Establishing Business Operations in Japan
Imagine that your biofuels company had decided to establish business operations in Japan. Your first decision would be whether to appoint an independent consultant or to hire an employee in Japan to help expand your business. Which one should you choose?
In the event that your company decided to appoint an independent consultant to help expand your business in Japan, be careful to structure the relationship such that the independent consultant would not constitute your “permanent establishment” in Japan. Under Japanese tax law, a permanent establishment of a foreign company in Japan subjects that company to corporate income tax in Japan based upon the revenues generated by and attributable to the company’s permanent establishment in Japan.
In order to ensure that your independent consultant would not be considered a permanent establishment under Japanese tax law, several guidelines must be followed. Your independent consultant should be a corporation, not an individual. Your company would enter into an agreement with the corporation to expand business in Japan on your behalf. The corporation would, in turn, hire an individual to perform these tasks. Your independent consultant would not have authority to bind you to any obligation whatsoever. It would not have the authority to sign contracts on your behalf in Japan. It could, however, assist you in negotiating business deals and in discussing the terms of contracts with potential customers in Japan. You would pay your independent consultant in the form of commissions, not in the form of a standard monthly (or annual) consulting fee. If your independent consultant were paid in the form of a standard monthly (or annual) consulting fee, the consultant might be considered a “standing agent” under Japanese tax law, which would constitute your company’s permanent establishment in Japan and subject you to corporate income tax in Japan.
In the event that your company decided to hire an employee in Japan, the employee would, under almost all circumstances, constitute your permanent establishment in Japan, which would subject your company to corporate income tax in Japan based upon the revenues that are generated by and attributable to that employee. You would also be required to pay U.S. corporate income tax on the revenues generated by and attributable to the employee in Japan because the U.S. taxes its corporations on their worldwide income, regardless of where it is earned. However, under the Convention between the U.S. and Japan for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income, which entered into force on July 9, 1972, you would be entitled to receive a partial tax credit in the U.S. for the corporate income tax paid in Japan. This would, to a certain extent, relieve the double taxation imposed upon your company by virtue of having an employee in Japan.
In addition, your employee in Japan would be entitled to all of the rights and safeguards accorded to employees under Japanese labor laws. Your employee would be entitled to participate in the Japanese National Health Insurance Plan and the National Welfare Pension Plan, and your company would be required to enroll in such plans. The payment of the premiums for such plans would be shared equally by your company and your employee in Japan. Your employee would be entitled to participate in the Japanese Worker’s Compensation Insurance Plan, and you would be required to pay the entire cost of the premiums for such plan. They would be entitled to participate in the Japanese Unemployment Insurance Plan, and you would be required to pay 75 percent of the premiums while the employee would be required to contribute the remaining 25 percent. Your employee would be entitled to receive between 10 and 20 days of paid vacation per year and approximately 25 days of paid holiday time per year. Japanese companies usually give their employees both winter and summer bonuses, which are equal to 3 months’ salary each.
You could not unilaterally change the terms of the employment contract between your company and the employee, especially if such changes were detrimental to the employee. You could not unilaterally terminate the employee’s employment unless you had “just cause” to do so. Just cause is narrowly defined under the Japanese labor laws and involves more than simple misconduct or negligence. You would have to show that the employee engaged in serious misconduct or that the employee repeatedly and systematically performed poorly in the execution of his duties. The standards of performance expected of the employee would have to be articulated in his employment contract, and written warnings would have to be issued to him if he failed to meet the performance standards. The employee would also have to be given a period of time within which to improve his performance after you had issued warnings to him before you could terminate him for just cause.
Branch Office or Subsidiary?
In the event that your company decided to hire an employee in Japan, your company would be required to establish a Japanese registered branch office or a Japanese subsidiary in which the employee could work.
In order to establish a registered branch office in Japan, you would have to appoint a registered representative who would be deemed to have the power and authority to represent the branch office. Your representative would have to be a resident of Japan but would not need to be a citizen of Japan. You would have to register the branch office’s place of business and its representative with the appropriate government authorities in Japan. An “initial inward direct investment” report containing details about your company and business objectives would also have to be submitted. Any claim or cause of action against the registered branch office or any risk or liability of the registered branch office would be considered to be a claim or cause of action against or risk or liability of your company in the U.S., since the registered branch office would be considered to be an extension of your company into Japan. The registered branch office would be taxed in Japan only on the income that it generated from sources in Japan. As indicated above, you would be taxed in the U.S. on the income generated by the registered branch office. However, under the U.S.-Japan Income Tax Treaty, you would be entitled to receive a partial tax credit in the U.S. for the corporate income tax that the registered branch office paid in Japan.
In the event that your company decided to establish a subsidiary in Japan, you would probably form a Japanese limited liability company (known as a “Yugen Kaisha”). In order to establish an LLC in Japan, you would be required to file an Application for Commercial Registration for the new subsidiary. You would also have to submit an “initial inward direct investment” report containing details about your company and business objectives in Japan. Furthermore, you would be required to file a report after you acquired shares in the subsidiary, which would describe the type, purchase price and amount of the shares purchased by your company. You would have to file various tax reports with the Japanese national and municipal tax authorities regarding the subsidiary. Finally, you would be required to make an initial capital investment in the subsidiary of at least 3,000,000 yen ($37,000). You would have to elect directors to serve on the subsidiary’s board of directors, and the directors would appoint the officers of the subsidiary. The directors on the board of directors of the subsidiary would have general supervision over the business operations of the subsidiary, and the officers of the subsidiary would be responsible for the day-to-day operations of the subsidiary. Any claim or cause of action against the subsidiary or any risk or liability of the subsidiary would be limited to the subsidiary and its assets, and would not be considered to be a claim or cause of action against or risk or liability of your company in the U.S., provided that the subsidiary was properly incorporated and operated in compliance with Japanese commercial laws. As a domestic Japanese company, the subsidiary would be taxed in Japan on its worldwide income. In addition to Japanese corporate income tax, local enterprise tax and corporate residence tax would also be imposed upon the subsidiary. The combined rate of tax on the subsidiary would be approximately 41 percent. As indicated above, you would be taxed in the U.S. on the income generated by the subsidiary. However, under the U.S.-Japan Income Tax Treaty, you would be entitled to receive a partial tax credit in the U.S. for the corporate income tax that the subsidiary paid in Japan. A withholding tax would also be imposed upon your company on the issuance of dividends to your company from the subsidiary. The rate of such withholding tax would be 10 percent.
Establishing business operations in Japan requires careful strategic planning and an in-depth understanding of the Japanese corporate, tax and labor laws. Depending upon your business objectives, you may wish to appoint an independent consultant or hire an employee in Japan. Your decision will have significant business, legal and tax consequences as you attempt to expand your business activities in Japan.
Author: Richard Weiner
Vice President, Fredrikson & Byron