Taxation of intellectual property in Japan

Abstract

Japanese tax law does not specifically define ownership with regard to intellectual property (IP). Rather, the tax law borrows its definition of ownership from Japanese civil law. Generally, there is no difference between legal and tax ownership of IP, which makes it difficult to separate such ownership. However, some cases appear to draw a distinction between legal ownership and economic ownership of intellectual property. In such cases, tax ownership does not automatically follow economic ownership. Rather, tax ownership can follow economic ownership only when real (not apparent) legal ownership underlies such economic ownership. Consequently, if real legal ownership does not underlie economic ownership, then taxable profit may result from transactions between a legal owner and an economic owner. Rules governing the transfer of IP are examined.

Japanese tax law does not specifically define ownership with regard to intellectual property (IP). Rather, the tax law borrows its definition of ownership from Japanese civil law. Generally, there is no difference between legal and tax ownership of IP, which makes it difficult to separate such ownership. However, some cases appear to draw a distinction between legal ownership and economic ownership of intellectual property. In such cases, tax ownership does not automatically follow economic ownership. Rather, tax ownership can follow economic ownership only when real (not apparent) legal ownership underlies such economic ownership. Consequently, if real legal ownership does not underlie economic ownership, then taxable profit may result from transactions between a legal owner and an economic owner.

RULES GOVERNING TRANSFER OF IP (TAX VERSUS LEGAL OWNERSHIP)

Patents

Legal ownership of patents, tradenames and trademarks (industrial IP) is initially created upon registration. Industrial IP is clearly identifiable by jurisdiction, as it is registered jurisdiction by jurisdiction. Additionally the transfer of industrial IP is relatively easy to execute from both a legal and tax perspective. As patents, tradenames and trademarks are legally jurisdiction-specific, it is also possible to transfer such IP from jurisdiction to jurisdiction for tax purposes.

Copyrights

Legal ownership of a copyright is initially established upon creation of the work of authorship (eg music or software) without any registration procedures. Like industrial IP, copyrights are also clearly identifiable. A notable difference between copyrights and industrial IP is the territory they cover. As a copyright is universally protected, it may be more difficult to segment copyright by jurisdiction. Additionally, it can be difficult to transfer a copyright by jurisdiction, although certain derivative rights in a copyright, such as airing rights of music or video, can be territorially based.

Under the Japanese legal structure, computer software is also subject to protection under copyright laws. However, it is difficult to distinguish copyrighted copies and the copyrighted software itself under Japanese copyright laws. This creates tax disputes regarding the withholding-tax consequences for payment for software products.

Know-how

Among that group of IP referred to as know-how, it is relatively less difficult to identify industrial or trade secrets. It is also less difficult to legally transfer such IP if appropriate contractual arrangements are made. Consequently, it is also less difficult for tax purposes to transfer know-how, although segmentation of know-how by jurisdiction can be more difficult.

Possible separation of tax ownership from legal ownership

There could be an occasion in which legal ownership, in its appearance, differs from tax ownership. However, economic ownership by itself cannot create a difference in tax ownership and legal ownership. Rather, economic ownership must be supported by recasting the legal ownership so it qualifies as tax ownership for income tax purposes.

For example, cost sharing for IP development can create tax ownership, which is different from legal ownership in appearance. A cost-sharing arrangement is an arrangement under which participants promise to bear their share of the cost for developing a patent. Because of these shared costs, the parties are entitled to the shared economic ownership of the patent.

In some cases, ownership of the developed IP legally belongs to the group's representative entity, while the other participants in the cost-sharing arrangement obtain economic and tax ownership of the IP asset. Frequently, such shared economic ownership is contractually granted in the sense that one participant holds legal ownership of the patent and the other participants are entitled to perpetually use the asset free of licensing fees. Because the participants are able to freely exploit the patent for the extent of its life, such participants have economic ownership of the patent. For Japanese tax purposes, such economic ownership can be enforced as long as the intention of the parties to share the ownership is established in a legitimate cost-sharing agreement. Existence of such legitimate arrangement and its documentation is very important to support tax ownership.

If a party participates in IP development for which a cost-sharing agreement exists, then transfer of ownership in the existing under-developed IP asset is recognized for tax purposes. In such a case, a sort of buy-in payment is required and could give rise to Japanese tax consequences, including royalty withholding tax in certain circumstances.

General explanation of the tax consequences for a transfer of IP

When a Japanese corporation sells an IP asset to a non-Japanese entity, gains and losses from the sale are primarily subject to corporate income taxes, regardless of whether it is Japanese-source or foreign-source. The gain/loss is calculated as the difference between the sales proceeds and the tax basis. If the sold IP asset was a self-developed IP, then the tax basis could be zero or an un-amortized balance of the capitalized expenses for the development. The gain/loss is aggregated to the profit/loss from other business operations and is currently taxed at the effective rate of 40%.

INDICES OF INTELLECTUAL PROPERTY OWNERSHIP

For legal purposes, IP ownership implies the exclusive and comprehensive right to use, exploit, and dispose of the IP without any claim from another party.

Generally, for tax ownership to follow economic ownership, economic ownership of IP should also provide the same exclusive and comprehensive right to use, exploit and dispose of the IP without any substantial claim from another party. In this sense, there could be no difference between tax and legal ownership. Therefore, a contractual agreement that grants the right to use and exploit certain IP, but excludes the expressed right to dispose of the IP, would be treated merely as a licensing-type of agreement for tax purposes.

Yet, if the strategy of a parent corporation is to not allow one of its wholly owned subsidiaries to dispose of an IP asset, then it could be irrelevant whether the subsidiary is granted the right to dispose of such IP. In such a situation, it is possible for the parties to enter into a contract under which the exclusive and comprehensive right to use, exploit, and dispose of the IP is expressly granted, despite the parties' intentions not to execute the disposal right during the life of the IP. In this case, tax ownership generally follows legal ownership.

As to patents and copyrights, the legal owner is clearly identifiable under the applicable law that protects such assets. However, know-how is only protected if it is kept a secret. In that sense, the legal owner of know-how is not always identifiable because the knowhow itself is not always clearly definable.

Legally in Japan, it is not possible to establish dual ownership of one asset. Hence, transfer of ownership from one group entity to another group entity can be executed in two ways.

One way to transfer ownership is to transfer the IP to a certain group entity. Jurisdiction-specific IP (eg industrial IP, including patents, tradenames and trademarks) may be easier to transfer inter-company for tax purposes. This ease of transferring results from the lack of issue regarding the IP's territory, hence the source of income for tax purposes is also not an issue.

The other way to transfer IP ownership between groups is to establish co-ownership for the IP. This is typically accomplished by sharing the costs of the IP's development. For Japanese tax purposes, this cost sharing can be accomplished by recasting activities that are carried out as development under an unincorporated joint venture. Certain copyrights and know-how that are universally protected without registration may fit into this arrangement if it is difficult to segment such assets into respective jurisdictions. Under such arrangement, any one co-owner may be able to globally exploit the developed IP without paying any royalty to the other co-owners.

In theory, it is also possible to use this latter structure for jurisdiction-specific IP, such as patents, tradenames, and trademarks. However, for jurisdiction-related IP, the former transfer method is generally simpler for the related tax consequences.

EXPLOITATION OF INTELLECTUAL PROPERTY

Taxation of different forms of income

Japan is one of the countries that adopted a credit system to avoid double taxation. Moreover, Japanese corporate tax laws do not distinguish capital gains and losses from ordinary profits and losses. All gains and losses are put into a single pool for calculating net profits and losses. Therefore, for a Japanese corporation, there is generally no distinction between capital gain, royalty income, and service fee income derived from the exploitation of IP.

On the other hand, under Japanese law it is important to identify the source of the gains or income because different sources of such income could treat the income differently. This distinctive treatment results from the different legal authorities that protect the various types of IP. It is also important to identify the source of income because a Japanese corporation must identify the income source for foreign tax credit purposes.

As to jurisdiction-specific IP (eg patents, certain types of copyrights, tradenames and trademarks), the source of income that is derived from such IP assets is determined based on the jurisdiction in which the asset is registered. Hence, there are limited disputes regarding the source of income from this type of IP assets.

However, the source of income derived from universally protected IP, such as certain types of copyrights and industrial or commercial know-how, could be subject to dispute if there is no legitimate limitation on the territorial scope of the IP. So, it is necessary for related legal documents to include a legitimate limitation on the territorial scope in order to clarify the income source.

Treatment of acquisition costs (expensing or amortization)

IP that is purchased from another party is usually amortized over its statutory life. For example, the statutory life of a patent is eight years, and 10 years for a trademark. An IP asset's tax basis is the net original acquisition cost of the accumulated amortization. Yet, expenses incurred for self-developed IP can be expensed as they are incurred. In this case, developed IP has a zero tax basis. Alternatively, it is also possible, at the option of the taxpayer, to capitalize the expenses and amortize, depending on the nature of the IP involved.

Tax planning

Transferring tax ownership of IP to a foreign manufacturing subsidiary in a low-tax jurisdiction is a viable tax-planning strategy. In this context, a subsidiary is an entity with more than 50% ownership belonging to the parent; a low-tax jurisdiction is a jurisdiction with an effective tax rate of 25% or less. Assuming a transfer of tax ownership is successful, the profit earned by the IP-holding manufacturing subsidiary would increase. In other words, profit generally shifts along with the IP.

To avoid withholding tax on the royalties, the manufacturing subsidiary should earn additional return on its IP in the form of sales proceeds from its goods. However, because the profit is accumulated in a foreign subsidiary that is located in a low-tax jurisdiction, there could be tax consequences under the Japanese anti-tax haven rule. Under certain circumstances, this rule can require current undistributed earnings in a controlled foreign subsidiary to be included, on an accrual basis, in the reportable income of the Japanese parent corporation. Because the manufacturing function is combined with the IP-holding function, it is, however, relatively easy to avoid application of the Japanese anti-tax-haven rule and therefore to achieve tax deferment. If the main business of the subsidiary - and consequently its main revenue source - is from the sale of its own manufactured goods, then it is possible for that subsidiary to license the IP to the other party without further increasing exposure to the anti-tax-haven rule. This possibility is conditioned on the manufacturing-subsidiary remaining in the primary business of manufacturing.

Shifting IP away from high-tax jurisdictions

Shifting IP (cost contribution, cost sharing, contract development) away from Japan - as one of high-tax jurisdictions - cannot be achieved tax-free because any disposition of IP as consideration is taxed in Japan.

An exception to this general rule exists under Japanese tax law for a certain type of contribution-in-kind to a foreign subsidiary. That is, certain IP registered, for example, in a foreign jurisdiction can be treated as an asset located outside of Japan. Such offshore IP can be contributed to a foreign subsidiary and receive a tax deferral.

Before being recently changed, Japanese tax law required that the acquiring foreign subsidiary be a newly established entity with a minimum shareholding ratio of 95% or more. Under the new law, however, the minimum shareholding requirement was abolished and the acquiring foreign subsidiary can be any foreign subsidiary (ie old or new).

IP that specifically covers a non-Japanese territory is ideal for this type of contribution. Conversely, IP that is universally protected must be segmented legally under the inter-company contract in order to utilize this contribution and receive the tax deferment.

It is also worth noting that under the treaty network, there is an exception to these general tax consequence: A US corporation's outright sale to a Japanese corporation of IP located in Japan does not trigger Japanese corporate tax if the consideration is (1 ) not contingent on the productivity, use, or disposition of the IP, and (2) if the selling US corporation does not have a permanent establishment to which such sale is attributable.

Deferral planning for IP profits

This section addresses the circumstances in which high-value IP, held by a Japanese company, is relocated to a subsidiary in a low-tax jurisdiction and thereafter generates a profit.

Upon relocation of IR recognition of revenue can be deferred by using an installment-- sales arrangement for an outright sale of IP. Hence, a seller of IP can defer Japanese taxation, if any, by adopting an installment-sales arrangement under which a non-contingent consideration is divided into at least three installments over a two-year period following the date of the IP's transfer.

After the IP relocation is executed, the tax deferral mechanism under Japanese tax law is subject to the anti-tax haven rule. Under this rule, undistributed earned profits from a controlled foreign corporation (CFC) in a low-tax jurisdiction is included in the reportable income of the Japanese parent corporation on an accrual basis. Unlike the CFC rule in the US, the Japanese rules review application of this rule on an entity-by-entity basis. If an entity is caught trying to avoid the anti-tax haven rule, then that entity entire profits are included in the reportable income of the Japanese parent company. Therefore, it is not possible to avoid the anti-tax haven rule by altering the nature of the subsidiary's earned income.

In accordance with this basic rule, an arrangement for deferring taxation of royalty income can be achieved if certain tests are satisfied. The first test is whether the primary business of the CFC, located in a low-tax Jurisdiction, is licensing the IPs: IP licensing cannot be the primary business of a Japanese corporation's CFC that owns the IP. Rather, such CFC should operate other business activities as its main business, or should use its IP for its own active business such as manufacturing and distributing products.

The other tests for deferring taxation on royalty income are:

* the substance test;

* the local management and control test;

* the unrelated party transaction test; and

* the local business test.

The first two tests should be met in any business operation. Assuming the first two tests are met, either the third test or the fourth test must be satisfied depending on the nature of the CFC's business operation.

If the CFC, which owns the IF, is primarily operating as a manufacturing business, then the fourth test should successfully be met. For example, this test can be met if manufacturing facilities are located in the CFC's country of incorporation.

If the IP-owning CFC is operating contract manufacturing or distribution as its main business, the third test should successfully be met. If the majority of a CFC's purchases or sales are with unrelated parties, this test is also met.

Discussion of favoured IP-owning jurisdictions

As the preceding sections explain, a pure IP-holding company should not be located in a jurisdiction where effective corporate income tax rate is 25% or less. This is because profit that is currently generated and retained in a CFC must be included in the reportable income of the Japanese parent company on an accrual basis - without exception.

Even if an IP-holding company is located in a low-tax Jurisdiction, the profit in that company can still be excluded from the scope of immediate inclusion under the Japanese anti-tax haven rule. This exclusion occurs under certain circumstances when the main business of the company Is not purely IP-holding, but includes other active business operations such as trading. Hence, for tax deferral purposes, it can be beneficial for a Japanese group of companies to own an active operating company, which is located in a low-tax jurisdiction, and which holds IP as its secondary business.