Pre-IPO Capital Structure: What a Share Transfer Defers, and What It Does Not

"We are aiming to list in three years. Is our current cap table a problem?" Founders whose businesses have found their footing bring us this question regularly. Behind it, usually, sits a different one: what actually happens on listing day.

Listing is not the day a founder sells shares. It is, however, the day shares start to move. Knowing what applies once they do lets you separate what has to be decided now from what does not.

The Framework That Applies When Shares Are Sold

Where an individual disposes of shares, the resulting income is taxed separately from other income. Article 37-10(1) of the Act on Special Measures Concerning Taxation imposes income tax at 15% on capital gains from general shares — those other than listed shares. After listing, Article 37-11(1) applies, at the same 15% on gains from listed shares.

Special reconstruction income tax sits on top. Article 13 of the Act on Special Measures for Securing Financial Resources Necessary to Implement Measures for Reconstruction following the Great East Japan Earthquake sets the individual charge at 2.1% of the base income tax amount — 0.315 percentage points on a 15% base. Add 5% local inhabitant tax and you have the familiar 20.315% figure, broken into its components.

The rate itself does not change on listing. What changes is the value of the shares and the range of people who can buy them.

Inserting a Holding Company

Article 772(1) of the Companies Act provides that one or more stock companies may effect a share transfer (kabushiki iten), and that a share transfer plan must be prepared. Shareholders of the operating company transfer their shares to a newly incorporated parent and receive parent-company shares in exchange. This is the standard route to a holding company.

The most commonly misunderstood point is the basis on which the individual shareholder escapes immediate tax. You will hear that it is enough to satisfy the "qualified" requirements of the corporate reorganisation rules. But qualification is a Corporation Tax Act concept; it does not itself govern how an individual shareholder's capital gain is treated.

The provision that does is Article 57-4(2) of the Income Tax Act. Where a resident transfers old shares to a share-transfer wholly owning parent company through a share transfer effected by the issuing company — limited to transfers in which no asset other than shares of that parent company is delivered to shareholders, disregarding consideration paid on a dissenting shareholder's appraisal demand — and receives shares of that parent company, the old shares are deemed not to have been transferred for purposes of Article 27 (business income), Article 33 (capital gains), and Article 35 (miscellaneous income).

The statutory condition is precise: nothing other than parent-company shares may be delivered. Introduce cash into the consideration and the provision stops applying.

Equally important, this is a deemed non-disposal — a deferral, not an exemption. Article 57-4(4) delegates the computation of the acquisition cost of securities received by the resident, and other necessary matters, to Cabinet Order. The delegated provision — Article 167-7(6) of the Income Tax Act Enforcement Order — provides that the acquisition cost of the old shares transferred to the parent company in the share transfer becomes the acquisition cost of the parent-company shares received. The cost base carries over unchanged. The argument that transferring early "locks in" a low cost base and is therefore advantageous does not sit with how the deferral is constructed.

The last row is the point. Inserting a holding company is not an operation that simply lowers the burden. It changes where — and how many times — tax arises, and it has to be decided together with the question of whether capital stays inside the company for reinvestment or moves to the individual.

Stock Options: The Founder Is Usually Outside the Regime

Article 29-2(1) of the Act on Special Measures Concerning Taxation provides that where a person acquires shares by exercising, in accordance with the contract, a share option meeting specified requirements (a "specified share option"), no income tax is imposed on the economic benefit arising on that acquisition. Nothing is taxed at exercise; the charge consolidates into the capital gain on eventual sale.

But the definition of the "directors etc." the provision covers expressly excludes two groups: an individual who, on the date of the grant resolution, held the number of shares in the company specified by Cabinet Order (a "large shareholder"), and that person's spouse or any individual in a special relationship specified by Cabinet Order (a "related person of a large shareholder"). A founder with a substantial stake is likely to fall within that exclusion, which means granting oneself qualified options to defer tax generally does not work. The qualified option regime is built for executives and employees, not for founders.

The requirements must be written into the option contract. The items in paragraph (1) run as follows:

• Exercise window — between the day two years after the grant resolution and the day ten years after it (fifteen years where the company satisfies the Ministry of Finance Ordinance requirements, including being less than five years from incorporation) (item (i))
• Aggregate exercise price in any year not exceeding ¥12 million (item (ii)). The proviso to paragraph (1) modifies this test: for a company less than five years from incorporation the exercise price is divided by two before applying the ¥12 million threshold, and by three for a company meeting the requirements including being between five and twenty years from incorporation
• The per-share exercise price must be at least the per-share value of the company's shares at the time the contract is concluded (item (iii))
• The option must be non-transferable (item (iv))

Item (iii) dictates sequence. Because the exercise price cannot fall below the share price at contract date, granting after the valuation has risen fixes that higher price as the floor. Who receives what while the share price is still low is a decision that cannot be retrieved later.

Fixing the Sequence

Capital structure in an IPO preparation reduces, in the end, to the order in which things are fixed.

• Which entity holds the founder's shares — and if a share transfer is used, whether the consideration can be built from parent shares alone (Income Tax Act Art. 57-4(2))
• When grants to executives and employees are made — the floor on the exercise price is set by the share price at contract date (Special Taxation Measures Act Art. 29-2(1)(iii))
• Who counts as a large shareholder — this fixes who falls outside the qualified option regime
• Whether the eventual seller is the individual or the company — this changes where and how often tax arises

Mapping shareholdings, transfer consideration, and grant timing onto a single capital policy table is where design for a listing begins. It is not work driven by a fiscal-year or quarterly deadline; it is work whose sequence needs to be fixed before the share price moves.

This article provides general information on tax systems and does not constitute individual tax consultation. Specific filings and tax computations are handled by licensed partner tax accountants whom we introduce.