Japanese tax structuring

 

Surviving Japanese business tax audits

4.  surviving Japanese business tax audits

In the previous section on taxes you will need to pay when doing business with Japan, it was apparent that there are two fundamental categories of tax, income taxes and withholding taxes, that need to be considered.

Traditionally there have been 3 simple structures used by foreign companies to reduce the tax they pay doing business in Japan:

  1. have no Japanese resident entity, simply sell through totally independent Japanese distributors and thus have no Japanese income tax liability (unless royalties were received in which case Japanese withholding tax on those royalties would be deducted at source),
  2. set up a 'Japanese customer liaison' subsidiary to almost eliminate Japanese income tax exposure by simply providing customer and distributor liaison support from the Japanese subsidiary (which further to the Japanese '105 rule' would pay income tax calculated on 5% of its total expenses) and have all contracts and revenues bypass the Japanese entity and flow direct to the foreign parent (with withholding tax on any royalties being deducted at source in Japan),
  3. set up a 'Japanese subsidiary distributor', offset the subsidiary's costs against its revenue and carefully calculate transfer prices to get cash flowing back to the foreign parent while hopefully eliminating Japanese domestic profits and income tax (with withholding tax on any royalties being deducted at source in Japan).
A fourth option, and probably the simplest of the 'complex' multi-tiered structures, is the 'service and support' Japanese 'branch office child of the foreign child of the ultimate foreign parent'. In this structure the ultimate foreign parent sells in Japan through 3rd-party distributors who are locally supported in Japan by the branch-office (which has no direct dealings with the ultimate parent and never participates in sales).

In the 1980's Japan's economy was booming, tax coffers were full and foreign company activities in the Japanese market were at relatively low levels. At that time any of the four structures described above could substantially reduce a foreign company's Japanese corporate tax burden without drawing undue attention from the Japanese tax authorities. Unfortunately all good things (especially tax breaks!) come to an end and since the early 1990's the decline in tax revenues caused by Japan's recession and the steady rise in the number of foreign companies succeeding in Japan has caused tax inspectors to more carefully scrutinize foreign companies' activities here and to increase the frequency of auditing them.

If you do business in Japan through a subsidiary company or office then that company or office will be directly liable for Japanese income tax and you should expect it to be audited by the tax authorities within 3 - 5 years of starting Japanese business. If you do business in Japan solely through a bona-fide economically independent 3rd party distributor then you will not be directly audited because you will have no Japanese income tax liability. Japan's tax codes place the initial burden of collection and payment of applicable withholding taxes, consumption taxes and tariffs on the Japanese importer. The independent distributor will be subject to audit though; at which time its contracts and the transfer prices paid to you, may come under scrutiny.

Based on my personal experience of Japanese tax audits, if you are doing business in Japan using one of the four structures described above, then you will need to satisfactorily answer questions regarding the following concerns:

  • a customer liaison subsidiary must be able to prove that the functions actually performed by it are in fact those of customer liaison and that it does not participates in sales activities - this means it never participates in sales negotiations, never executes contracts (even for small amounts) with Japanese customers, is not used as a business center by your head-office executives when they do sales negotiations with Japanese customers and is not involved in issuing of invoices or revenue collection.
  • a subsidiary distributor must be able to justify any transfer price paid to its foreign parent which is higher than the 'arms-length' transfer price calculated by the tax office, especially if it has a 'sole distributor' or 'master distributor' agreement with the parent.
  • a Japanese subsidiary company or office must be able to justify the cost of any inter-company leases of staff and equipment from the parent.
  • similarly a Japanese subsidiary company or office must be able to justify the cost of any interest paid on inter-company loans from the foreign parent (known as 'thin-capitalization').
  • a kabushiki kaisha must be able to prove that any highly commissioned employees are not performing duties usually performed by directors.

In my experience, Japanese tax inspectors tend to be far more amicable, helpful and much less obtrusive than their US or European counterparts - unless of course they suspect you are deliberately abusing the system. When compared with the US or Europe, the Japanese tax codes and especially Japanese revenue recognition rules are still relatively relaxed - there is plenty of scope to legitimately reduce taxes while staying within accepted legal boundaries.

If you satisfactorily answered the above concerns, then your tax structuring is legitimate - but that does not necessarily mean it is the most efficient.

5.  bad Japanese corporate tax structures to avoid >>


Japanese tax structuring

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