Surviving Japanese business tax audits
In the previous section about Japanese corporate taxes, we looked at the three main taxes, Japanese business income tax, Japanese withholding taxes and Japanese consumption (sales or VAT) tax, that your company or branch-office in Japan must pay. Traditionally, foreign companies doing business in Japan have used three simple structures to cut these Japanese corporate taxes:
- No Japanese resident entity; the foreign company sells through independent Japanese distributors, resellers and trading companies. The foreign company has no Japanese income tax or consumption tax liability unless it receives royalties from Japan, in which case its Japanese must deduct withholding tax on those royalties at source.
- Japanese customer liaison subsidiary; the foreign company incorporates a Japanese company, either a KK kabushiki kaisha or a GK godo kaisha (but not a branch-office) to offer only local language support. The subsidiary must not do any sales or order fulfilment for the foreign company’s Japanese customers, distibutors, resellers and other business partners. This reduces its Japanese business income tax exposure to the Japanese ‘105 rule’, with corporate income tax calculated on 5% of the Japanese company’s total expenses. The foreign company has no other Japanese income tax or consumption tax liability unless it receives royalties from Japan, in which case its Japanese customers must deduct withholding tax on those royalties at source.
- Japanese subsidiary distributor; the foreign company incorporates a Japanese company, either a KK kabushiki kaisha or a GK godo kaisha (but not a branch-office) as its Japanese distributor. The foreign company then carefully sets transfer prices (the prices at which it sells products and services to its Japanese subsidiary) which, when added to the Japanese company’s business expenses, reduce its taxable income. The foreign company has no Japanese income tax or consumption tax liability unless it receives royalties from its Japanese subsidiary, in which case its Japanese customers must deduct withholding tax on those royalties at source.
In the late 1980’s, the boom years of foreign companies setting up Japanese offices and companies, Japan’s economy was bullish, tax coffers were full and the National Tax Agency’s scrutiny of foreign company activities in the Japanese market was at a relatively low level. At that time, any of the three structures described above could substantially cut 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. Since the early 1990’s, tax revenues have steadily declined because of Japan’s seemingly endless recession, the need for tax revenues has steadily increased as Japan’s population ages, and the number of foreign companies succeeding in Japan has steadily increased. These factors have caused tax inspectors to very carefully scrutinize foreign companies’ Japanese business activities and to increase the frequency of auditing them: thus the National Tax agency’s landmark ruling against Amazon in the past decade.
If your company does business in Japan through a Japanese subsidiary company or office, then its Japanese company or office will be directly liable for Japanese business income tax, withholding taxes and consumption tax and you should expect Japan’s National Tax Agency to audit your Japanese office or company within 3 – 5 years of starting business in Japan.
If your company does business in Japan solely through a bona-fide economically independent arm’s-length third-party distributor, reseller, or trading company, then the tax office will not audit it because it has no direct Japanese corporate income tax, withholding tax or consumption tax liability. In this situation, Japan’s Corporation Tax Law puts the initial burden of collection and payment of applicable withholding taxes and consumption taxes on the Japanese importer. The tax office will at some time audit the importer though; at which time it will scrutinize its contracts and the transfer prices paid to your company.
Based on our experience of Japanese tax audits, including a very extensive audit of a US company’s branch-office in Japan that took nine months and tens of thousands of dollars to complete, if your company is doing business in Japan using one of the three structures described above, Japan’s National Tax Agency will expect you to satisfactorily answer questions about the following concerns:
- A customer liaison subsidiary must prove that it only provides customer support and does not take part in any way in sales activities. This means that its staff never take part in sales negotiations, it never signs contracts (even for small amounts) with Japanese customers, it is not used as a long-term business center by your head-office executives when they do sales negotiations with Japanese customers, it is not involved in order fulfilment, it is not involved in issuing invoices, and it does not collect revenue.
- A subsidiary distributor must prove any transfer price paid to its foreign parent which is higher than the equivalent ‘arms-length’ transfer price the National Tax Agency calculates. We recommend using the National Tax Agency’s transfer pricing confirmation service before starting business in Japan, which then avoids problems during tax audits.
- A Japanese subsidiary company or branch-office must justify the cost of any inter-company expenses for leases of staff and equipment from its parent. It must also attach documents describing any inter-company expenses to its tax-returns each year.
- A Japanese subsidiary company or office must justify the cost of any interest paid to its foreign parent on inter-company loans and accrued inter-company expenses. This is to prevent what is generally described as ‘thin-capitalization’, whereby a foreign company deliberately under-capitalizes its Japanese subsidiary and then lends cash to it at artificially high interest rates. Japan’s thin-capitalization rule states that regardless of interest rate, any interest on a loan from its parent or family company exceeding 3x the subsidiary’s paid-in capital is disallowed.
- A kabushiki kaisha must prove that any highly commissioned senior employees are not performing duties usually performed by directors.
- A Japanese branch-office of a foreign company must prove show how much involvement it has in any sales its foreign head-office makes to customers in Japan. A branch-office must attach a copy of its foreign head-office’s most recent balance-sheet to its tax-returns.
In our experience, Japanese tax inspectors are far more amicable, helpful and less obtrusive than their US or European counterparts, provided of course that they don’t suspect your company is deliberately abusing the system to avoid paying its fair share of Japanese taxes. When compared with the US or Europe, Japan’s Corporation Tax Law and revenue recognition rules are relatively relaxed, so there is plenty of scope to legitimately reduce corporate taxes while staying legal.
If your company can satisfactorily address the National Tax Agency’s concerns noted above, then your tax structuring will pass an audit, but that does not necessarily mean it is the most efficient way for your Japanese company or office to cut its corporate taxes.