Issues in international taxation

(Abstract)

    The role of international taxation changes corresponding to the fluctuation of domestic and global economic structures. While the change is not as simple as that old roles are replaced by new roles, it has become the manner in which it is diversified and complicated including old elements. In this article, I'd like to take a general view of the changes, including measures taken by the government of Japan, and the future prospects.
      

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New corporate law and tax avoidance ? Triangular mergers and other issues ?

(Abstract)

    In the U.S., the effective corporate tax rate has decreased by almost 10% in the last decade. This was caused by the U.S.-specific situation, the separation of corporate book accounting and tax accounting, as well as the spread of tax avoidance activities of U.S. companies utilizing offshore transactions.
    Tax avoidance not only reduces tax revenue that is necessary for the provision of public services but also gives rise to tax compliance issues and therefore significantly increases tax compliance costs. Due to the difference in legal systems or business cultures, company-wide tax avoidance activities have not spread in Japan, not like in the U.S. However, companies' global competition put the downward pressure on the effective corporate tax rate, which confronted multinational companies with the increased need for tax planning. Under such circumstances, recent trends in legal systems, particularly enforcement of the new Corporate Law, should be closely considered.
    This article considered suggestions for Japan in terms of tax avoidance issues, focusing on "triangular mergers and tax systems", a remaining issue in the new Corporate Law.
    The past development of the corporate reorganization tax system includes: introduction of equity-swap system and equity-transfer system and the development of relevant tax system in 1999 and the development of legal systems and tax systems regarding the corporate reorganization including qualified split, merger, investment in kind and subsequent incorporation in 2001. The relaxation of restrictions on merger consideration, effective from May 2007, will enable "triangular mergers", in which a subsidiary merges with another company by using shares of its parent company as a merger consideration. Relevant tax treatment will be discussed in FY2007 tax reform. A triangular merger can be broken down into an equity swap and a merger, so tax deferral can be granted without any big trouble under the conventional qualification requirements, unless it aims at certain purposes such as tax avoidance. A cross-border triangular merger must be otherwise responded, since it gives rise to issues in taxation right and taxation practices of relevant countries, as well as the risk of international tax avoidance activities such as corporate inversion transactions.
    Major view of Japanese academic society is that tax avoidance cannot be rejected unless there is a written specific provision in tax law. However, some doctrines or precedents insist that tax avoidance can be rejected even without any clear rejection provision under tax law, by relying on provisions under private laws (the concept to distinguish the usual tax avoidance rejection and the rejection based on private laws, regarding the former as "a narrow interpretation" and the latter as "a broad interpretation", by determining facts regarding taxation requirements, not based on appearances or forms but on true legal relations). Taxation practices tend to adopt this concept, too. However, there are issues in terms of predictability or legal stability, since it is not fully clarified which case would be subject to a narrow interpretation and which case to a broad interpretation.
    Thus, for the improvement of predictability or legal stability, legal amendment is necessary in order to regulate detailed countermeasures for each tax avoidance activity, at the same time introducing comprehensive rejection provisions against tax avoidance, by reviewing applicability of anti-avoidance doctrines in Japan which have been developed mainly in the U.S. It'd be helpful for Japan to pursue the economic substance doctrine of the U.S. according to Japan's actual circumstances, which imposes two objective requirements on taxpayers, "advantageous change in the economic position" and "necessity of business purposes (other than tax mitigation)".
    Once concrete rules were made, then it goes without saying that judicial responses are important in the application of such rules based on fact determination of each case. Recently, the Supreme Court has made a series of judgments regarding international tax shelters, and a relevant precedent theory has been gradually established. Tax authorities and academic society should refine the theory through the continuous review on the coverage of such precedents. In addition, positive discussions are necessary towards the full implementation of PAL rule and AR rule as a preventive measure against tax avoidance activities, and improvement of taxation infrastructures including shift of burden of proof, enhancement of information return, disclosure and registration of tax shelters.
    

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The concept of qualified mergers under corporate tax law : Type C reorganization in U.S. tax law and the necessity of qualification requirements that are not based on corporate law

(Abstract)

    The concept of qualified corporate reorganization under current tax law is based on corporate law. Logically, such dependence of tax law on private laws such as commercial law or corporate law should not be necessarily required. There has been a gap between commercial law and tax law in the past, but it was further widened by the enactment of the new Corporate Law, which not only granted flexibility of merger considerations but also changed the concepts of capital or dividend significantly. Corporate reorganizations under corporate law are not always qualified under tax law. Mergers, for example, must comply with corporate law in the first place, and then satisfy various qualification requirements under tax law, in order to be allowed tax deferral treatment.
    It is stated in the "basic policy for tax system regarding corporate reorganization including corporate divisions and mergers", a document published by the Government Tax Commission, that the underlying assumptions for tax deferral are "continuity of control over the transferred assets" at the corporate level and "continuity of investments" at the shareholder level. However, it is not clear why such bases are required or whether they are adequately reflected on positive law.
    Under these circumstances, this article considered the adequate form of such qualification requirements and the logical underlying assumptions in Japanese tax law, as referring to a type C reorganization of the U.S. Internal Revenue Code, which is referred to as "a practical merger". As a result, it has been found that the U.S. law expands the scope of tax-free reorganizations from a type A reorganization, which requirements are based on private law (state law), to a Type C reorganization by setting requirements peculiar to tax law. At the same time, countermeasures for the prevention of certain tax avoidance activities are also taken.
    The requirements for a type C reorganization aim at securing continuity-of-interest (COI) and preventing divisive transactions. The Japanese tax system can refer to the concept of COI first. Suggestions acquired from the consideration of COI include: 1) merger consideration should be limited to voting stocks, 2) certain nonqualified assets (boot) should be admitted, 3) reorganization provisions could be specific anti-avoidance provisions, 4) there may be a certain type of reorganization which can be done by acquiring control in exchange for assets (post acquisition COI), and 5) the concept of remote COI is useful in the qualification of triangular mergers.
    Then, in terms of the prevention of divisive transactions stated above, it was found that an acquisitive and a divisive reorganization should be strictly distinguished in Japan, too. It should be noted that a divisive transaction tends to become more like an assets disposition, since it selectively (or arbitrarily) carves out "partial assets" from a corporation. It is not like a merger in which "all assets" flow from one company to another. A divisive transaction is thus resembles asset sales, therefore strict requirements should be established separately from an acquisitive reorganization.
    Setting rules peculiar to tax laws, which are not based on corporate law may require costs, but such rules are necessary, since taxation was not taken into account in the enactment of corporate law. If qualification is to be examined under corporate law in the first place, it should be considered how to pick out disqualified transactions that are substantially equal to qualified transactions such as mergers or corporate divisions. Such consideration also helps in solving the problem that dependence on corporate law leads to intentional disqualification of reorganizations very easily.
    The enactment of the new Corporate Law further widened the gap between corporate law and tax law. This should be a good opportunity to clarify the bases for qualification of tax deferral, the difference between a disposition (sale) and a qualified reorganization and adequate qualification requirements.
    [Supplementary summary] The new Corporate Law will allow the flexibility of consideration used in reorganizations, and it gives rise to the possibility of inversion transactions in Japan. Such transactions have been regarded as problematic in the U.S. since the 1990's. An inversion is, in short, a transaction in which a U.S. corporation may reincorporate in a foreign jurisdiction and thereby replace the U.S. parent corporation of multinational corporate group with a foreign parent corporation. When all the transactions are complete, the foreign operations of the company will be outside of U.S. tax jurisdiction and the corporate structure also may provide opportunities to reduce the U.S. tax on U.S. operations. Therefore, in 2004, the U.S. congress enacted new rules, the Internal Revenue Code section 7874, which squeezed some of the tax benefits out of inversion transactions. Japan, too, should prepare countermeasures against inversion transactions, before the enforcement of provisions for the flexibility of consideration under the Corporate Law come into effect next year.

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Restriction of tax shelters in the U.S. and its applicability to Japan

(Abstract)

    This article aims at acquiring implications for Japanese legislative and interpretative theories, through the consideration of legislative and judicial countermeasures against tax avoidance adopted in the U.S. For that purpose, this article first confirmed the U.S.'s basic attitude toward tax law interpretation and the distance between its tax law and private law in determining material facts, and then reviewed development of judicial doctrines and legislative trend in the U.S. A recent opinion of the Supreme Court in Japan required a limited interpretation in the rule concerning the foreign tax credit, by regarding it as a policy-oriented system, although such system is hardly thought to sacrifice fairness. In a film lease through a partnership case, the Court disallowed the tax benefit otherwise obtainable through the accelerated depreciation, by regarding the film involved as "not being used for business", without finding it in particular as non-operating. Given the Court's stringent attitude against tax shelters that possibly undermine the principle of literal interpretation in the field of taxation, it would be more significant to reconsider desirable anti-avoidance measures that comply with the requirement of no taxation without statute, paying proper attention to the limit of non-literal interpretation, than to merely design some effective countermeasures against tax avoidance.
    The U.S. counterpart of the Japanese principle of no taxation without statute can be mainly found in the due process clause of the 5th amendment of the U.S. Constitution. However, in line with the negative attitude of the judicial branch in applying the economic substantive due process, I could find no judicial cases in the context of the U.S. federal taxation, which directly and squarely discussed the requirements comparable to those of Japanese no taxation without statute, except for the cases which handled the issue of retroactive legislation. There is a school of law interpretation that emphasizes the merit of literal construction as an adequate method of law interpretation in terms of securing the "rule of law" or the Separation of Powers. It is said that such a school has also given certain influence on the U.S. Supreme Court, but there remains a strong tendency to support non-literal interpretation, which puts emphasis on contexts including legislative history or intent, based on the traditional common law approach that aims at valid resolution on a case-by-case basis. Such interpretation is the source of law creation by courts. Recharacterization of transactions based on private law is also possible in the U.S., but such a method does not bear much benefit, since general anti-avoidance case law doctrines have been extensively developed.
    Precedent case law doctrines combating tax avoidance include the substance over form doctrine, business-purpose doctrine, sham transaction doctrine, step transaction doctrine and economic substance doctrine. All of them can be said to have the Gregory case as their origin or authority, therefore their coverage is similar and overlapped, while they are not clear in critical points. Recently, the economic substance doctrine has been attracting much attention, but its meaning differs depending on court opinions, legislative bills or commentators. However, it has gained reputations such as "the most objective judicially created doctrine for combating tax benefit derived from abusive transactions" or " the most easily, objectively and coherently applicable doctrine by taxpayers and the Internal Revenue Service" (The U.S. Department of Treasury). Since around 1999, along with close inspection of the judicial precedents, codification of the economic substance doctrine has been tried. A proposal has been made by the staff of the Joint Committee of Taxation that is less conflicting with the principle of no taxation without statute by limiting the scope of transactions to which the doctrine should be applied. The requirements of the economic substance doctrine are remarkably different from those of a possible general anti-avoidance provision generally understood in Japan, in that it includes the objective requirement of the substantial change in the economic position after the participation in the transaction and that it adopts the conjunctive analysis. In my view, it is difficult to apply the conjunctive analysis in Japan without clarifying applicable transactions.
    Topics in the consideration of similar legislative measures in Japan should include; 1)information collection regarding the past and present mechanism of tax avoidance, 2)finding and eliminating distortions in our current rules which nurture tax avoidance, 3)quantitative analysis regarding tax revenue loss and taxation fairness caused by the spread of tax avoidance and 4)examination of the possibility of implementing procedural measures including penalty and disclosure. Japan should aim at both achieving the provision of tax benefit in line with the purpose of the law and satisfying requirements of the principle of no taxation without statute. In order to achieve these goals, enhancement and positive disclosure of legislative materials are necessary as medium- or long-term objectives.

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Partnership and International Taxation

(Abstract)

    1. This article shallowly and widely examines potential problems of pass thru taxation in Japan, caused by international businesses or transactions conducted by so-called fiscally transparent entities, which are not subject to corporate tax, as referring to the international partnership taxation system in the U.S.
    2. In the U.S., an entity regarded fiscally transparent both in the residential country and the source country is classified into a pure entity. And an entity regarded fiscally transparent in one country but as a corporation in another country is classified into a hybrid entity. A hybrid entity is further classified into a regular hybrid entity and reverse hybrid entity.
    Taxation on a pure entity (partnership), which is regarded as tax-transparent, and taxation on a hybrid entity sometimes give rise to the same problems. Issues in the international partnership taxation include: 1) revenue recognition and the type of income at the time of investment, 2) domestic business of a foreign partner and PE equity definition/the source country/income allocation or filling requirements for a partnership/tax withholding obligation, 3) revenue recognition and the type of income at the time of transfer or distribution, 4) application of anti-abuse provisions and 5) beneficiaries of tax treaty.
    In addition, taxation issues peculiar to hybrid entities include 6) tax system to deal with tax heaven issues, dual consolidated loss relief, and an issue of domestic reverse hybrid entities.
    3. Considering the issues stated in section 2, pass thru taxation issues in Japan caused by international transactions can be found in: 1) categorization of entities (particularly issues caused by the election system), 2) PE/the source country /income allocation, 3) taxation at the time of investment, equity transfer and distribution, 4) tax withholding obligation and 5) information return.
    In addition, hybrid entities are utilized for the double acquisition of income category or loss relief. It gives rise to the issue of: 6) corporate tax avoidance in countries where hybrid entities are regarded as corporations. It suggests the importance of establishing and reviewing the tax system to deal with tax heaven issues.
    4. Ultimately, it is indicated that each issue should be more deeply considered, based on the points stated above.

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Hybrid Entity and International Tax Avoidance Scheme

(Abstract)

    In the U.S., the introduction of Check-the-Box Regulations eliminated the trouble of determining tax treatment for entities; a difficult task both for tax authorities and taxpayers, and legal stability was achieved regarding treatment of entities.
    However, it also gave rise to the new issue of international tax planning involving the use of hybrid entities, for which two countries adopt different tax treatments. The U.S. authorities have taken measures to prevent such tax planning issues just after the introduction of Check-the-Box Regulations. Nevertheless, hybrid entities are still among the issues of the U.S. taxation.
    International tax avoidance schemes utilizing hybrid entities include the inappropriate use of tax treaty benefits and the avoidance of subpart F application. The former scheme aims at no or minimum tax imposed by both countries, by creating payments that are treated as deductible under the domestic tax system, and then combining tax treaty benefits and preferential measures under the foreign tax system.
    The U.S. authorities restricted such abusive use of tax treaty benefits, by the revision of the Internal Revenue Code and issuance of the new Regulations. Such approach would have the same effect as the revision of tax treaties themselves. In Japan, too, such schemes have recently emerged that aim at creating income that is not subject to any country's taxation, so it may be helpful to refer to the approach of the U.S. as a countermeasure for tax planning.
    While the latter scheme, the avoidance of subpart F application, is done by using abusive techniques such as: 1)hybrid branch arrangements in which a taxpayer makes an election for a "hybrid branch", which is treated as a branch under the U.S. tax law, in order to convert subpart F income into the income generated from transactions between a head office and a branch, and 2)so-called "check and sell" transactions in which a taxpayer changes an election from a subsidiary to a branch, just before transferring the stock of a subsidiary which conducts a business, so that the transaction would be treated as a business assets transfer, not as a stock transfer, which would otherwise be treated as subpart F income.
    The U.S. authorities have taken various measures including expressing its position and warning toward taxpayers in the Notices, issuance of temporary Regulations and even litigations. However, they have been faced with unexpected results, such as withdrawal of temporary Regulations as a result of strong opposition from Congress and the business community, and defeat in litigations in the Tax Court rejecting IRS's interpretation. Thus, authorities have not been able to take valid measures toward the avoidance of subpart F application utilizing hybrid entities.
    Considering the experience of the U.S. regarding hybrid entities in the past decade after the introduction of Check-the-Box Regulations, it is indicated that the drastic introduction of elective or discretionary taxation systems, without appropriate and preliminary implementation of countermeasures against tax avoidance, is liable to nurture abusive tax transactions and tax planning activities that are extremely difficult to deal with afterward, and therefore create confusion. It is also reconfirmed that prevention of such confusion is important, not only for the tax authorities but also for taxpayers.

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Recent issues in treaty shopping and review of its history

(Abstract)

    An important issue in the recent advance of globalization is the measure toward so-called crossborder tax shelters. Crossborder tax law arbitrage by taxpayers, that is an abusive tax avoidance transaction utilizing loopholes or differences of laws, often possesses complex mechanism, due to the utilization of tax systems both under the domestic law and the tax treaty. To deal with such crossborder tax arbitrage, not only agile revision of domestic law but also constant monitoring and review of treaties are indispensable. In addition, closer cooperation among enforcement authorities is also necessary, in order to grasp realities of transactions and adequately apply treaty rules or domestic laws without causing double taxation or double non-taxation.
    Recently, advanced crossborder tax plannings, in line with various technologies of M&A or supply chain management, have been contributing to the enhancement of multinational companies' competitiveness, based on their global production, sales and research strategy. Most of these tax plannings may be based on reasonable business purposes, but it is difficult to judge legitimacy of such legal arbitrage chosen by taxpayers. Particularly regarding so-called treaty shopping, conflicts between taxpayers and authorities are doomed to increase. Currently in Japan, many of the international taxation cases under mutual agreement procedures or court decisions seem to focus on transfer pricing, permanent establishment attribution or foreign tax credit, according to the press reports. Thus, complex arbitrage tax shelter cases involving tax treaty issues have not attracted specific attention so far. Nevertheless, it does not mean that international tax shelter attempts utilizing treaties are few. Rather, it should be regarded as an urgent and important issue and clear guidance on treaty interpretation should be provided, considering the fact that difficult problems have emerged in the qualification examination for benefits under tax treaties, due to the complication of overseas entities caused by the diversification of M&A techniques or utilization of investment funds, as well as that promoters with highly technical knowledge are involved in crossborder tax shelters.
    Recently, there is a global trend toward tax treaty revisions that include tax exemption in the source country, aiming at the activation of investment exchange, and many treaties started to introduce tax benefit limitation rules. This article considers recent issues regarding such trend of tax treaties, by first reviewing relevant experiences of the U.S., Europe and other countries, and then extracting their achievements and future issues.
    The history of treaty shopping in the U.S. started with combats with companies of third countries, which conduct so-called stepping stone method to escape from taxation in the U.S., the source country, as well as in their residential country. Abuse of treaties with Netherlands Antilles, Holland and Luxembourg in the course of such transactions was gradually addressed by the revision of treaties that included benefit limitation rules. Domestic laws such as earnings stripping rules or conduit rules also played an important role. In addressing such issues, a precious lesson was learned that existing treaty loopholes must be corrected concurrently and simultaneously, otherwise the time lag between treaty revisions would be utilized for the conduct of treaty shopping. While the U.S. thus focused on the introduction of benefit limitation rules, European countries took more diversified measures. They first dealt with issues involving domestic foreign investment companies by establishing anti-tax avoidance provisions under the domestic law. They also reviewed individual treaty provisions starting from concepts of residents. These experiences of the U.S. and European countries have been integrated into the model treaty of OECD.
    At present, introduction of benefit limitation rules is further spreading. There is a movement toward the refinement of benefit limitation rules in order to deal with a so-called "inversion transactions". Japan has established and enforced benefit limitation rules for Japan-U.S. and Japan-U.K. treaties. However, considering domestic and overseas situations, Japan should be fully prepared for the spread of treaty shopping issues. In that case, it should immediately work toward the establishment of common interpretation and enforcement guideline, based on close bilateral or multilateral cooperation. 

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Limitation on benefits (LOB) provisions under tax treaties

(Abstract)

    The new Japan-U.S. tax treaty which entered into effect in 2004 was a significant shift for Japan from its long time tax treaty policy. , The new treaty exempts taxation by the source country on certain types of dividends and other investment income and included comprehensive limitation on benefits (LOB) provisions for the first time. This U.S.-style comprehensive LOB provision was also included in the new Japan-U.K. tax treaty signed in February this year.
    This article considered how an adequate form of anti-abuse rules for tax treaties should be, based on the review of past discussions at the OECD, anti-abuse rules included in the past tax treaties concluded by Japan, as well as those in the new treaties with the U.S. and U.K..
    As preventive measures against the abuse of treaties, the commentary of OECD Model Tax Convention suggested various approaches as follows: the beneficial owner approach, the look-through approach, the subject-to-tax approach, the channel approach and the exclusion approach. The U.S. has taken the comprehensive limitation on benefits approach ever since its conclusion of the revised U.S.-Germany tax treaty in 1989, which does not grant all benefits under the treaty, unless requirements of "a qualified resident" are satisfied.
    Many of Japanese tax treaties before the new Japan-U.S. tax treaty reserved taxation right of the source country on investment income, although the rates were lower than those under the Japanese domestic law. Those treaties did not include comprehensive anti-abuse provisions, mainly because Japan had not concluded treaties with tax haven countries. Some treaties included rules following the beneficial owner approach, the subject-to-tax approach and exclusion approach suggested in the commentary of OECD Model Tax Convention. The revised Japan-France tax treaty which entered into effect in 1996 exempts taxation by the source country on a certain type of dividends paid by a subsidiary to its parent, and included limitation on benefits provisions, but, not comprehensive ones, for the first time as a tax treaty concluded by Japan.
    Comprehensive limitation on benefits provisions under the new Japan-U.S. tax treaty include requirements for qualified residents, which are roughly categorized into; 1)criteria for a qualified resident (such as an individual, a company more than 50% of its shares is held by an individual, a listed company, etc.) and 2)criteria for income (the resident must be engaged in the active conduct of a trade or business in the State of which it is a resident, etc.). It also includes a provision which grants unqualified resident the treaty benefits, if approved by the competent authority of the State from which benefits are claimed. Provisions of this treaty are basically similar to those included in treaties concluded by the U.S. since its treaty with Germany concluded in 1989.
    Comprehensive limitation on benefits provisions of the new Japan-U.K. tax treaty are basically the same with those in the new Japan-U.S. tax treaty except for some differences in criteria for a qualified resident, such as the exclusion of the base erosion test and inclusion of an equivalent beneficiary test (a resident of a State that has a tax treaty with Japan or the U.K., which satisfies certain requirements such as the inclusion of LOB provisions equivalent to those of the Japan-U.K. tax treaty) and a main-purpose test for anti-treaty shopping (treaty benefits will not be granted if the main purpose of the business is the abuse of the treaty).
    It is expected that Japan will try to conclude treaties that are similar to the new Japan-U.S. treaty and new Japan-U.K. treaty, which basically exempt taxation by the source country on investment income, with other countries. Accordingly, anti-treaty shopping rules will become even more important. Japan should consider not only adequate provisions countermeasures against the abuse of treaties, but also proper tax administration, based on the actual circumstances of treaty shopping and the implementation of the new Japan-U.S. tax treaty and other new treaties. In order to prevent treaty shopping without imposing disproportionately high costs and burdens to taxpayers, the countermeasures should be effective and efficient, for example, by making qualified resident criteria as objective as possible, and in case of treaties in which effective information exchange is not guaranteed, by including stricter procedures for claiming treaty benefits. 

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Introduction and review of discussions in the U.S. regarding theories recommending the switch into the foreign income exemption method (or destination principle taxation)

(Abstract)

    Theories of international tax policy have traditionally supported the worldwide system and foreign tax credit method, in view of the capital export neutrality, and the U.S. has actually adopted the worldwide system for a long time. But recent theories have been actively recommending the switch into the territorial tax system and foreign income exemption method. It seemed that such theories had been discussed only in the academic society, but the fiscal 2005 report largely dealt with the theory recommending the switch into the exemption method, etc., probably for the first time in governmental documents.
    Theories are rare that recommend the switch from the pure worldwide system to the pure territorial system. Many recommend the switch from the quasi-worldwide system (which includes tax deferral for a foreign subsidiary's income and limits on foreign tax credit) to the quasi-territorial system (which exempts foreign income tax except for portfolio income, that is subject to the credit method). The theory dealt in the fiscal 2005 report also recommends tax exemption on foreign source business income. The report proposed 2 plans, the SITP (Simplified Income Tax Plan), which is based on the theory recommending the switch into the exemption method, and the GITP (Growth and Investment Tax Plan), which aims at consumption-type income tax model. Under the GITP, the destination principle taxation is proposed as an international taxation method.
    While theories of international tax policy have traditionally supported capital export neutrality and foreign tax credit method regarding capital income taxation, recent discussions actively support the switch into the exemption method. In considering the relation between those theories, at first, it should be recalled that, even within the context of capital income taxation, the optimal method, the foreign tax credit method or the exemption method, may largely depend on the underlying assumptions of the model. Even after the establishment of capital export neutrality theory, various model theories have been developed that examine variable factors such as the size of the nation (big or small) or its tax rates, and the optimal method changes according to the model. Capital export neutrality theory remains the most famous, but theoretically, it may only be said that optimality of the foreign tax credit method or the exemption method depends on "time and circumstances".
    Next, it should be noted that capital export neutrality is a theory regarding capital income tax, while recent theories that support the switch into the exemption method are mainly on business income tax. A theory that only deals with taxation at the level of business entities, ignoring underpinning investors, is conceptually more similar to a theory of added-value tax than that of comprehensive income tax. However, people who support the switch into the exemption method, either from the practical or academic viewpoints, do not seem to put much importance on whether the theory is conceptually based on comprehensive income tax theory or value-added tax theory. This is maybe because they feel it useless to impute entities' level taxation to investors' level, and business income taxation might be able to look only at business entities' level. This is similar to the case of the theory that suggests the necessity of the realization method in a context of domestic taxation.
    Theories have not been fully organized yet as stated above, but it may sometimes be necessary to make recommendations for actual tax system. Thus, the reform plans in the fiscal 2005 report should be regarded as a rather snap decision, which was made against the backdrop of various theories of international tax policies. 

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A case study on the prevention of international value-added tax (VAT) shelters

(Abstract)

    Discussions on tax shelters in Japan have focused on income tax issues so far, but in Europe, measures against value-added tax shelters have also been developed in tax practices. In Japan, too, tax shelter issues are expected to worsen if consumption tax is to be raised in the future. This article overviews problematic cases of international tax shelters, as well as possible countermeasures against them, by considering the RAL case in the U.K.
    The outline of the case is as follows: Using the scheme proposed by an accounting firm, RAL Holdings Ltd., a company that operates amusement arcades in the U.K., underwent a corporate reorganization and founded a company (CI) in Channel Islands, which are outside the EU territory, that directly provides services for customers, aiming at avoiding tax by transferring the place of supply of services. RAL insisted that, due to the reorganization and change of trade channels, sales of CI were not subject to the U.K. VAT according to the EU 6th directive, and the U.K. VAT imposed on the charges for services provided by group companies for CI within the U.K. should be refunded according to the EU 13th directive. U.K. tax authorities rejected this claim and the case was taken into the U.K. VAT Tribunal, which concluded that RAL was liable to account for U.K. VAT, since services were supplied from "fixed establishments" located within the U.K. The European Court of Justice reviewed application conditions of the Article 9 of the EU 6th Directive, and approved taxation right of the U.K. based on the provision that "the place of the supply of the services relating to:... entertainment...activities, ...shall be the place where those services are physically carried out", without judging the existence of fixed establishments.
    In the process of rejecting the tax shelter scheme used in this case, the following concepts and methods were presented: 1)abuse of law, 2)economic substance doctrine, 3)definition of fixed establishments and 4)limited interpretation doctrine. 1) is an established general principle of European law, and there have been discussions regarding whether it is applicable to VAT avoidance activities or not. In the argument of another case, the European Court of Justice ruled that transactions that solely aim at VAT avoidance are considered as "abuse of law", therefore such transactions should be ignored in the imposition of VAT. It defined two conditions for the judgment of abusing transactions: a) the transactions concerned, notwithstanding formal application of the conditions laid down by the relevant provisions of the legislation, result in the accrual of a tax advantage the grant of which would be contrary to the purpose of those provisions,, and b) it is apparent from a number of objective factors that the essential aim of the transactions concerned is to obtain a tax advantage. 2) is the doctrine on which the U.K. tax authorities relied in the conclusion of RAL case, but whether the economic substance doctrine is applicable or not depends on the provisions of the law. 3) is similar to so-called PE definition that source countries apply when claiming the taxation right for direct tax. There was an issue of the legal interpretation, the definition of "fixed establishments" and an issue of fact determinations regarding existence of such establishments. As to 4), the U.K. tax authorities insisted that transactions which aim at tax avoidance without any business purpose do not fall into "supply" or "economic activity" ruled under the EU 6th directive. The European Court of Justice rejected such interpretation in the argument of another case.
    RAL case presented suggestions as follows: 1)As an international tax avoidance scheme, VAT in the consuming country can be avoided by transferring the legal place of supply of services. This relies on the rule that services are taxable in the country where the supplier is located. Such tax avoidance scheme can take place under the existing law of Japan, and 2)VAT avoidance activities create tax-free transactions in the consuming country, which distort competitions within the country and virtually transfer taxation right of the country to the country from which services are supplied. If the latter country does not impose tax, double tax exemption occurs and it increases incentive for tax arbitrage. However, under VAT system, it is scheduled that taxpayers will bear no economic burden from VAT, therefore the argument that tax avoidance impairs the fairness of taxation does not necessarily apply to VAT, not like in the case of income tax.
    It is projected that adequate measures against tax avoidance activities would be necessary also for Japanese consumption tax. The European Court of Justice seeks for balanced resolutions when rejecting tax avoidance activities, showing considerations also for taxpayers' situations. Japan, too, should seek for legal interpretation and resolutions that comply with object and purpose of statutory law. For that purpose, it is important that legislative authorities represent object and purpose of statutory law as carefully and clearly as possible. 

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