https://www.wsj.com/articles/SB849547523117601000　

By Nicholas E. Benes and Yoko Ito

Dec. 3, 1996 12:01 am ET

To ensure the success of its highly touted “Big Bang” package of financial reforms, the Japanese government should focus on making it easier for companies to conduct mergers and acquisitions, or M&As. The way to do this is by extending existing low capital-gains tax rates to sales of unlisted companies. The government might even succeed in raising more tax revenue if it acted on capital gains.

To revitalize its economy, Japan very badly needs a more active, dynamic M&A market. Without acquisitions, companies cannot rapidly “restructure,” synergies cannot be created and new competitors (including foreign companies) have trouble quickly bringing new know-how and products to the market. Clearly, to continue growing as a mature economy, Japan needs more rapid change, and the system has very few mechanisms that promote this.

It is well known that Japan’s M&A market is one of the most inactive and closed among major developed nations. What is much less well understood is that taxes, perhaps more than “culture,” are largely responsible for stunting the growth of the Japanese M&A market. In policy making for the “Big Bang,” this is useful because tax laws can be changed more easily than culture.

At present, if a company’s founder who is its controlling shareholder sells shares after the company has been listed for more than a year, he can opt to use either the standard 26% cap-gains tax rate or a flat tax rate of 1% times the total proceeds of the sale transaction. But if he sells before his company goes public, he may not elect to use the low 1% rate. Understandably, the 1% rate usually is considered fabulously attractive by most owner-managers, since the book value of the shares they hold (the tax basis) is extremely low.

This drastic shift in tax treatment–from 26% to 1%–takes place in a span of only 366 days. To a potential seller of a company, this means that waiting to go public with an IPO is pretty clearly the “road to riches.” Even if they cannot wait until the requisite first year has passed since the IPO, if they go public such entrepreneurs can still benefit from tax regulations allowing early-stage investors (who invested before the IPO and sold less than one year after it) to file at a 13% capital-gains tax rate.

In Japanese tax law, the policy justification for these wonderfully low tax rates is that the system has been designed to let entrepreneurs enjoy their just “founder’s profit.” There is nothing wrong with this policy at all; Japan needs it badly at the current stage of its transition toward a more diversified economy. The problem is that the policy is narrowly restricted to sales of shares that are listed on stock exchanges, because M&A transactions did not come to mind when these tax laws were first drafted.

Taxes are crucially important because all the likely Japanese sellers have very low tax bases. Most Japanese companies that are feasible targets for an acquisition are ones where a founding family or manager controls much of the stock. When one talks about truly attractive and likely acquisition targets in Japan, one is generally not talking about listed companies with diffuse ownership, but about those with owner-managers.

Such an entrepreneur–the prospective seller in an acquisition transaction–almost always has a very low tax basis in his stock (essentially, the book value of the original investment), because he has raised his company from startup. If you think about it, low tax bases are a natural outcome of having an inactive M&A market, because obviously there is almost no one who has bought his company from someone else.

With this background, it is easy to understand why it is often extremely difficult for a potential acquirer to offer a deal to an owner-manager of an unlisted company that can possibly compete with the after-tax result of an IPO. Mathematically, the buyer would have to offer a price that is at least 34% higher than the price that the seller could expect from the IPO, the “competing” alternative. It is true that in the typical IPO the selling founder will get less actual liquidity than if he sells in an M&A deal, especially in Japan where trading volume is extremely thin in markets for newly listed stocks. But still, when added to the loss of independence and the trauma of an M&A transaction, this gap of 34% can be hard to overcome.

This sharp contrast in tax treatment may not be an overwhelming problem if the target company is still more than four or five years away from an IPO and still has doubts as to whether it will grow steadily and profitably enough to meet the many criteria for listing. Often, such an entrepreneur is uncertain whether an IPO will ever happen at all in Japan’s absurdly overregulated equity markets.

However, taxes often pose a truly insurmountable barrier to an acquisition if the target is a fast-growth company in Japan that is close to an IPO. Unfortunately, many truly attractive companies arguably are in this category, less than three or four years form a public offering. In such cases, there usually needs to be overwhelmingly compelling strategic logic and synergy to offset the effect of the difference in taxes.

Actually, there is no policy reason why the present low tax rate election that is offered to “founders” with respect to sales of listed shares should not be extended to unlisted companies. Years ago the securities firms lobbied the Ministry of Finance to allow the 1% rate to be used, as a means of promoting more frequent stock trading so that they could make more money. It should be very easy to extend this tax treatment to unlisted companies, and there is no reason not to do so, except simply that no one ever lobbied for that. In fact, because there currently are so few M&A transactions in Japan, the tax-revenue loss from this simple adjustment would be negligible. Indeed, it could easily result in a tax-revenue gain as the number of transactions increases dramatically.