New legislation concerning tax-free reorganizations, one of the most notable changes in the Japanese government's proposal for the 2017 tax reform, has been enacted.
Under the new legislation, passed on March 27, 2017, the scope of transactions qualifying as tax-free reorganizations has been expanded to include certain types of spinoffs, which historically have been considered taxable transactions. In addition, the ownership requirements for certain intra-group demergers have also been relaxed, making it easier for multinationals to meet the requirements for tax-free treatment. As enacted, the amendments concerning qualified spinoffs will be applicable on or after April 1, 2017, and those concerning the relaxed requirement for intra-group demergers will be applicable on or after October 1, 2017.
A demerger that satisfies certain requirements (ie, a qualified demerger) is tax-free to the transferor and its shareholders. Accordingly, capital gains (and losses) are not recognized by the transferor (nor its shareholders) upon the transfer of assets and liabilities; as a result, capital gains tax does not apply. Since the transferee's tax basis in the assets and liabilities does not receive a step-up in basis upon demerger, a carryover basis results. In addition, the transferee shares received by the transferor's shareholders are not treated as a deemed dividend.
Existing rules limit the ways that a demerger occurring between group companies can be considered a qualified demerger. In cases of demergers occurring between sister companies, the benefits for a qualified demerger are granted only when it is expected that there is (i) a continuation of the relationship between the transferor and the parent company of the transferor after the demerger and (ii) a continuation of the relationship between the transferee and the parent company of the transferee (as well as of the transferor) after the demerger.
The new legislation relaxes requirement (i) above so that after the transfer, it is no longer a requirement to continue the relationship between the transferor and its parent after demerger. Thus, a demerger meeting the ownership requirements immediately before the demerger (but not following the demerger) will also qualify for tax-free treatment.
Companies commonly use spinoff transactions to dispose of a business. Under current law, however, a spinoff may not satisfy all of the necessary requirements for classification as a qualified demerger. The new legislation extends tax-free treatment to two types of spinoff transactions: (i) a spinoff of a business division where a company puts a business segment into a separate company and distributes its shares to the shareholders of the company and (ii) a spinoff of an existing subsidiary by a company so that the subsidiary is owned directly by the company's shareholders. These types of spinoffs qualify for tax-free treatment only if certain conditions are met.
The proposed changes aim to provide more flexibility to companies (especially public companies) that are separating or disposing of non-core or unprofitable business units. Under current law, a company that wishes to remove an unprofitable business unit from its operation through spinoff schemes cannot in most cases fulfil the requirements for tax-free treatment. By expanding tax-free restructuring options to cover certain business unit spinoffs, in contrast, the new rules will likely encourage a greater frequency of such reorganizations.
The process will not necessarily be simple. The conditions that have to be met in order to qualify for tax-free spinoffs are not straightforward. In particular, the consideration for the spinoffs cannot involve property other than shares or other equity interests of the transferee; no party can have a majority control over the transferor and the transferee after the spinoff; the principal assets and liabilities of the business would have to be transferred; and the spun-off business is expected to continue. In addition, there is a requirement that at least 80 percent of employees are expected to engage in the spun-off business, and that the directors, key management executives, statutory auditors and accounting advisors are expected to continue holding such management positions after the transfer. A company seeking to determine if a spinoff qualifies for tax-free status would need to evaluate whether these conditions have been met.