Tax audits can be the most annoying thing in managing overseas operations. Especially differences in business culture and language makes it tougher than you would expect. So how do you prepare for tax audit in Japan? Your best preparation comes from daily operations. Below, we have arranged tax issues by chart of accounts for your reference. We hope it will give you an idea regarding tax issues in Japan.
Account PayablesAccount Payables are one of the very first items which are highlighted during tax audits. In principle ,tax deductibles for income taxes are recognized on accrued basis based on fact that services and goods are delivered. Payables which are not settled for an extended period of time are subject to questioning from the tax auditors. Also, for payables which had been waived by the creditor, gain from forgiveness of debt must be recognized at the time of notice. In any case, your closing financials does not have to reflect the expense deductible of the Japan Tax Code. As long as it is adjusted at the point of calculating taxable income, you are not challenged during tax audit. Therefore, whatever accrual basis the company is applying to the global operation, it can be used for the Japan business in most cases. But please note that the accounting principle needs to be consistent from year to year. Justifiable reasoning needs to be in place when accounting principle change.
Account ReceivableIf a specific customer's Account Receivable is identified as uncollectible, it is written off by removing the amount from Account Receivable as bad debts expense. For Japan tax purpose, when is it recognized as uncollectible? In principle, 1 year after the latest payment from the debtor is the timing to write off as bad debt. At least 1 JPY needs to be recognized for Account Receivable as memorandum value. Other cases such as when reorganization plan comes into place are timing to use the allowance method. Check with your accounting office to see what steps can be taken depending on the legal status of debtor. Provision Fund for Bad Dept has strict guidelines. Please note that if you do not recognize bad debt at the year that is applicable under Japan tax code, you will not be able to go back in retrospect for tax purpose. In case Account Receivable is in currency other than Japanese Yen, you may need to convert at year end. Be sure to confirm with your tax accountant on the requirement of yearend conversion.
Accrued BonusThere had been many cases when we engage with new client, we are offered stories that previous accounting office did not allow them to accrue bonus. Of course you can accrue bonus. It is just that in most cases accrued bonus may not be deductible for tax purposes. When meeting certain conditions, employee bonus may be all deductible even if you accrue them, so contact your tax office 3 month before closing to see how it is done. Unfortunately for director bonus, accruing them as tax deductibles at the year-end is not allowed. Director bonus in most cases is not tax deductible so consult with your tax accountant closely for director compensation if you want to secure them as tax deductible expenses.
Accrued ExpenseAs noted in Accounts Payables, tax deductibles for corporate income are recognized on an accrual basis not cash basis. Therefore, when you are recognizing in a cash basis, you need to accrue at the end of the year or simply make accrual adjustments when calculating taxable income for filing tax returns. For below expenses, even if you have not made payments, you are able to claim as tax deductible based on accruals. 1. Rent 2. Interests 3. Leasing expenses Depending on your business characteristics, there may be other items you may claim as tax deductibles, so consult with your tax accountant at the time of closing. Besides recognizing tax deductibles as accruals, you are able to recognize deductibles on a cash basis under certain conditions. This is when you make payments for expenses extending for more than a month, be sure to check what is best for the company with the accounting office.
Accrued SeveranceSeverance pay is only deductible at the point of payment for calculating taxable income. Even if employment contracts or other company policy states a formula for severance pay making accruals possible, the timing a company can claim as tax deductible is at the time of payment. Accrued expense in general is accepted, but timing for payroll payment is predominately cash basis. Of course you can accrual severance pay for your financial statements, but be sure not to forget to make adjustments when adjusting taxable income. In the corporate tax return, there is a document which will show the adjusting figures up to date. Confirming balance outstanding every year for historical adjustment is advised.
Bank AccountBanks in Japan provide passbooks which you can insert into the ATM machines to print your transactions. In most cases this is fine for tax audit. But for other compliance related audits, banks can issue certificate of balance outstanding in English with extra charge. Interest arising from bank accounts is withheld income tax and inhabitant tax so amounts printed in passbooks are net figures after withholding amount. Banks also issue interest statement of gross amount on paper so it is important to preserve this document. Depending on how you process payments, passbook printouts may only show a lump sum of payment not being able to identify transaction one by one.
CapitalAmount of capital may be the most important figure when you consider tax in Japan. Why? It is because many measures in the tax code define the operation of a company by capital not by amount of sales. When you consider increasing capital amount, the timing will affect your tax position. So close communication with the tax accountant will benefit you in the long run and avoid you from unexpected tax circumstances. Some notable tax area concerning amount of capital are as follows, 1. Corporate Income Tax Rate 2. Scope of Inhabitant Tax 3. Allowance for bad Debt 4. Deductible Entertainment Expenses 5. Deductible Donations The date of capital increase or decrease will be decided based on company registration. Therefore, you will need to plan ahead considering the administrative procedures required. In addition, you will need to submit notification documents for changes in capital amount to the national tax office as well as the local tax offices.
Capital ReserveMaximum amount of Capital Reserve you can have is half of paid in capital as stated by the Japan Company Act. The balance between capital and capital reserve will be up to the company. Traditionally in Japan, when choosing business partners, companies are judged by the amount of capital for stability and credibility. But the more capital you have, the more liable you will be for pro-forma basis taxation if applicable. So there is a price to pay for credibility in Japan. Company can make transfer between capital and capital reserve by holding a board meeting and shareholder meeting in most company structures in principle. Another importance aspect of Capital Reserve is, some tax codes define an operation of a company on the gross amount of Capital and Capital Reserve. It is critical when discussing tax measures whether or not it is decided based solely on Capital or combined figures of Capital and Capital Reserve.
Deferred AssetsDeferred assets under the Japanese Tax Code consists of 2 categories. One is deferred assets recognized in generally accepted accounting principle such as 1. Inaugural Expense 2. Business Commencement Expense 3. Research & Development Expenditures 4. Share Issuing Expense 5. Bond Issue Cost Another is deferred tax uniquely defined under the Japanese Tax Code. The Deferred Tax uniquely defined under the Japan tax code are expenditures which benefit is expected to extend more than 1 year on certain conditions. Examples are giveaways of promotional usage equipment and lease repayments. Deductible amount varies depending on certain criteria for this Japan tax code unique deferred tax. Some royalties fees fall into deferred assets so we advise you work closely with the accounting office.
EquipmentsWith prices of computer related equipment going down there may be fewer items to book as assets but in case you do book as assets, below are things you need to be careful. 1. Purchase Price 2. Start of Business Use 3. Usage of Accelerated Depreciation 4. Disposal Date Purchase price of equipment is most important since setup related fees are considered as part of purchase price. Check with your tax accountant so that you do not expense setup fees subject to asset recognition.This is a typical topic during tax audit. The next important item is the date for start of business use. Just receiving the equipment from the vendor does not allow you to depreciate. Depending on the time you purchase, there may be accelerated depreciation measures available, so check with your accounting office. Lastly, if you dispose equipments you will need some sort of proof that you had disposed the equipment. Your tax accountant will have ideas what type of documentation is necessary depending on the equipment.
Intercompany LoanDuring the past few years, intercompany loans has become a hot topic during tax audit in Japan. The reason for this is because many companies do not have a loan agreement in place. This makes it easier for tax auditors to challenge intercompany loan related transactions. You should always consult with your tax accountant on the following items for intercompany loans. 1. What items needs to be included in the loan agreement 2. What is a reasonable interest rate? 3. Does the loan agreement need to be in Japanese? The best way to deal with this is to have the accounting office review the loan agreement after the draft is completed by the legal office so that intercompany loan agreement is in place meeting all your requirements.
InventoryA company’s method of estimating inventory is decided by declaring the method to the tax office. Consult with your tax accountant first before submitting the form. It is usually submitted with the establishment notification as soon as the company is registered. Valuation loss is rarely allowed in the Japanese taxation system except being affected by disasters. The tax code clearly states that the following events are not subject to valuation loss. 1. Price Fluctuation 2. Excess Production 3. Change of Retail Price Besides products, materials such as wrapping materials, office supplies and catalogs are subject to inventory count in principle. But by meeting certain standards, expenses can be recognized at once without recognizing inventory. Consult with your tax accountant whether your circumstance apply.
Loss Carried Forward
Loss Carried ForwardThe amount of carried forward loss a company can use has been extended from 7 years to 9 years in 2012. In order to apply, you are required to submit the blue form notification to the tax authorities and your capital amount needs to be below the threshold of medium and small size company defined in the Japanese tax code. The balance outstanding for carried forward losses are included in every year’s tax return so please make sure your tax accountant is submitting them correctly. Besides maximizing the usage of carried forward losses for deductible losses, there is a way to apply for refund as well, so consult with your tax accountant if you are in a position to do so.
Petty CashHaving petty cash is not advisable considering risk of bad management. Employee takes less responsibility in preserving receipts and invoices when petty cash arrangement is provided. Hence, many mishandled settlements occur leading to adjustments during tax audit. Obviously, employee takes better ownership of receipts and invoices when expense reimbursement system is in place. If circumstance of providing petty cash must be met, please consult with your tax accountant in what kind of reconciliation procedure must be in place to satisfy the tax authorities during tax audit. In addition, it is always good to confirm with your tax accountant how to deal with situation when receipt and invoice are not provided in certain transactions.
Prepaid ExpenceExpenses such as below are in principle recognized based on the service period. 1. Insurance 2. Rent 3. Interest But exceptions apply to those expenses meeting certain condition which allows expense recognition on cash basis. In other words, even if the payment is upfront, a company can claim the full payment amount as expense in the fiscal year which it was settled. Consult with your tax accountant since consistency is also a key in qualifying for this benefit. Please note that consumption tax is recognized at the point service is provided not when payment is settled.
Provision Fund for Bad Dept
Provision Fund for Bad DeptRegardless of accounting policies a company may have, Japan Tax Code has severe limitations on what they allow as provision fund for bad debt in dealing with accounts receivable. Depending on the status of legal liquidation, limit is decided. The most common legal proof is notice from lawyers and court which states the condition of debtor. The date of this notice will determine the timing of allowing a provision fund for bad debt. Usually, this notice from lawyers and court are received by the sales personnel. Guidance to sales personnel to pass this notice to the accounting personnel in charge will be essential for timely process. You should always consult with the tax accountant on the timing and conditions when making provisions for bad debt.
Retained Earning Carried Forward
Retained Earnings Carried ForwardIf you have invested in Japan and are thinking about dividends, you will need to monitor Retained Earnings Carried Forward for your Japan investment. Under the Japan Company Act, a company is required to reserve 10% of gross amount of dividends. In order words, a company can provide dividends up to 10/11 of the Retained Earnings. Please note that in principle, a company has obligations to withhold 20% of the gross dividends and make payments to the tax office the following month on the 10th day. Tax treaty on withholding on dividends differs from country to country so consult with your tax accountant on scenario planning for dividend arrangements.
Software & Related Costs
Software & Related CostsConsidering the fact that most employees use devices and equipments which connect to various networks, it is not surprising that tax auditors see software related transaction as an area to be challenged during the audit. Software transaction can be itemized in general as following items. 1 Purchase Expense 2 Installation Fees 3 Customizing Fees 4 Data Conversion Fees 5 Employee Training Fees 6 License Fee 7 Debugging Fee You should observe your invoice carefully with the tax accountant so that appropriate tax filing can be made without mistake. Is the scope of software purchase recognized correctly? Are all expenses deductible recognized? You do not need to follow Japan tax code depreciation but you will need to adjust accordingly during the tax returns if you chose to depreciate in a different manner.
Profit and Loss Statement
Advertising MarketingAdvertising fees are generally paid in advance as prepaid expenses. In preparing consumption tax returns, timing of claiming as consumption tax receivables is at the time service is provided. Advertising fees are highlighted in one aspect for income tax purposes. Japan tax code restricts income tax deductibles by deeming certain transactions as entertainment expense regardless of how is it is treated accounting wise. A guideline of advertising related fee being deemed as entertainment is determined by the characteristic of advertising. In case the expenditure of the advertising is targeted to a certain individual, the more likelihood the transaction will be deemed entertainment expense for tax purpose.In case it is targeted to mass audience ,it will not be deemed as entertainment.
Commisions (Outsourcing Fee)
Commisions (Outsourcing Fee)When engaging with an individual in a subcontractor agreement, careful attention needs to be provided considering withholding income tax obligations. The tax authority in Japan loves to challenge subcontractor engagement to full time employment. In case the subcontractor engagement does not qualify as such under the tax code in Japan, it will be deemed as salary to full time employee status staff subject to withholding income tax obligations. Questions which needs to be asked are
- Is the subcontractor responsible for his performance?
- Is the subcontractor under supervision of the company?
- Does the subcontractor have constraints regarding working hours and place of work?
Commisions (Transactions outside Japan)
Commisions (Transactions outside Japan)When making commission payments to non-Japanese entity or individuals overseas, you will need to ask the following questions regarding such commission. 1. Is the commission subject to withholding income tax? 2. Will it be subject to withholding for special reconstruction income tax? 3. Is the tax treaty applicable? In case of intercompany commission, executed signed agreement must be in place. And to make sure of the following, 1. Actual transaction is made in accordance with the intercompany agreement 2. Proof of transaction 3. Logical explanation for the transaction amount There are incidents when commission transaction expands to transfer pricing issues. Relevant transfer pricing documentation will be necessary in these circumstances.
Cost of Goods Sold
Cost of Goods SoldInventory management will be the focal point for cost of goods sold. Some of the key questions you will need to ask is, 1. Are inventory recognized at the right timing when goods are shipped from overseas? 2. Are goods returned being recognized as inventory at correct timing with sales cancelation? 3. Are recognition of sales and costs of goods in line at year end? Significant changes in profitability from year to year in earnings after sales needs to be carefully monitored. Any hike up in costs to sales ratio must have logical explanation. This may trigger audits in transfer pricing as well if it involves intercompany transactions. Since recognition differences in inventory count effects earning after sales, tax auditors in Japan takes a close look in inventory count methods. In case there is a difference in inventory count method between company accounting policy and tax code principle in Japan, there are 2 ways of dealing such situation. Resolution 1: Consult with your tax accountant to see if there is a possibility of electing the inventory count method of your company by submitting a notification form. Resolution 2: Work with your tax accountant to make adjustments for taxable income tax.
Cost of Services
Cost of ServicesCost of Sales for service sales can get ugly during tax audit in Japan since clear definition is not stated in Japan the tax code. The rule of the thumb is any explanation which can be interpreted as logical to a person who is explained of the service for the first time can be considered safe. A logical allocation based on some key index figures are, 1. Number of hours 2. Number of employee or staff 3. Floor area ratio As with most accounting policies, consistency will be the key element in making a persuasive argument to the tax auditors. In addition, there is always a cultural business interpretation whether a practice is logical or not. Therefore, it would be advised that you consult with a tax accountant whether or not what you are trying to implement is logical by Japan tax code.
Directors' compensationDirectors’ compensation may be considered deductible for most countries, but in Japan, it is limited. In Japan, directors’ compensation has been considered to be a handy method to manipulate financial results from the view of the tax authorities and therefore, there are certain rules for directors’ compensation to be deductible under Japan tax code. In many cases, directors’ compensation is comprised of fixed portion and variable portion which is generally determined based on the result during the year stated in the contract with the company. However, variable portion based on the result is generally non-deductible and certain action should be taken for that variable portion to be deductible. To avoid the situation of directors’ compensation already accounted for is not deductible, careful attention should be paid from the time when deciding the ratio of fixed and variable portion of the compensation in the contract when assigning a director for the company in Japan. Also,providing housing and supporting living expenses as fringe benefit can also be considered as director's compensation in some conditions
DividendWhen arranging payments for dividends from unlisted companies in Japan, make sure you withhold 20% withholding income taxes. Always be sure to check with your tax accountant to see if tax treaty applies. Many treaties allow deduction or exemption for withholding income tax. Apart from tax treaty documents, there are cases when you need to prepare documents from your tax jurisdiction so advance preparation is critical to enjoy tax treaty benefits. Please be aware that holding period of 6 month with shareholding requirements of 25% will require in many cases for tax treaties. Recognition timing of dividends differs depending on the company structure of KK(Kabushikigaisha) & GK(Godogaisha). For KK, stockholders meeting must be held and depending on how you state in your article of incorporation, board meeting must also be held. For GK, equivalent of board meeting must be held.
Employee SalariesAs a general accounting practice in Japan, companies often separate director compensation and employee salaries. Director compensation are more focused during the tax audit compared to employee salaries. When focusing solely on employee salaries, unpaid salaries and bonuses are not tax deductible in principle. But when meeting certain conditions you will be able to accrue your employee bonus at yearend. In trying to meet such conditions, careful planning is necessary so consult with your tax accountant at least 3 month in advance. There will be some administrative requirements as well as accounting posting requirements in order to meet these conditions.
EntertainmentMajority of entertainment expenses may be considered deductible for most countries but in Japan, it is limited. The tax code has been put in place to regulate companies claiming entertainment expenses which in reality are personal expense of individuals made on company accounts. In general, entertainment expenses are not considered deductible unless you are corporation with small capital amount. Therefore, careful decision making needs to be made on what expenses are entertainment or not. This is one of the favorite topics for tax auditors during tax audit so the company should be well prepared. In principle, entertainment expense is decided on the following 3 elements.
- Expense made to business related partners
- Expense made for anticipating future business
- Expense made on non-business setting