Summary of selected taxation issues in Japan

When doing business in Japan, it is common to use financially opaque corporations, while using partnerships and other financially transparent entities is relatively less popular. This article focuses on corporate income tax (CIT). In addition to CIT, Japanese businesses are also subject to consumption tax (VAT). However, in principle, the VAT rate in Japan is relatively low at 10%, so in practice CIT tends to get more attention than VAT in Japan.

Implementing global minimum tax

Japan is one of the countries that have adopted the 15% global minimum tax proposed by the Organisation for Economic Co-operation and Development (OECD) through the Global Anti-Base Erosion Rules (GloBE). Japan has amended its relevant domestic CIT laws and regulations to incorporate most of the GloBE model rules and their substantial updates in the additional administrative guidance released by the OECD.

Japan has already adopted the “income inclusion rule” (IIR). This is a major element of the global minimum tax, which allows Japan to impose additional taxes on Japanese parent companies that have subsidiaries in jurisdictions with effective tax rates of below 15%.

The Japanese IIR is applied to fiscal years beginning on or after 1 April 2024. Japan has not yet taken legislative steps regarding the other two key elements of the GloBE model rules, commonly known as the QDMTT (qualified domestic minimum top-up tax, preventing Japanese companies from being under-taxed) and the UTPR (undertaxed profits rule, allowing Japan to tax Japanese entities within a multinational enterprise group that is under-taxed because of the absence of QDMTTs or IIR taxes levied by other jurisdictions).

The Japanese government has expressed interest in adopting both measures but has not provided a detailed road map for implementing them.

CFC legislation and high-tax policy

It is believed that Japanese multinationals were not actively engaged in tax planning, so the tax revenue from the global minimum tax is expected to be minimal. Japanese multinationals apparently consider that the main concern with the global minimum tax is the increasing compliance costs, rather than the higher tax burden.

Given the enormous compliance costs of the global minimum tax, Japanese multinationals now request that the government scale down the so-called controlled foreign company (CFC) legislation. However, the Ministry of Finance reportedly stated that the global minimum tax would not make the CFC legislation unnecessary or redundant. So far, the government has not announced any tax reform proposals that would respond to this request from Japanese multinationals.

There has been some debate as to why Japan needs CFC legislation. One explanation could be that Japan aims to remain a high-tax country. According to the Ministry of Finance, Japan’s effective CIT rate (including local taxes) is 29.74%. Meanwhile, under the Japanese hybrid international tax system (where capital gains from disposing of shares in foreign subsidiaries are fully taxable in Japan, but 95% of dividends from those foreign subsidiaries are exempt), Japan may not have opportunities to levy its taxes even if foreign subsidiaries are under-taxed abroad.

Thus, the Japanese international tax system may be vulnerable to international double non-taxation arising from income shifting to subsidiaries in low-tax jurisdictions. In other words, Japan could only maintain its high CIT if something were to be done about profit shifting.

In this way, the CFC legislation plays a key role in Japanese tax policy. It is notable that, even in the era of the global minimum tax, there may still be motivations to shift income from Japan to offshore jurisdictions, seeking a lower tax rate of 15% rather than Japan’s high CIT rate of 29.74%.

One would argue that the CFC legislation will remain irreplaceable to protect Japan’s tax base despite the 15% global minimum tax. Furthermore, while the global minimum tax applies to multinational enterprise groups with EUR750 million (USD818 million) or more in revenue, the CFC legislation covers even small and medium-sized enterprises, and individuals. In short, it is unclear whether Japan will overhaul its CFC legislation.

Net operating loss utilisation

Not only does Japan have a high (effective) CIT rate, but it also strictly restricts the amount of net operating losses (NOLs) that can be used to offset future profits. Japan has strict restrictions on loss carryforwards and carrybacks. In most cases, companies cannot claim a refund by loss carryback. NOLs can be carried forward for 10 years, but they can be offset only against up to 50% of the corporate income of each business year.

Japan allows domestic corporations to elect for the group tax relief regime, which allows the current losses of one group member to offset the current profits of another group member, but only when they are in a 100% direct or indirect shareholding relationship.

Japan is very different from jurisdictions, like the US, that allow consolidation even when there are minority shareholders. Furthermore, in recent years, there have been several tax disputes in which tax authorities have applied the anti-tax avoidance rule to deny the transfer of loss carryforwards between group companies through qualified reorganisations.

It will take several more years before the courts deliver their decisions in these cases, leaving legal uncertainty regarding corporate reorganisations that could facilitate utilising group losses.

Modest tax incentives

Another distinctive feature of Japanese CIT is that it provides only modest tax incentives. Japan has poor cost-recovery provisions for business investment in machinery and buildings. While the full expensing regime has recently become popular, as in the UK and the US, it does not seem to be part of Japanese tax policy. In addition, refundable or transferable tax credits are not common in Japan.

One of the major tax incentives for businesses in Japan would be the R&D tax credit. This tax credit is non-refundable, and the credit amount is determined based on a certain percentage of the R&D expenses. In principle, this percentage fluctuates between 1% and 14% depending on the year-on-year increase or decrease in R&D expenses. For example, if the current R&D expenses are the same as the previous year’s, the percentage will be 8.5%.

There is a ceiling on the R&D tax credit, which is 25% of the current CIT liability before tax credits are applied (this ceiling can be pushed up to 45% under certain conditions). It makes it unlikely that the R&D tax credit will result in a drastically low effective CIT rate in Japan. Any amounts above the ceiling will evaporate and will not be carried forward.

Accordingly, it is said that the companies that benefit the most from the R&D tax credit are large enterprises with stable profits and CIT liabilities. In contrast, startups with initial losses (and no current CIT liabilities) have fewer benefits.

The R&D tax credit accrued by one business line can also reduce the CIT liability on the profits of other business lines that may not require intensive R&D activities. Some may find it ironic that less-innovative companies with profitable businesses that do not involve much R&D would benefit the most from the R&D tax credit.

Japan will introduce a new tax incentive, known as the “Innovation Box” regime, from 1 April 2025. As the Innovation Box is also a modest tax incentive, it may be questionable whether it will be a real game changer. The Japanese Innovation Box provides a 30% deduction for qualified IP income. There is a ceiling for the deduction at 30% of current income (before the Innovation Box is applied) minus any unused loss carryforwards.

Assuming a typical effective tax rate of 29.74% in Japan, a 30% deduction would reduce the effective tax rate only to about 21%. Thus, the Innovation Box may not sound like a significant tax cut. It is way above the 15% global minimum tax rate.

The Innovation Box covers only patents and AI-related software programs. Income from licensing or domestic sale of such intellectual property is covered, but so-called embedded royalties are not. Income from related party transactions (including licensing to a foreign subsidiary) is excluded, even if the transactions are done at the arm’s length price.

Companies must apply to the Ministry of Economy, Trade and Industry to be eligible for the Innovation Box. The ministry is working on drafting guidelines for applications. In sum, it appears that further improvements are needed to make Japan’s tax system more competitive.