Impact on Japanese Corporations of Japan Fiscal 2021 Tax Bill
Executive Summary
To reach its zero greenhouse gas emissions goal by 2050 and to revitalize its economy after the COVID-19, the Japanese government has incorporated two major tax-cut incentives in the Japan Fiscal 2021 Tax Bill (the Bill), amending to the Increased Competitiveness Enhancement Act (the Act) in 2021. These amendments encouraged businesses, or taxpayers, to invest in digital technology for business transformation and production technology that allows for accelerating decarbonization with promised tax credits and depreciation savings. As tax plays an important role in corporate financing, corporations in Japan will have different investment strategies to respond to such tax incentives, especially for long-term assets.
Description of the Policy
Introduced as an essential part of the Industrial Competitiveness Enhancement Act in 2020, the Japan Fiscal 2021 Tax Bill has amended two major tax-cut-related measurements - carbon neutrality and digital transformation - with the intention to incentivize Japanese businesses to successfully recover from the downturn resulting from the pandemic and to promote technological innovation in business operations that will benefit Japan in driving long-term economic growth and achieving the green economy domestically. Taxpayers whose business is accordingly executed under the business plan in line with those specific conditions stated in the Act and certified by the Ministry of Economy, Trade, and Industry can be eligible for access to the tax incentives.
The first part of the Bill addresses the Japanese government’s efforts to reach its zero greenhouse gas emissions goal as corporations are eligible for a 5 - 10% tax credit or 50% special depreciation when making carbon-neutral investments to reduce the amount of greenhouse gas emitted from the production process and to products which will help accelerate decarbonization. Each corporation has a total limited investment of up to 50 billion JPY that must be stated in its environmental adaptation plan and certified by March 31, 2024, for eligibility. The second part of the Bill focuses on digital transformation within the business operational process. The more use of digital technologies can lead to an improvement in business productivity and better development of new products and services. Different types of related investments include machinery, equipment, and software that help plant’s automatization and provide warehouse solutions specifically for E-commerce. Corporations whose business adaptation plans are certified by March 31, 2023, are qualified for 3 - 5% tax credits or 30% special depreciation on a total amount of 30 billion JPY investment.
History of Policy’s Adoption
In December 2013, the Japanese Cabinet approved the Act with “the purpose of revitalizing the Japanese economy and enhancing the industrial competitiveness of enterprises doing business in Japan”. The Act was expected to enhance competitiveness by overseeing the Japanese economy to avoid three distortions, including over-regulation, under-investment, and delay in consolidation. More importantly, to enhance even industrial competitiveness, the Act provides the flexibility to regulators to propose special arrangements for corporations operating in certain fields with the objective to bring renovation. This provision intended to boost business internal innovation and to promote more venture businesses to the markets, thus benefiting the Japanese economy as a whole.
With a big trend to digitization in the business world on top of the outbreak of the pandemic that further expands the demands for digital software and supply chain management, the Japanese government recognized the need to accelerate the digital transformation to not only recover from the downturn but also give businesses conducting in Japan a competitive advantage in productivity and efficiency after the recovery. Additionally, climate risks to businesses were wide-recognized after the 2019 UN’s International Labour Organization report which indicates a potential 80 million job loss if the global temperature continues to rise. As a result, the Japanese government identified a niche for local corporations through tax incentives to sustain themselves in the market and avoid climate risks by incorporating decarbonization strategies into business operations and developing eco-friendly products.
Policy’s Enactment Impacts on Corporate Finance
The Bill can lead to a rise of digital transformation and decarbonization technologies investments industrial-wide, especially for those working in manufacturing. On an individual basis, such tax incentives can result in an immediate increase in the Weighted Average Cost of Capital (WACC) even if everything stays the same within corporations. Due to the promised tax credits, the effective tax rate will go down and leave the cost of debt higher, thus increasing the WACC. Corporations with better liquidity typically favor debt financing because of the tax deductibility. The decrease in effective tax with a higher cost of debt may divert their preferences at certain levels. However, earning the eligibility of the tax credits and depreciation rate requires the corporation to make additional investments and how to finance can directly affect the overall financial condition of the corporation.
Both investments in digital transformation and decarbonization technologies are typically considered long-term investments because they add value to the businesses in the long run and are not expected to be paid back within a year. Thus, most businesses will choose to record those assets under capital expenditures (CapEx) to enjoy less taxable operating income resulting from the depreciation savings. Yet, long-term investments generally have a higher risk due to uncertainty and potential inflation in the future. The higher risks associated with the uncertainty may hinder business leaders from making direct investments in such technologies because the payback period is longer and there is no guarantee for the increase in productivity and efficiency which can lead to greater profitability. If the business is not profitable, the tax incentives become meaningless. In consequence, how to make such investments - through debt or equity financing that will ultimately change the internal structure of the corporations - is the key to leveraging the high risk.
Larger-scale corporations could still have a preference for debt financing because their market shares can better promise them profitability generated from the invested technologies and the easier access to capital ensures them to sustain in the long term and wait for the maturity of the invested technologies. Despite the fact that the cost of debt will increase which leads to a higher WACC, they do not need to dilute their ownership and solely enjoy the tax credits or depreciation savings that can generate higher net income after tax at the same time. On the other side, if the larger-scale corporations do not have a strong hold on ownership delusion and want to allocate the high risk, they can still consider equity financing because of the increase in the cost of debt due to a lower effective tax rate. Especially the larger-scale corporations have wider access to capital markets, their calls for technology investments can receive better responses. With more liquidity in the cash flow, they will shrink the time period required to pay back the technology investment.
In contrast, small and mid-size enterprises (SMEs) will be the primary actor in the Bill and put more leverage on equity financing because they have less liquidity in cash and confidence in covering the debt and interest expenses when making such long-term investments. The hardship of bearing the high risk then “forces” them to conduct equity financing to allocate the risk. Also, because of the innovative technologies, they can become more appealing to investors as long as they have a solid position in their current financial statements. However, SMEs should also understand that a greater composition in equity may look unfavorable because it indicates that SMEs will have to make more money from the original sales, thus generating a higher risk. The higher WACC calculated from an increase in cost of capital will create a lower net present value of the firm in the next round of financing, especially when the adaptation of new technology does not bring an expected return in profitability.
The tax incentivizes businesses to adopt digitization and carbon-neutral technology generally takes a longer term to pay back, regardless of the size of the corporation. However, easing the tax burden at the early stage of adoption, it opens a door for those businesses to access the equity market due to its potential success in higher productivity and efficiency, thus enhancing the overall economic environment.
