Taxation in the Asia-Pacific Region/Japan

JAPAN

Introduction

Investment Considerations

Taxation of Resident Entities

Taxation of Nonresident Entities

Taxation of Groups of Companies

Branches and Subsidiaries

Corporate Assessments and Payments

Taxation of Individuals

Personal Assessments and Payments

Withholding Taxes

Other Taxes

Introduction

Honshu, Hokkaido, Kyushu, Shikoku, and the many smaller islands that make up Japan constitute a total area of about 378,000 square kilometers (146,000 square miles). In 1994, Japan had 125 million residents. The unit of currency is the yen (¥).

Under the Japanese constitution, there are three branches of government: executive, legislative, and judicial. The Diet, the legislative branch, is responsible for approving proposed tax legislation, which is first drafted by the Tax Bureau of the Ministry of Finance. Generally, this legislation goes into effect on 1 April of each year. Japan's forty-seven prefectures also can levy and collect their own taxes.

International services: Koji Tajika, Tohmatsu & Co., Tokyo
Audit services: Takio Suzuki, Tohmatsu & Co., Tokyo
Tax services: Toshiaki Katsushima, Katsushima & Co., Tokyo
Management consulting services: Shoichi Hayasaka, Tohmatsu & Co., Tokyo
Telephone-Tohmatsu & Co.: +81 (3) 3457-7321
Telecopier-Tohmatsu & Co.: +81 (3) 3457-1698
Telephone-Katsushima & Co.: +81 (3) 3454-1251
Telecopier-Katsushima & Co.: +81 (3) 3455-8651

Investment Considerations

Forms of Business Organization. The principal form of limited liability organization is the stock company or corporation (kabushiki kaisha-KK). The KK is comparable to the corporation in the United States, and foreign investors often use this form. Branches of foreign corporations are also recognized and are commonly used by foreign investors. Other business entities include limited liability companies, limited and unlimited liability partnership companies, unincorporated partnerships, and sole proprietorships; however, foreign investors rarely use these business forms.

Corporate entities are subject to corporate income tax. In the case of unincorporated partnerships, each partner is subject to corporate or personal income tax on that partner's share of the partnership income.

Exchange Controls. In principle, international transactions can be carried out without restriction. However, certain international transactions require either specific approval from the authorities or the submission of prior notices.

In general, foreign investors, including Japanese companies in which 50% or more of the shares are held by nonresidents or by companies incorporated under foreign law, must report any inward direct investments to the appropriate authorities within fifteen days after making the investment. Stricter rules apply to specific types of investments.

Dividends, interest, and other revenue, as well as capital, may be freely repatriated, provided that the original investment was properly introduced.

Local Participation Requirements. Foreigners are generally allowed to own 100% of the capital of their Japanese operations. Exceptions exist in the following sectors: agriculture, forestry, and fishing; leather products manufacturing; mining; and petroleum.

Investment Incentives. A corporation that acquires or produces qualifying machinery or equipment for use in its business within one year of acquisition may receive a credit against its corporate income tax liability. The credit generally equals 5% of the cost or 20% of the corporate income tax, whichever is smaller, and acts as a substitute for additional depreciation. In addition, a corporation may claim a credit equal to the lower of 20% of certain incremental research and development expenditures or 10% of the corporate income tax before the credit.

To promote inbound foreign investment and imports, an incentive is offered to Japanese branches and subsidiaries of foreign corporations involved in manufacturing or software development. This incentive allows for either an extended loss carry-forward period of ten years for losses incurred in the first three years of a company's existence or an additional 20% depreciation deduction on certain buildings and machinery.

Taxation of Resident Entities

Resident corporations are subject to tax on worldwide income, including business profits, rents, interest, dividends, royalties, and certain capital gains. A corporation is resident in Japan if it is incorporated there. Branches of foreign corporations are not considered to be resident in Japan. The location of management and control does not determine classification as a resident or nonresident corporation.

Corporate Income Tax Rates. Corporations are subject to both national and local income taxes. The national income tax is called corporate income tax. The local taxes consist of inhabitants tax and enterprise tax.

Corporate income tax. A corporate income tax rate of 37.5% applies to corporations whose amount of issued capital is more than ¥100 million. A tax rate of 28% applies to the first ¥8 million of annual income of corporations whose capital amounts to no more than ¥100 million. After the first ¥8 million, the 37.5% rate applies.

Inhabitants tax. Inhabitants tax is assessed by both prefectural and municipal governments and is calculated as a percentage of corporate income tax due. The corporation is required to pay a corporation tax and a per capita levy.

The tax basis of the corporation tax is the amount of the corporate income tax before deducting any tax credits. The standard tax rate is 17.3% in aggregate (5% for the prefecture, 12.3% for the municipality), and the maximum tax rate is 20.7% (6% for the prefecture, 14.7% for the municipality).

The per capita levy is paid to each local government unit in which the taxpayer has a place of business. The tax varies with the amount of the taxpayer's stated capital and the number of employees at each location.

Enterprise tax. Enterprise tax is a prefectural tax on the income of a corporation attributable to a branch, head office, factory, or other kind of permanent establishment situated in Japan. The basic rate of enterprise tax applicable to a corporation with ¥10 million or more in capital and operations is 12%, but certain exceptions apply.

A reduced rate applies to a corporation with ordinary income of ¥7 million or less, unless its capital amounts to ¥10 million or more and its offices, factories, and so forth are located in three or more prefectures. The rates are 6% for ordinary income up to ¥3.5 million and 9% for ordinary income between ¥3.5 million and ¥7 million. The applicable enterprise tax rate for electric power suppliers, gas suppliers, and insurers is 1.5% of their gross proceeds.

Each prefecture's rate may vary from these standard rates by up to 10%.

Taxable Income. Generally, taxable income in an accounting period must be determined by deducting from gross revenues the total costs and expenses associated with such revenues. Exchanges of property, forgiveness of debts, or transactions not at fair market value produce taxable income unless the transactions meet requirements specified in the tax laws.

Inventory valuation. The taxpayer may value inventories at either cost or the lower of cost or market. Cost methods permitted include the first-in, first-out; last-in, first-out; average-cost; most-recent-purchase; and retail methods. Rules are also provided regarding the use of standard costs.

Dividend income. Dividends received by a Japanese corporation from another Japanese corporation may be deducted (excluded) from the recipient corporation's income. Eighty percent of the dividends received from less-than-25%-owned affiliates can be deducted. Dividends received from 25%-or-more-owned affiliates are 100% deductible.

Dividends received by a resident corporation from a foreign subsidiary are taxed as ordinary income. However, if the foreign subsidiary is at least 25% (or a lower percentage as per treaty) controlled by the resident corporation for over six months, the dividends may be grossed up for foreign taxes on the subsidiary's income, out of which the dividend is paid. The resident corporation may claim an additional foreign tax credit for this underlying tax.

Foreign-source income. Foreign-source income is normally treated in the same way as domestic income. It is included in taxable income, and the related foreign income tax is credited against the liability for Japanese income tax. Foreign branch income of a Japanese company is subject to corporate income and inhabitants taxes but not enterprise tax. Interest, dividends, and royalties from foreign sources not attributable to foreign branches, however, are subject to all income taxes, including enterprise tax.

The credit against foreign income tax is limited. To calculate the limit, subtract losses from total foreign-source income. Multiply that by corporate income tax, and divide the result by total worldwide income.

However, two-thirds of foreign-source income that is not taxable in the foreign country is deemed to be domestic-source income, and total foreign-source income may not exceed 90% of worldwide income, with a few exceptions. Also, foreign tax paid at an effective rate in excess of 50% is disallowed to the extent of the excess. The carryforward period for the foreign tax credit is three years.

An indirect foreign tax credit applies when a Japanese corporation receives a dividend from a first-tier foreign subsidiary in which it has a holding of 25% or more and specified requirements are met. This credit may be extended to cover income taxes paid by second-tier foreign subsidiaries if certain conditions are fulfilled.

Exchange differences. Realized foreign exchange gains or losses are treated as ordinary income or expenses and are recorded in yen at the exchange rate in effect at the time of realization. Unrealized exchange gains and losses on short-term receivables or payables (term of less than one year) should generally be included in taxable income by restating the yen value of such items using the exchange rate at the end of the accounting period, but if permission is obtained, such gains and losses may be deferred until settlement. Unrealized exchange gains and losses on long-term receivables or payables (term of one year or more) must normally be deferred until settlement.

Capital gains. Capital gains or losses of a corporation derived from sales of securities and property are taxable (or deductible) as ordinary business income or losses. Capital gains from real property (but not buildings or other fixed assets), as well as leasehold rights to real property, are subject to a surtax in addition to corporate income tax. The rate of the surtax is 30% if the property was held for two years or fewer, 20% if the property was held for between two and five years, and 10% if the property was held for more than five years.

Deductions. Ordinary and necessary business expenses recorded for financial statement purposes are generally deductible. Expenses that are not deductible or are subject to limitations include bonus payments to officers, entertainment expenses, and charitable contributions. Resident corporate taxpayers that file ''blue form" tax returns are allowed to deduct special reserves and allowances, if the provisions are also recorded in the books of account.

Depreciation. Depreciation may be computed using either the straight-line method or the declining-balance method. The methods generally assume a 10% residual value. However, the assets may be depreciated down to a residual value of 5%. The sum-of-the-year's-digits method and the retirement fund system can also be used if special permission is received from the tax authorities. The useful lives of fixed assets are generally prescribed by statute.

In addition to the ordinary depreciation expense, corporations meeting certain requirements may accelerate the depreciation of certain assets. This special additional depreciation is expressed as a percentage of the ordinary depreciation expense and is deducted each year. For example, qualifying corporations may be allowed 15% of ordinary depreciation for new machinery, plant, and so forth, if such assets are installed as part of an approved restructuring plan.

Special initial depreciation (first-year depreciation) is allowed at a percentage of the acquisition cost of eligible assets, including qualified facilities to prevent pollution (18%) and buildings and machinery located in specified underdeveloped areas of Japan (8% and 15%, respectively).

Intangible assets, such as patents, trademarks, and certain rights, must be amortized on a straight-line basis, generally over a five- to ten-year life. The cost of goodwill may either be deducted currently or amortized.

Interest. Interest expenses are generally deductible, However, companies that are thinly capitalized may be denied deductions for interest paid to a foreign related party. Also, restrictions have been imposed on the deductibility of interest when land has been purchased but is not immediately developed.

Directors' remuneration. Remuneration of directors is not deductible to the extent that it exceeds certain limitations. Bonus payments to directors are not deductible. Termination payments are deductible only if they are approved by the shareholders.

Taxes. National and local income taxes are not normally deductible. Other taxes are normally deductible. Enterprise tax, although a tax on income, is generally deductible in the year following that in which it was paid. Tax-related penalties and interest are not deductible.

Provisions. Corporate taxpayers are allowed to deduct provisions for various reserves. Reserves for bad debts can range from 0.3% to 1.3% of receivables outstanding at year-end based on the taxpayer's industry. Provisions for employee retirement allowances are subject to special limitations.

Tax Treatment of Losses. Operating losses may be carried back one year and carried forward five years. The carryback and carryforward provisions are available only to taxpayers filing the special "blue form" tax return. The carryback provisions are not applicable for local tax purposes. Also, one-year loss carrybacks have ceased for four years effective 1 April 1992.

Taxation of Nonresident Entities

Nonresident entities are subject to tax only on income earned from sources within Japan.

If a nonresident entity maintains a fixed place of business (such as a branch) in Japan, it must generally file a tax return and pay income taxes on its Japanese-source income in the same manner and at the same rates as a Japanese company. Having a nontrading office in Japan, however, does not subject a nonresident entity to Japanese income taxes. Subject to the provisions of tax treaties, a nonresident entity with a construction or installation project in Japan must file a tax return and pay Japanese income taxes if the project lasts for more than one year. Having an agent in Japan may also subject a nonresident entity to Japanese income taxes.

If a nonresident entity does not have a fixed place of business in Japan and receives taxable Japanese-source dividends, interest, and royalties, tax is withheld from this income. Click for information on Withholding Taxes.

Taxation of Groups of Companies

Consolidated tax returns are not permitted. Each affiliated company must calculate its income tax liabilities on an arm's-length basis. Losses in one company may not be set off against the taxable income of other related companies. Only when a loss-making company is liquidated can a company that owns its shares or that has made a loan to it write down or write off its investments for tax purposes.

Transfer-pricing rules apply to foreign related party transactions. Prices should be determined on an arm's-length basis in accordance with the comparable uncontrolled price method, the resale price method, or the cost-plus method. If these methods cannot be used, another method is allowed. Transfer pricing is becoming increasingly important in Japan, and it is expected that enforcement efforts will continue.

If the effective rate of foreign tax on a nonresident subsidiary's income is 25% or lower, anti-tax haven rules may apply. The shareholding percentage required to trigger inclusion of a tax haven subsidiary's earnings in income for Japanese tax purposes is 5%.

Branches and Subsidiaries

The tax treatments of subsidiaries and branches differ in a number of important ways. If a Japanese branch of a nonresident entity is incorporated as a Japanese subsidiary, income tax will be incurred on any unrealized appreciation in the branch and in assets transferred to the new corporation. Such income tax may be deferred if the company follows certain requirements.

Corporate Assessments and Payments

Tax returns for corporate income, enterprise, and inhabitants taxes must be filed with the appropriate national and local tax offices within two months following the end of the accounting period. Interim tax returns must be filed for the first six-month period, and an estimated tax payment must be made no later than the eighth month of the accounting period. The amount of the prepayment due is the lesser of one-half of the prior year's tax liability or the estimated tax per the interim tax return. The balance of the tax liability is payable when the final tax return is filed.

Taxation of Individuals

An individual is resident in Japan if his or her domicile is in Japan. A domicile is an individual's center of living. For tax purposes, the concept of domicile in Japan is similar to that in the United States. An individual who has had his or her residence in Japan for one year or more may also be considered a resident. Residence refers to the individual's presence in Japan. Thus, an individual who lives in Japan for a year or more, even if his or her center of living is in another country, could be considered resident in Japan. However, an individual who meets the residence requirements but (a) does not intend to live permanently in Japan and (b) has had his or her domicile or residence in Japan for five years or fewer is considered a nonpermanent resident. (The "five-year period" is currently being debated, and this rule could be abolished soon.)

Permanent resident individuals are subject to Japanese income tax on their worldwide income. Nonresident and nonpermanent resident individuals are subject to Japanese income tax on Japanese-source income.

Treatment of Families. Spouses are taxed separately, provided that the wife has income of her own above a specified amount. In such a case, the spousal allowance is not available to either spouse.

Personal Income Tax Rates. Personal income taxes consist of national income tax and local inhabitants and enterprise taxes.

National income tax. National income tax rates are progressive. Click to see National Income Tax Rates Table.

Inhabitants tax. Inhabitants tax, for both prefectures and municipalities, consists of per capita and income levies. Click to see Inhabitants Tax - Levy on Income Rates for Individuals Table. The tax for the per capita levy varies from ¥2,200 to ¥3,900 per year, depending on the size of the population of the individual's home municipality.

Enterprise tax. Individuals are subject to a local enterprise tax on income from businesses or professions generally at 5%, although rates of 4% or 3% may be used, depending on the type of business.

Taxable Income. Japan has adopted the aggregation principle for individual income taxation. Under this system, various categories of income are computed separately. The results are added together to obtain the individual's aggregate ordinary income. Allowable deductions are then taken to arrive at the individual's taxable income.

Exceptions to this aggregation principle apply to forestry income; capital gains from the sale of land, buildings, and certain securities; business or miscellaneous income from the sale of land; and retirement income. These four types of in come are computed and taxed separately from aggregate ordinary income. The taxpayer also may have his or her dividend income taxed separately. If the individual so elects, his or her tax liability for these income items can be satisfied by withholding taxes.

Employment income. Taxable employment income is equal to gross receipts from employment minus a standard employment income deduction. Employment income includes not only salaries and wages but also certain taxable economic benefits, such as employer-paid children's tuition fees and tax equalization allowances. In contrast, commuting expenses are not taxable, and only a relatively small portion of the cost of employer-provided housing is taxable.

Capital gains. Capital gains from the sale of stocks, convertible bonds, or bonds with stock purchase warrants are taxed separately from other income at the rate of 26% (20% for the national income tax and 6% for inhabitants tax). A withholding tax option is also available for certain transactions made through a securities broker.

Gains from the sale of land and buildings are taxed separately from other income. Gains from the sale of land held for no longer than five years are considered short-term gains; marginal tax is computed on those gains. Gains from the sale of land held for over five years are considered long-term gains and are taxed at the rates of 32.5% on a capital gain up to ¥40 million and 39% on a capital gain over ¥40 million (with lower rates for some residential property). A special deduction of ¥1 million per year is allowed for long-term gains (¥30 million for residential property).

Deductions and Reliefs. Deductions include those for casualty losses; social security premiums; life and casualty insurance premiums; contributions to government authorities; contributions to educational, scientific, or public institutions approved by the minister of finance; and contributions to institutions for scientific research.

A number of personal allowances are deductible from aggregate ordinary income or from other income. These include a basic allowance, a spousal allowance, and a dependent allowance, each of ¥380,000 (¥330,000 for inhabitants tax). Further allowances may be claimed for physically handicapped persons, widows and widowers, working students, and aged persons. A special dependent allowance of ¥530,000 (¥410,000 for inhabitants tax) is available for dependents age sixteen to twenty-two. A special additional spousal deduction of up to ¥380,000 (¥330,000 for inhabitants tax) is available if the taxpayer's total income does not exceed ¥10 million.

Special tax refunds of ¥50,000 (national tax) and ¥20,000 (inhabitants tax) will be given in 1995.

Personal Assessments and Payments

Taxpayers do not usually need to file returns if their employment income does not exceed ¥20 million and their tax liabilities are settled through withholding. Individuals who file their income tax returns must pay the final tax by 15 March each year for income accrued during the previous calendar year. Taxpayers who filed a final tax return and had a tax liability of ¥150,000 or more must make prepayments of income tax for the current year by 31 July and 30 November. Each prepayment is normally one-third of the previous year's tax liability, less amounts withheld at source. Any prepaid or withheld payment over the total tax due is refundable if the taxpayer files a final return.

Withholding Taxes

Dividends. Dividends paid to a resident company are subject to a 20% withholding tax, which is creditable against the recipient's final corporate income tax liability. Dividends paid to a resident individual are subject either to a 20% withholding tax that can be set off against the recipient's personal income tax liability or to a 35% final withholding tax.

Dividends paid to nonresidents are subject to a 20% withholding tax, which is usually final.

Interest and Royalties. Payments to a resident company of interest on bank deposits, bonds, and debentures are subject to a 15% national withholding tax and a 5% local withholding tax, which are normally creditable against the recipient's national corporate income tax liability and local inhabitants tax liability, respectively. The same rates apply to resident individuals, but the withholding taxes are final. Interest payments on loans are exempt from withholding tax.

A withholding tax of 10% (20% if the payment exceeds ¥1 million applies to patent and other royalty payments made to residents. Payments made to companies may be credited against the recipient's income tax liability.

In the case of nonresidents, interest paid by a Japanese bank on deposits made in the bank's offshore account is exempt from withholding tax. Interest paid on other deposits with a bank, as well as on bonds and debentures, is subject to a 15% withholding tax. A 20% rate applies to other interest payments to finance business in Japan (except for that on short-term credit).

A withholding tax of 20% applies to royalty payments made to nonresidents.

If interest or royalty payments are related to a nonresident's permanent establishment in Japan, the tax withheld can be credited against the recipient's final corporate income tax liability. Otherwise, the withholding tax is final.

Rates Under Double Tax Treaties. Japan has tax treaties with other countries. The withholding tax rates for treaty counties generally reduce or eliminate the withholding taxes on dividends, interest, and royalties. When the nontreaty rate is lower, it applies instead.

Other Taxes

Consumption Tax. The consumption tax system is designed so that, unless otherwise specified, a flat 3% (5% from 1 April 1997) rate of tax applies to goods and services. The Japanese government collects the tax at each stage of the production and distribution channel. The taxpayer may then claim a credit for consumption tax paid to its suppliers. Similar to a value added tax system, this credit mechanism pushes the consumption tax liability forward through the production and distribution chain. The tax ultimately reaches the consumer. Therefore, at least in theory, the consumer absorbs the consumption tax as a part of the purchase price without receiving credit.

Under the consumption tax system, the sale, lending, or leasing of assets and the rendering of services are subject to taxation at many stages. To prevent tax accumulation, the tax on purchases is deductible from the tax on sales. Individual proprietors and corporations apply the purchase tax credit based on their accounting books or invoices received.

Social Security Taxes. Japan's social security programs include health insurance, welfare pension, unemployment insurance, and worker's accident compensation insurance programs. The premium for health insurance is generally 8.2% of monthly remuneration; the premium for a welfare pension is generally 14.5%. These premiums are borne equally by employers and employees. The premium for unemployment insurance is 1.15%, of which 0.75% is paid by the employer and 0.4% by the employee. The premium for worker's accident compensation insurance ranges from 0.6% to 14.9% of total compensation paid to employees and is paid entirely by the employer.

Inheritance Tax. Heirs and legatees domiciled in Japan who acquire property by inheritance or bequest are subject to tax on the property regardless of its location. Heirs and legatees not domiciled in Japan are subject to tax only on property that is located in Japan at the time of the decedent's death. Certain exemptions and allowances are permitted in the computation of taxable property. An exemption of ¥50 million plus ¥10 million for each statutory heir is retroactively effective from 1 January 1994. Inheritance tax rates are progressive and range from 10% on taxable amounts ¥8 million or lower to 70% on taxable amounts over ¥2 billion. A 20% surtax is levied on transfers to nonfamily heirs.

Gift Tax. Only individuals are liable for gift tax. A donee domiciled in Japan is liable for gift tax on all gifts of property within and outside Japan. A donee not domiciled in Japan is taxable only if the gift was located in Japan at the time it was made. There is an annual exemption of ¥600,000. Gift tax rates are progressive and range from 10% on taxable amounts ¥1.5 million or lower to 70% on taxable amounts over ¥100 million.

Registration Taxes. A variety of transactions have to be registered with registry offices. Tax must be paid upon such registration. Click to see Registration Tax Rates on Selected Transactions Table.

Land Value Tax. Individuals and corporate entities owning real estate located in Japan may be subject to a land value tax of 0.3%. The tax base is the real estate's value for inheritance tax law purposes (generally 70% to 80% of the property's fair market value) less a specified deduction.

Some types of property are exempt from this land value tax, including land owned and used by an individual as his or her personal residence, provided that the total area does not exceed 1,000 square meters.

Local Taxes. The principal local taxes are the inhabitants taxes and the enterprise tax. Other local taxes include:

* Fixed assets tax and city planning tax, payable by the registered owners of land, buildings, ships, or any other kind of depreciable assets, excluding vehicles, on the book value of those assets. Rates vary.

* Enterprise establishment or business facility tax, levied on enterprises located (generally) in cities of 300,000 or more people. The amount payable is based on the size of the building used and the taxpayer's payroll.

* Real property acquisition tax of 4% of the property's assessed value, reduced to 3% for residential property.

* Landholding tax on the certain acquisitions of land, payable at 3% of the acquisition cost at the time of purchase and 1.4% annually for the first ten years.

Miscellaneous Taxes. Various deeds or commercial documents are subject to stamp tax. Other minor taxes include a securities transaction tax on the sale of securities through security dealers, a liquor tax on manufacturers or importers of alcoholic drinks, and gasoline and road taxes on refineries or importers of gasoline.