At the end of the previous section about tax structures to avoid when doing business in Japan, we asked: “What is the most tax-efficient way to set up a directly owned and operated Japanese sales office?”
Of Japan’s many corporate entities, there are three that companies most often use when setting-up to start business in Japan:
- Register a branch-office in Japan.
- Incorporate a Japanese kabushiki kaisha “KK” company (similar to a US C-corporation).
- Incorporate a Japanese godo kaisha “GK” company, sometimes called a Japanese LLC (similar to a US LLC except it cannot be taxed as a partnership).
There are also some exotic cross-border structures, such as the tokumei kumiai – godo kaisha “TK-GK” (silent partnership) and tokutei mokuteki kaisha ‘TMK’ special purpose company. Despite the value of the tokumei kumiai – godo kaisha “TK-GK” (silent partnership) as an efficient tax structure for real-estate and other investments, we don’t include it here because setting-up a TK-GK tokumei kumiai – godo kaisha structure needs expert legal and tax accounting support generally beyond the resources of smaller companies. Similarly, for companies considering investments in Japanese special situations, real-estate development, etc., the tokutei mokuteki kaisha ‘TMK’ special purpose company is a valuable and tax-efficient option, but we exclude it from this discussion for the same reasons as the TK-GK.
Of the three structures we consider here, the least tax-efficient, and in my opinion best avoided, is the Japanese branch-office. If your company registers a branch-office in Japan, your CFO must understand that he or she is exposing it not only to Japanese corporate taxes on the branch-office’s sales, but also to the full range of Japanese tax liabilities (business income tax, withholding tax, and consumption tax) on any sales your head-office, or directly controlled group companies, do in Japan that in any way involve the branch-office. Japan’s Corporation Tax Law treats all sales made by a foreign company with a branch-office in Japan as the branch-office’s sales unless the foreign company can prove the branch-office had no involvement. The foreign company must produce proof of the Japanese branch-office’s involvement in each sale and include a proportionate amount of such sale in the branch-office’s income. The Japanese tax office has the right at audit to demand your company’s head-office accounts to verify: 1) each sale it makes in Japan, 2) the branch-office’s involvement, and 3) the amount of income reported. So not only does a branch-office in Japan expose its head-office to the full range of Japanese corporate taxes on all sales it makes in Japan, it also opens your company’s head-office financials to a Japanese tax audit. For corporate tax purposes, it’s generally best to avoid using a Japanese branch-office. Where a branch-office in Japan might be useful, is in a doubled-up ‘foreign parent’ – ‘Japanese child’ structure, but even so, the tax office might question its legality. In such a structure, foreign company ‘A’ does business in Japan through arm’s-length distributors, while its subsidiary foreign parent ‘Z’ supports its Japanese activities through its branch-office ‘Z’. Many asset management and investment companies do business in Japan using such a structure, with foreign parent ‘Z’ often being a Cayman Islands SPC. Again, setting-up such a structure as a legal structure that is not guilty of tax evasion, needs specialist tax and legal advice. Incorporating a Japanese kabushiki kaisha “KK” company is a necessary solution in certain situations, such as satisfying corporate governance requirements with a Board of Directors, but doesn’t offer any special tax benefits. “But those Japanese business myths tell us that 99% of Japanese companies set up as kabushiki kaishas!” you say. Agreed, but 99% of those kabushiki kaishas are ‘mom and pop’ shops with no profits left after paying mom, pop, and their suppliers. Those KKs do not function at the Japanese subsidiary layer of a global corporate structure so tax efficiency was not a consideration in their choice. Starting a Japanese KK kabushiki kaisha company is generally a good choice for a pure Japanese customer liaison office (although you must consider Amazon’s experience and the qualifiers noted in the previous section), and usually the best choice for starting a Japanese sales office. Unless you try to use an inflated transfer price (which a tax audit will look for), your profits from doing business in Japan can only flow back to the foreign parent as post-tax (i.e. less effective Japanese corporate income tax of 34.1% or 30.86% depending on paid-in capital) dividends, which will then presently lose a further 20% Japanese withholding tax less tax treaty relief. For KK kabushiki kaisha subsidiaries of US companies, this is not a burden, as the US – Japan tax treaty eliminates the withholding tax for dividends paid to a US parent holding 50% or more of the kabushiki kaisha’s shares. A less well-known tax inefficiency of the Japanese KK kabushiki kaisha company relates to how it pays its representative directors and non-working directors. If it pays bonuses to such directors, or bonuses out of proportion to its earnings to working directors, the tax office considers those bonuses paid from profits, even if the KK made a loss (such as if the KK kabushiki kaisha is a pure customer liaison office). That means that if such a director earns a US$100,000 bonus, the KK kabushiki kaisha will incur a US$34,100 or US$30,860 (depending on paid-in capital) corporate income tax charge even if it reported a loss. If you incorporate a KK kabushiki kaisha as your Japanese subsidiary company but want to pay bonuses to your non-working and representative directors, then structure their compensation based on an annually fixed ‘divide-by-12’ salary package which assumes a certain level of performance. In the following year, you can then retroactively increase or decrease compensation depending on the actual performance achieved, although you could not have this written as part of a director’s service agreement. Although often called the Japanese LLC, the GK godo kaisha does not have the US LLC’s “treat me as a corporation or treat me as a partnership” tax benefit. A GK godo kaisha must file annual financial statements and tax-returns just as a KK kabushiki kaisha must and for the same income, expenses and paid-in capital will pay the same taxes. Just as with the KK kabushiki kaisha, starting a GK godo kaisha company is generally a good choice for a pure Japanese customer liaison office and for starting a Japanese sales office. Just as with a KK, profits from doing business in Japan can only flow back to the foreign parent as post-tax dividends, which will then presently lose a further 20% Japanese withholding tax less tax treaty relief. For GK godo kaisha subsidiaries of US companies, this is again not a burden, as the US – Japan tax treaty eliminates the withholding tax for dividends paid to a US parent holding 50% or more of the godo kaisha’s units. Where the GK godo kaisha wins is for US sole members, because the IRS allows a GK as a disregarded “check the box” entity under US Treasury regulations §301.7701-2(b)(8) (while a KK is a per se corporation). This is why several large US companies use GKs for their business in Japan. As we noted above, there are complex structures using TK tokumei kumiai silent partnerships, other structures involving multiple parent and child entities dealing amongst each other (which is how large Japanese companies lower their corporate income taxes) and there are also creative ‘preferred agent or distributor’ structures using an arm’s-length third-party entity, but such structures are complex to set up and run. So, to answer the question at the top of this page, for most companies starting business in Japan, we consider a GK godo kaisha GK is the most tax efficient entity for US companies and the KK kabushiki kaisha is the most tax-efficient entity for all other companies to set up.