New Foreign Dividend Exemption Systems in Japan: Tax Considerations for Distributions from U.S. Subsidiaries

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1 New Foreign Dividend Exemption Systems in Japan: Tax Considerations for Distributions from U.S. Subsidiaries by Jim Carr, Jason Hoerner and Adrian Martinez KPMG LLP Mountain View, CA INTRODUCTION Japan has enacted legislation that will exempt foreign dividends from income taxation. Under these new regimes, Japanese companies may be able to exclude from their taxable income dividends received from U.S. and other foreign subsidiaries. With these measures, Japan will join a growing list of Organization for Economic Cooperation and Development (OECD) member nations that have some form of exemption system for dividends from foreign subsidiaries. Notably, the U.S. is not currently a part of this list. The U.S. may in fact now be moving in the opposite direction with recent White House proposals apparently aimed at increasing the effective rate of current U.S. taxation on foreign income earned by foreign subsidiaries of U.S.-based multinational corporations. Many non-u.s. corporate enterprises not accustomed to the complexity of the U.S. income tax system may be surprised to learn of the myriad tax issues and filing obligations associated with simply distributing earnings from their U.S. subsidiaries. This article briefly discusses the new Japanese provisions and then attempts to highlight a number of relevant U.S. tax issues associated with distributions by U.S. companies to non-u.s. shareholders. The article also discusses certain relevant aspects of the U.S. income tax treaties with Japan. Japan passed legislation with effect from April 1, 2009, that will exempt from Japanese taxation 95% of certain dividends received from foreign subsidiaries. 2 Taxes covered under the exemption include the National Corporate Income Tax and local corporate income taxes such as the Inhabitant Tax, Enterprise Tax, and Special Local Corporate Tax. To qualify for this exemption, the Japan parent corporation must have held at least 25% of the shares in the foreign subsidiary making the dividend for at least six months as of the date on which the obligation to pay the dividend is fixed. The holding ratio is based on the number of outstanding shares or voting power. The 25% ownership requirement may be reduced if the foreign corporation resides in a country that has a tax treaty with Japan with a reduced holding (ownership) threshold for indirect foreign tax credits. Foreign tax credits will no longer be available under the exemption system, either with respect to indirect income taxes or withholding taxes. The exemption system will be applicable for dividends, including dividends on preferred shares, paid in fiscal years of the recipient (the Japan parent company) beginning on or after April 1, For distributions received from foreign corporations that do not meet the requirements for the dividend exemption, withholding tax on the dividends is eligible for direct foreign tax credits or deductions, while indirect foreign tax credits will no longer be available to relieve double taxation. The Japan dividend exemption rules are accompanied by new rules for specified foreign subsidiaries, or entities that were subject to Japan tax haven (anti-deferral) rules. A specified foreign subsidiary is generally a foreign company that is more than 50% owned by Japan resident individuals or corporations and either: 1) has an effective tax rate of 25% or less; or 2) has its head office in a country that has no income tax system. Under prior law, the undistributed profits of the specified foreign subsidiary were included in the taxable income of its Japan parent company. Under the new rules, the earnings of specified foreign subsidiaries (before deduction of distributions) will be included in the taxable income of its Japan parent company, while the dividends received by the Japan parent company may qualify for the exemption, subject to certain limitations. These new Japan tax exemption for foreign dividends may create an incentive for U.S. subsidiaries with Japan parent companies to declare distributions. Interestingly, the Japan exemption system does not appear to be dependent on or impacted by the treatment under the tax laws of the distributing company's country of residence. However, to the extent they repeal the ability of Japan companies to claim foreign tax credits for withholding taxes on dividends and/or indirect tax credits on distributed U.S. earnings, Japan parent companies are well advised to 2 Article 23-2 of the Corporate Tax Law and Article 22-3 of the Corporate Tax Cabinet Order, 2009 Tax Reform (Japan). Ministry of Finance Draft Provision, available at See also KPMG Tax Corporation, Japan Tax Newsletter (December 2008), available at

2 consider the potential U.S. tax cost of any distribution in advance. Their U.S. subsidiaries are also well advised to assist in identifying the potential U.S. income tax requirements associated with such distributions to their foreign parent companies, including quantifying dividends based on earnings and profits, reporting requirements, withholding taxes, tax treaties, application of the Foreign Investment in Real Property Tax Act, and other areas. 3 GENERAL BASIS OF TAXATION FOR DISTRIBUTIONS Distributions from U.S. corporations to foreign shareholders may generally be taxed on one of two bases. The gross amount of a distribution to a foreign shareholder may be subject to a gross basis U.S. withholding tax at 30%. 4 Exceptions may arise by application of an income tax treaty between the United States and the shareholder's jurisdiction of residence. 5 Exceptions may also apply under U.S. statutes or regulations. 6 As a withholding agent, the distributing corporation has certain duties and reporting obligations with respect to withholding, including the requirement to withhold on the entire amount of the distribution, although in certain cases it can elect to reduce the amount of withholding. 7 The distributing corporation may have joint and several liability with the foreign beneficial owner of the income for the withholding tax as a withholding agent, 8 and may also be subject to penalties for failure to withhold the proper amounts or failures to properly report withholding. 9 Because withholding generally applies to the gross amount of the payment, the withheld tax may often exceed the amount of tax ultimately due. For example, a distribution may consist of a taxable dividend, as well as a generally nontaxable return of capital. Though only the dividend portion is taxable by the United States, withholding may apply to the gross amount of the distribution. The withholding provisions may require the distributing corporation, as withholding agent, to withhold a percentage based on the gross amount of the distribution. Although there are various exceptions which permit the distributing corporation to elect to reduce withholding in specified circumstances, 10 the provisions do not generally require the withholding agent to first determine that portion which will be subject to tax in the hands of the beneficial owner. EARNINGS AND PROFITS (E&P) A U.S. subsidiary should determine its E&P based on U.S. tax principles before distributing cash or other property to its shareholders. Under U.S. tax principles, there is an important distinction between distributions and dividends with respect to corporate shares. A distribution does not give rise to a dividend in every case. Distributions are generally only treated as dividends up to the amount of the distributing corporation's E&P. 11 E&P consists of two parts: accumulated E&P and current year E&P. 12 The distinction between current and accumulated E&P can be significant. A distribution by a U.S. corporation to its shareholders is deemed first paid out of the distributing corporation's positive current year E&P and then from its positive accumulated E&P. 13 Taxpayers must account for accumulated E&P on a year-to-year basis because, to the extent distributions exceed current year 3 An analysis of the state and local tax issues associated with distributions is beyond the scope of this article. 4 See 881(a)(1). 5 See infra note E.g., 881(e) (no tax imposed on interest related dividend from a regulated investment company). 7 Regs (c); Regs Regs (a)(2) and (h). 10 Regs (c)(2) (c)(1); see also 316(a). 12 See 316(a). 13 Regs (a); Rev. Rul

3 E&P, distributions will reduce accumulated E&P in reverse chronological order, beginning with the most recent year (discussed in more detail below). 14 The starting point for calculating E&P is generally current year taxable income. 15 A corporation must then make a variety of adjustments, which may relate to timing or permanent differences. Examples of some adjustments include requirements that depreciation be computed on a straight line basis rather than an accelerated basis (a timing difference), or the add-back of tax exempt income and certain expenses that are nondeductible in computing taxable income (a permanent difference). 16 Still other adjustments must be made for distributions of appreciated property, liabilities, certain distributions of stock and securities, receipt of tax-free distributions, and discharge of indebtedness income (among other things). 17 If a U.S. subsidiary making a distribution has undergone any corporate separation 18 or been a party to a reorganization, 19 a proper allocation of E&P may be required between the acquired or distributing corporation and the acquiring or controlling corporation(s). 20 For example, the positive E&P of an acquired corporation transferred to an acquiring corporation in a reorganization generally increases the acquiring corporation's E&P. 21 Under the "hovering deficit rule," a deficit in E&P of the transferor (acquired) corporation cannot be applied against the accumulated E&P of the transferee (acquiring) corporation, but it may be applied against the transferee's positive, post-acquisition E&P. 22 If the acquiring corporation has an accumulated deficit in E&P, the acquired corporation's positive E&P is not offset by the deficit and does not reduce the acquiring corporation's current year E&P except to the extent accumulated after the date of distribution or transfer. 23 U.S. corporations making distributions may also need to take into account the impact that transfer pricing adjustments under 482 can have on E&P. Such adjustments can reduce or increase U.S. taxable income and E&P is adjusted accordingly. When the IRS makes an allocation of income or deductions among related parties under 482 (a primary adjustment), appropriate secondary adjustments may also be made with respect to other related parties affected by the allocation. A primary adjustment may increase the income of one related party, but the corresponding secondary adjustment may decrease the income of a related party, even if the secondary adjustment does not impact the U.S. income tax liability of the related party. A correlative adjustment may be made by the IRS to account for the primary and secondary adjustments. 24 For example, assume a U.S. corporation has two foreign subsidiaries, F1 and F2. F1 sells property to F2 at a price that is less than arm's-length. The IRS makes a 482 adjustment such that the income of F2 is allocated from F1 to F2. To account for the primary and secondary adjustments, a correlative adjustment could be a deemed dividend from F1 to its U.S. parent company, followed by a deemed capital contribution to F2. 25 The effects of correlative adjustments may be mitigated by certain elective procedures which generally involve the establishment of interest bearing accounts between related parties and a 14 Regs (a). 15 Regs (a). Note that book income (net income) may also be used as a starting point for calculating E&P under Regs (a). 16 See 312(k), (n). 17 See 312 generally. 18 E.g., pursuant to E.g., under 368(a)(1)(C) or (D) (h). 21 Regs (c)(2)-1(a)(2) (c)(2)(A), (B). 23 Regs (c)(2)-1(a)(5), (6). 24 See generally Regs (g)(3)(i). 25 See Central de Chihuahua, S.A. v. Comr., 102 T.C. 515 (1994); Rev. Rul , C.B. 79.

4 corresponding settlement of intercompany accounts. 26 The repayment of the accounts will not be treated as a dividend for any purpose. A complete description of how to determine E&P is beyond the scope of this discussion. To identify all the required adjustments to arrive at a corporation's E&P, a corporation must perform the necessary E&P analysis or seek appropriate tax advice. DIVIDENDS, RETURNS OF CAPITAL, OR CAPITAL GAIN U.S. subsidiaries that distribute property to a Japan parent corporation will most likely need to determine the extent to which all or portions of the distribution will be treated as a dividend, a return of capital, or capital gain with respect to the shares in the distributing company. The distinction is important because a dividend is generally subject to gross basis U.S. withholding tax, which may be reduced by an applicable tax treaty (e.g., under the dividend articles of the U.S. tax treaties with Japan). All or a portion of the distribution may also qualify as a taxfree return of capital (i.e., reduction of tax basis in the shares of the distributing company). Any capital gain from shares in the distributing company can be subject to U.S. tax (e.g., if capital gain is attributable to a U.S. trade or business of the distributee, or the distributing corporation owns a certain amount of U.S. real property). A distribution of money, securities or any other property 27 by a corporation is treated as a dividend if made by a corporation to its shareholders out of its E&P accumulated after February 28, 1913, or out of its E&P for the taxable year computed as of the close of the taxable year. Current year E&P is determined without diminution by reason of any distributions made during the taxable year and without regard to the amount of the year-to-date E&P at the time the distribution was made. 28 A distribution of property is treated as a dividend first, to the extent of the distributor's current year E&P, and then to the extent of accumulated E&P. 29 However, if the distributing corporation has negative current E&P and positive accumulated E&P, the amount of the distribution treated as a dividend depends exclusively on accumulated E&P. The distributing corporation must first subtract a pro rata amount of its negative current E&P from its positive accumulated E&P. The difference between the pro rata amount of negative current year E&P and the positive accumulated E&P represents the available E&P at the time of the distribution. At the end of the year, the distributing corporation's accumulated E&P will be the sum of the amount (if any) of accumulated E&P (as determined after the distribution) and the remaining amount of negative current year E&P. 30 Dividends of E&P are included in the gross income of the shareholder receiving the distribution. 31 As discussed above, with numerous exceptions, withholding generally applies to the gross amount of distributions made to a foreign person. Among the exceptions available is an election by the distributing corporation not to withhold on a distribution to the extent it is not paid from accumulated E&P or current E&P. 32 For this purpose, the accumulated and current E&P must be based on a reasonable estimate prepared by the distributing corporation. 33 To the extent the distribution exceeds both current and accumulated E&P, it is deemed to be a return of the shareholder's investment in the corporation and reduces the shareholder's tax basis in the distributing corporation's shares. The amount representing a return of basis is not treated as recognized gain and may not be subject to U.S. tax. 34 Thus, U.S. subsidiaries making distributions to their Japan parent companies may wish to determine the tax 26 See Rev. Proc , I.R.B Property for this purpose does not include stock in the corporation making the distribution, or rights to acquire such stock. 317(a) (a). 29 Regs (a); Rev. Rul , C.B Id (c)(1). 32 Regs (c)(2)(i)(C). 33 Regs (c)(2)(ii).

5 basis of the parent company in the U.S. subsidiary's shares. Basis in shares is generally defined as the total cost of acquiring the shares, increased by any subsequent capital contributions and decreased by any prior return of capital distributions. 35 If the shares of the distributing corporation were acquired in a tax-free reorganization, the parent company may have received a carryover basis in the distributing corporation's shares (i.e., the holder's basis is determined by reference to the basis in the hands of the former holder). 36 The capital gain of a foreign shareholder from a distribution that exceeds both the distributor's positive E&P and the tax basis of shares in the distributing company could be subject to U.S. tax under some circumstances. The amount of a distribution remaining after a complete return of basis is treated as capital gain, as though from the sale or exchange of the shares. 37 Such gain could be subject to U.S. tax if it qualifies as U.S.-source income that is effectively connected with a U.S. trade or business, although in practice U.S. source treatment may be uncommon except for corporate sellers that are brokers or dealers in securities. 38 The other, more common, scenario in which such gains may be subject to U.S. taxation involves situations in which the distributing U.S. corporation has substantial investments in U.S. real estate. In such situations, the source rules are modified for capital gains of foreign corporations with respect to investments in the shares of U.S. corporations. The withholding requirements in such situations are also substantially modified. 39 These issues are discussed in greater depth below. Distributions of Appreciated Property If a U.S. subsidiary of a foreign parent company distributes property, the distributing company must generally recognize gain in an amount equal to the excess of the fair market value of the property over the distributing corporation's adjusted tax basis in the property as if the distributing corporation had sold the property. 40 If the property distributed is subject to a liability, the fair market value of the property cannot be less than the amount of the liability. 41 The gain recognized by the distributing corporation increases its current E&P and, after the distribution, the distributing corporation would reduce its accumulated E&P by the fair market value of the property distributed. 42 Liquidating Distributions In general, if a domestic subsidiary distributes money or other property to a domestic parent company in complete liquidation, the parent corporation will recognize gain or loss as if it received the property in full payment for its shares. 43 The gain would equal the fair market value of the property it receives from the distributing 34 Glenshaw Glass v. Comr., 348 U.S. 426 (1940) (return of basis is not an accession to wealth, it is not subject to U.S. income tax). See also PLR (return of basis is generally not classified as income within the meaning of 61 because it is not an accession to wealth); PLR (receipt constituting a refund or return of basis is not generally classed as income within the meaning of 61 because it is not an accession to wealth) See 362(b) (c)(3). 38 This is in part because the capital gain must be attributable to an office or other fixed place of business in the United States. 865(a)(2); (e)(2); Regs (b)(1). 864(c)(2). Different tests apply where a foreign corporation is engaged in the conduct of a banking, financing or similar business. Note also that the extraordinary basis adjustment rules of 1059 may also apply in circumstances where the recipient foreign corporation is claiming a dividends received deduction under Regs (c)(4) (b)(1). This rule does not apply to an obligation of such corporation distributed to a shareholder (b)(2), 336(b) (b)(2). If the property is not appreciated, 312(a)(3) may apply and the distributing corporation reduces its E&P by the adjusted basis of the distributed property.

6 corporation less its adjusted basis in the distributing corporation's shares. 44 There are important exceptions for liquidations of 80%-owned subsidiaries. If a domestic parent corporation owns 80% or more of the vote and value of a domestic liquidating corporation, neither the parent corporation nor the liquidating corporation will recognize gain or loss. 45 However, if a foreign parent corporation (e.g., a Japan parent company) receives a liquidating distribution from an 80%-owned U.S. subsidiary that would otherwise qualify for nonrecognition of gain or loss, the liquidating domestic corporation still must recognize gain or loss on the liquidating distribution of property, 46 unless the parent corporation uses the distributed property in the conduct of a U.S. trade or business for 10 years, beginning immediately after the liquidation (among other things). 47 A special exception exists for the general rule of gain or loss recognition with respect to liquidating distributions. If the U.S. company making a liquidating distribution to a foreign parent company is an "applicable holding company," the liquidating distribution will be treated as a distribution (i.e., dividend, nontaxable return of capital or capital gain). 48 A U.S. distributing corporation qualifies as an applicable holding company if it is the common parent of an affiliated group, its stock is directly owned by the foreign recipient of the distribution, substantially all of its assets consist of the stock of the other members of the group and it has not been in existence at all times during the five years preceding the date of the liquidation. 49 If a foreign parent corporation (e.g., a Japan parent company) receives a liquidating distribution from a less than 80%-owned U.S. subsidiary, any gain with respect to the shares could be subject to U.S. tax if it qualifies as U.S.-source income that is effectively connected with a U.S. trade or business. 50 Distributions of Stock If a U.S. subsidiary distributes the stock of another corporation to its foreign parent, the distribution would be subject to dividend/return of capital/capital gain analysis as described above. 51 However, if the U.S. subsidiary distributes additional shares of its own stock to its foreign parent corporation, the distribution will not be subject to taxation in the United States. 52 Instead, the distribution of additional shares is treated as a continuation of the shareholder's interest in the distributing corporation. 53 The shareholder's basis in the distributing corporation's shares 43 Section 336(a), (d) limits the amount of loss recognized (a), 337(a). In addition, the liquidating subsidiary must be solvent; in other words, for the distribution to qualify as a 332 liquidation, the recipient parent must receive at least partial payment for the stock which it owns. See Regs (b) (e)(2) (nonrecognition provisions of 337(a), (b)(1) do not apply to liquidating distributions to foreign corporation that owns 80% or more of distributing corporation). 47 Regs (e)-2(b)(2)(i). To qualify for the exception, the liquidating U.S. corporation must attach a statement to its tax return that complies with the requirements of the regulations. Among other requirements, the statement must provide an agreement by the taxpayer, with respect to property entitled to nonrecognition, that the foreign distributee corporation irrevocably waives any right under any treaty (whether or not currently in force at the time of the liquidation) to sell or exchange any item of such property without U.S. income taxation or at a reduced rate of taxation, or to derive income from the use of any item of such property without U.S. income taxation or at a reduced rate of taxation. The taxpayer must also agree to an extension of the statute of limitations with respect to the liquidating domestic corporation on the distribution of each item of property. See also PLR (foreign corporation did not recognize taxable gain under 367(e)(2) on the complete liquidation of its wholly-owned U.S. subsidiary when it converted to a limited liability company through a liquidation transaction) (d) (d)(2)(A). 50 See 331; 865(a)(2), (e)(2); Regs (b)(1). 51 See generally 301(c), 317(a). 52 See generally 305(a).

7 it held before the distribution was made is divided among the old and new shares in proportion to the fair market value of all of the shares. 54 In addition, the holding period of the shares held before the distribution tacks onto the new shares. 55 An exception to the requirement to withhold may apply to such distributions. 56 Finally, because the stock dividend is not subject to U.S. tax, the distributing corporation will not reduce its current or accumulated E&P by the amount of the distribution. 57 Taxpayers must be aware that not all stock distributions will qualify for this nontaxable treatment. For example, if the recipient of the distribution elected to receive shares of the distributing corporation in lieu of cash, the stock distribution may be treated as a normal distribution of property. 58 In addition, if the distribution (or a series of distributions of which such a distribution is part) results in the receipt of property by some shareholders and an increase in the proportionate interests of other shareholders in the assets or earnings of the corporation, the distribution will also be treated as a normal distribution of property. 59 The latter exception may arise when the distributing corporation has two classes of common stock, one paying cash dividends and the other paying stock dividends. Under such conditions, the stock dividends are taxable because the proportionate interests in the corporation of the shareholders who receive stock increase every time they receive a dividend. 60 Reporting: Form 5452 U.S. distributing corporations that distribute money or property to their foreign parent companies should consider whether they need to file a Form 5452 with their U.S. income tax returns. U.S. corporations that make distributions to their shareholders that do not qualify as dividends must file a Form 5452 with their U.S. corporate income tax returns. 61 A non-dividend distribution includes a distribution made in the ordinary course of business that may be considered fully or partially nontaxable as a dividend because the payor corporation's E&P is less than the amount of the distribution. 62 Non-dividend distributions do not include tax-free stock dividends or distributions exchanged for stock in liquidations or redemptions. 63 For example, if a corporation's E&P is $50,000, it distributes $70,000 to its shareholders, and $50,000 of the $70,000 distribution qualifies as a dividend; the remaining $20,000 reduces the recipient's basis in the distributing corporation's shares and must be reported on Form 5452 as a nondividend distribution. If the distribution caused the recipient to recognize capital gain because it exceeds both E&P and share basis, then the amount of capital gain should be reported on the Form The method and timing of filing a Form 5452 depends on the taxable year of the taxpayer. Calendar year taxpayers must attach the form and supporting information to the income tax return for the taxable year in which the non-dividend distributions were made. 64 A fiscal year taxpayer must attach the Form 5452 to the tax return due for 53 In addition, 317(a) provides that stock of the distributing corporation is not considered "property" for purposes of the Code (a); See also Regs (a) (4); Regs (e). 56 Regs (c)(2)(i)(A) 57 See generally 312(d)(1) (b)(1) (b)(2). 60 Regs (a). There are additional exceptions to the general 305(a) rule provided in 305(b). A detailed analysis of each exception is beyond the scope of this article. Taxpayers that intend to issue stock dividends must consider whether any of the exceptions provided in 305(b) apply before relying on the tax exemption rule in 305(a). 61 Instructions to Form 5452: Corporate Report of Nondividend Distributions (Rev. Dec. 2006). 62 Id. 63 Id. 64 Instructions to Form 5452: Corporate Report of Nondividend Distributions (Rev. Dec. 2006).

8 the first fiscal year ending after the calendar year in which the non-dividend distributions were made. 65 The U.S. distributing corporation must file certain supporting documents with Form 5452 and with its U.S. income tax return. 66 If the distributing corporation's total assets were at least $10 million for the taxable year, the taxpayer must provide a schedule of differences between the Form 5452 E&P calculation and the book-tax adjustments reported on the return. The U.S. distributing company must also provide a year-by-year computation of the corporation's accumulated E&P and a schedule of differences since the incorporation of the company. 67 WITHHOLDING TAXES As discussed above, U.S. corporations making distributions with respect to their stock must be aware of their duties to withhold tax and to report with respect to such distributions and withholding. With certain specified exceptions, withholding generally applies to the gross amount of a distribution by a U.S. corporation to its foreign shareholders. This gross-basis withholding generally applies irrespective of the actual amount of income subject to U.S. tax. As a result, the withholding tax liability may exceed the amount of tax ultimately due with respect to the distribution. Under U.S. law, a dividend from a U.S. corporation will generally be treated as U.S.-source, ordinary income of the recipient shareholder. 68 A 30% U.S. withholding tax may apply to the gross amount of the distribution provided it is not effectively connected with a U.S. trade or business of the foreign corporation receiving the dividend and the tax rate is not reduced by a U.S. tax treaty. 69 Under the regulations, distributing corporations must withhold 30% of the entire amount of the distribution, unless an income tax treaty applies to reduce the withholding or the distributing corporation elects to reduce the amount of withholding in permissible circumstances. 70 To the extent a portion of the distribution constitutes a nontaxable return of capital or capital gain, gross-basis withholding may still apply unless the distributing corporation elects to reduce the amount of withholding. The election to reduce withholding is made by actually reducing the amount of withholding at the time the payment is made. 71 For example, a distributing corporation may elect not to withhold on a distribution to the extent it represents a nontaxable distribution payable in stock or stock rights 72 or to the extent it represents a distribution in part or full payment in exchange for stock. 73 Special withholding provisions apply in the case of distributions from U.S. Real Property Holding Companies (discussed below). 74 Finally, it is worth noting that distributing corporations that fail to withhold the necessary amounts will be liable for the withholding tax 75 and potential penalties for failure to withhold and fulfill the necessary reporting 65 Id. 66 Rev. Proc , C.B. 677, provides additional detail of the contents of the supporting documentation required for Form Id (a)(2) (a). 70 Regs (c)(1). 71 Regs (c)(2). 72 Regs (c)(2)(i)(A). Special rules also apply to intermediaries. Regs (c)(2)(i), (A) (E). 73 Regs (c)(2)(i)(B). 74 Regs (c)(4). 75 See 1461.

9 requirements. 76 Therefore, it is in every distributing corporation's best interests to seek tax advice in order to comply with the U.S. withholding tax system. 80/20 Companies While dividends from U.S. corporations are generally treated as U.S.-source income that may be subject to U.S. gross basis withholding tax at 30%, dividends received by a foreign parent company from certain "80/20" domestic subsidiaries may be exempt from gross basis U.S. withholding tax. 77 A U.S. company qualifies as an 80/20 company if at least 80% of its gross income for a prescribed period is derived from active foreign business income. 78 Active foreign business income means gross income which is derived from sources outside the United States (or attributable to income so derived by a 50% or more subsidiary of such corporation) and attributable to the corporation's (or subsidiary's) active conduct of a trade or business in a foreign country. 79 The income testing period for this determination is the three-year period ending with the close of the taxable year immediately preceding the year of payment of the relevant dividend. 80 If a foreign corporation has no gross income from any source for the three-year period, testing is applied to the taxable year in which the dividend is paid. 81 The nontaxable amount of the dividend is equal to the product of the dividend and the proportion that the corporation's total foreign-source gross income bears to its total gross income from all sources for the relevant three-year period. 82 The remainder of the dividend would be subject to the 30% gross basis withholding tax, which may be reduced by an applicable treaty or by other exceptions available in the regulations. Dividends from Regulated Investment Companies (RICs) Although RICs are generally subject to taxation as corporations, most RICs may deduct dividends paid to shareholders when computing taxable income. 83 Exemptions from withholding tax may apply for certain interestrelated dividends paid by RICs to foreign parent corporations. Interest-related dividends are defined as any dividend that is designated by a RIC, as such, in a written notice mailed to its shareholders no later than 60 days after the close of its taxable year. 84 The amount of interest that can be designated as an interest-related dividend is limited to the RIC's qualified net interest income for the taxable year. 85 Interest-related dividends are exempt from the 30% gross basis withholding tax as long as certain other requirements are met. 86 The withholding agent must receive a 76 Regs (a)(2) and (h) (d); 871(i)(2) (c)(1) (c)(1)(B) (c)(1)(C) (d). 82 Section 861(c)(2)(A) provides a method for calculating the percentage of interest paid by an 80/20 corporation that is subject to taxation, but this method is also applied to dividends from 80/20 corporations by virtue of 871(i)(2)(B). Thus, 881(d) provides exemption by citing 871(i)(2)(B) which, in turn, provides the calculation method by citing 861(c)(2)(A). As of the date of delivery of this article to the publisher, a proposal has been introduced by the Obama administration that would repeal the 80/20 company provisions. See, General Explanations of the Administration s Fiscal Year 2010 Revenue Proposals, Department of the Treasury, May 2009, available at 83 RICs are also permitted to pass through the character of their long-term capital gains to their shareholders by designating any dividends paid as capital gain dividends to the extent of available net capital gains (k)(1). 85 Id.

10 Form W-8BEN that certifies the beneficial owner of the shares is not a U.S. person. 87 Short term capital dividends received by foreign corporations are also exempt from U.S. withholding tax. 88 The RIC must designate a dividend as a short term capital gain dividend by written notice mailed to its shareholders no later than 60 days after the close of its taxable year, and the portion of each distribution that can be so designated is limited to the ratio of qualified short term capital gain to the total amount designated as a short term capital dividend. 89 Forms 1042 and 1042-S Any person, U.S. or foreign, that has control, receipt, or custody of an amount subject to withholding or who can disburse or make payments of an amount subject to withholding must file an information return on Form 1042 and Form 1042-S to report certain amounts paid during the preceding calendar year. 90 Form 1042 is the withholding agent's annual return summarizing all amounts of tax withheld on certain income of foreign persons. Form 1042-S summarizes tax withheld on income by that withholding agent on the income with respect to a specific foreign person. Amounts required to be reported on Form 1042 and Form 1042-S include corporate distributions (such as dividends), items of passive income (such as interest, rents, and royalties), and effectively connected income, to name a few. 91 Forms 1042 and 1042-S generally must be filed with the Internal Revenue Service by March 15 in the year following the calendar year in which the payments are made. 92 The applicability of an income tax treaty does not relieve the withholding agent of the obligation to file a Form 1042-S. 93 For example, if a U.S. corporation pays a dividend to its Japan parent corporation, but the dividends would not be subject to income tax by virtue of the U.S.-Japan tax treaty; nevertheless, the withholding agent should still file Form 1042-S to report the payment of dividends to that Japan parent. Foreign Investment in Real Property Tax Act The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) added provisions to the Code that cause a foreign person's gain or loss from the disposition of a U.S. real property interest (USRPI) to be taken into account as if such person were engaged in the conduct of a trade or business in the United States and as if such gain were effectively connected with the conduct of such business. A U.S. real property interest includes any interest (other than solely as a creditor) in real property located in the United States or in the U.S. Virgin Islands, and any interest (other than solely as a creditor) in a domestic corporation that is or was a U.S. real property holding corporation (USRPHC) during a specified testing period (typically five years preceding the date of the distribution). 94 In general, disposition of a USRPI by a foreign person may result in gain that is treated as effectively 86 For example, the dividend cannot be: 1) paid to a controlled foreign corporation to the extent the dividends are attributable to income received by the RIC on a debt obligation of a person to whom the CFC is considered to be a related person; 2) attributable to income received by the RIC on indebtedness issued by the RIC dividend recipient or an entity in which the recipient of the RIC dividend is a 10% shareholder; or 3) paid to any person within a foreign country with respect to which the IRS has determined that exchange of information is inadequate to prevent evasion of U.S. income tax by U.S. persons. See 881(e)(1)(B) (k)(1)(B)(ii) (e)(2) (k)(2)(C). 90 Regs (b)(1). 91 Regs (c)(2). Exceptions to reporting on Form 1042-S are provided in Regs (c)(2)(ii). 92 Regs (b)(1). 93 Regs (b)(1) provides that a return must be filed even though no tax was required to be withheld during the preceding taxable year (c)(1)(A)(ii). Regs (c).

11 connected with a U.S. trade or business that is subject to U.S. tax at the normal graduated rates applicable to U.S. residents and U.S. corporations. Furthermore, a U.S. or foreign person acquiring a USRPI from a foreign person may be required to withhold U.S. tax on the entire amount realized by the foreign person (including assumption of liabilities). A U.S. subsidiary of a Japan parent company generally will be classified as a USRPHC if the fair market value of the corporation's USRPIs, held directly and indirectly, equal or exceed 50% of the total of the fair market value of its USRPIs, interests in real property located outside the United States or the Virgin Islands, and assets that are used or held for use in trade or business. 95 A domestic corporation generally is presumed to be a USRPHC unless it is established that the corporation was not a USRPHC within the five year testing period. The regulations provide a presumption that the fair market value of a corporation's U.S. real property interests is less than 50% of the fair market value of the aggregate of its assets if the total book value of its U.S. real property interests is 25% or less of the book value of the corporation's assets. 96 Foreign corporations that hold U.S. real property interests and that are entitled under a U.S. tax treaty to nondiscriminatory treatment with respect to those interests may elect an alternative regime for the taxation of USRPI's by electing to be treated as domestic corporations. 97 If the foreign corporation makes this election, it will not be subject to gross basis withholding on any gains from the disposition of USRPIs. However, once the election is made, it can only be revoked with the consent of the Treasury Secretary. 98 An election to be treated as a domestic corporation may be made only if all of the owners of all classes of interests (other than interests solely as a creditor) in the foreign corporation at the time of the election consent to making the election and agree that any gain from the disposition of such interest will be taxable in the United States. 99 In addition, the foreign corporation must also waive all treaty benefits with respect to gains and losses on dispositions of USRPIs and agree to be taxed as a domestic corporation on such gains. 100 This election applies only to tax withholding, reporting, and return requirements under FIRPTA. The foreign corporation will still be treated as a foreign corporation for all other tax matters and transactions. Apart from the election to be treated as a domestic corporation, the normal withholding obligation of the FIRPTA regime can be reduced or eliminated if the IRS issues a withholding certificate to the U.S. subsidiary. 101 Either the transferor or the transferee of the property may apply for a withholding certificate by completing an application and delivering it to the IRS. 102 Once it is received, the IRS generally will attempt to respond to the application within 90 days. 103 A withholding certificate obtained prior to the transfer may notify the transferee that no withholding (or reduced withholding) is required. 104 To apply for a withholding certificate, the applicant must complete Form 8288-B and provide certain information. 105 The application must set forth the law and facts that (c)(2); see also Regs (b)(1). 96 Regs (b)(2)(i) (i); Regs (b) (i)(2) (i)(3). 100 Id. Regs (c). 101 Regs (a). 102 Id. 103 Id. 104 Id. 105 The application must set forth the names, addresses, and identifying numbers of the person submitting the application and the other parties to the transaction. The applicant must also specify whether it is the transferor or transferee in the transaction. The application must provide the following information regarding the property subject to the transaction: the type of property interest, contract price, and the class or type and amount of interest in the USRPHC. The application must identify the

12 support the claimed exemption. 106 This could apply, for example, if the distribution by the U.S. company does not exceed the foreign shareholder's share of E&P and the foreign shareholder's stock basis in that U.S. company. If the certificate is sought on the basis of an agreement for the payment of tax, the application must include a signed copy of the agreement and a copy of the security instrument proposed by the applicant. 107 Finally, if the certificate is sought on the basis that reduced withholding applies (e.g., under a tax treaty), the applicant must include a calculation of the maximum tax that may be imposed on the disposition. 108 The IRS will not consider incomplete applications for withholding certificates. Applicants must ensure that they have all existing taxpayer identification numbers for the parties involved in the transaction and all applications for withholding certificates should be signed by the appropriate officer of a corporation. 109 The payment of the withholding tax will not excuse the foreign parent company from requirements to file a U.S. tax return reporting the gain arising from the disposition of the shares in the USRPHC. For a foreign corporation, a U.S. federal income tax return, Form 1120-F, must generally be filed and any tax due must be paid by the applicable filing deadline. 110 The tax withheld by the U.S. subsidiary making the distribution may be credited against the amount of income tax reported in such return. 111 To claim a refund of over withheld amounts, the foreign parent would have to attach Form 8288-A to its tax return to establish the amount withheld that is available as a credit. If the amount withheld exceeds the foreign parent's maximum tax liability, with respect to the disposition, then the foreign parent may seek an early refund of the excess if it has received a withholding certificate, 112 or a normal refund, upon the filing of a tax return. 113 U.S. persons that are required to deduct and withhold tax on payment to nonresidents are liable for that tax. 114 Therefore, if a U.S. subsidiary of a foreign parent company is required to deduct and withhold tax from a dividend and fails to do so, it may be held liable for the payment of the tax and any applicable penalties and interest. 115 In addition to the payment of interest and penalties, corporate officers or other responsible persons may be subject to a civil penalty equal to the amount that should have been withheld and paid over. 116 If the withholding agent's tax liability is otherwise paid (e.g., with the subsequent filing of a tax return or issuance of a withholding certificate), even if the IRS does not collect the unpaid withholding tax from or impose penalties on the transferee, the transferee may be liable for the payment of any interest for the period between the due date of the withholding and date of payment of the tax or issuance of the withholding certificate. 117 basis for issuing the withholding certificate. Regs (b), Rev. Proc , I.R.B. 211 (requirements for withholding certificate applications). 106 Regs (b)(4)(ii). 107 Regs (b)(4)(iii). 108 Regs (b)(4)(i). 109 Regs (b)(1), Rev. Proc , I.R.B See 6072; see also Regs (a). A foreign corporation that maintains an office or place of business in the United States must either file Form 1120-F by the 15th day of the third month after the end of its taxable year, or request an extension. If a foreign corporation does not have an office or place of business, it must file Form 1120-F by the 15th day of the sixth month after the end of its taxable year, or file a Form 7004 to request a six-month extension of time to file. There are additional filing deadlines for foreign corporations facing special circumstances, such as new corporations filing for short periods, corporations that have dissolved, etc. See Regs (b); Instructions for Form 1120-F. 111 Regs (f)(1). 112 Regs (g). 113 Regs (f)(1), (2). 114 Regs (e)(1). 115 Id. 116 Regs (e)(2)(i).

13 Note that even if the U.S. subsidiary making a distribution in excess of stock basis is not a USRPHC, FIRPTA reporting can still apply to the transaction until the parties establish to the IRS that the U.S. subsidiary is not a USRPHC. 118 Upon request by a foreign interest holder, the U.S. subsidiary must issue a statement certifying to its foreign interest holder that the U.S. subsidiary was not a USRPHC at any time during the previous five years (or the period in which the interest was held by its present holder, if shorter). 119 The statement must be received within 30 days of the relevant transfer. The Japan parent company may not rely upon the U.S. corporation's statement unless the statement is also sent by the U.S. corporation to the IRS within 30 days of being sent to the Japan parent. 120 As noted above, if a U.S. subsidiary of a foreign company is required to deduct and withhold tax from a dividend and fails to do so, it may be held liable for the payment of the tax and any applicable penalties and interest. 121 However, if the U.S. subsidiary fails to submit the necessary statements or notices to the IRS in certain limited circumstances which would have eliminated the initial obligation to withhold, and the U.S. subsidiary has a reasonable cause for such failure, the IRS may grant relief under Rev. Proc Under such circumstances, the U.S. subsidiary must file the statements or notices with the IRS, 123 along with an explanation describing why its failure to file the statements or notices in a timely manner was due to reasonable cause. 124 Once the IRS receives the request for relief, the IRS will respond to the U.S. subsidiary within 120 days. If, after 120 days, the U.S. subsidiary is not notified by the IRS, the U.S. subsidiary is deemed to have established reasonable cause and will not be subject to penalties. TAX TREATY CONSIDERATIONS If a foreign corporation is entitled to the benefits of an income tax treaty with the United States, the provisions of each treaty must be considered to determine if withholding or other U.S. taxes are reduced or eliminated. Below, we discuss some of the relevant provisions of the Japan treaty with the United States. U.S.-Japan Income Tax Treaty Article 10 (Dividends) Under the U.S. income tax treaty with Japan, the U.S. withholding tax on dividends paid by a company that is a U.S. resident and beneficially owned by a resident of Japan is generally limited to 10%. 125 The rate of withholding can be reduced to 5% if the beneficial owner of the income is a company that owns directly or indirectly, on the date on which entitlement to the dividends is determined, at least 10% of the voting stock of the company paying the dividends. 126 Notwithstanding these rates, a dividend may be exempt from tax if the beneficial owner of the dividends is a company that has owned, directly or indirectly, more than 50% of the voting stock of the company paying the dividend for the 12-month period ending on the date dividend entitlement is determined and satisfies certain requirements under Article 22 (Limitation on Benefits). 127 The requirements of Article Regs (e)(3)(i), (ii). 118 See Regs (c)(3)(i). 119 Regs (g)(1)(i), (c)(3)(i), (b)(4)(iii). 120 Regs (c)(3). 121 Regs (e)(1) I.R.B Required under Regs (g)(1)(ii)(A), (h), and (c)(3)(i), (d)(2), and (b)(2), (b)(4). 124 Id U.S.-Japan Income Tax Treaty, Art. 10(2)(b). 126 Id. at Art. 10(2)(a).