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Choosing A Tax Structure For A Japan Business

Background

As professionals, we are often asked by clients to assist in the legal establishment of an entity in Japan. Typically, this will be either an incorporated entity (a Kabushiki Kaisha (“KK) or a Good Kaish (“GK”)) or a Japan branch of a foreign company. (This article contains information about Setting up a Business in Japan – How to Choose a Business Entity.)

A vital issue that needs to be addressed is how the newly established entity will recognize income in Japan – this is referred to as the new company’s tax structure.

In order to avoid future problems with the Japanese tax authorities, is important that a Japan entity have an appropriate tax structure and it is critical that lawyers document this tax structure at the same time (or very soon after) the entity is being established.

Tax structure is related to the concept that an entity established in Japan must have a commercial purpose, i.e., the Japanese authorities have an expectation that a Japan entity has (at least) a plan to make profit. It is not possible to only recognize expenses in Japan.

Related to tax structure, are the issues of transfer pricing and permanent establishment (“PE”) risk. Both concepts relate to the requirement that an appropriate amount of profit is recognized (and taxed) in Japan.

This article discusses the most common tax structures utilized by foreign businesses in Japan and also provides an overview of transfer pricing and permanent establishment issues.

Is Tax Structure An Issue For My Client?

Tax structure may not be an issue for a stand-alone business operating only in Japan. Such businesses will simply recognize income earned and expenses incurred in Japan. In addition, permanent establishment and transfer pricing will generally not be of concern since there is no foreign parent to be considered (see below for an explanation of permanent establishment and transfer pricing).

However, tax structure (along with transfer pricing and permanent establishment) will be an issue when a foreign company sets up an entity in Japan.

For example, an Australian software company that establishes a subsidiary in Japan. In such a case, a decision will need to be made about the role of the Japan entity. Will the new subsidiary sell directly to Japanese customers or will sales to Japanese customers continue to be made from the Australian headquarters? If sales are made from the Australian headquarters, how will the Japan entity earn income as compensation for the support activities it is undertaking in Japan?

Documentation

It is very important that a new entity’s tax structure be formally documented. This should include preparation of internal company documents (board of director minutes, etc.) and also inter-company documents (for example buy-sell agreements between the parent company and the new Japanese subsidiary.)

Related Issues – Permanent Establishment and Transfer Pricing

  • Permanent Establishment

An important issue associated with choosing a Japan tax structure is permanent establishment (“PE”) risk.

The key to understanding PE is to consider the activities that a Japan entity is undertaking in Japan on behalf of a foreign company.

A PE arises when activities being performed by the Japan entity on behalf of the foreign parent exceed a certain threshold. For example, if a Japan entity moves from merely liaising with Japanese clients to signing contracts in Japan on behalf of the foreign parent.

If a Japan entity is deemed to be a PE of a foreign company, the foreign company will become liable for Japanese corporate tax on income related to Japan.

Guidance regarding what constitutes a PE can be found in Japanese domestic law. Double tax treaties (“DTA”) add clarity and may expand the scope of activities that can be undertaken by a Japan entity on behalf of the foreign parent.

For example, Article 5 of the Australia-Japan Double Tax Treaty (2008) defines the situations in which the activities of a Japan entity could constitute a PE of an Australian company. The DTA also lists a number of situations in which an Australian company would not be deemed to have a PE in Japan.

A full list of Australia’s double tax treaties (including the Australia-Japan DoubleTax Treaty (2008))can be found on the Australian government’s Treasury website at https://treasury.gov.au/tax-treaties/income-tax-treaties.

  • Transfer Pricing

Tax structure is also related to the concept of transfer pricing. Transfer pricing has become a serious focus of tax authorities around the world and Japan is no exception. Transfer pricing rules are designed to ensure that global businesses recognize an appropriate amount of income in each jurisdiction in which they operate. In particular, the tax authorities want to prevent profits from being shifted from high tax jurisdictions to low tax jurisdictions.

In simple terms, transfer pricing principles require that cross border transactions between two related parties (for example transactions between an Australian parent and it’s Japan subsidiary) must be done on an arm’s length basis. Arm’s length simply means that the Australian parent and the Japan subsidiary should deal with other as though they are third parties.

Any payments by the Japan entity to an offshore, related party need to be justified in terms of services provided and the price that would be paid if those goods / services were provided by a third party.

What Tax Structures Are Commonly Used by Foreign Companies in Japan?

For most clients there are two basic options for recognizing income in a Japan entity – a Cost-Plus approach and a Buy-Sell approach.

Option 1: The Cost-Plus Approach

The Cost-Plus approach is a very common tax structure for the Japan subsidiaries of foreign companies in Japan.

Under a Cost-Plus model, sales to Japanese customers are made from and recognized in the foreign parent. The Japan entity’s role is to provide sales and marketing support services on the ground in Japan but not to engage in direct sales to Japanese customers. The Japan entity invoices the overseas parent for its expenses plus an agreed mark-up (e.g., 7% or 8% of total expenses).

Scope of Activities Permitted Under a Cost-Plus Model

Japan provides few formal guidelines with respect to activities that are permitted under a Cost-Plus arrangement.

However, based upon audit experience, a Cost-Plus arrangement will be accepted by the Japanese tax authorities when the Japan subsidiary’s services are limited to the performance of auxiliary (i.e., non-sales) activities for the foreign parent company. Such activities could include the following:

  • Providing technical assistance to customers
  • Information gathering and customer relations
  • Assisting with installation and maintenance of products sold in Japan, Presentation by Japan entity personnel of standard price list presentations to Japanese customers
  • Training customer personnel in the use of products sold
  • Providing limited warranty services for products sold, and
  • Performing other service-type activities

The following activities generally can not be performed by a Japan entity operating under a Cost-Plus approach:

  • Receiving orders from customers
  • Signing contracts, and
  • Performing an important role in the sales function – for example negotiation of major contract terms, handling of defective product returns

Permanent Establishment Risks Associated With A Cost-Plus Model

If the scope of activities undertaken in Japan are too broad, the Japan tax authorities may deem that the Japan entity represents a permanent establishment (PE) of the foreign parent – for example, if the Japan entity is undertaking sales activities on behalf of the Australian parent. As noted above, if the Japan tax authorities conclude that the Japan entity represents a PE, the foreign parent may be liable for Japanese corporate tax on income associated with Japan.

In general, PE risk should be low if the Japan entity limits the activities it performs for a foreign parent under a Cost-Plus arrangement. (See above for a discussion of the activities permitted under a Cost-Plus arrangement).

Transfer Pricing Risks Associated With a Cost-Plus Model

Under a Cost-Plus arrangement, a percentage expense mark-up needs to be determined. This represents the amount (in addition to the Japan entity’s actual expenses) that the Japan entity will charge the foreign parent – usually by way of an annual invoice. As noted above, the level of the mark-up should be set in such a way that it reflects the amount the foreign parent would pay if it engaged a third party to undertake the services in Japan.

Problems will arise if the Japan tax authorities determine that the mark-up percentage has been set too low. Although there is little formal guidance provided by the Japanese tax authorities, mark-ups of between 7% to 10% are reasonably common and accepted.

Option 2: Buy-Sell Model

Under a Buy-Sell tax structure model, the Japan entity makes sales directly to customers in Japan. Profit recognized in Japan is the difference between the buy price (i.e., the price at which the Japan entity purchases product from the foreign Parent) and the sell price (i.e., the price at which the Japan entity sells to customers in Japan).

A Buy-Sell structure allows the Japan entity to perform the broadest scope of activities in Japan.

Transfer Pricing Issues Associated With the Buy-Sell Model

If a Buy-Sell model is utilized, the Japan entity will purchase product directly from the foreign parent. As discussed above, the inter-company price needs to be set using the arm’s length principle. Arm’s length means a price that would apply if the Japan entity and the foreign parent were unrelated parties. If the Japan tax authorities determine that the inter-company price is shifting profits out of Japan (for example if the foreign parent is overcharging the Japan entity), then additional corporate income tax, penalties, and interest may be assessed.

Permanent Establishment Issues Associated With A Buy-Sell Model

A Buy-Sell Model is most likely to be attacked by the tax authorities based on transfer pricing. However, technically a permanent establishment could exist if uncompensated activities were being performed in Japan.

Summary

In summary, where an Australian company is establishing operations in Japan, consideration needs to be given to an appropriate tax structure (means of recognizing income in Japan) that is consistent with the activities that will be undertaken in Japan. In addition, the related issues of transfer pricing and permanent establishment need to be managed.

Contact AA International Law (AAI Law) to learn more about how we can assist your company to determine an appropriate tax structure in Japan.

The above is provided for general information purposes only and does not constitute advice to undertake or refrain from undertaking any action. Only qualified Japanese professionals are able to advise on Japan immigration, legal, and tax matters.