Economic Insight: SME classification standard under the Corporation Tax Act should be revised

SATO Motohiro
Faculty Fellow, RIETI

Small and medium-size enterprises (SMEs) account for as much as 99% of the total number of companies and around 70% of employment in Japan. SMEs enjoy various forms of preferential tax treatment.

While the national corporate tax rate is 23.2% in principle, a preferential tax rate is applicable to SMEs with respect to the portion of income up to 8 million yen. As a current, temporary measure, the preferential tax rate has been reduced to 15% from the previous 19%. In addition, SMEs are allowed to deduct 100% of carried-over losses from taxable income, whereas large companies may only deduct up to 50%.

As for taxation related to research and development, SMEs are eligible for preferential treatment in terms of the deduction rate and the upper limit on the deduction amount. As a result of the tax system revision in FY2024, loss-making SMEs that have raised wages are allowed to carry over this deduction for up to five years.

The issue here related to how company size is measured. Companies known as “major” newspapers and talent agencies, in fact, belong to the SME category, for example. Why is that?

SME Classification Standard under the Corporation Tax Act

Under the Corporation Tax Act, companies are classified into large companies, which are capitalized at more than 100 million yen and SMEs, which are capitalized at 100 million yen or lower. However, companies have significant discretion over the amount of capital recorded on their balance sheets. If companies somehow keep the capital amount below the 100-million-yen threshold, they are classified in the SME category.

The trend concerning the pro forma standard tax, one of the two local corporate taxes, has shed light on the inducement for holding down the capital amount. The pro forma standard tax is applicable only to companies capitalized at more than 100 million yen. The number of companies to which this tax was applicable declined after peaking in FY2006, and in FY2020, the number fell to two-thirds of the peak level. Presumably, this trend reflects deliberate attempts to avoid taxation.

As a result, it has been decided that from FY2025 onwards, even when companies that have until now been classified as “large companies” reduce the capital amount to 100 million yen or lower, they will remain subject to the pro forma standard tax as long as the sum of the capital and capital surplus amounts is more than one billion yen. Still, it cannot be denied that this new taxation standard is arbitrary.

Meanwhile, in major European countries, turnover is used to define the category of smaller companies that are eligible for preferential tax treatment. Turnover has also been adopted as one of the classification criteria under the new international taxation framework agreed upon among members of the OECD (Organization for Economic Cooperation and Development) and other countries.

Under “Pillar One” of the framework, which represents the revision of the principles of international taxation, multinational companies with a global turnover of more than 20 billion euros and profitability above 10% are subject to taxation. Under “Pillar Two,” which provides for the imposition of a global minimum effective tax rate of 15%, companies with combined financial turnover above 750 million euros are subject to the global minimum tax.

Turnover as a New Classification Criterion

In Japan as well, I would like to propose using turnover, in place of capital, as a criterion for SME classification. A more gradual reform would be to avoid applying preferential tax treatment to SMEs with a turnover of above a certain threshold while keeping the classification based on the capital amount.

Turnover has already been used as a classification criterion for the purpose of taxation in the case of consumption tax. Businesses with a taxable turnover of more than 10 million yen are obligated to collect the consumption tax from consumers and pay the collected tax to the tax authorities.

Turnover naturally goes up or down from year to year. If turnover is adopted as a classification criterion, the classification of companies with a turnover near the 10-million-yen threshold could move between “large companies” and “SMEs” from year to year. Therefore, I would like to propose using the average turnover over the three years prior to the year of taxation as a criterion.

From the viewpoint of encouraging corporate growth, one possible option is to refuse to treat SMEs as such in principle once they have exceeded the turnover threshold (outgrown the SME category) even if they later fall back below the threshold.

Generally speaking, turnover represents the result of corporate activity, so it is presumed to be an appropriate benchmark of company size. This can be a new classification criterion for dividing businesses into large companies and SMEs.

>> Original text in Japanese
* Translated by RIETI.

August 24, 2024 Weekly Toyo Keizai

September 26, 2024

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