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How Controlled Foreign Corporation Rules Look Around the World: Japan

7 min readBy: Sebastian Dueñas, Daniel Bunn

The second post of this series explains how the Controlled Foreign Corporation (CFC) rules work in Japan. CFC rules were incorporated by Japanese legislation in 1978. In 2017, Japan amended its CFC legislation to adjust the rules with some of the recommendations provided in the OECD BEPS project.

Japan had a worldwide tax systemA worldwide tax system for corporations, as opposed to a territorial tax system, includes foreign-earned income in the domestic tax base. As part of the 2017 Tax Cuts and Jobs Act (TCJA), the United States shifted from worldwide taxation towards territorial taxation. until 2009, meaning its taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. system was designed to tax corporate income regardless of whether it was earned in Japan or in foreign locations. Before the 2009 tax reform the Japanese system was similar to the U.S. worldwide tax system prior to 2017. Similar to the U.S. reform, the Japanese tax reform was motivated by the tax deferral levels reached by Japanese subsidiaries operating abroad. Instead of bringing foreign profits back to be reinvested in Japan, the profits were held offshore.

In 2009, Japan introduced an income tax exemptionA tax exemption excludes certain income, revenue, or even taxpayers from tax altogether. For example, nonprofits that fulfill certain requirements are granted tax-exempt status by the Internal Revenue Service (IRS), preventing them from having to pay income tax. for foreign dividends remitted by non-Japanese subsidiaries of Japanese corporations (a so-called participation exemption), moving towards a more territorial system of taxation.

The structure of the Japanese CFC rules is now very similar to the way the rules are structured in many other countries. As with many other systems, the Japanese rules begin with a determination of whether a foreign company is a CFC for purposes of corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. . The determination combines a total ownership threshold with a single ownership threshold as happens under U.S. legislation. The rules also generally apply to all income received by the CFC, with specific exemptions for active business income, which is a common characteristic with some European Union member countries. Finally, the rules include the application of a corporate tax threshold for the CFC income to be taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. for the parent corporation.

Shareholding requirement for the control determination in Japan

To determine if a foreign entity is a CFC, Japan combines two ownership tests and an additional test to target specific tax arrangements. Under the first test, a foreign-related corporation (FRC) is considered a CFC if 50 percent of the shares of the company are owned by Japanese shareholders. Under the second test, a Japanese shareholder is defined as a company or any associated person that holds 10 percent or more of the outstanding shares of a CFC.

The third test is a de facto test under which a foreign company is considered a CFC by de facto control. This means that in specific cases when the two ownership tests have been applied and there is not enough evidence to characterize the foreign company as a CFC, the third test is applied to qualify a foreign corporation as a CFC. A foreign company is a de facto CFC if it is determined that Japanese resident individuals or corporations do not have apparent direct or indirect ownership but have the right to claim all or almost all of the residual assets of the foreign corporation.

To illustrate how the rules work, imagine that Sara and Japan Co. are both Japanese persons and each directly owns 26 percent of a foreign entity called ForCo A. Because both Sara and Japan Co. own a total of 52 percent of the foreign corporation under Japanese rules, ForCo A is considered a CFC. Additionally, both Sara and Japan Co. each hold 26 percent of the shares of ForCo A, making them Japanese shareholders of the corporation (10 percent is the amount established to be considered as a shareholder).

For a second example, imagine that foreign corporation ForCo B is going to end its operations and be liquidated and there are no direct or indirect Japanese shareholders registered. Then, when the ForCo B is liquidated, the remaining assets are distributed to Japanese individuals or corporations through various arrangements. The fact that the assets are distributed to Japanese individuals and corporations means that ForCo B can be considered a CFC under the de facto control test.

Applicability of the rules

Once an entity is categorized as a CFC, it is necessary to determine what part of the foreign income earned by the corporation should be taxed in Japan. If a foreign subsidiary is in a country where there is no income tax, or the corporate tax rate is less than 30 percent of the Japanese corporate tax rate in case of shell companies and 20 percent of the trigger rate in the case of companies producing passive income, then CFC income of the foreign subsidiary is taxed in Japan. There is no way to establish a standardized trigger rate because the Japanese corporate income tax varies by firm size, income level, and region, leading to a complex system.

The purpose of the rules is to avoid having Japanese multinationals move their investments into other countries where low or no taxes are paid and allow them to partially or totally avoid the Japanese corporate income tax.

CFC rules may be waived if a foreign subsidiary conducts an active business in the foreign country that involves the use of a fixed place in the country (it can be an office, store, factory, or other place to conduct its activities). Even if it has been demonstrated that there is an active business, certain passive income is taxed in the hands of the Japanese parent company. Under Japanese legislation, that passive income includes dividends, interests, royalties, and capital gains.

The rules are not applicable when the gross income of a CFC does not exceed 20 million yen or does not exceed 5 percent of the aggregate net income before tax in a fiscal year. The rules then exempt income that is below the threshold even if it is CFC income, and as a consequence, the income is not taxed in the parent company.

In 2017, Japan included in its CFC rules not only passive income but also all income that is earned by a foreign-related company that is qualified as a Paper Company, a Cash Box, or a company incorporated in one of the Black-Listed territories. The 2017 rules also require that any of these kinds of foreign companies are subject to a corporate tax rate that is less than 30 percent of the Japanese corporate tax rate.

Paper companies are business entities with no substance (like physical assets or employees) or without its own administration or management where the head office is.

Cash box companies are business entities that meet both of two tests; first a passive income test that measures if the CFC has more passive income than assets, and second an asset test that measures if the CFCs total amount of securities, loan and receivables are higher than the total assets. In the case of financial subsidiaries, the formula is modified, and the CFC income inclusion is partially taken from the comparison between the larger of income generated from overcapitalization or the sum of leasing fees, royalties, capital gains, and abnormal income.

The black or white list method is a suggestion made by the OECD on BEPS Action 3 to include a list of countries that do not comply with the basic taxation standards established in the BEPS project. When there is a CFC incorporated in one of the countries on the black list, then all CFC income is taxed at the parent level.

What is the type of income that is taxable, all income or just passive income?

Japanese legislation mainly targets foreign passive income (dividends, interest, royalties, and capital gains), and income derived from low-tax jurisdictions. In the case of paper companies, companies considered as cash boxes, and black-listed CFC companies, all CFC income is taxable in Japan.


Japan is a country with a complex multilayer system to calculate the corporate income tax. As a consequence, the CFC income determination has evolved as a complex set of rules to complement the corporate income tax. It would be a great idea for the Japanese authorities to address a simplification of the rules to facilitate the entry of new capital investments into their economy.

Note: This is the second of nine posts which describe how CFC rules work in the United States, China, Spain, Germany, Colombia, France, Netherlands, Japan, and the United Kingdom. A longer discussion of the history of CFC rules and more details on these countries can be found here.

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