2.2 Domestic source income

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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.

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Below are examples of income which are subject to CIT.

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a) PE income – subject to CIT

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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.

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b) Income from personal services rendered in Japan - subject to 20% non-final WHT and CIT

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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.

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c) Rents from real estate - subject to 20% non-final WHT and CIT

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d) Capital gains from real estate - subject to 10% non-final WHT and CIT

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e) Capital gains from “real estate company shares” – subject to CIT

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“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.

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f) Capital gains from “controlling shares” – subject to CIT

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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.

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g) Income from loans to non-business residents – subject to CIT (not WHT)

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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.

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Below are examples of income which are subject to final WHT.

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a) Dividends – subject to final WHT at 15% (portfolio) / 20% (others)

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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.

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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. 

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b) Interest – exempt (publicly traded bonds), or subject to final WHT at 15% (other bonds and deposits) / 20% (others)

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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.

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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.

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c) TK distributions – subject to 20% final WHT

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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.  

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d) Royalties – subject to 20% final WHT

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The scope of royalties under domestic law is as below.

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(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).

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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.

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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. 

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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.