Thin Capitalization Rule and Earnings Stripping Rule

The two rules are similar and are both trying to restrict interest expenses paid to its parent/affiliate companies. But they are a little bit different in their target. Here are the rules:

Thin Capitalization Rule

The interest paid to its affiliated company overseas that owns more than 50% of its shares is allowed to be deductible only up to the amount corresponding to its loan triple of its equity. For example, if its capital is 10M Japanese Yen and retained earnings are 3M. The interest expenses are only allowed only for its loan up to 39M(13M * 3) yen. If the total loan is 50 million yen, the interest on the remaining 11 million yen loan (50M – 39M) will not be deductible.

Earnings Stripping Rule

You can deduct interest expenses paid to overseas affiliated company from taxable income only at maximum 50% of its taxable income. The exception is that the rule is not application if the total interest is less than 10 million yen.

Can an LLP be considered as a pass-through entity?

There were some arguments whether a Delaware Limited Liability Partnership (LLP) should be treated as a pass-through entity or not. If it is regarded as a pass-through entity, income or loss made through an LLP has to be included in Japanese taxable income.

As of today (May 2018), it is regarded as a pass-through entity.

There have been several contradicting rulings by Japanese courts but recently in 2017, Japanese Supreme Court gave the decisive ruling that sent many in Japanese and US tax community in panic.

デラウェア州LPSの法人該当性が争われた事案~平成27年7月17日最高裁判決

Japanese Supreme Court rules that a Delaware limited partnership is a corporation

Then, after strong criticism and the change in the tax law that limits loss from partnership for passive members, the National Tax Agency announced a memo in “English” saying that
a Delaware limited partnership is fiscally transparent. (It is rare to make its official announcement not in Japanese. Some people think that it is too embarrassing for Supreme Court if NTA denies their ruling in Japanese.)

Now we have the conclusion here. An LLP can be treated as a pass-through entity.

It affects your tax situation if you do business or invest into something through an LLP. If you are an active partner, your loss in the partnership can be offset against your Japanese loss.

Employee Buyout -EBO

If no one in your family will take your business over, you may want to consider passing it to directors or employees of your company.

Upside is that the person knows the business well. He has been working in the company for long. The education necessary to take over the business will be relatively mild.

The downside is money. He may not have enough money to buy out the business. Also, if your company has taken loans from banks, you are likely a guarantor of the loans too. The successor director/employee will be required to guarantee the loan instead of retiring you. That will be difficult for him to accept.

As to the money to buy out, if the company is performing well or has enough assets on its balance sheet and the successor seems capable, banks will be able to consider lending you money. Also, there are venture capitals or private funds that will provide you with fund to buy out the shares.

The company can also issues preferred shares without or limited voting rights to you so you will have right to receive dividends while the successor will have shares with voting right to control the company management. If the shares with voting right is only a small portion of the total shares, the money needed for buyout will be limited. According to the tax law, shares with voting right can be the same valuation as those without voting right. Therefore, if the majority of the existing shares are non voting shares, the valuation of the shares with voting right can be limited, based on the proportion.

But you still want to keep more than 1/3 shares that give you a veto, because the new management can issue new shares to dilute your shares and therefore reduce your right to receive dividends.

Points to consider

You should avoid giving shares to your employees for free. There will be gift tax. Gift tax can be higher than capital gain tax that you will have to pay in case you sell it. The gift tax can go up to 55% while the capital gain tax is flat 20.42%. Even if your intention is to give the shares for free, you will want to compare the both scenario carefully. You may be able to reduce the total tax amount paid by you and him by raising his salary for years and letting him buy your shares.

Not only family member but other can be the successor of you business

We would think that the business succession of SMEs is usually to pass it to his next generation in his family. That is still the majority of the cases but it is not always true. These days, there are more successions to directors or employees who are not from his family or selling to a total third party.

If you would like to leave your business to your heir, you will have to worry about the inheritance tax. You would like to know how to lower the tax.

If you would like to pass it to your employees or directors who have been working in your company, he must know the business and its relations like important suppliers and clients. It will be easier to carry on the day to day operation than heirs who can be new to the business. The typical issue is cash he has. If your company is big enough, the valuation can be easily higher than the amount a normal personal can afford to buy its shares. In typical situation, the person will set up a company and borrow money through the company, with security of the company assets backing the loan. If you have been the guarantor of the company loan, the employee successor has to guarantee the loan to replace you. That can be very difficult for him and you may need to negotiate with banks.

These days, M&A is becoming more common. You will get cash in return and that will probably be the most important advantage. Also, buyers should know that business or they are already in the same business industry. They will benefit from a synergy. There are many private companies that provide M&A consultation and matching service such as Nihon M&A Center or Strike. There is also a public sector service provider such as 事業引継ぎ支援センター. Japanese government is interested in keeping SMEs running and operating.