Article re Selecting Tax Structure
12 mins read

Selecting a Tax Structure for a Japan Business

{The following is based on an article originally written for the Journal of the Japan Foreign Lawyers Association (“RBA”)}

Background

Tax structure refers to the method by which a business recognizes income in Japan. In order to avoid problems with the Japan tax authorities, is very important that a Japan entity have an appropriate tax structure.

Tax structure is related to the requirement 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, the issues of transfer pricing and permanent establishment risk need to be considered.

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.

When Will Tax Structure Be Important?

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, transfer pricing and permanent establishment will not be of concern since there is no foreign parent to be considered (see below for an explanation of transfer pricing and permanent establishment risks).

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, a U.S. 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 it sell directly to Japanese customers or will sales to Japanese customers continue to be made from the U.S. headquarters? If sales are made from the U.S. headquarters, how will the Japan entity earn income for the support activities it is undertaking in Japan?

Important Related Issues – Transfer Pricing and Permanent Establishment

  • Transfer Pricing
    Tax structure is related to the concept of transfer pricing. Transfer pricing has become a focus of tax authorities around the world, including those in Japan. Transfer pricing rules are designed to ensure that 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 a foreign parent and a Japan entity) must be done on an arm’s length basis. Arm’s length simply means that the foreign parent and the Japan entity should deal with other as though they are third parties.

    Any payments that are made to the Japan entity or by the Japan entity by / to an offshore, related party need to be justified in terms of services provided and the price that would be paid if those services were provided by a third party.
  • Permanent Establishment
    The second issue that needs to be considered when choosing a Japan tax structure is permanent establishment (“PE”).

    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 permanent establishment arises when the level of activity being performed in Japan by the Japan entity on behalf of the foreign parent exceeds a certain threshold. For example if a Japan entity starts signing contracts in Japan on behalf of the foreign company.

    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. Importantly, double tax treaties (“DTA”) often add clarity and 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 Japan-U.S. Tax Treaty (2003) defines the situations in which the activities of a Japan entity could constitute a PE of a U.S. company. The key aspects can be summarized as follows:

    – Article 5 (1) – a U.S. company may have a PE in Japan if it carries on business in Japan through a fixed place of business through which the business of an enterprises is wholly or partly carried out on.
    – Article 5 (5) – a PE may arise if a person acting on behalf of the U.S. company (e.g., the Japan entity) has and habitually exercises an authority in Japan to conclude contracts in the name of the U.S. company.
    – Article 5 (6) – by way of exception to Article 5 (5), a U.S. company will NOT be considered to be a PE in Japan if it carries on business in Japan through an independent agent acting in the ordinary course of their business.

What Tax Structures Are Available For a Japan Entity?

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

(It may be possible to combine the two approaches however this can be burdensome from an administrative viewpoint and is beyond the scope of this explanation.)

Option 1: Cost-Plus Model

A 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 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%).

Scope of Activities Permitted Under a Cost-Plus Model

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

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

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

By contrast, the following activities may not be performed by the Japan entity under a Cost-Plus approach:

  • Signing contracts,
  • Receiving orders from customers, and
  • Performing an important role in the sales functions such as sales negotiations of major contract terms, handling of defective products that are returned.

Permanent Establishment Risks Associated With A Cost-Plus Arrangement

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 foreign parent. As noted above, if the Japan tax authorities conclude that the Japan entity represents a PE, the foreign parent would be liable for Japanese corporate tax on income associated with Japan.

In general, the PE risk would 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 Arrangement

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. 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 Japan tax authorities, mark-up percentages of between 7% to 10% are common.

Option 2: Buy-Sell Model

Under the Buy-Sell model, the Japan entity make 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 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 by way of the foreign parent overcharging the Japan entity), then additional corporate income tax, penalties, and interest may be assessed.

Permanent Establishment Issues Associated With the 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 international 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 JAPAN VISA™ 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.