International Tax in Japan
This article is an overview on the Japan’s international tax system from both inbound and outbound perspectives.
1 General tax system
1.1 Taxable person (resident / non-resident)
Japan generally applies worldwide taxation with foreign tax credit system, i.e. any income whether arisen in or outside Japan, shall be taxable in Japan, for residents (domestic companies). On the other hand, for non-residents, Japan shall tax only domestic source income. In this regard, specific source rules are stipulated for each type of income (see further below).
The issue whether a company is resident or non-resident is decided by “Head Office” test, which is very formal approach. Under the test, a company incorporated in Japan must always have its “Head Office” in Japan, and so be regarded as a Japanese resident even if it is managed and controlled outside Japan. Whereas, a company incorporated outside Japan cannot have its “Head Office” in Japan, even if it is managed and controlled in Japan. Accordingly it cannot be a Japanese resident, apart from the PE issue.
1.2 Taxable income
Any type of income and capital gains are taxable as ordinary income. The exception is that 95% of dividends from foreign subsidiaries are exempt if certain conditions below are satisfied:
i) 25% (ownership / voting power);
ii) 6 months (holding period); and
iii) Non-deductible at source (anti-hybrid mismatch)
This means that Japan does not tax foreign source income earned by subsidiaries whether they retain profits or repatriate them, unless the CFC rule is applicable (see further below).
1.3 Tax rate
The corporate tax rate applicable to taxable income is effectively around 30%, which can vary due to the local taxes and frequent tax reforms. Whereas, the withholding tax rate is generally 20% imposed on gross income, although the rate varies depending on the nature of income (see further below).
2 Inbound into Japan
2.1 Business entities and trusts
2.1.1 Legal entity
Domestic legal entity is generally subject to Corporate Income Tax (CIT). There are several legal forms available as below.
Kabushiki Kaisha (KK) – joint stock company (public / private)
(Former) Yugen Kaisha (YK) – private limited company, abolished in 2006, but a grandfathering clause exists so you can buy formerly incorporated YKs
Godo Kaisha (GK) – limited liability company, which is less regulated (e.g. annual account is not required to disclose to public) and enjoys more flexibility in its management
Gomei Kaisha / Goshi Kaisha – partnership company
Ippan Shadan Hojin – general incorporated association, which can be tax exempt if it is a non-profit business entity
2.1.2 Transparent entity (partnership)
Domestic partnership is not subject to tax, and instead its partners are subject to tax. There are several legal forms as below.
Nin’i Kumiai (NK) – general partnership (GP) (having only general partners)
Yugen Sekinin Jigyo Kumiai - limited liability partnership (LLP) (having only limited partners)
Toshi Jigyo Yugen Sekinin Kumiai - limited partnership (LPS) for investment business (having general and limited partners)
If partners are non-resident, they are subject to tax only when they earn domestic source income in Japan. In this point, one important thing to note is that if one of the partners have a PE in Japan on behalf of the partnership, all the other partners are deemed to have a PE. This means that foreign partners need to file a tax return with regard to PE income, even though they themselves do not have any physical connection with Japan. Nevertheless, there is a special provision for foreign limited partners of LPS. If they own less than 25% interest, a PE held by another partner can be disregarded.
2.1.3 “Pay-through” entity / arrangement
“Pay-through” entity / arrangement described below can enjoy a special treatment, i.e. profit distributions are deductible at payer’s level and subject to final WHT.
Tokutei Mokuteki Kaisha (TMK) – specific purpose company
Tokumei Kumiai (TK) – silent partnership
TMK is often used as a real estate investment vehicle to avoid CIT exposure in Japan. Typically, less than 50% of interests in a TMK are held by foreign investors, and remaining interest are held by another entity incorporated in Japan, so as to satisfy a condition to apply the deductible dividends. Further, such entity is financed by the foreign investors to reduce taxable income in Japan. For overall tax efficiency, various factors must be taken into consideration such as:
WHT on dividends, interest and TK distribution (including application of relevant tax treaty);
Interest limitation rule; and
Taxation at recipient’s level.
Please note that TK distribution is not subject to interest limitation rules.
Other than above, trust can be also available as investment vehicles. There are three types as below.
General trust – “flow through” treatment, i.e. debt and assets as well as income are directly allocated to beneficiaries
Qualified investment trust – deferral treatment, i.e. profit distributions are subject to final WHT (as dividends or interest) only when they are remitted
Disqualified investment trust – legal entity treatment, i.e. subject to CIT at trust level, and profit
distributions are subject to final WHT
2.1.5 Foreign entity and trust
Foreign entity and trust are non-residents, and hence they are subject to tax only when they earn domestic source income in Japan (please see below).
2.2 Domestic source income
2.2.1 Income subject to CIT
Some types of income which are regarded closely connected to Japan are subject to CIT at the same rate as applicable to residents, although local tax can vary.
Below are examples of income which are subject to CIT.
a) PE income – subject to CIT
Japan generally follows the AOA. However, the definition of PE is broader than the current OECD Model, i.e. agent PE includes an agent who conducts material negotiation on behalf of the principal. Also, the recent court case admitted that a warehouse which does not have a preparatory or auxiliary nature can constitute a PE.
b) Income from personal services rendered in Japan - subject to 20% non-final WHT and CIT
Such income is generally regarded as a business income under tax treaties. Hence, seeking treaty protection would be very important to avoid taxation if there is no PE in Japan.
c) Rents from real estate - subject to 20% non-final WHT and CIT
d) Capital gains from real estate - subject to 10% non-final WHT and CIT
e) Capital gains from “real estate company shares” – subject to CIT
“Real estate company shares” are defined as shares that derive 50% or more of the value directly or indirectly from real estate located in Japan. There is a de minims rule, which requires 5% ownership for listed companies / 2% ownership for non-listed companies, to exclude capital gains from minority shares, which are regarded as passive investment income. Also, relevant tax treaty can be helpful where the treaty rule is different from the domestic rule.
f) Capital gains from “controlling shares” – subject to CIT
If a non-resident own 25 percent or more shares in a domestic company, such shares are regarded as “controlling shares”, which are taxable when transferred. In many cases, however, taxation on capital gains from shares are restricted by tax treaties. Thus, seeking treaty protection would be helpful. Alternatively, shares in a domestic company can be transferred indirectly by using holding company structure, i.e. transferring shares of a company that holds shares in a domestic company, to avoid taxation on direct transfer.
g) Income from loans to non-business residents – subject to CIT (not WHT)
Such income is treated as other income than interest income, although it is actually interest income in nature.
2.2.2 Income subject to final WHT
In general, passive investment income including dividends, interest and royalties are movable and easy for foreign investors to earn without physical presence, and hence they are typically subject to withholding tax when paid to non-residents. In Japan, the withholding tax rate is generally 20%, although it varies depending on each category of income.
Below are examples of income which are subject to final WHT.
a) Dividends – subject to final WHT at 15% (portfolio) / 20% (others)
In general, dividends, including profit distributions from an investment trust, are subject to 20% WHT, although some dividends such as ones from listed companies are at 15% rate. The WHT rate can be reduced by way of treaty application in many cases. Further, under some treaties concluded or amended recently, dividends can be exempt if certain participation requirements are met. Please note some treaties include a special provision for deductible dividends, i.e. paid by TMK, to deny reduction of WHT.
Interestingly, profit distributions from an investment trust is taxable as dividends only if the trust is entrusted with an office in Japan (place-of-the-office rule). In this point, treaties usually provide that only dividends paid by a resident should be taxable (residence-of-the-payer rule). Accordingly, the WHT on profit distributions from a foreign trust would be stopped under treaties.
b) Interest – exempt (publicly traded bonds), or subject to final WHT at 15% (other bonds and deposits) / 20% (others)
In general, interest on loans is subject to 20% WHT. Nevertheless, interest on bonds and deposits are at 15% rate, and interest on publicly traded bonds is exempt. As mentioned above, interest on loans to non-business residents is subject to CIT instead of WHT. In any case, tax treaties can reduce WHT in many cases.
In some countries, classification of interest (debt) / dividends (equity) can be a problem. However, in Japan, legal classification of debt and equity is generally respected, and simply income from debt is regarded as interest while income from equity is regarded as dividends.
c) TK distributions – subject to 20% final WHT
In Japan, TK distribution is the “third category” of financing instruments. Hence, some treaties specifically include a provision for TK distributions to allow Japan tax TK distribution. However, this is not all the case. If a tax treaty does not care about TK distribution specifically, income classification issue, i.e. whether dividends income, interest income or other income, may arise. In this regard, although there is no decisive interpretation, it should be treated as interest income, since its provision broadly covers income arisen from debt-claims of every kind.
d) Royalties – subject to 20% final WHT
The scope of royalties under domestic law is as below.
(i) Royalty for an industrial property right or any other right concerning technology, a production method involving special technology or any other equivalent right or method (industrial royalty), or consideration for its transfer (gains from the alienation);
(ii) Royalty for a copyright including right of publication, neighbouring right, and any other equivalent right (cultural royalty), or consideration for its transfer (gains from the alienation); or
(iii) Royalty for machinery, equipment or any other tool (rents from equipment).
Unlike the current OECD model, royalties include considerations for the transfer of intangibles and rents from movable properties. Accordingly, these are also included in the scope of royalty provisions under some treaties.
Interestingly, the definition of royalties under domestic law does not refer to any royalty for information concerning commercial experience or commercial knowhow such as trade secrets, commercial strategy, customer lists, distribution channel, and commercial data and so on, which are generally treated as royalty under treaties. This means that Japan might not tax royalties for commercial knowhow under business income provision under domestic law if there is no PE.
By contrast, service fees for intellectual work can be treated as cultural royalty if any copyright is regarded as transferred.
Another point to note is that domestic law adopts the place-of-the-use rule for royalties, under which royalties are taxable when intangibles or movable properties are used in Japan, unless relevant treaty provides differently. In this point, treaties generally adopt the resident-of-the-payer rule, and so Japan would be allowed to tax royalties when the payer is a resident of Japan or a PE in Japan.
2.3 Japan’s tax treaties
Please see here.
3 Outbound from Japan
3.1 Taxation on foreign source income
As explained, Japan adopts worldwide taxation system and accordingly taxes foreign source income earned by residents. However, as an important exception, foreign dividends from certain subsidiaries are 95% exempt. By contrast, capital gains from shares in foreign subsidiaries are fully taxable. Hence, a careful tax planning is required to avoid such taxation. One option would be using a hold company structure to avoid direct transfer, or alternatively stripping retained profits by way of dividends before selling shares would be another option.
Another important point to note is that Japan adopts foreign tax credit system to avoid double taxation, and there is only an overall limitation rule, as opposed to country by country / income by income limitation rule. Thus, a careful tax planning is also important in this regard, to make use of FTC as efficient as possible by utilising excess limitation to set off excess credits arisen from different type of income / arisen in different countries.
Also, it is important to note that although separate legal entities are respected, and income attributed to foreign subsidiaries are excluded from the parent’s income generally, CFC rule may apply if certain conditions are met. So, avoiding the application of the CFC rule is a key issue for CFCs, especially for those located in low tax jurisdictions whose tax rate is lower than 20%.
From above, classification of a foreign entity setup by a Japanese parent, i.e. whether it is transparent or opaque, can be very important. If it is a transparent entity, profits derived and losses incurred by the entity are directly included at the parent’s level. Whereas, if it is a legal entity, CFC rule as well as foreign dividends exemption are both applicable. For the question how to classify a foreign entity, it is crucial whether the entity is given the legal status to own property in its own name, to retain own rights and to bear own obligations under the foreign law.
3.2 CFC rule
Japan adopts mixed tests for the application of the CFC rule: tax rate test, economic activity test and income type test. The scope is unlimited and covers all underlying foreign subsidiaries as long as they are directly or indirectly held more than 50% of the shares by residents of Japan.
Importantly, dividends from underlying subsidiaries, 25% or more of the shares in which are held by the CFC, are excluded from the CFC income. This corresponds to the foreign dividends exemption system.
3.2.2 Tax rate test
Under this test, if the effective tax rate applicable to a CFC is 30% or more, such CFC is not subject to further tests and exempt from the CFC rule. Thus, a CFC located in “middle tax jurisdictions”, whose effective tax rate is between 20% and 30% such as the Netherlands (or even Germany) cannot automatically escape from the CFC rule. However, such CFC can escape from the CFC rule if it passes the "screening” test described below.
3.2.3 "Screening” test
Under this test, CFC’s income (other than certain dividends) is fully included in the parent’s income if the CFC falls under certain categories of potentially abusive companies as below.
Paper company - a company which has no fixed place of business and is not managed and controlled in the CFC state
Cash box company - a company whose total passive income on total assets is more than 30% (excess profits test) and total passive investment assets on total assets is more than 50% (asset type test)
Black list company - a company which is a resident of specifically listed countries as “tax haven”
If a CFC is located in middle tax jurisdictions, it would be safe and exempt from further tests provided that it is not classified as either type of company. Whereas, if a CFC is located in low tax jurisdictions, whose effective tax rate is less than 20%, it needs to satisfy further tests described below, in addition to the “screening” test.
3.2.4 Economic activity test
A CFC located in low tax jurisdictions needs to pass economic activity test to avoid full application of the CFC rule. This test consists of four tests below to be satisfied. If either test is not satisfied, the CFC income (other than certain dividends) is fully included in the parent’s income.
(1) Main business test
CFC’s main business must not be on a negative list, or “passive business” list. The list includes, among others, shareholding business and IP managing business. Accordingly, holding companies are disqualified unless they have a headquartering (HQ) function, although dividends from their subsidiaries can be excluded from the CFC income anyway.
IP management companies are also disqualified unless they have another business which is regarded as primary one. For the question how to decide the primary business is being taken into account various factors such as human resources, assets and main source of income.
(2) Substance test
CFC must engage in business activities with a fixed place of business in the CFC state.
(3) Management test
CFC must be effectively managed and controlled in the CFC state. To secure this, it is important that the CFC has personnel to make important business decisions and such decisions are substantially made in the CFC state.
(4) Anti-base company test
CFC must satisfy either condition:
For financial, wholesale (without a HQ function) or transportation companies, more than 50% transaction must be with unrelated parties; or
For other companies, main location of business activities must be in the CFC state.
3.2.5 Income type test
Even if a CFC located in a low tax jurisdiction passes all the economic activity tests, specific “passive income” earned by the CFC is partially included in the parent’s income. The passive income here includes:
dividends from minority shares (less than 25% shareholding);
interest without involving a proper money-lending function;
royalties from any kind of intangibles; and
capital gains from minority shares (less than 25% shareholding)
Nevertheless, royalties can be excluded from the passive income if intangibles are self-developed, or purchased or licensed for fair price and used for active business.
3.3 Other rules
3.3.1 TP rule
Japan adopts the transfer pricing rule and generally follows the OECD TP guideline. If related party transactions are not at arm’s length, i.e. with different price or conditions from those of unrelated party transactions, the income allocated to residents can be adjusted upwards.
There can be seen a global trend to move IPs from high tax jurisdictions including Japan to more preferable (tax efficient) jurisdictions. In such restructuring cases, considerations for the transfer of IPs must be in accordance with arm’s length principle and they will be generally taxed at ordinary rate. However, it can be mitigated by utilising carried forwarded losses (if any) for example.
Alternatively, moving R&D function itself without legal transfer of existing IPs can minimize the exit taxation. In any case, the key point should be moving important people to have sufficient capacity to manage IPs.
3.3.2 Earning stripping rule
The deduction of interest payment is limited to 20% of EDITDA.
Importantly, under the current rule, any interest paid to a bank in Japan is deductible without subject to the limitation. This is so even if the money borrowed by a bank is used to acquire a company in Japan. This mean that the acquiring company can deduct interest payment from its income without including a dividend from the acquired company. Further, such interest payment can be used to offset the business profits of the acquired company by mergering or consolidating tax returns with the acquiring company.
3.3.3 Impact of the BEPS initiatives
Most BEPS initiatives have been already introduced in Japan, such as limitation of no inclusion treatment for deductible dividends (Action 2), reinforcement of CFC rule (Action 3), enhancement of interest limitation rule (Action 4), inclusion of anti-treaty abuse provisions (Action 6), new PE definitions (Action 7) and stregthening TP rules (Action 8-10).
Appendix - Resources available in English
Ministry of Finance – Tax Policy
National Tax Agency – Tax Administration
Ministry of Justice Japan - Japanese Law Translation
SOZEISHIRYOKAN (The Association of Fiscal Documents) – Corporation Tax Act
Supreme Court - Judgements