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Taxation of Japan Director Compensation

Japan has complex rules regarding the taxation of director compensation. This is true both on the corporate and individual side. Multinational corporations (MNCs) should have a clear understanding of these rules because director compensation is often scrutinized in audits by the Japanese tax authorities.

This article focuses on some of the most important corporate tax issues associated with director compensation.

In particular, we examine the rules that cause a wide range of important compensation items to be either non-deductible per se or require advance reporting to the tax office.

We then conclude with a number of suggestions for strategies that can be employed by MNCs to mitigate risk while also rewarding director-level employees.

I. Definition of Directors For Japan Tax Purposes

The definition of a director under the Japanese Corporation Tax Law is significantly broader than a common understanding might suggest.

For Japanese corporate tax purposes, the term ‘‘director’’ may include all of the following:

  • a board member (Torishimari-yaku)
  • a statutory auditor (Kansa-yaku) (see footnote 1)
  • an executive officer (Shikkou-yaku)
  • an accounting adviser (Kaikei-Sanyo)
  • an adviser-secretary (Kanji)
  • a liquidator (Seisan-nin) (see footnote 2); and
  • a person who engages in corporate management. (see footnote 3)

Many of the positions listed are found only in relatively large Japanese domestic companies. This includes positions such as executive officer (Shikkouyaku), accounting adviser (Kaikei-Sanyo), and adviser-secretary (Kanji).

II. Some Initial Considerations

A. Conceptual Framework

It is useful to consider the conceptual background to Japan’s tax rules regarding the corporate deductibility of director compensation.

If a Japanese corporation pays a bonus to a director, the payment is generally not deductible for Japanese corporate tax purposes. The definition of bonus is broad enough to cover most non-periodic payments.

The rationale for this position is as follows. Because of a director’s inherent closeness to the business, a bonus payment to a director is viewed as a distribution of company profits (similar to a dividend) rather than an expense. Distributions of profit are made from after-tax profit and are generally not deductible.

The situation has improved since the New Company Law was introduced in May 2006. However, the risk of non-periodic payments to directors being deemed nondeductible remains high.

It is therefore vital that director compensation be carefully planned.

B. Scope of the Rules

Some types of compensation are subject to separate, special rules that are beyond the scope of this article.

These out-of-scope compensation items include:

retirement allowances;
stock options; and
the employee portion of the salary paid to an employee-director.

C. General Non-deductibility Rules

Japanese law contains general rules that make some types of compensation nondeductible per se. These rules apply equally to director and non-director compensation.

Nondeductible items include:

  • payments based upon concealed facts or fraudulent accounting; and
  • unreasonably high salary

III. Compensation that is Deductible

Three broad categories of director’s compensation are deductible for Japanese corporate tax purposes.

They are:

  • fixed compensation
  • compensation notified in advance to the tax office; and
  • performance-based compensation

If an item of compensation does not fit into one of the three categories (or is otherwise outside the scope of the rules), it will not be deductible for Japanese corporate tax purposes.

A. Fixed Compensation

1.Basic Fixed Compensation Rule

Compensation paid to a director in equal regular installments is deductible for Japanese corporate tax purposes.

Each payment must be the same amount throughout the fiscal year (with some exceptions that will be discussed below). ‘‘Regular’’ means paid in intervals of one month or less (for example, daily, weekly, or monthly).

2. Revisions to Compensation

The law recognizes that director compensation may sometimes be changed (for example, because of an annual pay raise). In order for the new compensation amount to be deductible, strict procedural requirements must be met.

a. Ordinary Revisions. Revisions must be made within three months after the beginning of the company’s new fiscal year. For example, a company with a June 30 year-end would need to revise director’s compensation before the end of September. This is depicted in Figure 1.

Figure 2 illustrates when the decision to review the director’s compensation is made after the first three months of the fiscal year, resulting in the additional component of the compensation being nondeductible.

Also, each payment made before the revision must be the same (old) amount and each payment after the revision must be the same (revised) amount. This requirement can cause practical problems if the revision is approved very close to the date on which the director’s next salary is due to be paid.

However, in a question and answer release in December 2008 (revised in April 2012), the Japanese National Tax Authority indicated that in these situations, the first payment after the revision may be the old amount with the revised amount being paid in subsequent pay periods.

b. Retroactive Revisions: If a revision to director’s compensation is made retroactively, the full retroactive payment will be nondeductible.

For example, assume a company has a June 30 year end.

If a meeting at the end of September approves an increase in director compensation starting from July, then the July, August, and September payments would be fully nondeductible. This is depicted in Figure 3.

c. Late Revisions (Basic rule): If the revision is made after three months from the beginning of the fiscal year, the difference between the new compensation amount and the old compensation amount will not be deductible.

d. Late Revision (Exceptions to the basic rule described in c.): As noted above, changes to director compensation must in principle be made within three months of the start of a new fiscal year.

However, there are three situations in which director compensation may be revised outside the three-month period from the start of the new fiscal year:

ⅰ. Special circumstances. This covers situations in which external forces dictate that compensation revisions must take place at a specific time each year.

A typical example would be a Japanese subsidiary that is required to wait for its parent company’s annual shareholders meeting to approve group company director compensation.

ⅱ Unavoidable circumstances. This covers unexpected changes in the status of a director or significant changes in the director’s duties. Typical examples include:

  • The unexpected resignation of the company chairman resulting in the vice president moving into the chairman role
  • Changes in a director’s duties because of a merger
  • A director’s compensation being reduced because of serious illness (or increased again when the director recovers and resumes her duties)

ⅲ Deterioration in company’s earnings. When a company suffers genuine business difficulties, it may be possible to reduce director compensation. To take advantage of this concession, a company usually needs to show strong evidence. That evidence could include showing that a reduction was made to all employee compensation (that is, not only to the director’s compensation). Problems such as temporary cash flow difficulties or failure to meet performance goals would generally not be sufficient.

B. Compensation Determined and Notified in Advance

It is possible to make non-regular ‘‘incentive’’ payments to directors. However, those payments are not technically a performance bonus because they are paid from (and thus deducted from) the current year’s profit rather than the (previous) year in which the performance occurred. Also, the tax authorities must be notified of those payments in advance.

1. Requirements

For these non-regular payments to be deductible, the following requirements must be met:

  • the remuneration amount(s) must be predetermined
  • the payments must occur at a time specified in advance; and
  • advance notice must be filed with the tax office

2. Notification to the Japan Tax Office

It is critical that the tax office’s deadlines be met. Failing to meet these deadlines generally results in the payments being treated as nondeductible. The Japanese tax authorities are generally inflexible on this point.

The application form must be filed before the earlier of:

  • the beginning of a director’s bonus period; or
  • within three months after the first day of the fiscal year

a. Information to be included

The information required to be notified to the tax office is quite basic and includes:

  • when the payment is to be made; and
  • the amount to be paid

It is critical that the actual payment is the same as the amount notified to the tax office.

If the payment amount differs from the pre-notified amount, all payments throughout the director’s annual service (that is, from one annual shareholders’ meeting to the next) risk being nondeductible.

b. Special Deadline in the Case of a Deterioration in Earnings

The law recognizes that sometimes a previously notified bonus amount cannot be paid because of a significant deterioration in the company’s performance. In those cases, it may be possible to change the bonus amount with a further notification to the tax office. The notification deadline in those cases is the earlier of:

  • one month after the extraordinary shareholders’ meeting that amends the director’s bonus amount; or
  • the day before the first predetermined bonus amount is to be paid

C. Performance-Based Compensation For Directors

Finally, the law provides for genuine performance-based compensation. This type of compensation is both deductible in the current year and does not need to be specifically defined in advance.

However, this type of compensation is available only in very limited situations. Typically, subsidiaries of foreign companies operating in Japan will be unable to meet the requirements.

In order for performance-based compensation to be deductible, the following requirements must be met:

  • The company cannot be a family corporation. The definition of the term ‘‘family corporation’’ under Japanese tax law is complex. (Note that it does not refer to the shareholders being related by blood.) In simple terms, the concept refers to a closely held corporation in which 50 percent or more of the equity is owned by a single shareholder group. Consequently, the Japanese subsidiary of a foreign corporation would often fit the definition of a family corporation.
  • The company must be one that submits a securities report under the Financial Instrument and Exchange Law. This would typically only apply to a Japanese listed company.
  • A maximum payable amount needs to be determined based on an objective calculation method.
  • The company’s compensation committee must put in place procedures to implement the objective calculation method within three months after the start of the fiscal year. This methodology needs to be disclosed in the company’s annual securities report. (See above.)
  • The performance-based compensation needs to be actually paid within one month after it has been calculated.

IV. Japan Tax Audit Issues

To conclude the discussion of deductible compensation, the following are examples of problems that may arise in tax audit situations.

A. Fees Paid to the Director’s Personal Company

In order to ensure deductibility, some companies enter into consulting agreements with unrelated entities that are controlled by the director (the director’s personal company). Those agreements may not be invalid per se, but they are often subject to scrutiny by the tax authorities. The risk is that payments to a personal company will be recharacterized as director compensation and thus be nondeductible for Japanese corporate tax purposes.

Those agreements may also be an issue in the company’s regular commercial code audit. Given the potentially significant impact of non-deductibility on the company’s financial statements, auditors may try to determine the risk that those payments will be considered nondeductible.

Several factors may increase the risk of consulting payments being recharacterized as nondeductible director payments. These include:

  • If the director receives no compensation directly from the company (that is, her whole economic benefit derives from the consulting fees paid to her personal company), this may increase the perception that payments to the personal company are actually for the director service.
  • A written consulting agreement should be in place between the company and the personal company. Also, clear evidence should be available that shows substantial consulting services are actually being performed.

B. Fringe Benefits Paid to Directors of Japanese Companies

Fringe benefits are a common feature of compensation packages in Japan. An issue arises for directors when the monthly value of those fringe benefits varies.

A common example is reimbursement of utilities when the value would rarely be exactly the same month to month.

The deductibility of those expenses is generally based on whether the value of benefits provided to the director is basically stable. It is generally not required that each payment be for the same amount.

C. Retirement Payments to Directors of Japanese Companies

Japanese tax rules regarding director retirement payments are complex and beyond the scope of this article.

Reasonable retirement payments to a director are normally deductible for Japanese corporate tax purposes.

However, in some cases, retirement payments are made to directors but those individuals continue to be involved in the management of the company. In those situations, there is a risk that the retirement payment may be recharacterized as a nondeductible director’s bonus.

D. Loans to Directors of Japanese Companies

Loans to directors are yet another area in which care must be exercised. For example, the Japanese subsidiary of a foreign company may make loans to a director for the purpose of settling the director’s individual tax liability.

Such situations are often scrutinized by the tax authorities to ensure that the advance represents a genuine loan and not merely a disguised bonus.

There are several factors that may support the characterization of those payments as a loan. They include:

  • A written agreement that includes an appropriate interest rate.
  • A clear repayment schedule.
  • Evidence that repayments have actually been made by the director. In our practice, we have seen situations in which the U.S. parent has advanced funds to a director for the purpose of repaying a loan from the Japanese subsidiary. This can raise both withholding and deductibility issues.

V. Solutions and Suggestions

We conclude this article with several suggestions to assist MNCs in maximizing deductibility and minimizing tax audit risk:

  • Always ask the fundamental question: Does this individual need to be a director? In many cases, especially in subsidiaries of foreign companies, it is simply not necessary to make most individuals a director. A senior (non-director) title will usually be sufficient. AA International Law (AAI Law) is able to provide introductions to reliable nominees who can take on the director role.
  • MNCs must ensure that the rules regarding director compensation are well understood. Errors can be very costly. Director compensation should be structured to satisfy the dual goal of rewarding the director and clearly ensuring maximum deductibility.
  • A review of director compensation should be included as part of a regular tax risk review.
  • Directors often receive different types of payments from the same company. This might include regular compensation, pre-notified bonuses, and fringe benefits. It is essential that the facts for each payment are clearly documented, for example, in shareholder’s meeting minutes.
  • In the case of MNCs, it may be possible for some payments to be made by the home office or some other non-Japanese affiliated company for which services are performed. However, those payments should not be charged back to the Japanese subsidiary. Note that when this strategy is employed, deductibility in the paying jurisdiction must be confirmed.
  • Care must be taken when assigning job titles. Because the definition of director is very broad, it is important that employment agreements entered with non-directors do not give the impression that an employee is in fact acting as a director. Titles such as ‘‘director of sales’’ should be avoided both in employment agreements and on business cards.


  1. Statutory auditor (Kansa-yaku) does not mean an individual who examines financial reports to determine if they present a true and fair view. Rather, this is an internal position with responsibility to oversee the management of the company. Historically, the position was required (at least nominally) in all Japanese companies regardless of size.
  2. This position is relevant to a Japanese corporation in the process of being wound up.
  3. This needs to be emphasized. Even if an individual does not hold one of the listed official positions, it is technically possible they could be covered by the director rules if it is deemed they are engaging in corporate management.

Contact AA International Law (AAI Law) to learn more about how we can assist your company with issues arising from the compensation of directors 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.