Decoding "Domestic Source Income" in Japan: What U.S. Businesses Need to Know Before Entering the Market

Japanese Attorney at Law - Bengoshi L.L.

• 7 min read

For any foreign enterprise, including U.S. businesses, looking to operate in or with Japan, a clear understanding of what constitutes "domestic source income" (国内源泉所得 - kokunai gensen shotoku) is fundamental. This concept lies at the heart of Japan's international taxation system, determining whether and to what extent a non-resident individual or a foreign corporation will be subject to Japanese income or corporate tax. Getting this wrong can lead to unexpected tax liabilities and compliance burdens. This article aims to shed light on the main principles and categories of domestic source income under Japanese tax law.

The Foundation: Why "Domestic Source Income" Matters

Japanese tax law, like that of most countries, asserts its right to tax based on two main connecting factors: the residence of the taxpayer and the source of the income. While resident individuals and corporations are typically taxed on their worldwide income, non-resident individuals and foreign corporations are generally taxed only on income derived from sources within Japan.

The rules defining domestic source income, often referred to as "source rules," therefore perform a critical function: they delineate the scope of Japan's taxing jurisdiction over foreign entities and non-resident individuals. These rules are primarily found in Article 161 of the Income Tax Act (for individuals and certain income types for corporations) and Article 138 of the Corporation Tax Act (for corporations).

Historically, Japan's source rules were significantly shaped by the 1962 tax reforms. More recently, the 2014 tax reforms brought about substantial changes, particularly for business income, with a clear legislative shift towards an "attributable income principle" (帰属主義 - kizoku shugi). This aligns more closely with international standards, such as the OECD Model Tax Convention, especially concerning profits attributable to a Permanent Establishment (PE).

Key Categories of Domestic Source Income for Foreign Corporations

For foreign corporations, Article 138 of the Corporation Tax Act is the primary provision outlining what constitutes domestic source income subject to Japanese corporate tax. The 2014 reforms significantly restructured this article. Let's explore the main categories under the new rules:

1. Income Attributable to a Permanent Establishment (PE) in Japan (PE帰属所得 - PE kizoku shotoku)

This is arguably the most significant category for foreign corporations actively doing business in Japan. Under the post-2014 rules (Corporation Tax Act Art. 138, para. 1, item 1), if a foreign corporation conducts business through a PE in Japan, the income attributable to that PE is considered domestic source income.

The principle applied here is based on the Authorized OECD Approach (AOA). The PE is treated as a hypothetical distinct and separate enterprise dealing independently with the foreign corporation of which it is a part. The income attributable to the PE is calculated by considering:

  • The functions performed by the PE.
  • The assets used by the PE.
  • Internal dealings (transactions) between the PE and other parts of the foreign corporation (e.g., its head office).
  • Other relevant circumstances.

This category also explicitly includes income derived from the transfer (sale) of the PE itself. This approach marks a departure from the pre-2014 concept of "income arising from business conducted in Japan," providing a more refined framework for profit attribution that recognizes the economic contributions and risks undertaken by the PE.

2. Income from the Operation or Holding of Assets Located in Japan (国内にある資産の運用又は保有により生ずる所得)

This category (Corporation Tax Act Art. 138, para. 1, item 2) covers income generated from assets situated in Japan. Examples include:

  • Interest on Japanese national or local government bonds.
  • Interest on bonds issued by Japanese domestic corporations.
  • Interest on deposits made with a business office located in Japan.

However, certain types of investment income that are subject only to withholding tax at source and not to corporate assessment taxation (unless attributable to a PE) are excluded from this specific category for corporate tax assessment purposes. For example, interest on corporate bonds received by a foreign corporation without a PE in Japan might be subject to withholding tax but not further corporate tax assessment, unless such interest is attributable to a PE it might have for other activities.

3. Income from the Transfer of Assets Located in Japan (国内にある資産の譲渡により生ずる所得)

Income from the sale or disposition of certain assets located in Japan (Corporation Tax Act Art. 138, para. 1, item 3) is also domestic source income. The scope is defined by Cabinet Order and primarily includes:

  • Gains from the transfer of real estate located in Japan.
  • Gains from the transfer of rights existing on real estate in Japan.
  • Gains from the cutting or transfer of timber located in Japan.
  • Gains from the transfer of shares in a Japanese domestic corporation under specific circumstances, such as:
    • The sale of shares accumulated for the purpose of acquiring control (a "cornering" transaction).
    • The sale of shares that is economically similar to a business transfer (e.g., sale of a significant stake by a controlling shareholder). This is often relevant in M&A contexts.
    • The sale of shares in "real estate-rich" corporations (不動産関連法人 - fudōsan kanren hōjin), where the value of the corporation is predominantly derived from Japanese real estate.

4. Consideration for the Provision of Certain Personal Services (人的役務の提供事業の対価)

Income received by a foreign corporation for the provision of personal services (as specified by Cabinet Order) in Japan, such as those by entertainers, athletes, or certain professionals, is treated as domestic source income (Corporation Tax Act Art. 138, para. 1, item 4).

5. Rental Fees from Real Estate, etc., in Japan (不動産等の貸付けによる対価)

Rental income from real estate located in Japan, or from the leasing of ships or aircraft to residents or domestic corporations for use in Japan, is domestic source income (Corporation Tax Act Art. 138, para. 1, item 5).

6. Other Income Sourced in Japan as Defined by Cabinet Order (その他その源泉が国内にある所得として政令で定めるもの)

This is a catch-all category (Corporation Tax Act Art. 138, para. 1, item 6) for other types of income designated by Cabinet Order as having a Japanese source. Examples include insurance proceeds related to domestic business operations, gains from the receipt of assets located in Japan as a gift, and economic benefits received concerning business conducted or assets held in Japan.

No Hierarchy Among Categories, but Distinction from Withholding Tax Regimen

A notable change introduced by the 2014 reforms was the abolition of the previously existing hierarchy among the different categories of domestic source income within Article 138. Under the new system, a single item of income can potentially fall under multiple categories. Any such overlaps are then reconciled at the stage of calculating the corporate tax base.

Crucially, the 2014 reforms also streamlined the relationship between income subject to corporate tax assessment and income subject only to withholding tax. Many types of investment income (like interest, dividends, and royalties not attributable to a PE), which were previously listed within Article 138 and could be subject to both withholding and corporate assessment tax, are now primarily dealt with under the Income Tax Act's withholding provisions for foreign corporations without a PE. This effectively specializes Article 138 of the Corporation Tax Act to define the scope of income subject to corporate assessment tax. The method of taxation for a foreign corporation—whether it's full corporate tax assessment or final withholding tax—largely depends on whether it has a PE in Japan and whether the Japan-source income is attributable to that PE (as per Corporation Tax Act Art. 141).

Modification by Tax Treaties: The Treaty Override Principle

While domestic law establishes the baseline, Japan has an extensive network of tax treaties that can modify these source rules and the resulting tax liabilities. A fundamental principle in Japanese international tax law is that where a tax treaty provides for rules different from domestic law, the treaty provisions will prevail (Corporation Tax Act Art. 139, para. 1; Income Tax Act Art. 162).

This treaty override is critical in several contexts:

  • Sourcing of Income: A treaty might define the source of a particular income item differently than Japanese domestic law. For instance, as mentioned, domestic law may use a "place of use" criterion for royalties, while a treaty might use a "payer's residence" criterion. The treaty rule would then apply for residents of the treaty partner country.
  • Permanent Establishment (PE): Treaty definitions of what constitutes a PE are paramount. If a foreign corporation's activities in Japan do not meet the treaty's PE threshold, Japan cannot tax its business profits, even if those activities might fall under a broader domestic law PE concept.
  • Taxation of Specific Income Types: Treaties often provide exclusive taxing rights to one country or limit the tax rate the source country can impose (e.g., on dividends, interest, royalties). For example, Japanese domestic law generally allows for taxation of gains from the sale of shares in Japanese companies under certain "business transfer-like" conditions. However, many of Japan's tax treaties (like the one with the U.S., Article 13(7)) restrict Japan's right to tax such capital gains realized by a resident of the other treaty country, unless the shares are part of a PE or are shares of a real property-rich company.
  • Internal Dealings for PEs: For foreign corporations with PEs in Japan, if an applicable tax treaty does not follow the AOA approach of fully recognizing internal dealings (e.g., internal interest or royalties between a PE and its head office), Japanese domestic law (Corporation Tax Act Art. 139, para. 2) will defer to the treaty. This means that, for calculating PE profit under such older treaties, certain internal dealings that domestic law might otherwise recognize (following the AOA) will not be taken into account, thus preventing a conflict with the treaty terms.

Practical Implications for U.S. Businesses Entering the Japanese Market

For U.S. businesses, understanding these Japanese domestic source income rules is the first step in assessing potential Japanese tax exposure. Key considerations include:

  • Nature of Activities: Will the activities in Japan give rise to a PE under the Japan-U.S. Tax Treaty? This is crucial for business profits.
  • Type of Income: Is the income from investments, services, royalties, or asset sales? The specific character of the income will determine which source rules apply.
  • Location of Assets and Performance of Services: The physical location of assets or where services are performed can be determinative for certain types of income.
  • Contractual Arrangements: The terms of contracts (e.g., for sales, licensing, services) can influence the sourcing of income.
  • The Japan-U.S. Tax Treaty: Always analyze the treaty provisions alongside domestic law, as the treaty can significantly alter taxing rights, often providing more favorable treatment (e.g., lower withholding rates, narrower PE definitions, or exemptions for certain capital gains).

Conclusion

The definition and scope of "domestic source income" are pivotal for any foreign enterprise, including U.S. companies, operating in Japan. It determines the reach of Japanese taxation and is a critical factor in structuring business operations, investments, and cross-border transactions. The 2014 tax reforms have further refined these rules, especially concerning income attributable to PEs, generally aligning them more closely with international norms like the AOA. However, the interplay with Japan's extensive tax treaty network means that a careful, case-by-case analysis is always necessary. For U.S. businesses, a thorough understanding of both Japanese domestic law and the provisions of the Japan-U.S. Tax Treaty is indispensable for effective tax planning and compliance. Given the inherent complexities, especially in structuring larger operations or transactions, consulting with tax professionals experienced in Japanese international taxation is strongly recommended.