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Japan Permanent Establishment (“PE”) Risks


Japan’s National Tax Agency (NTA) continues to aggressively challenge nonresident taxpayers, and a major weapon in its artillery continues to be that of alleging a Japan permanent establishment (“PE”).

The NTA’s increased scrutiny of PE issues can be attributed to two emerging trends. First, many multinational enterprises responded to the global financial crisis and ensuing economic downturn by restructuring their worldwide operations. This is also true for many Multinational Enterprises (“MNEs”) operating in Japan and across Asia. Second, technological advances have made it possible for many foreign enterprises, to rely on streamlined e-commerce based business models, such as operating remotely through servers physically located in Japan.

These global cost-saving trends have meant reduced tax revenue for the Japanese government and resulted in the NTA, world renowned for challenging nonresident enterprises, taking even more aggressive positions toward foreign investors seeking to minimize their exposure to Japanese corporate tax. By way of illustration, it is now commonplace to find the NTA seizing the hard drives of businesses, especially of those in the financial services industry, to search for e-mails or other electronic evidence to support a PE challenge.

This article examines the PE concept and its attendant risks in light of these trends and in the context of tax structures commonly used by foreign companies in Japan.

The Concept of Permanent Establishment in Japan

Domestic tax law in Japan essentially follows the OECD model tax treaty definition. A PE can be created through a branch PE, a construction PE, or an agent PE.

Branch PE

A branch PE is created when a nonresident has a branch or other fixed place of business in Japan through which the business of the enterprise is partly or wholly carried on. In many cases in Japan, determining a fixed place of business is fairly straightforward, with examples including an office, factory, warehouse, branch, and quarry, particularly if the facility is owned by the nonresident. In cases that are not as clear, for example when the nonresident is granted access to office facilities in Tokyo by a customer or related entity, the extent to which the facility is at the disposal of the nonresident is a factor used to determine whether that access creates a PE. These factors are highlighted in the commentary to the OECD model treaty, which Japan as an OECD member generally recognizes for the purpose of tax treaty interpretation.

Construction PE

A construction PE arises when a building site or installation project in the country lasts for a definite period of time. In Japan, such projects are deemed a PE when they last longer than 12 months. Again, Japan follows the OECD regarding cases in which employees may come and go or be replaced, or smaller projects may cease and begin, by considering them as a whole when determining the 12-month PE threshold.

Agent PE

An agent PE risk exists when the nonresident has an agent located in Japan who has and habitually exercises the authority to conclude contracts on behalf of the nonresident. In Japan this authority extends to negotiating key terms of a contract, such as price, quantity, and payment terms. In 2008 Japan’s domestic tax law was amended to include an independent agent PE exemption. In light of the change, activities performed by an independent agent acting in the ordinary course of business are not deemed to be a PE.

Interestingly, some double tax treaties (“DTA”), for example the Australia- Japan income tax treaty include an expanded agent PE definition that reflects the NTA’s position on what level of contracting authority creates an agent PE.

It provides that a person, other than an agent of independent status, who has and habitually exercises the authority to substantially negotiate contract terms or conclude a contract on behalf of a foreign enterprise, will be deemed a PE. This treatment extends to persons who manufacture or process goods or merchandise belonging to the foreign enterprise.

PE Exemption — Preparatory Activities

In line with the OECD model treaty, a branch PE or agent PE will also not arise if the activities performed in Japan are auxiliary or preparatory in nature.

Under section 5(4) of the OECD model treaty, auxiliary or preparatory services include the following:

  • storage, display, or delivery of goods or merchandise
  • market research or collection information
  • processing goods or purchasing goods
  • liaising with customers (non-sales activities); and
  • other preparatory activities

For a number of foreign corporations doing business in Japan, this provision is of utmost importance. This is highlighted in the ensuing sections of this article.

Tax Structures and Business Reorganizations

Nonresidents commonly use one of the following tax structures to recognize income in Japan: cost-plus, buy-sell, or commissionaire.

Cost-Plus Structure

The cost-plus structure is widely used in Japan. Under cost-plus, the foreign corporation sells products directly to customers in Japan, while support services, such as those listed in the section titled ‘‘PE Exemption — Preparatory Activities,’’ above, are performed by a related entity in Japan. The relationship between the entities is governed by a services agreement, which should clearly list the rights and responsibilities of the Japanese entity. The related entity is compensated by way of a markup on its expenses, generally between 5 and 10 percent.

The cost-plus therefore allows for the foreign entity’s Japanese-source business profits to escape taxation in Japan, leaving only the markup paid to the related entity as profits subject to Japanese corporate tax. Consequently, the NTA is often quick to assert that the Japanese entity is an agent PE or branch PE of the foreign corporation, which would result in the profits derived from the sales to Japanese customers being subject to tax.

PE Risk

Under a cost-plus, an agent PE will be alleged if evidence can be found where authority to negotiate contract terms is granted to the Japanese entity by the foreign corporation. This can arise in different forms — from e-mail correspondence to results from a customer audit. It is imperative that the services agreement clearly prohibit the Japanese entity from concluding customer sales contracts on behalf of the foreign corporation and does not otherwise grant the Japanese entity authority to negotiate key terms of sale.

Buy-Sell Structure

The term ‘‘buy-sell’’ refers to the use of a Japan based distributor, often a related party, that sells goods to customers located in Japan. The distributor purchases the goods from the nonresident entity, for example the manufacturer of the goods, and on-sells to Japanese customers. The difference between the buy and sell prices reflects the distributor’s taxable profits. (See Figure 2.)

There are two different types of distributor models within the buy-sell/distributor structure. These are often referred to as the fully fledged distributor (FFD) and the limited risk distributor (LRD). As the name implies, the FFD performs a significant number of functions in Japan, such as marketing, sales and pos sales support, and customer training. It also bears a number of risks, such as currency fluctuations, defective inventory, and bad debt. The FFD is therefore required, under transfer pricing principles, to recognize profits in Japan that reflect these functions and risks.

By contrast, and as the name suggests, the risks and functions borne and performed by the LRD are significantly lower than the FFD. Often the activities performed by the LRD are limited to storage, delivery, and basic customer liaison activities such as providing customers with standard literature and product updates generated by the nonresident principal or manufacturer.

Risks (such as foreign exchange, credit, and market fluctuations) are generally borne by the nonresident. As such, the profits recognized in Japan by the LRD are somewhat less than those of an FFD.

Commissionaire Structure

A commissionaire is a structure that in the past was unique to civil law jurisdictions in Europe but is now gaining wider use, particularly in Asia. The commissionaire acts on behalf of an undisclosed principal in the local market.

The commissionaire sells goods, in its own name, issuing an invoice to the customer. The commissionaire then receives a sales commission from the principal. (See Figure 3.)

The commissionaire structure provides a number of tax-planning opportunities. First, the risks and functions performed and borne by the commissionaire are generally less than those performed by the LRD (see the section entitled ‘‘Buy-Sell,’’ above), which for a high-tax jurisdiction like Japan, means that less taxable profit is recognized in Japan. For example, legal title to the goods passes directly from the principal to the customer within the borders of the local market. This means that risks such as currency or defective inventory are borne by the offshore principal. Second, the passing of legal title within Japan may provide some benefits from an indirect tax viewpoint, where the principal becomes responsible for collecting any Japanese consumption tax levied on the sales amount invoiced to the customer. Third, from a U.S. tax perspective, the twin use of a commissionaire and check-the-box election may provide greater subpart F (the U.S.’s anti-controlled- foreign-corporation regime) planning opportunities.

PE Risk

An important aspect of PE determination in Japan is the need to consider the practical versus theoretical risk. This is perhaps best highlighted by the commissionaire structure. In Europe the prevailing view (recently confirmed in France’s Zimmer (1) case and Norway’s Dell (2) case) is that a commissionaire is unlikely to create a PE because the commissionaire contracts with the customer in its own name, and not in the name of the foreign principal.

In Japan, based on informal discussions between the authors and the NTA, it seems reasonable to conclude that the legal structure of a commissionaire will generally be respected from a PE perspective (to reach a Zimmer conclusion), but that each case will be dealt with on a facts and circumstances basis.

Given the typical relationship between a Japanese-based commissionaire and offshore principal, the risk of the NTA asserting an agent PE should always be considered.

Corporate and Business Reorganizations

In response to the economic downturn, multinationals have been scaling back in Japan.

While some have ceased operations altogether, others with operations in multiple Asia Pacific countries are reorganizing to take advantage of significant cost savings by centralizing business functions in one jurisdiction (typically Singapore and more recently Hong Kong) rather than having those functions reproduced in many.

Singapore is currently the jurisdiction of choice for centers of operations because of its advanced infrastructure, well-developed treaty network, and favorable corporate tax rate. Hong Kong is gaining ground on Singapore, mainly because of its quickly expanding tax treaty network.

With increasing frequency, MNEs operating in Japan are using tax-efficient supply chain management strategies to align tax planning and business strategies.

For many MNEs in Japan, this restructuring may take the form of shifting from a buy-sell structure to a commissionaire structure.

All of these arrangements come with an ever-present risk of a transfer pricing challenge; however, that discussion is outside the scope of this article. Of particular focus here is the potential PE risk created by these arrangements post-conversion when Japan’s tax base is diminished as a result of such restructurings. These PE risks are discussed above.

Extreme care must be taken by all members of an enterprise’s cross-border planning, implementation, and operational team to avoid potential PE risks. As a practical risk management issue, all employees should be familiar with the PE concept; the selected business structure; and potential, initial, and ongoing risks.

Server Issues in Japan

With the rapid improvement of technology, exchanges are now offering high-frequency trading.

Traders take advantage of this infrastructure to conduct high-frequency, algorithm-based transactions that can be executed automatically — a millisecond can be worth millions.

To conduct these kinds of transactions, programs must have quick access to quote information, which is used to generate, route, and execute orders automatically.

The Tokyo Stock Exchange allows investors to access this information directly from their system. The closer that servers can be placed to the exchange’s data centers to receive market information, the less delay in each transaction, and the more money made on each trade.

As a result, there has been a significant increase in offshore funds and traders using servers located in Japan to maximize profits on trading within its borders.

The question has arisen whether the server, through which these trades are conducted, constitutes a branch PE.

Before June 2010, Japan’s tax laws did not provide guidance on the matter, so stakeholders were forced to turn to the OECD model treaty and accept a certain amount of risk with the practice. In that environment, based on the OECD commentary, common wisdom advised that the risk of a PE was low when the server was not ‘‘at the disposal’’ of the nonresident.

Since that time the NTA has provided formal guidance on the issue. Agreeing with the OECD, the NTA stated that foreign investors conducting high-speed trades via a server located in Japan do not have the right to dispose of, or exercise virtual control over, a server; otherwise a PE could be created. Further, foreign investors should be limited to ‘‘receiving and enjoying an environment for high-speed placement of orders.’’

These incidents of control should be avoided:

  • ownership or leasehold right to the server
  • using the server at its discretion for activities other than high-speed trading
  • rights or options to purchase the server; and
  • physical access to the sever space

Clearly there is little ambiguity that a nonresident holding an ownership interest in a server located in Japan will create a PE for the nonresident. Further, a nonresident leasing a server located in Japan, typically governed under a co-location agreement, may still create a PE for the nonresident lessee.

Therefore, it is critical that the co-location agreement restricts the rights and control the offshore lessee has over the server. Provisions that grant a lessee the right to sublease the server or gain unrestricted physical access to the server space or equipment should be avoided at all costs.


Steps taken by the Japanese authorities to clarify some aspects of the PE concept are consistent with their policy of providing greater tax certainty to foreign investors. These should be commended.

However, spurred on by the global economic downturn and the need to find additional revenue, Japan’s tax authority has become increasingly more aggressive in identifying PE issues.

Potential PE risks should be considered not only when planning new operations and reorganizing existing operations, but also when merging with or acquiring ongoing concerns in Japan. Poorly planned or executed cross-border operations can result in millions of dollars lost in legal fees, back taxes, penalties, and business disruption costs.


  1. Sté Zimmer limited, CE, Mar. 31, 2010, No. 304715, 308525, 10e et 9e s.-s.
  2. Dell Products (NUF) v. Tax East, 10-032855ASD-BORG/03.

Additional Credits – The coauthors on the original version of this article were attorneys Jude Balsamo and Paul Previtera.

Contact AA International Law™ to learn more about how we can help your company manage permanent establishment (“PE”) risk 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.