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Japan: Constructive dividends from reduction of paid-in capital

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2001 tax reform

Japan's tax reform 2001 has changed the tax treatment of constructive dividends arising from a reduction of paid-in capital.

The Japanese Commercial Code recognizes several methods of reducing paid-in capital, including the redemption of issued shares, reduction of par value of shares, etc. A constructive dividend is recognized for tax purposes only when a company pays out a consideration to its shareholders at the time of a paidin capital reduction.

Corporate shareholders and constructive dividends

The following scenario can be used to explain the new rules. A corporate shareholder receives a consideration of 100 from a capital reduction. Its tax base in the shares is 80. The total amount of paid-in capital (40) and capital surplus (10) related to the redeemed shares is 50.

The new rules provide that the constructive dividend is the difference between the amount received (100) and the total (50) of paid-in capital (40) and capital surplus amounts (10). The constructive dividend amounts to 50.

The old rules provide that the amount of constructive dividend is the difference between the amount received (100) and the greater (80) of either the tax basis in shares (80) or the total (50) of paid-in capital (40) and capital surplus amounts (10). The constructive dividend thus amounts to 20 in comparison with 50 under the new rules.

The new constructive dividend rules also influence the calculation of capital gains and losses from a reduction of paid-in capital. Constructive dividends are deducted from the consideration and the balance is compared with the tax basis of the shares to calculate a capital gain/loss.

Under the old rules, the balance of 80 (consideration of 100 minus constructive dividends of 20) equals the tax basis (80) in the shares. Therefore no capital gain or loss is recognized.

Under the new rules,...