Issues with withholding tax
Up until the tax reform, whether dividends received by foreign investors of Sukuk issued by Japanese companies are subject to Japanese withholding tax has been under discussion. Japan is a country that imposes tax principally based on a ‘legal nature’ and not ‘economic effect.’ Sukuk is often called an Islamic bond, but the legal nature of Sukuk is not the same as that of conventional bonds.
From a Japanese legal and tax viewpoint, Sukuk could be deemed as a trust beneficial interest, and thus, the withholding tax exemption applicable to conventional bonds may not be applicable to Sukuk.
This ambiguity in tax treatment has caused Japan to lag behind other countries with regard to attracting investments from Islamic investors. The tax reform will create a level playing field between tax treatment for J-Sukuk and conventional bonds.
J-Sukuk under the tax reform will have the following characteristics:(i) J-Sukuk is a special kind of beneficial interest pursuant to the Act on Securitization of Assets (Securitization Act);
(ii) Under certain conditions, withholding tax and several other taxes regarding J-Sukuk are exempt;
(iii) The typical structure of J-Sukuk is real estate Sukuk Ijarah, but the Securitization Act does not restrict the structure of J-Sukuk to only real estate Sukuk Ijarah; and
(iv) Sukuk could be issued a structure other than one which uses a special kind of beneficial interest pursuant to the Securitization Act. However, the tax treatment of such type of Sukuk is unclear.
These features are explained below.
Legal nature of J-Sukuk
The legal nature of J-Sukuk is a special kind of beneficial interest pursuant to the Securitization Act. Under the Securitization Act, one can establish a trust called a specified purpose trust (SPT). An SPT can issue an ordinary beneficial interest and a special kind of beneficial interest called a ‘quasi-bond beneficial interest’ (QBI), which has the following features:
(i) the schedule and amount of principal redemption is pre-determined;
(ii) the schedule and amount of dividends are pre-determined (fixed rate or floating rate such as Libor+α);
(iii) a beneficiary of a QBI shall have no right to instruct the trustee as to administration and disposition of the trust assets;
(iv) a beneficiary of a SPT shall exercise its beneficiary right through a beneficiaries’ meeting; and
(v) the voting rights of a QBI’s beneficiaries are limited to certain significant matters such as amendments to the trust agreement, exemptions of liability of the trustee, etc., and termination of the SPT.
It is often questioned whether the term ‘quasi-bond’ would cause any issues under Shariah. The Securitization Act uses such a term because the economic nature of a QBI is similar to that of conventional bonds.
However, the legal nature of a QBI is not debt but a beneficial interest, and dividends from a QBI are not interest.
The Financial Services Agency of Japan (J-FSA) has discussed this issue with reputable Shariah scholars and was advised that the term ‘quasi-bond’ would not cause a QBI to be non-compliant with Shariah.
Under certain conditions, withholding tax and several other taxes regarding J-Sukuk are exempted
The tax reform stipulates that under certain conditions, withholding tax and several other taxes regarding J-Sukuk are exempted.
First, if a QBI is recorded and traded under the book-entry transfer system in Japan, income tax (withholding tax) shall not be imposed with respect to dividends from J-Sukuk received by a nonresident or foreign corporation.
Second, tax reform also stipulates the exemption of real estate transfer taxes relating to J-Sukuk. Real estates are typical assets which Japanese companies want to use as assets for backing the issuance of Sukuk. Thus, the exemption of real estate transfer taxes relating to J-Sukuk is significant.
Typical J-Sukuk structure
The typical J-Sukuk structure to be adopted under the tax reform is the real estate Sukuk Ijarah scheme below and each of the following taxes shall not be imposed in relation to such scheme as a result of the tax reform.
(i) Real property acquisition tax and registration and license tax for the transfer of ownership of real estate at the time of entrustment
(ii) Real estate acquisition tax and registration and license tax for the repurchase of real estate by the trustor at the time of the SPT’s termination
(iii) Tax for capital gains from the sale and purchase of J-Sukuk where an assignment of J-Sukuk is made among foreign investors
(iv) Dividends from J-Sukuk received by a non-resident or foreign corporation
Flexibility of J-Sukuk: other assets
Under the Securitization Act, a SPT may acquire any assets, roughly speaking, other than a partnership contract or an anonymous partnership agreement rights, a beneficial interest of a money trust, and shares or equity beyond certain amounts.
Thus, other than real estate, which we referred to above as a component of the typical J-Sukuk structure, movable property, intellectual property, vessels, aircraft, or other assets can also be used to back the issuance of J-Sukuk.
Flexibility of Japanese Sukuk
For the purpose of clarification, Sukuk do not have to be issued using a QBI of a SPT. For example, a limited liability company as set forth in the Companies Act, which is a vehicle often used in securitization transactions in Japan, may issue Sukuk backed by a beneficial interest with real estate or other assets as its trust property. Such Sukuk might have more flexibility than J-Sukuk.
However, as noted above, there is a possibility that dividends received by foreign investors of such Sukuk shall be subject to Japanese withholding tax.
Conclusion
The J-FSA is now trying to promote Islamic finance in Japan. The J-FSA announced in “The Action Plan for the New Growth Strategy” published in December 2010, that it will promote the development of the Sukuk market in Japan.
In addition to the tax reform, the Tokyo Pro-Bond Market, which is a flexible bond market recently established for professional investors, announced that it would accept J-Sukuk as listed products in the Tokyo Pro-Bond Market.
rm Nishimura & Asahi. They can be contacted at
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