J@pan Inc -- Inheritance Taxation Planning

Speaking with the oracle of Otemachi.
By John Dodd / Photos by Andy Rain

Takashi Hongo

When the founder of McDonald's Japan, 78-year-old Den Fujita, passed away on April 21, 2004, he bequeathed a rags-to-riches story worthy of dramatization. Born in Osaka, he was brought up bilingually and worked as a translator to earn pocket money during high school. After World War II, with his father dead and family home and most assets destroyed, Fujita started an import business, the profits from which paid his college tuition. He graduated from the University of Tokyo in 1951.

He remained in the import business and, as the story goes, ate his first McDonald's meal while on a business trip to the States in 1967. Impressed with the speed and convenience, he felt the Golden Arches had a future in Japan. Four years and numerous negotiations later, he won the right to become McDonald's joint venture partner in Japan. Fujita opened his first restaurant on July 20, 1971, on a tiny 50 sq. meter lot in Ginza, Tokyo.

Fujita took a huge risk in opening his first restaurant; back then everyone said that Western food eaten with the hands wouldn't sell in Japan. He proved the naysayers wrong. Today McDonald's Japan is by far the largest fast food chain in the country. In 2004 the company had 3,774 restaurants and sales of JPY308 billion (US$2.68 billion). By the time of his death, Forbes identified Fujita as the 437th richest person in the world.

Fujita's is a pretty good story and one that normally would inspire both journalists and future generations of readers to consider entrepreneurship and the meaning of life.

But instead what captivated the Japanese media was the inheritance tax that his heirs had to pay. He left a massive estate worth JPY49.1bn, consisting of real estate, bank deposits, and shares in McDonald's Holdings Japan. The inheritance was purportedly the sixth largest on record in Japan, and the tax hit punctured an otherwise fairytale ending to a productive life. The total tax, JPY-12.2bn, attracted widespread commentary about the fairness of hitting surviving families of successful individuals for death taxes especially after the person earned, rather than inherited, the money, and had already paid income and capital gains taxes.

Are Death Taxes Fair?
Inheritance tax is a hot topic anywhere, and, because of a rapidly graying society where more than 30 percent of business owners are older than 60, nowhere more so than in Japan. The tax was introduced in 1905 and then modified by the Occupation Forces in 1950. It was meant to forestall the accumulation of wealth within certain business families, reinforcing the egalitarian aspect of Japanese society, where everyone is expected to work for their rewards, and everyone gets a chance.

This philosophy appeals to the masses, who wish to maintain the fiction that everyone in Japan is middle class; so the tax is structured to target a small, enviable segment of the population - successful business people and artists/celebrities who have made more than their fair share.

But in the last 20 years another segment of the population has come to be hit by inheritance tax. This segment, which has public sympathy, presents a problem for politicians. It consists of regular company employees grandparents living on modest plots whose value has skyrocketed. Many of these people moved back to the ruins of postwar Tokyo and Osaka and carved out a living under the toughest circumstances. They never made much money. They don't want to move, and they certainly don't feel rich or lead extravagant lives. So when they pass away, the tax bill comes as a shock to their heirs.

Because such people form a sizable voting bloc, the government has been trying to adjust the tax regime. One result is that the valuation of houses on plots up to 240 square meters in area has been reduced by as much as 80 percent. The deduction now stands at JPY70-100 million, depending on the number of heirs to the estate.

Regardless of whether you think the government has the right to make everyone start at zero (relatively speaking) in terms of economic advantage, the reality is that the families of successful entrepreneurs, artists, and the elderly in inner Tokyo are all slapped with a heavy tax when the main provider passes away. These heirs, in Den Fujita's case a 75 year-old widow and 52-year-old son, lose a large chunk of the family estate, something that does seem a cruel punishment considering how people like Fujita built their fortunes from nothing.

Are Death Taxes Productive?
In 2003, the inheritance tax earned Japan revenues of about JPY1.1trn* (US$9.6bn), about 2.5 percent of overall tax revenues of JPY43.4 trillion**. So it is a heavy burden for some, but not a significant contribution to the national treasury. In fact, not that many people actually pay death duties - as noted, the voters wouldn't stand for it - and in 2003 the number of heirs was 115,000 people, claiming a piece of estate from about 45,000 deceased. What is notable over the last five years is that a growing number of people, about 4 percent, or 4,600 in 2003, were unable to pay their taxes in cash and instead elected to pay in kind, forking over actual assets. Interestingly, this small group accounted for a whopping 20 percent of all inheritance tax monies paid, about JPY230bn, indicating that the majority of them had real estate, companies, and other illiquid assets that are of little benefit once broken up. It seems that the tax regime is hardly producing a worthy result for such an egalitarian ideal.

The government recognizes the difficulties and ill will that the inheritance tax causes, so without abandoning the goal of a level playing field, it has slowly started changing the rules. The first change was an increase in basic deductions, from 70 percent down to 50 percent from 2003, accompanied by an increase in the allowable level of gifting that can be done by aged people to their offspring (2003). Next were substantial deductions for refurbishment of a family home that would otherwise be taxed (2005), and most recently (2005) the ability for families to pay their taxes in-kind and thus protect them from the harsh realities of a negative market.

This last rule change in particular went a long way to alter public opinion, as previously the Tax Office could refuse assets that were impaired and in some circumstances could make the cash-poor family go bankrupt or have to take out usurious loans. Assets that the Tax Office can now no longer refuse include real estate bordering dangerous or eroding cliffs and properties with no right of way or legal access.

*Nikkei Shimbun
**Ministry of Finance

Alleviating the Pain
Since inheritance tax in Japan does come with a substantial number of deductions, in reality it doesn't touch the average salaried worker to any great extent. The basic deductions for a family of two can exceed JPY80m - not surprisingly the same as the price for an average high-end family home in the suburbs of any major city.

But if you’re self-employed, or making a higher than average income, then inheritance tax should be on your agenda. It is precisely these high achievers who use the services of a licensed inheritance-planning expert, typically one of Japan's roughly 67,000 registered Certified Public Tax Accountants (CTA).

Perhaps the most reputed and capable expert of all is 59-year-old Takashi Hongo, whose company, TACT Consulting, assists businesspeople throughout Japan. I was introduced to Hongo-san by an acquaintance who recently sold his property management business, and wanted to retire knowing that his family was taken care of.

TACT Consulting began life in 1975 as Hongo Accounting, established to service the external accounting needs of small- to medium-sized companies. However, early on, Hongo realized that his older customers greatest need lay in property utilization and inheritance/succession issues. So, after a number of projects in this area, in 1983 he renamed the company TACT Consulting and started focusing on the problem. Today he and his partners are acknowledged gurus in the field. Hongo refers to his company as a "specialist hospital for business owners with tax concerns."

I spoke with Hongo-sensei about the current tax regime and how he assists business owners to prepare for the inheritance tax.

What percentage of the population in Japan do you think are worth more than 100 million yen?
Hongo: I don't really know but the clients that we are dealing with definitely have over that amount. These are people who run or own companies generally.

To answer your question, though, my guess is that based on the Pareto [80-20] principle, 20 percent of the population in Japan is probably worth over JPY100 million, and they are the source of 80 percent of the government's income tax revenues.

How do such people protect their assets from death taxes?
Hongo: There are two ways for such individuals to deal with their inheritance taxes: either pay up, or restructure family assets so as to reduce tax liabilities. And, of course, one should always take advantage of deductions. These come and go, as the government tries to loosen some of its older citizens' entrenched attitudes towards saving and personal consumption.

For example, three years ago, the government passed a temporary law that allows people aged 65 or older to make a one-time gift of cash or assets to their children aged 20 or older with an exemption of gift tax up to JPY25 million. However, under this law, the tax must be paid at the time of inheritance and is later refunded.

This galvanized many aged wealthy individuals to liquidate some assets prior to death and share them with loved ones. A result was that an extra JPY1 trillion was pumped back into the economy.

Recently, it is also common to form family trusts and holding companies to protect assets and provide successor planning and minimal disruption to family business operations. While a trust is an effective way to reduce tax liability, it is also more prone to infighting between trustees and beneficiaries. So in this sense, a holding company may be more viable. Holding companies are definitely popular in Japan.

The new company law introduced in May 2006 is making it much easier for families to create a holding company. What are your views on this?

Hongo: In terms of tax compliance the new law is straightforward and thus makes it easy for a family to have a holding company. However, the rules on the transfer of stock ownership and corporate governance are more stringent. Probably the key consideration for a wealthy individual looking to incorporate will be the fact that he or she won't be able to hold 100 percent of the stock. The government will judge viable, independent companies [ones not considered a tax dodge] as being those that have at least 11 percent of the stock held by a non-family member. In other words, people will need to create a kabushiki kaisha [stock company], with all the corporate compliance that entails.

What about donations, gifting to charities?
Hongo: Japanese have no tradition of charitable donations. However, this is changing because people would rather choose the beneficiary of their wealth than give it to an anonymous bureaucracy. Charitable gifting of amounts up to JPY25 million is nontaxable. Moreover, parents can transfer stocks to their children in any amount over many years at a low rate of tax.

After the War there was a major shift in how inheritance tax was levied, wasn't there?
Hongo: Yes, before the war, the eldest son traditionally received the family assets. This opened the tax system up to all kinds of manipulation by the family members. However, the postwar constitution dictated that all assets be divided fairly among siblings. So these days, in form, everyone pretends to observe the tradition by having mom control the inheritance. But in reality, every family member wants the inheritance split evenly since the old system often caused family members to become estranged from one other. The government encourages such equal redistribution by offering tax deductions of JPY10 million per child receiving the inheritance.

What impact does inheritance tax have on wives?
Hongo: There are several tax outcomes for the widow. The wife of the rich individual may elect to be taxed up to JPY160 million upon inheritance and receive all the assets, or she can receive half of the assets taxfree. In the latter case the other half of the inheritance is shared among the children and they pay the tax.

If a parent dies and their children can't pay the inheritance tax, what does the Tax Office do?
Hongo: Typically, the taxman first seizes the most liquid assets, being any cash in family accounts. Then they work their way through the assets per their liquidation viability - so the next type of asset targeted is usually publicly traded securities, land, then shares in privately held companies. It's probably worth noting that if the heirs sell a company that has been losing money, there is no transfer tax.

What about an overseas asset such as property?
Hongo: Well, for a start, the Tax Office would have to know that the asset exists. If they do, then it is included in the taxable asset list.

Actually, on the topic of offshore tax planning, I think it's fair to say that since Japanese taxes have traditionally punished the very rich, there has been a flight of such individuals abroad. In view of this, the Japanese government has decided to adopt a more internationally acceptable system of taxation, particularly in terms of lowering the top rates of tax, and so I expect that we will see more of the super-rich opting to stay. The moves by the government are already very visible and among them, the inheritance tax has come down from 70 to 50 percent, the upper income tax rate has dropped from 65 to 50 percent, the upper corporate tax rate is down from 50 to 40 percent, and the capital gains tax on sale of stocks of listed companies or from dividends is now a flat rate of 10 percent.

Apart from property, would it be fair to say that selling one's company is the major source of income for super-wealthy individuals in Japan?
Hongo: Yes, and so M&A Advisory is a fundamental part of our business. Generally speaking, three types of companies are being sold these days. These are companies under 10 years old run by younger entrepreneurs wanting to cash in; companies between 10 and 30 years old whose owner is over 60 and wants to retire but doesn't have a successor; and companies older than 30 years, which have long histories but whose share holders are looking for a settlement to cash out. An M&A transaction involving the last type of company can get complicated if it's non-listed or privately owned.

We do an average of three or four deals per year. These are handled by a team of 50, comprising 35 consultants and 15 support staff.

The taxes on gains by the principals are 10 percent on earnouts from listed company M&As, and 20 percent for unlisted companies (15 percent for non-resident Japanese since there would be no resident's tax). This last point about not having to pay resident's tax is one reason why many private company M&As happen before December; it is possible for the seller to leave to live overseas before January 1, and thus be officially out of the country when local taxes are calculated. This means that they do not have to pay the 5 percent resident's tax for earnings in that year. We don't condone this type of behavior, but it does happen.

What do you think of M&As? Do you think they are trending upwards?
Hongo: Yes, very definitely. People are starting to become wiser about the value of cash. Watching their colleagues benefit from an earnout, they start to feel more relaxed about trying it themselves.

When the owner of a privately held company dies and the main asset is shares in the company, how does the Tax Office value those shares?
Hongo: Yes, this is a real problem. Typically the shares of such companies are considered as inferior assets and thus difficult to sell, so they are often deemed as having no market value. But to the family, the shares may represent vital future income, so they don't want the shares taken by the Tax Office at a low valuation. The way to prevent this from happening is either a family trust, or a holding or trust company.

Actually, trust companies are quite popular in Japan and are intended to provide succession stability. Just look at the company data of any major listed company, and you'll find that a large number of shares are held by a group-related yugen kaisha [limited private company], holding company or trust company put in place for that specific purpose.

A recent example of this was the Livedoor attempt to buy out Fuji TV's trust company, Nippon Broadcasting Corporation. Similarly, for the Ministry of Transport, the trust entity behind it is the government. This may sound like a strange example, but it follows the concept.

What are the rules for foreigners and dual citizens in terms of estate planning?
Hongo: If you are a non-Japanese, and you don't live in Japan, then your assets may be sold and the proceeds returned to your estate in your country of residence without interference from the Japanese Tax Office. If you are resident in Japan, then you will be taxed the same as a Japanese.

As for Japanese living overseas or with overseas assets, basically, as long they are Japanese citizens, regardless of their locations, they will be taxed on their assets upon death. The practical issue, of course, is whether the authorities can assess or even detect the existence of such assets. You can be sure, though, that all funds traveling out of Japan are carefully tracked and questions will be asked if no settlement is made in due course. JI

TACT Consulting Co., Ltd.
President: Takashi Hongo
PCP 16F 1-11-1 Marunouchi, Chiyoda-ku
Tokyo 100-6216
Tel: 03-5208-5401
Web: www.tactnet.com