Japanese corporate tax structures to avoid
In the previous section on Japanese tax structures and Japanese corporate tax audits for foreign companies doing business in Japan, we noted that even if your company’s Japanese corporate tax structure uses one of the three traditional structures and passes a tax audit, it might still be an inefficient structure to use.
The first structure we looked at for starting business in Japan, is dealing only through third-party distributors with no resident Japanese subsidiary company or office. This might be income tax efficient, but it probably won’t realize your company’s full potential value: as we noted in the section on direct sales in Japan, your Japanese sales revenues will often be far higher if you have a Japanese sales office, than will ever be achieved selling through Japanese distributors and resellers. In the simplest sense, your company eliminates a 34.1% Japanese corporate income tax charge by ‘staying out’ of Japan, but in doing so loses a 30% – 60% margin to a Japanese distributor that might anyway only ever realize 20% – 30% of your true potential sales in the Japanese market.
Many other foreign companies starting business in Japan, do so with the second structure we considered in the previous section: the Japanese customer liaison subsidiary, which reduces the Japanese corporate income tax charge to 0.17% of the Japanese subsidiary’s operating cost. The challenge with the Japanese customer liaison subsidiary is that to legitimately keep up its status as a pure customer liaison office, the Japanese subsidiary must have absolutely no contact or communications with a Japanese customer or distributor which directly results in sales. It must exist solely to provide arm’s-length technical and product support and must not negotiate contracts, fulfil orders, collect cash from customers, or support any such sales-related activities.
Having once managed a customer liaison office in the Japanese software industry for several years, I do not recommend it as a long-term tax reducing structure because its downside risks are increasingly unacceptable unless it simply supports one or more totally independent third-party Japanese distributors or resellers and never interacts directly with customers. The challenge is that over time, the role of the Japanese customer liaison subsidiary or office begins to blur, especially because (despite those myths of doing business in Japan) most Japanese business people do not speak fluent English and will gravitate to dealing with your Japanese subsidiary and not with your company’s head-office. The inevitable tendency is for a customer liaison office to evolve into a very poorly structured (from the perspective of reducing Japanese corporate tax) sales office in all but name. We have even known Japanese customer liaison offices with employees on sales compensation plans with revenue quotas.
The Japanese tax office (specifically the Tokyo Regional Taxation Agency) highlighted the potential downside of Japanese customer liaison offices in 2009, when it demanded $190,000,000 in back taxes from Amazon.com International. Amazon claimed that its Japanese subsidiaries were only supporting its Japanese operations as customer liaison offices and were not generating revenue: the Japanese tax office disagreed. The Japanese tax office made its ruling against Amazon after an extensive audit and employee interviews apparently revealed emails and other communications showing Amazon’s corporate management’s deep involvement in day-to-day decisions at the Japanese subsidiaries.
Fortunately for Amazon, the US and Japanese tax officials later agreed to waive the tax ruling further to the US – Japan Tax Treaty, but the lesson from the Japanese tax office’s ruling against Amazon is clear: as Japan’s population ages, its working population shrinks, and its tax revenues decline, foreign companies and their Japanese offices are increasingly on the tax office’s radar: any foreign company using the customer liaison subsidiary structure must prepare for the possibility that the Japanese tax office challenges the office’s purpose. If your company wants to defend its claim that its Japanese subsidiary company is operating as a pure customer liaison office, then it must make sure there is no daily interaction between its foreign managers and subsidiary employees, especially in any areas connected with processing orders, issuing invoices, or collecting payments. In our experience there are few foreign companies that can take such an arm’s-length ‘hands off’ approach to their Japanese operations.
If you are 100% confident that your Japanese distributor is maximizing your sales in the Japanese market and the intangible Japanese brand value of your products, then either of the above structures (arm’s-length distributors, with or without a customer liaison office) might be ideal. Ultimately both structures are tax efficient, but very likely only on a small part of your potential Japanese market value, because in our experience, many foreign companies could do substantially more business in Japan with a Japanese subsidiary sales office or company than through a third-party distributor.
So, for those companies that do not want to bet their future success in Japan on a distributor, but would rather enter the Japanese market and start profitable and tax efficient business in Japan, what is the most tax-efficient way to set up a directly owned and operated Japanese sales office?