local tax is levied on unlisted

shares. As to listed shares, until 31 March 2008, the tax rate is 10 14 percent including local tax as a special measure, excluding any The amount of income tax credit differs according to the to- shareholder who owns listed shares amounting to 5 percent or tal taxable income of the taxpayer (the shareholder) receiving the more of the total value or the total number of all the outstanding dividend. shares of a single company and receives dividends from that com- 15Cheryl D. Block, Corporate Taxation 417 (2nd ed. 2001). It pany. (Strictly speaking, until 31 December 2003, the aforemen- is, of course, important to distinguish a genuine “mere change in tioned 10 percent tax rate consists of the national income tax form” spin-off from other corporate distributions, which generally only. On or after 1 January 2004, the national income tax rate are taxable events. In other words, spin-offs for improper pur- will be reduced to 7 percent and local tax (prefectural inhabitant poses such as the bailout of corporate earnings and profits using tax) will begin to be levied at the rate of 3 percent, thereby mak- the spin-off transaction should not be allowed. This concern pre- ing the rate 10 percent in total). On or after 1 April 2008, the tax sumably led to the addition of a “device requirement” in the IRC rate will be 20 percent, including local tax. by the U.S. Congress. 13In the case of split-offs, the situation is similar — that is, no 16In the spring of 2005, the revised Commercial Code is sup- tax preferential treatment is afforded approximately split-offs. In posed to be proposed to the Japanese Diet. It is now envisioned the Chugai case, Chugai was taxed at the capital gains rate for that the revision may probably include the allowance of distribu- the distribution of Gen-Probe shares (the tax amount was said to tion of dividends in kind (as a result, the distribution of shares in have been approximately ¥22.5 billion). The shareholders of a subsidiary as dividends will become possible even under the Chugai presumably were taxed through withholding. However, Commercial Code, thereby making the U.S. type spin-offs under Chugai itself paid out cash to its shareholders in an amount equal the Commercial Code possible). However, without appropriate to the tax to be paid by those shareholders. This amounts to up to tax benefits for such revision, the situation surrounding spin-offs approximately ¥12.5 billion. Therefore, Chugai bore ¥35 billion in would not change and the U.S. type spin-offs would not be actu- total of tax burden. ally implemented in Japan.

894 • 8 September 2003 Tax Notes International