Outline
Although the corporate tax rate will be reduced by the amendment, some rules will be abolished or changed, for the purpose of increasing taxable income. Some previously deductible expenses related to accrued items, which are not clearly defined or which are realized over a long-term period, will be disallowed. Certain reserves have been specifically targeted as described below. The effective date for the application of the new rules is taxable years beginning on or after April 1, 1998. Therefore, companies whose fiscal year ends December 31, 1998 are not subject to these new rules unless the companies were founded on or after April 1, 1998.
Bad Debt Reserve
1.Large Companies (Capital of more than Yen 100 million)
1 Statutory percentage will be repealed and average percentage of actual write off of bad debt ("actual percentage") will take its place. However, for the fiscal years of 1998 through 2002, the statutory percentage is also allowed to be used, although the percentage will be gradually phased out as shown in the chart below.
Statutory Percentage (1/1000)
Taxable Year
Type of Business Previous FY ended FY ended FY ended
Ratio Dec. 1998 Dec 1999 DEC 2000
Wholesale/Retail 10 10 8.0 6.5
Manufacturing 8 8 6.5 5.0
Financial/Insurance 3 3 2.5 2.0
Retail installment sales 13 13 10.5 8.5
Others 6 6 5.0 4.0
Statutory Percentage (1/1000)
Taxable Year
Type of Business FY ended FY ended FY ended FY ended
Dec 2001 Dec. 2002 Dec 2003 DEC 2004
Wholesale/Retail 5.0 3.0 1.5 0
Manufacturing 4.0 2.5 1.0 0
Financial/Insurance 1.5 1.0 0.5 0
Retail installment sales 6.5 4.0 2.0 0
Others 3.0 2.0 1.0 0
2 Receivables outstanding at the end of the taxable year are to be classified into separately evaluated receivables and ones evaluated together in a single pool ("general receivables").
- Separately evaluated receivables:
- Deductible amount is calculated in the same manner as the special bad debt reserve under current law.
- General receivables:
- Deductible amount is calculated by the actual percentage. (Statutory percentage
- is also available for the taxable years beginning before March 31, 2003.)
3 Limitation of deduction for bad debt reserve is the sum of the limit for separately evaluated receivables and general receivables.
4 For companies whose fiscal year ends December and which were founded on or after April 1, 1998, the ratio for " FY ended Dec. 1999" is applied for the year ended December 1998 as well.
2.Small Companies (Capital of Yen 100 million or less)
- 1 Statutory percentage is available as before. No phase out rule to apply.
- 2 Receivables outstanding at the end of the taxable year are to be classified into separately evaluated receivables and general receivables.
- Separately evaluated receivables:
- Deductible amount is calculated in the same manner as the special bad debt reserve under current law.
- General receivables:
- Actual percentage or statutory percentage may be selected.
- 3 Limitation of deduction for bad debt reserve is the sum of the limit for separately evaluated receivables and general receivables.
- 4 16% increase of the limitation for the small companies is extended for another 3 years.
3.Matters To Be Attended To In Closing Account
(1) Statutory percentage for large companies will be phased out over the next five years and will not be available after that time. Therefore, companies currently applying only the statutory percentage should evaluate the effect of the change by comparing the amount of deduction of the statutory percentage to that of the actual percentage. If the company would take bad debt losses or account for provision for separately evaluated receivables by examining each doubtful receivable, it would help to minimize the negative effect caused by this change.
(2) Special bad debt reserve is to be merged into bad debt reserve. Before the amendment, a special bad debt reserve could be created if 40% or more of a certain receivable is expected to be uncollectable, and the district director of a tax office confirms the amount of the reserve. The amended provision does not include this provision. This is because if a part or all of a receivable is expected to be uncollectiable, it falls into the group of "Separately Evaluated Receivables". As the receivables in this group are evaluated separately, it is not necessary to set up a pre-determined percentage, such as 40% for the uncollectable portion.
(3) In connection with the amendment, the company may need to reconsider its way of managing collection of the receivables as well as development of a system of valuation of the receivables. Without such a system, the company may have difficulty getting a tax benefit from the deduction of bad debt reserves, as deduction allowed for general reserves is to be calculated based on the actual experience, which includes partial write off. Therefore, the company needs to have the capability to evaluate doubtful receivables separately to account for actual experience. Also, current economic circumstances may add to the value of such a system.
Bonus Payment Reserve
1 The deduction for bonus payments using a reserve system will be abolished progressively from fiscal years starting on and after April 1, 1998.
The limit allowed for tax purposes (A) for companies, whose fiscal year ends December, is computed against the limit for current tax purposes.
Previous FY ended FY ended FY ended FY ended Ratio Dec.1998 Dec.1999 Dec.2000 Dec.2001 A A A x 5/6 A x 4/6 A x 2/6
FY ended FY ended FY ended Dec.2002 Dec.2003 Dec.2004 A x 2/6 A x 1/6 0For companies whose fiscal year ends December and which were founded on or after April 1, 1998, the ratio for " FY ended Dec. 1999" is applied for the year ended December 1998 as well.
In order to avoid the increase in taxable income due to the phase out of the reserve system, the company should revise the payment terms and notification procedures, as outlined below.
2 From fiscal years starting on or after April 1, 1998, a bonus, which meets all the following conditions, is allowed for tax purposes.
- 1 The bonus amount is notified to employees by the last date of the fiscal year.
- 2 The bonus is paid by one month after the day following the fiscal year end in which is notified.
- 3 The amount is expensed for the fiscal year which ? is notified.
The above new rules are applied for companies, which were founded on or after April 1, 1998, from the fiscal year ended December 1998.
Retirement allowance reserve
From the fiscal year starting on and after April 1, 1998, the amount accumulated in the retirement allowance reserve will be decreased progressively.
The amount accumulated in this reserve for companies whose fiscal year end is in December is computed against the amount required for retirement allowance at the end of fiscal year as follows:
Previous FY ended FY ended FY ended FY ended FY ended Ratio Dec.1998 Dec.1999 Dec.2000 Dec.2001 Dec.2002 40% 40% 37% 33% 30% 27%
FY ended Fiscal Year Dec.2003 2004 23% 20%For companies whose fiscal year ends December and which were founded on or after April 1, 1998, the ratio for " FY ended Dec. 1999" is applied for the year ended December 1998 as well.
The transition from retirement allowance reserve to approved pension fund is thought as countermeasures.
For any specific questions regarding these articles, do not hesitate to contact Hiroshi Isawa at 03- 3288-3357(telephone) or at 03-3506-2459(fax).US Final Regulations Classifying Transfers of Computer Programs and Japanese Tax Treatment on The Transfers of Computer Programs
IRS Issues Final Regulations Classifying Transfers of Computer Programs
The IRS has issued final regulations (Reg. Section 1.861-18) that classify certain transactions involving computer programs for purposes of the international provisions of the Internal Revenue Code and for interpreting U.S. tax treaties. They were finalized after giving consideration to various opinions and comments raised regarding the proposed regulations issued on November 27, 1996.
The regulations, which became effective October 2, 1998, apply to transactions occurring pursuant to contracts entered into on or after December 1, 1998. Taxpayers may elect to apply transition rules for contracts entered into prior to December 1, 1998.
The regulations make reference to specific Internal Revenue Code sections dealing with sourcing of income. However, the addition of these source rules, arguably, does not provide taxpayers with additional information. The normal source rules apply after the regulations determine the proper classification of the specific transaction.
Perhaps the most fundamental distinction drawn by the final regulations is between a transfer of a copyright right and a transfer of a copyrighted article. For the international tax provisions, this distinction is critical to whether revenues from the transaction are treated as royalty income, rental income, or sales proceeds. The final regulations also provide guidance regarding the revenue attributable to the provision of services or know-how.
Categories of Transactions
The regulations generally require that transactions involving the transfer of a computer program, or the provision of services or of know-how with respect to a computer program (collectively, a transfer of a computer program), be treated as being solely within one of four categories:
- 1. A transfer of a copyright right in the computer program;
- 2. A transfer of a copy of the computer program (a copyrighted article);
- 3. The provision of services for the development or modification of the computer program; or
- 4. The provision of know-how relating to computer programming techniques.
Copyright Rights
The transfer of a computer program will be classified as a transfer of a copyright right if, as a result of the transaction, a person acquires one or more of the outlined "copyright rights:"
- 1. The right to make copies of the computer program for purposes of distribution to the public by sale or other transfer of ownership, or by rental, lease or lending;
- 2. The right to prepare derivative computer programs based upon the copyrighted computer program;
- 3. The right to make a public performance of the computer program; or
- 4. The right to publicly display the computer program.
The determination as to whether a transaction, involving the transfer of a copyright right, will be classified as either a sale or exchange, or a license generating royalty income is made on the basis of whether, taking into account all facts and circumstances, there has been a transfer of all substantial rights in the copyright. A transaction, involving the transfer of a copyright right, that does not constitute a sale or exchange will be classified as a license.
Copyrighted Article
If a transaction involves the transfer of a computer program without any of the copyright rights (described above) or the provision of services or know-how, unless more than a de minimis grant of such rights is transferred, the transfer of the computer program will be classified solely as a transfer of a copyrighted article.
The determination as to whether a transaction, involving the transfer of a copyrighted article, will be classified as either a sale or exchange, or a lease generating rental income is made on the basis of whether, taking into account all facts and circumstances, the benefits and burdens of ownership have been transferred. A transaction, involving the transfer of a copyrighted article, that does not constitute a sale or exchange will be classified as a lease.
Under the regulations, the right to (1) use software development tools to create an insubstantial component of a new program, or (2) modify the source code to correct minor errors and make minor adaptations to a computer program is considered to be a de minimis copyright right. However, the final regulations do not provide that where no independent value attaches to the exploitation of the right to prepare derivative computer programs, such right must be treated as de minimis. Treasury and the IRS believe that in most (but not all) cases where no independent value attaches to the grant of the right to prepare derivative computer programs, the right is de minimis.
Provision of Services
The determination of whether a transaction involving a newly developed or modified computer program is treated as either the provision of services or another classification under the regulations is based on all the facts and circumstances of the transaction, including the intent of the parties as to which party is to own the copyright rights in the computer program and how the risks of loss are allocated between the parties.
Provision of Know-how
The provision of information with respect to a computer program will be treated as the provision of know-how only if the information is - (1) Information relating to computer programming techniques; (2) Furnished under conditions preventing unauthorized disclosure, specifically contracted for between the parties; and (3) Considered property subject to trade secret protection.
Elective Transition Rules
The regulations apply to transactions occurring pursuant to contracts entered into on or after December 1, 1998. Taxpayers may elect to apply the regulations to all transactions occurring pursuant to contracts entered into in taxable years ending on or after October 2, 1998. Taxpayers may also elect to apply the regulations to transactions occurring in taxable years ending on or after October 2, 1998, pursuant to contacts entered into before the current year, provided the taxpayer would not be required, under the regulations, to change its method of accounting as a result of such election, or the taxpayer would be required to change its method of accounting but the resulting §481(a) adjustment would be zero.
Automatic Accounting Method Changes
A taxpayer is granted consent to change its method of accounting for contracts involving computer programs, to conform with the prescribed classifications in the regulations. In order to obtain automatic consent to change a method of accounting, Form 3115 must be filed.
Other Considerations and Planning Opportunities
The regulations also provide taxpayers with several planning opportunities and items for further consideration. A few of these items are briefly discussed below.
Sourcing: Sales vs. Leasing or Royalty Income
As a result of providing guidance to classify transfers of computer programs as either sales or exchanges or licenses, in the case of transfers of copyright rights, or sales or exchanges or leases in the case of transfers of copyrighted articles, taxpayers may have an opportunity to review existing agreements related to such transfers and re-source sales income as licensing or leasing income in order to increase foreign source income.
Transfer of Copyright Rights vs. Copyrighted Articles
In making the determination under the final regulations whether copyright rights have been transferred, the right to copy the transferred computer program for distribution to the public arguably is the most important factor in determining whether a transfer of a computer program involves the transfer of a copyright right.
Consider the results of Examples 8 and 9 in the final regulations. Example 8 involves the transfer of a master disk to an OEM under a non-exclusive license, from which an unlimited number of copies of the computer program can be made on the hard drives of computers the OEM manufactures for distribution to the public. The example concludes that the arrangement involves the transfer of a copyright right, i.e., the ability to make an unlimited number of copies of the program for distribution to the public. Example 9 also involves the transfer of a computer program to an OEM. However, the OEM receives physical disks covered by shrink-wrap licenses. Under the license agreement the OEM is not permitted to make additional copies of the program. Rather the OEM may only load a single copy of each program onto the hard drives of computers the OEM manufactures for distribution to the public. Contrary to the result in example 8, example 9 concludes that a copyright right has not been transferred to the OEM and, the efore, the transfer is characterized as the transfer of a copyrighted article.
It is important to note that the regulation applies irrespective of the physical, electronic or other medium used to effectuate a transfer of a computer program. It appears that a difference in treatment does occur in the examples above. As a result, the proper treatment is still unclear in the situation of an OEM that receives a master disk under a non-exclusive license, from which a specific number of copies of the computer program can be made on the hard drives of computers the OEM manufactures for distribution to the public.
Treaty Implications
As these regulations modify domestic law with regard to classifying transfers of computer programs, taxpayers may have an opportunity to reduce or eliminate withholding taxes on transfers of computer programs into the U.S. by Japanese companies (if the transfers of computer programs are treated as sales or license income as a transfer of copyright rights). Conversely, U.S. multinationals may be faced with asymmetrical treatment with respect to transfers of computer programs: the U.S. classifies the transfer of a computer program as the sale of a copyright right, whereas, the local country (for example, in Japan) characterizes the transaction as a license, subjecting the "royalty" to local country withholding tax. U.S. multinationals subject to "double taxation" will likely have to consider the costs/benefits of applying to U.S. Competent Authority for relief.
Japanese Tax Treatment on the Transfer of Computer Program
Under Japanese tax law, there are no clear guidelines or statutes such as the final regulations discussed above. Following is a summary of current Japanese tax treatment on the consideration paid by a Japanese company with regard to transfer of a copyright right or copyrighted article by a foreign company.
Transfer of Copyright Right
Under the Japanese income tax law, consideration paid for the use of, or transfer of, a copyright is subject to withholding tax. The term "copyright" used in the tax law is defined by reference to the Copyright Law. The tax law describes consideration paid for use of or transfer of copyright as all the consideration paid for the right of reproduction, performance, recitation, broadcasting ......use of copyrighted article.
Under the Copyright Law, "copyright" includes the right of reproduction, the right of distribution, the right of lending, etc. therefore, a transfer of the right of reproduction is categorized as a transfer of a copyright right and is treated as Japan source income. If a foreign company has no PE (permanent establishment, such as branch or an office) in Japan, only 20% withholding tax will apply. (No corporate tax will be due.) If the payment is made to a U.S. company, and such transfer is a true transfer of the copyright rights, such transfer is treated as a transfer of a capital asset, thus, tax exempt under the Japan/US Tax treaty. If the transfer is not regarded as a true transfer of a capital asset, the payment is classified as royalty and is subject to withholding tax.
Transfer of Copyrighted Article
Under the Copyright Law, a copyrighted article is defined as products expressing thoughts, emotion in the form of literature, science, arts or music (Article 2-1 of the Copyright Law). And copyrighted article of a program is listed as an example of copyrighted article (Article 10-1-9). Therefore, consideration paid for the right of reproduction or the lending of a computer program (copyrighted article) is categorized as the use of copyright under the Copyright Law, and thus, is treated as a royalty for tax purposes. However, a transfer of copyrighted article is not defined as a copyright under the Copyright Law, therefore, it is not treated as a royalty, which is subject to withholding tax.
As a practical matter, there is no specific definition with regard to "a transfer of copyrighted article" under the tax law, therefore, each case should be reviewed on a case by case basis taking into account all the facts and circumstances. As a result, discrepancies may occur, namely, in the situation where a foreign company thinks it is a transfer of copyrighted article, thus, treated as a sales under the U.S. tax law while Japanese tax authorities treat it differently.
For example, as in the example 9 described above, when a Japanese company purchases a necessary number of copies in order to load a single copy of each program onto the hard drives of computers for distribution to the public, it is treated as a transfer of copyrighted article under the U.S. rules, however, it may be considered as the granting of a right to lend a copyrighted article (a part of copyright) for Japanese tax purpose. In this case ,, the payment would be subject to Japanese withholding tax as a royalty income.
In the case of so-called packaged software with a low selling price and which is widely used, if a Japanese distributor purchases the packaged software (products) and sells them to customers without any change to the products (since the products are shrink-wrapped, the products cannot be opened), such transfer is treated as a sale of products such as a sale of books, therefore, the transfer would not be subject to withholding tax.
As you can see, the Japanese tax authorities tend to limit the scope of "a transfer of copyrighted article". Consequently, most transactions are treated as a royalty payment subject to 20% withholding tax (reduced tax applies under the respective tax treaties).
Ongoing Issues
With the rapid growth in the software industries, there are more difficult cases to determine which are license transactions or sales transactions such as a packaged software. When a Japanese company pays consideration to a foreign company, the Japanese company will tend to limit the interpretation of a no withholding tax transaction as much as possible since a payer has an obligation to collect withholding. With the announcement of the final regulation, more and more conflict will be expected. Japanese companies should consider using professional advice on whether withholding tax should apply, how to manage a foreign company requests not to withhold taxes or if a foreign company applies to the Competent Authority process, etc.
For any specific questions regarding these articles, do not hesitate to contact Thomas W. Hatheway at 03-3288-4350(telephone) or contact to Kazuo Ando at 03-3506-2430 (telephone).
