Chapter 6
CORPORATIONS

A. Ordinary Corporation Taxes

The corporation has always exerted a certain fatal fascination for the legislator looking for a source of additional revenue. Corporations are impersonal entities, often without the ability to voice as strong a political protest as other groups of taxpayers. The stockholders are a relatively small group, and even they do not immediately feel the impact of the tax. Thus it is that, not only in Japan but in many other countries, heavy taxes are imposed on the corporation with hardly any semblance of economic justification or logic, merely because such taxes are found politically popular, easy to administer, and productive of substantial revenues. Indeed, what is chiefly surprising about the present Japanese taxes on corporations is not that they fail to conform to a rational pattern, but that they yield so little revenue.

Fundamentally, however, a corporation is but a particular kind of aggregation of individuals, formed for the purpose of carrying on a given business. Provided that the corporation does not become unduly large, and that it conducts itself with proper attention to the rules laid down by law, there is no reason, in principle, either to encourage individuals to use the corporate form or to deter them from using it. Ordinarily, therefore, it is not proper to impose a substantially heavier tax on business done in the corporate form than on business done through an unincorporated enterprise, or vice versa. Any such differential will in fact, tend to impair the efficiency with which the economy is operated by inducing a movement away from that form or organization which is most efficient in production towards that form of organization that is given the lighter tax burden.

If all corporations distributed their entire earnings immediately in the form of dividends, and if all taxpayers reported their dividends completely, there would be no problem. There would be no occasion for any tax on the corporation at all as long as the earnings of the corporation were being fully assessed in the hands of the respective stockholders. However, corporations do not thus immediately distribute all their earnings. Consequently, if no tax is levied on the corporation, and if individual stockholders are taxed only when earnings are distributed, a discrimination results in favor of the corporation as compared with the unincorporated enterprise. The owner of an unincorporated enterprise must pay individual income tax at once on the concern's profits, while the stockholder in a corporation need pay the individual tax only when the profits are actually distributed in dividends, which may be only after the lapse of a long period of time. If this distribution is deferred long enough, the postponement of the corresponding individual tax may be almost as much of a benefit as a complete waiver of the tax. Moreover, unless as is recommended elsewhere in this report, capital gains are included in full in taxable income, the stockholder may reduce his individual tax even further. He can sell his shares and thus get his share of the retained corporate earnings in the form of a capital gain, rather than as dividends, thus paying a lighter tax.

It is possible to devise a tax system which will eliminate almost completely all discrimination between the corporation and other forms of doing business. However, such a system would be quite complicated. The less effective administration and compliance that would result from this complexity might well result in far greater inequities than those that would in theory be avoided by the strict adherence to principle. But it is possible to select a combination of simple elements that will achieve a fairly close approximation to equity as between corporate and other forms of doing business, and that will at the same time prevent any serious avoidance of individual taxes.

The combination that is proposed for this purpose consists of three elements:

The first two items consist respectively of an approximate withholding tax at a flat rate of the shares of the stockholders in the earnings of the corporation, and an approximate allowance for this withholding tax in the return of the individual shareholder. Where are all earnings are distributed to stockholders, part (3) will not apply and these two elements will be the only elements in operation. With such full distribution, individual stockholders subject to marginal rates of tax above 53% will find that they are just slightly better off than if they had been owners of an unincorporated business with a profit equal to their share of the corporate profit before tax. Stockholders subject to marginal rates of tax of 53% or less, will find themselves slightly worse off than they would be as individual proprietors. For example, if the corporation had a net taxable income of 1,000,000 yen, it would first pay a tax of 350,000 yen, and then declare the remaining 650,000 yen out as dividends. If there are ten equal shareholders, each would get 65,000. If one shareholder is subject to a 60% top rate (as might happen if we consider the effect of local taxes based on income), this dividend will increase his gross tax by 39,000 yen, but he will also obtain the 25% tax credit of 25% of 65,000 or 16,250 yen. Thus his own net tax will be increased by 22,750 yen and the net addition to this income after tax will be 42,250 yen. On the other hand, if the had had an unincorporated business that earned an amount equal to his one-tenth share in the earnings of the corporation, or 100,000 yen, the 60% tax on this amount would have left him with only 40,000 yen.

If a stockholder is taxable at only 40%, he will have his gross tax increased by 26,000 yen, subject to a credit of 16,250 yen, leaving him with a net addition to his income of 55,250, instead of the 60,000 yen he would have had if he had earned 100,000 as an unincorporated business. Thus there will still be some tax discrimination between businesses that are incorporated and unincorporated, but the amount seems to be tolerably small, and at least is not always in the same direction. For the case where all the income is distributed, the differences could be eliminated entirely by somewhat more elaborate method of computing the tax of the individual. Indeed, such a method has long been used in Great Britain. However, even the British method leaves some differential when earnings are not entirely distributed, and requires the stockholder to make a computation that is slightly confusing to the uninitiated. It therefore seems on the whole best to adopt the simpler method, at least for the time being. If the time comes when the income tax is working smoothly, it may then be proper to consider shifting to the British method, or even to still more refined methods of equalizing the burdens on incorporated and unincorporated business.

The third element in our corporation tax plan, the interest surcharge on accumulated earnings reserves, applies only when a corporation does not distribute all of its earnings in dividends. It is, however, in no sense a penalty for such accumulation, nor should it have the effect of repressing such accumulations, as compared with the degree of accumulation that would take place in the absence of all tax considerations. Rather, in the absence of such a surcharge, the existence of the income tax on the individual stockholders produces a positive incentive for increasing accumulation within the corporation beyond the point where it is desirable for economic reasons. The proposed surcharge is intended to do no more than to approximately counterbalance this pressure for accumulation of earnings which arises from the income tax on stockholders.

For example, if the stockholders of a given corporation have incomes that bring them up to the 55% tax bracket, then in principle each stockholder should bear a current tax of 55% on the earnings of the corporation. If all of the earnings are distributed they will in fact bear a tax of 54.5%, composed of the 35 yen corporation tax on each 100 yen of corporation income, plus individual tax on 55% of the 65 yen distributed as dividends, or 35.75 yen, less the 25% tax credit, or 16.25 yen, or a total tax of 54.5 yen. However, if the corporation defers the payment of dividends, the tax immediately payable is only 35 yen. To be sure, if the earnings are distributed as dividends in a later year, the additional tax of 19.5 yen will then be payable. But in the meantime the taxpayer and the corporation have had the use of this 19.5 yen, in effect interest free, unless the proposed surcharge is imposed. Imposition of this surcharge, which in this case would amount to one per cent each year on the 65 yen of earned reserves, or 0.65 yen per year, would represent a modest interest charge of slightly over 3.3% per year for the use of this 19.5 yen.

The weight of this interest charge will vary somewhat with the amount of tax which is considered to have been deferred, which in turn will vary with the rate to which the individual stockholder is subject. For example, if the stockholder was in a 40% bracket, so that he would have paid on additional tax of only 9.75 yen if the 65 yen of earnings had been distributed immediately, the surcharge of 0.85 yen per year would represent an interest charge of slightly over 6.6%. On the other hand, if the stockholder is subject to a top rate of 65% (which might occur even with the maximum rate of 55% proposed elsewhere in this report, because of the addition of local surtaxes), the tax postponed would be 26 yen and the implied interest rate only 2.5%. However, adjusting for these variations in individual tax rates would mean an almost hopelessly complicated tax, and accordingly it is necessary to be satisfied with striking a rough average. In any case, where this implicit interest charge appears too heavy, it will usually be possible for the corporation to transfer a suitable portion of the earned reserves to capital through the issuance of a stock dividend, thus producing an immediate settlement of tax liabilities on an individual basis and correspondingly reducing or eliminating the interest surcharge on the corporation.

However, even with this surcharge, there remains some opportunity for those in the top income brackets to make use of the corporate device to avoid their proper tax liability. To set the rate of surcharge for the ordinary corporation sufficiently high to provide an adequate interest charge for the case of individuals in the highest brackets would mean imposing an undue burden in case of stockholders with smaller incomes. There remains, therefore, the need for some special measure to prevent such abuse of the corporation, not only to protect the revenues but to avoid the development of financial structures that are unsuited to the efficient conduct of business.

The simplest method of doing this is merely to apply a higher rate of surtax to the earned reserves of "family corporations". Thus, for example, if the rate on such corporations were 9% rather than 1%, then even for taxpayers subject to a 65% rate, the effective interest charge for the postponed tax would be 15%, which appears to be adequate to prevent any undue amount of tax avoidance by this method. On the other hand, if the tax should happen to apply in a case where tax avoidance is not a substantial motive, and where the taxpayer for one reason or another cannot prevent the application of the surcharge by distributing earnings, the burden will still not be excessive.

For this purpose, a family corporation should be defined as one in which a substantial percentage of the stock is owned directly or indirectly by taxpayers who are members of a few families. For example, a family corporation could be defined as one in which five or less families held at least 50% or more of the stock, or four families held 45% or more, or three families 40% or more, or three families 35% or more, [# sic double ' three families'] or two families 30% or more, or one family 25% or more. For this purpose, a family would include any individual taxpayer, his children, parents, brothers, sisters, their spouses and other persons claimed as the dependents of the foregoing. A family corporation would itself be considered a family for the purpose of applying the rule to corporations in which a family corporation held stock. To avoid applying the higher rate to small incorporated family enterprises where tax avoidance is not a problem, it may be desirable to subject the first 500,000 yen or so of earned reserves to only the regular 1% rate. Thus the application of this higher interest surcharge would be restricted to cases where it would actually be needed to prevent undue avoidance of tax.

Given a consistent application of these three elements in the taxation of corporations, there is no occasion for further taxes at the national level on corporations.

The excess profits tax should without a doubt be repealed. Under present conditions, where the base for the "excess profits" is a book value that bears no relation to the present value of the assets, it is certainly a mockery to subject such profits to an excess profits tax. Likewise, even after revaluation, the revised book value will not generally be a reliable guide to determine which profits are "excess" in any realistic economic sense.

Actually, while a tax on excess profits sounds like something that everyone ought to approve, in practic it is extremely difficult, if not impossible, to define "excessiveness" with the precision that is necessary for a workable tax law. At least this is surely true of the still abnormal and rapidly changing business activity of present-day Japan.

Also, there is no occasion for the continuation of the present tax that is collected from corporations when they liquidate. The proper treatment here is to require liquidation dividends to be divided into two parts, the part corresponding to the earned reserves, and the part corresponding to the capital of the corporation. The part corresponding to the earned reserves should be treated in all respects as a dividend, that is, the total amount should be included in the taxable income of the recipient, and 25% of the amount allowed as a credit against his individual income tax. The part corresponding to the capital of the corporation should be treated as a realization from the disposal of the stock. Any difference between this realization amount and the cost of the stock should be treated as capital gain or loss. In order to make the tax effective, it would have to be provided that the earned surplus was first distributed by the liquidating corporations to its shareholders. Of course, the dividend treatment would only be allowed on that part of the distribution that had already been subjected to the corporation income tax.

At present, in addition to the corporation tax, corporations are required to withhold a 20 percent tax from dividends paid to stockholders. Stockholders in turn may credit this withheld tax against their individual tax liability in addition to the 15 percent credit for dividends. However, the whole rationale of the 35 percent corporation tax and the proposed 25 percent tax credit is one of treating the corporation tax as a rough form of withholding on the shares of the stockholders in the earnings of the corporation. Hence it is neither logical nor necessary to have in addition a second and different form of withholding. Accordingly, it is recommended that the withholding of tax by corporations on dividends to stockholders be discontinued. If it were true that the 35 percent corporate tax is by itself inadequate as a withholding measure, the proper remedy would be to increase the rate of this tax, rather than to add another complication to the tax structure.

This treatment of liquidation will produce a fair and equitable tax, without providing any substantial opportunity for evasion, assuming that capital gains are to be taxed in full, as recommended elsewhere in this report. The present provisions for a flat rate tax on the liquidation of corporate profits with complete exemption of such profits from individual income tax represents a wide-open avenue for tax avoidance which will cause endless trouble if it is not eliminated.

It is worth reemphasizing at this point that the whole of this corporate tax structure is based on the assumption that capital gains will be fully taxed to individuals. Unless this is done, so that sooner or later all income, whether distributed or not, is made subject to the individual income tax, this entire program will be invalidated. Indeed, without such full inclusion of gains in individual taxable incomes, it appears to be almost impossible to design a corporation tax system that will not be illogical, capricious and discriminatory at many points.

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B. Removal of Tax Exemptions

The number of corporations exempt from corporate income taxes appears relatively high. The number and types of corporations incorporated under the laws of Japan compiled as of June 30, 1949 by Research and Programs, ESS[# Economic and Scientific Section in GHQ], are set forth below:

Joint Stock Company (Kabushiki-Kaisha)	159,280
Limited Joint Stock Company (Kabushiki Goshi Kaisha)	92
Limited Partnership (Goshi Kiasha)	82,880
Unlimited Partnership (Gomei Kaisha)	25,455
Limited Company (Yugen Kaisha)	44,624
Mutual Company (Sogo Kaisha)	26
Ordinary or non-exempt Corporations Sub-total		312,357
Incorporated Foundation (Zaidan Hojin)	5,776
Incorporated Association (Shadan Hojin)	4,787
Wolly Exempt Sub-total		10,563
Special Corporation: Wholly exempt for approximately 49,000 that are reported as taxable as cooperatives at 25% plus excess profits tax.		297,243
Total		620,163

Dissolutions have not been taken into account in these totals. Some of these corporations, it appears, had been dissolved before June 30, 1949, but had failed to file notice of dissolution. Efforts are now being made to determine the extent of such unreported dissolution.

The analysis shows that a very large per cent of Japanese corporations are exempt from all corporation taxes. Many of these exempt corporations owe their exempt status to Article 34 of the Civil Code which permits the incorporation of Associations or Foundations concerned with religious ceremonies, religion, charity, science, technology and other public services with the permission of the Minister in charge. A prefectural governor may be the competent minister to establish certain types of tax-exempt organizations. Likewise, the Social Workshop Law of 1938 authorizes the creation of exempt corporations to assist the unemployed and handicapped by providing technical training. In addition, if one-half of the persons employed come from relief rolls, a subsidy is made available by the prefecture. In 1948-1949, 80 per cent of the subsidy was paid by the National Government.

Spot checks indicate clearly that the exempt status of these corporations calls for immediate investigation and study, particularly as no control has apparently been maintained over their activities since incorporation. Indeed, under existing law, the Ministry of Finance has no control whatsoever, over the granting of these exemptions, nor any right to review subsequently the activities of such corporations. To remedy this situation, the Internal Revenue Code should first be amended so as to define clearly and with particularity the purposes and objects for which corporations could be operated wholly or partially exempt from taxation. The Ministry of Finance should then be given the sole authority to determine whether or not a corporation is entitled to that statutory exemption. All corporations claiming exemptions should be required to obtain an exemption certificate from the Ministry of Finance. This would include all existing corporations even though they might now be considered exempt. At least every three years the exemption status would be reviewed to determine whether the corporation's past activities justified exemption under the law. At the present time, Article 18 of the corporation tax law requires tax returns on the profit-making activities of religious corporations and labor unions, and corporations taxes are payable on these profits. This should be extended so that every corporation, including all exempt corporations, would be required to file an annual return covering all of their income and expenses. It would be preferable to have the color of the return for exempt corporations some color other than that used for ordinary corporations and individuals, or than the blue return for unincorporated business that keep books.

Many exempt corporations are engaged in profit-making activities and compete directly with both ordinary corporations and individuals. If no profits are made or if an exempt corporation making profits distributes all of them, the carrying on of profit-making activities by exempt corporations is not as serious a problem as it might be, because in another chapter of this report is recommended, in order to integrate the personal and corporation income taxes, that shareholders be permitted to take as a credit against their taxable income, 25 per cent of the dividends they have received from a taxable domestic corporation. The net amount of tax discrimination is thus relatively small. But spot checks indicate that these exempt organizations are making profits which are spent in further expansion of their activities or in entertainment, both of which may have little or no value for the advancement of the purposes that justified the exemption. This income that is derived by an exempt corporation from profit-making activities should clearly be subject to the corporation income tax rates. It is noteworthy that Article 63, Local Tax Law, as amended in 1949, grants and exemption from the enterprise tax to all corporations that are exempt from the corporate income tax, except the income that is derived from their profit-making activities. On this income the enterprise tax is applicable.

Some exempt corporations are managed by a To, Do, Fu, Ken, City, Town or Village. Their business activities fall under the following categories;

• Electricity
• Gas
• Water-works
• Transportation
• Crematories
• Funeral services
• Cemeteries
• Slaughter-houses
• Public markets
• Theaters, including movies
• Libraries
• Hospitals
• Hotels
• Bath houses
• Reservoirs
• Seeds
• Public Halls
• "Tkarakuji"-(a kind of lottery)
• Horse racing
• Bicycle racing

Most of these activities are exclusively for the public benefit and, it would seem, should be exempt from the income tax. To tax any of these corporations would raise a problem of intergovernmental relations because the various local autonomous bodies do not subject to tax any of the activities carried on by the National Government. But certainly some study should be made of these governmental corporations to determine the extent to which their profit making activities should be taxed.

All exempt corporations should, therefore, be required to file annual returns so to segregate, on a separate schedule of the return, the income that was derived from profit-making activities. On income from profit-making activities, all non-governmental corporations would compute and pay 35 per cent corporate income tax. All other income reported would be exempt. These information returns and the auditing of them will furnish the Ministry of Finance with the necessary information to determine whether there has been a misuse of the statutory exemption and also whether there are any particular abuses. In addition, a continuous study of exempt corporations by technically trained economists and statisticians should be carried on by the Ministry of Finance. These studies would prove invaluable in the future to assist in any determination as to what should be the general exemption policy.

The problem of exempt corporations extends far beyond the national income tax. Any exemption from tax, not only on the national level, but also on the prefectural and local levels, can all too easily be abused or give rise to undesirable discrimination. All existing exemptions from excise taxes, the property tax and other national and prefectural and local taxes should therefore be reviewed at once, and where abuse and discrimination is found the exemption should be withdrawn.

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C. Accounting Periods of Corporations

All corporations, other than those that are exempt, are required to report on their operations every six months. The report is due within two months following the close of the six-month period. If the accounting period for the corporation is longer than six months, the first report and payment will be considered tentative and subject to adjustment on the final report due within two months after the close of the fiscal year. These reports due every six months require examination, audit and reassessment, and therefore place a tremendous burden on the administration agencies and to a certain extent on the corporations.

It is recommended that all corporations report on a final consolidated twelve months' return. All corporation returns could then be examined and reassessed with considerably less personnel or with more effectiveness with the same or added personnel. In order to prevent the loss of early collections that would result from a twelve months' return, corporations should be required to file an interim return at the end of the first six months of their fiscal period and pay 50 per cent of the tax of the previous fiscal period, unless there were attached to the return a statement showing in detail the reasons for which that amount of tax would not be payable because of the decreased income of the corporation or of the seasonal character of the business. In the event the statement should prove to erroneous, then a penalty would be added to the tax due plus interest from due date.

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D. Number of Corporations

Some discrepancies exist as to the number of corporations which are said to be subject to the corporation income tax. According to a corporate population study made by the Research and Programs division of ESS the numbers of corporations of various types as of 31 March 1949 are set forth below:

The above corporate population includes some corporations that were dissolved prior to March 1949. Although a study is now being made, it is impossible at this time to determine the number of such dissolutions.

According to the Ministry of Finance, 193,172 ordinary corporations filed income tax returns as of March 31, 1949. This figure should be compared with the corporate population of 305,502 which was the total found by Research and Programs, ESS, for March 31, 1949 for Joint Stock Companies, Limited Joint Stock Partnerships, Limited Partnerships, Unlimited Partnerships, Limited Companies, and Mutual Companies. The discrepancy amounts to 112,330. Also, according to the Ministry of Finance, 49,749 special corporations filed returns as of 31 March 1949. For this there is no comparable figure in the study of corporate population by Research and Programs since the corporate population set forth by Research and Programs may be considerably overstated due to dissolutions that may have occurred.

But in any case, the large differences in these figures indicate that something is seriously wrong, and an investigation into possible sources of these discrepancies is of the highest urgency.

If the above discrepancies should prove largely due to the dissolved corporations, then another recommendation now to be made seems mandatory - that is the Internal Revenue Code should be amended so as to require all corporations in dissolution to file, thirty days after the appropriate corporate action is taken to dissolve, a statement on a particular form with the Ministry of Finance, setting forth the name of the corporation, a copy of the resolution authorizing dissolution, the date of the corporate action, the revenue office in which the corporate tax returns have been filed for the past five years, or for whatever period of that five years that it was in existence. Copies of this form should also be sent to the local and national local tax offices where the corporation has been subjected to tax. Mandatory penalties should be provided for failure to file said forms.

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E. Intercorporate Dividends

At present dividends received by a corporation from another corporation are included in the taxable income of the recipient corporation. This means that where one corporation owns shares in another a heavier tax is imposed than when a distribution of profits is made directly to the ultimate individual shareholder without passing through one or more intermediate corporations.

In general, there is no reason to discriminate in this extent against the use of subsidiary corporations, or holding companies, or the ownership generally by corporations of stock in other corporations. Indeed, there are many situations in which such arrangements constitute the most rational and effective mode of organization for the carrying on of business. Particularly in international trade, the setting up of subsidiaries to handle the affairs of a business in foreign countries has many advantages. Such a tax penalty on these arrangements is accordingly undesirable.

To be sure, there are occasions where the piling up of holding companies, and particularly the pyramiding of control, produces concentrations of power and complicated interrelationships that may be considered undesirable. But a blanket tax penalty on all such intercorporate relationships is hardly a wise or effective way of curbing these abuses: if they are to be curbed it will have to be by more direct and selective means.

Accordingly, we recommend that all extra burdens on the holding of shares by corporations and on the payment of intercorporate dividends be removed as far as possible. For the income tax, we recommend that this be done very simply by excluding, from the net taxable income of corporations, all dividends received from other taxable domestic corporations. This will avoid the double taxation of intercorporate dividends and at the same time ensure that an adequate tax is collected from corporations. This will also tie in very readily with provisions for the carryover or carry back of losses, since only the taxable income need be considered for such purposes, and the dividends received can be left out of account altogether.

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