Japan: Changes to permanent establishment allocations
15 May 2014
Posted by: Author: Koichi Inoue
Author: Koichi Inoue (Jones Day)
Under the most recent tax reform, approved by the Diet in March, Japan has changed its general tax rules applicable to a foreign corporation having a permanent establishment in Japan ("FCPE"). Under the current Japanese domestic tax law, which adopts the "force of attraction" principle, all income arising from sources within Japan is fully taxable regardless of whether such income is attributable to the FCPE. Under the revised Japanese domestic tax law (the "New Domestic Rules"), (i) income attributable to an FCPE will be taxable regardless of the source; and (ii) income attributed to an FCPE will be calculated in line with the Authorized OECD Approach (the "AOA"). Please note that the concept of an FCPE under the Japanese domestic tax law will remain unchanged. FCPEs are generally divided into the following three categories: (i) a branch, or any other fixed place where business in Japan is conducted; (ii) a construction site or installation project; and (iii) an agent PE. The concept of PE under Japanese domestic law is slightly broader than that under the OECD Model Tax Convention.
Under the New Domestic Rules, (i) internal dealings within a single entity will be recognized (e.g., internal royalty, internal interest, internal service fees (including appropriate mark-ups), etc., will need to be charged to calculate Japanese corporation tax); (ii) a mere purchase by an FCPE of goods for its head office will generate profits; (iii) prices of internal dealings not in line with the arm's-length principle will trigger the taxation equivalent of transfer pricing taxation; and (iv) an FCPE may claim a foreign tax credit on its Japanese corporation tax return. Reasonable cost allocation from a head office to an FCPE, such as the allocation of overhead expenses related to administrative functions performed by the head office for the benefit of the FCPE, without any mark-ups, will continue to be deductible. In addition, some documentation requirements (including documentation similar to transfer pricing documentation) will be imposed on FCPEs.
Note: The New Domestic Rules explicitly provide that if an income tax treaty not incorporating the AOA is applicable, internal interest for non-financial enterprises and internal royalties will not be recognized, and a mere purchase of goods will not generate profits for Japanese corporation tax purposes.
The New Domestic Rules will apply to the corporation tax for a fiscal year commencing on or after April 1, 2016.
This article first appeared on mondaq.com.