Issues observed in the Consolidated Tax Return System (now the Group Tax Relief System)

Corporate tax is normally levied on individual corporations. In Japan, however, the Consolidated Tax Return System—which taxes companies on a group basis—was introduced in August 2002. Since then, the number of corporate groups applying to use the system has increased year by year, and as of June 2018, a total of 1,821 groups had applied for the system. Then, in April 2022, the Consolidated Tax Return System was replaced with the Group Tax Relief System.

Under the former Consolidated Tax Return System, a corporate group was treated as if it were a single corporate entity for tax purposes. However, it was easy to foresee that some companies would exploit this system by acquiring corporations with large amounts of loss carryforwards, making them subsidiaries, and then using the acquired entity’s loss carryforwards to avoid paying taxes. For this reason, a variety of provisions have been established in Japan to prevent the abuse of loss carryforwards.

Yasui, who studies the nature of corporate taxation, explores the treatment of loss carryforwards under the Group Tax Relief System, comparing it with the German Corporate Income Tax Law in order to identify problems.

Tax avoidance through the abuse of loss carryforwards

What, then, is a loss carryforward in the first place? Yasui explains: “Article 2, Item 19 of the Corporation Tax Act stipulates that when the amount of deductible expenses exceeds the amount of income in a given fiscal year, the excess—put simply, the deficit—is defined as a ‘loss amount.’ This loss amount may be carried forward for ten years from the following fiscal year, and it may be included in the calculation of deductible expenses against income during that period (Article 57, Paragraph 1 of the Corporation Tax Act). Losses carried forward into subsequent fiscal years in this manner are referred to as loss carryforwards.”

For example, suppose Company A had a deficit of 100 million yen in the previous fiscal year, but made a profit of 50 million yen this fiscal year. Since tax is levied on income for the current fiscal year, the company would owe no tax for last fiscal year when it was in the red, but in the current year, it must pax tax on the 50 million yen of income. However, looking at the company’s performance over the past two years, it still has a cumulative loss of 50 million yen, so one could say that Company A is being forced to bear an unreasonable tax burden. The loss carryforward system was created to prevent these kinds of situations. “A corporation’s fiscal year is nothing more than a period established for the purpose of calculating its income, and by offsetting losses against profits from preceding or subsequent fiscal years, it is possible to determine the corporation’s true income. Therefore, the loss carryforward system is not a beneficial measure, but rather a system that must be established in the first place,” explains Yasui. Based on Article 14 of the Constitution, which sets forth the principle of equality, it is held that taxation should be conducted according to tax-bearing capacity (the ability to pay tax). Yasui advocates for the necessity of fair taxation based on this kind of ability-to-pay principle.

However, as mentioned earlier, with the introduction of the Consolidated Tax Return System, it became possible for companies to reduce their tax burden via arbitrary mergers. “To prevent this, while Japan’s Corporation Tax Act permits the transfer of loss carryforwards in the case of qualified mergers, it imposes various conditions on those transfers. The problem, however, is that in trying to cover every possible scenario, these conditions have become increasingly complex,” says Yasui.

Yasui notes that provisions of the German Corporate Income Tax Act (or KStG for short) serve as a contrasting example to Japan. He explains as follows: “Germany also has an intercompany relationship framework similar to Japan’s Group Tax Relief System, but the regulatory requirements for loss carryforwards under the German system are extremely simple. Instead, strict conditions are imposed to ensure compliance, such as requiring guaranteed profit contributions or loss absorption for a minimum of five years. In this respect, whereas Japan’s regulations can be described as ex ante controls, Germany’s represent ex post controls.”

Examining the anti-abuse provisions for loss carryforwards by comparing Japanese and German corporate tax laws

Both Japan and Germany, says Yasui, have systems in place to prevent the abuse of loss carryforwards by loss-making corporations. In Japan, Article 57-2, Paragraph 1 of the Corporation Tax Act stipulates: “When a specified shareholder acquires more than half of the total number of outstanding shares, etc. of a loss-making corporation and, within five years of such acquisition, any one of the five ‘specified events’ provided for in the same paragraph occurs, the loss carryforwards of the loss-making corporation shall be forfeited for the fiscal year including the date on which such specified event occurs and for subsequent fiscal years.” However, Yasui sees a problem with this language: “These ‘specified events’ are unclear, and disputes can arise about the applicability of a specified event, so the original purpose of preventing the abuse of tax loss carryforwards may not be accomplished.”

On the other hand, the first three sentences of Section 8c, Paragraph 1 the German KStG, which contain the anti-abuse provision on loss carryforwards of loss-making corporations, states that “where more than 50% of the shares in a corporation are acquired, all tax loss carryforwards of the target company are forfeited.” However, the same paragraph contains multiple exemption clauses, such as the group clause, which specify cases in which forfeiture does not apply. Moreover, the introduction of Section 8d in 2016 further relaxed some of these restrictions.

In other words, although the KStG bases its application primarily on the fact of a change in share ownership, it also provides multiple exemption clauses that allow the loss carryforwards to be reinstated. However, according to Yasui, some of the conditions for applying those exemptions remain unclear, and it has been pointed out that they do not necessarily apply to acquisitions made for legitimate business purposes. Thus, it became apparent that the issues found in the German law—which serves as a contrasting example to the Japanese one—are also different in nature.

“From the standpoint of fair taxation, these issues cannot be overlooked. Going forward, I will continue to examine how best to prevent the abuse of loss carryforwards by loss-making corporations, while also referring to the debates taking place in Germany,” says Yasui.