Expiring Tax Exemptions May Increase Japan's Reputational Risk

Several tax exemptions in Japan are likely to expire at the end of this month (fiscal year-end), with varied consequences on the financial markets. Takehiro Sato reviews the major impacts of the expiration in Morgan Stanley's latest Global Economic Forum.

Taxation of interest income from Euro bonds issued by residents would "effectively halt euro bond issuance by residents", argues Sato. Should the taxation become long-term, this could affect the Japanese capital markets, as would the withholding tax of interest income from offshore deposits held by non-residents. Though unlikely to cause "much damage", this could prompt a quiet exit of capital from Tokyo's offshore market, according to the report.

Furthermore, expiration of the provision on the taxation of interest income from repo transactions conducted by foreign financial institutions would similarly impair Japan's reputation risk. As Sato explains:

Foreign financial institutions receive exemptions from income and corporate taxes on interest income paid by domestic financial entities for bond repo transactions. Expiration of these exemption provisions could increase repo transaction costs by restoring income and corporate taxes on interest income.

In this case, and in the earlier examples too, there are certain mitigating circumstances that could minimize the effect of these tax exemption expirations. Current tax treaties between Japan and the UK and US, for example, would prevent new taxation even if the exemption provisions expire in the special provisions law, according to the report.

Sato concludes:

We do not foresee a major panic in financial markets from the actual expiration of laws expiring at the fiscal year-end, as explained above. However, we expect increased reputational risk, due to heightened concerns from foreign investors about legal risks in the Japanese market. The ruling coalition can technically re-adopt the revised special provisions law with a two-thirds or larger super-majority in the Lower House at the end of April, which is 60 days after original passage by the Lower House at the end of February, based on constitutional rules. Yet it will be difficult to erase the loss of credibility from the general populace and investors just with the re-adoption of laws that initially expired on April 1 at the end of April.