On March 18, 2014, the Tokyo District Court affirmed corporate tax assessments against two tax payers: Yahoo Japan Corporation ("Yahoo Japan"), a Tokyo Stock Exchange listed company, and IDC Frontier Inc. ("IDCF"), a wholly owned subsidiary of Yahoo Japan.

The main issue of the Yahoo Japan case was whether, upon a tax-qualified merger, the surviving company (Yahoo Japan) was entitled to utilize net operating losses ("NOLs") of the acquired company pursuant to Article 57 of the Corporation Tax Act of Japan ("Act"). In Yahoo Japan, while Yahoo Japan formally satisfied the requirements of Article 57, the tax authorities denied Yahoo Japan's utilization of the NOLs of the acquired company by applying Article 132-2 of the Act, a general anti-avoidance rule. Under Article 132-2, if the corporate tax burden is determined to be unduly decreased due to a reorganization transaction (i.e., it would be unfair for Yahoo Japan to utilize the tax losses of the acquired company after the merger), the Japanese tax authorities are empowered to deny the reorganization transactions (e.g., merger, company split, share exchange, etc.) or the book entries thereof and compute the taxable income or net operating losses as they deem appropriate

The main issue in the IDCF case was whether a company (IDCF) that was newly incorporated as a wholly owned subsidiary of the transferor upon a company split was entitled to recognize goodwill (which is recognized only in the case of a nonqualified company split and is depreciable for five years on a straight line basis) pursuant to Article 62-8 of the Act. In IDCF, the transferor company was scheduled to sell its shares in IDCF upon the completion of company split, and thus the company split did not formally fulfill the requirements of a tax-qualified company split. Accordingly, IDCF recognized goodwill pursuant to Article 62-8 of the Act. Nonetheless, the tax authorities also denied IDCF's recognition of the goodwill and deduction of depreciation expense for corporate tax purposes by applying Article 132-2 of the Act.

The court held in each case that Article 132-2 of the Act is applicable not only to (i) cases where the reasonableness or economic substance of a reorganization transaction is questionable, but also (ii) cases where acts constituting part of reorganization transactions formally satisfy certain requisite conditions of corporate reorganization taxation (by virtue of which the company can enjoy a decrease of its tax burden). However, the allowance of such a decrease in the tax burden would clearly conflict with the underlying policy of the corporate reorganization taxation system or the relevant provisions. Further, the court concluded in each case that the tax authorities' denial pursuant to Article 132-2 was legitimate and dismissed Yahoo Japan's and IDCF's claim.

These two judgments were the first judgment in which a court applied Article 132-2 of the Act, and the scope of the Article 132-2 was interpreted broadly. Both Yahoo Japan and IDCF appealed the judgments, and the cases are now pending in the Tokyo High Court.

If the decisions of the Tokyo District Court are upheld, the predictability of tax decisions for corporate reorganizations would regress, and tax practitioners would be required to give careful consideration to the risk of denial by the tax authorities pursuant to Article 132-2 of the Act when providing tax advice.

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