The long-awaited reform of the tax on fixed income financial instruments under the Japanese law finally came into effect on 1 January 2016. The change is a part of an extensive tax reform approved by the Diet and promulgated back in 2013. The core target beneficiaries for the tax reform actually are individuals; however, there are also some key changes, mainly favorable, affecting non-resident investors to facilitate cross-border investment.
The 2016 tax reform on income derived from financial instruments primarily intends to unify the taxation framework around equities and fixed income instruments for the benefit of individual retail investors. The initial proposal for this tax reform dates all the way back to June 2003 when the Tax Commission under the Cabinet Office of the government of Japan officially declared to unify the taxation on financial instruments.
There were two major goals: the first was to simplify the esoteric tax return process that varies by the type of financial instrument, and the second was to allow individual investors to net-off gains and losses arising from the various financial instruments that they hold. You may wonder, why such a tax reform for individuals?
The answer is the serious issue of a rapidly-aging society, coupled with a declining birthrate, in Japan. The government eyed some JPY1,600trn of financial assets – mostly just sleeping in bank deposit accounts held by individuals – to achieve sustainable growth even while the national population declines.
The challenge for the government was how to unleash household wealth into the securities market, enabling more effective use of existing financial assets to support the growth of Japan’s economy. So, it could have been totally irrelevant to non-resident investors; however, the government took the opportunity to also review the taxation of income arising from fixed income financial instruments to support cross-border investment by non-residents – another key investor group.
No more “clean” or “dirty”
When the Japanese Bond Income Tax Exemption Scheme (J-BIEM) was introduced in June 2010, non-residents became eligible for tax exemption on income from corporate bonds, subject to certain procedural requirements.
However, the exemption has not been that simple. Unlike the mainstream practice in global bond markets, clean (or tax-exempt) bonds turn dirty (or taxable) once booked in an account held by a taxable entity between two coupon payment dates. Dirty bonds remain dirty until the next coupon payment date even if they are subsequently purchased by a non-taxable entity if such a transfer happens prior to the next coupon payment date.
Such JGBs are flagged as “temporarily taxable” and kept booked in the segregated taxable account of the local agent bank held with the Bank of Japan (BOJ) because the BOJ was restricting the transfers of JGBs from a taxable account to a tax-exempt account held by direct participants with the BOJ in between two coupon payment dates. The purpose of such transfer restriction was obviously to have only non-taxable JGBs to be booked with the tax-exempt account at the BOJ level.
Now, here is the good news. On 1 January 2016, that rather peculiar “temporarily dirty” bond taxation framework was repealed. The taxability of the coupon arising from fixed income financial instrument handled by the BOJ and JASDEC is simply determined by the tax status of the holder as of each payment date.
Consequently, when a bond is held by a taxable entity as of its coupon payment date, the coupon will be taxed for the whole coupon period; likewise, when a bond that is held by a non-taxable entity as of a coupon payment date, the coupon will be tax-exempt for the whole coupon period.
This is argu-ably the most important change in the bond tax reform, one that significantly benefits J-BIEM eligible non-resident investors, and is expected to improve the investors’ appetite toward Japanese bonds (as was intended by the government).
Accordingly, the operational efficiency of the settlement and taxation procedures has increased. The transfer restriction between coupon payment dates imposed by the BOJ has been lifted and the BOJ has ceased to automatically transfer dirty bonds held by tax-exempt entities from taxable accounts to tax-exempt accounts on coupon payment dates.
The tax adjustment per coupon payment date by the BOJ that used to be the remedy for nontaxable entities that purchased “dirty” bonds in the midst of coupon period has also therefore been abolished.
Drilling down the process
Let’s have a closer look at the detailed changes of settlement and reporting practices as the result of the change mentioned above. First, the “CLEN” or “DIRT” qualifier in tag 22F in SWIFT settlement instructions is no longer subject to prematching on the Pre-Settlement Matching System (PSMS) of JASDEC, and is just ignored if included in instructions.
Fewer items for pre-matching may arguably result in fewer mismatches, thus potentially contributing to reduced settlement failures caused by unintended mistakes in settlement instructions. Second, SWIFT MT535 (statement of holdings) reports from local agent banks have ceased to include the “CLEN” or “DIRT” qualifiers.
Turning eyes to taxation procedures, there are also some notable changes. Firstly, and most importantly, the application to acquire tax-exempt status under J-BIEM shall be renewed every five years from 1 January 2016 onwards.
Submission of a J-BIEM application had been one-time event until the end of 2015, and this is a new requirement to ensure the effectiveness of the Know Your Customer (KYC) process. Qualified Foreign Intermediaries (QFIs) approved by the National Tax Agency shall run KYC for such periodic renewal of the J-BIEM application form.
For this application renewal requirement purpose, all J-BIEM applications submitted on or before 31 December 2015 are deemed to be submitted on 1 January 2016.
Therefore, those forms shall be renewed prior to 1 January 2021, assuming no amendment during the next five years. If any changes made to any of the items set forth in the submitted application, such as a change of address or the name of the entity, shall be reported by amendment application immediately.
The five-year clock resets upon submission of an amendment application. Secondly, the withholding tax agent for fixed income financial instruments is changed from issuers to the local agent bank that pays out coupons and redemptions to final beneficiaries either directly or via QFIs. With this change, Mizuho Bank started functioning as a one-stop withholding tax agent for both fixed income securities and equities.
Redemption income of discount bonds
Another major change in the tax reform package relates to the taxation on redemption income of discount bonds. For this tax purpose, discount bonds include the following:
1. Zero-coupon bonds issued at a discount and redeemed at par
2. Separate Trading of Registered Interest and Principal of Securities (STRIPS)
3. Non zero-coupon bonds issued at a deep-discount (i.e. 90% or less of the face value) and redeemed at par
As a general rule, redemption income derived from discount bonds is subject to withholding tax at maturity coming up on or after 1 January 2016. This is a newly added taxation; however, the government simultaneously adjusted the J-BIEM scheme to cover this withholding tax on such redemption income under the umbrella of J-BIEM for the benefit of non-resident investors.
The National Tax Agency released a new version of the J-BIEM application with an additional tick-box for discount bonds to incorporate this change. Investors that newly apply for the tax exemption status under J-BIEM on or after 1 January 2016 are strongly recommended to double-confirm whether the application form is up-to-date.
Given this revision to the J-BIEM framework, redemption income on discount bonds is subject to withholding tax if and only if it is held at maturity by a taxable investor with no available remedy under any tax exemption framework, such as J-BIEM or double tax treaties.
For nonresidents, if taxable, the tax rate is 15.315% on “deemed redemption income”. Deemed redemption income is calculated based on the redemption amount and the rate determined based on the tenor (i.e., the period from issuance to maturity) of the bond as follows:
1. Tenor up to one year: 0.2% of the redemption amount
2. Tenor over one year: 25% of the redemption amount
Transfer restrictions on CPI-linkers, T-bills and STRIPS lifted
Finally, let’s briefly touch upon the nice secondary effect of the tax reform package that benefits investors. Transfer restrictions that existed for CPI-linked JGBs, T-bills and STRIPS JGBs are abolished due to the changes in the taxation framework. From 1 January 2016, those bonds are able to be freely transferred between all types of investors, including individuals and taxable institutional investors regardless of the maturity.
The taxation on redemption income on discount bonds and five-year expiry rule of J-BIEM application shall require closer attention, but the operational burden caused by the clean/dirty dichotomy as well as the transfer restrictions on T-bills, linkers and STRIPS have become things of the past.