Japan's "Attributable Income" Principle (Kizoku Shugi): How Does It Impact Foreign Companies with PEs?

For foreign companies conducting business in Japan through a Permanent Establishment (PE) – such as a branch, factory, or certain types of dependent agents – a critical aspect of their Japanese tax liability is the determination of profits attributable to that PE. Japan undertook a significant reform in its corporate tax law in 2014, fundamentally shifting how these profits are calculated. This reform moved Japan from an "entire income" or "force of attraction" type principle for certain PEs to an "attributable income" principle (帰属主義 - kizoku shugi), aligning its domestic law more closely with international standards, particularly the Authorized OECD Approach (AOA). This article explores this shift and its implications for foreign companies with Japanese PEs.

1. The Pre-2014 Landscape: The "Entire Income Principle" and its Limitations

Prior to the 2014 tax reforms, Japan's domestic tax law applied different scopes of taxation depending on the type of PE a foreign corporation had in Japan. Most notably, if a foreign corporation had a "fixed place of business PE" (事業所PE - jigyōsho PE), such as a branch or office, it was generally subject to Japanese corporate tax on its entire Japan-source income (全所得主義 - zen shotoku shugi). This meant that all income sourced in Japan, regardless of whether it was directly earned by or economically connected to the activities of that specific PE, could be taxed in Japan. This was often referred to as a "force of attraction" type principle, where the mere presence of such a PE could draw in other, unrelated Japan-source income of the foreign corporation for Japanese taxation purposes.

For other types of PEs, such as construction PEs or certain dependent agent PEs, the pre-2014 rules were somewhat closer to an attributable income concept, generally taxing only the Japan-source income that could be attributed to the activities of that specific PE.

This "entire income principle" for fixed place of business PEs created a significant divergence from the profit attribution rules found in most of Japan's tax treaties, which typically followed the OECD Model Tax Convention's Article 7. Treaty Article 7 generally limits the source country's (Japan's) right to tax the business profits of a foreign enterprise to only those profits attributable to the PE situated in that country. This discrepancy often meant that the actual scope of Japanese taxation for companies from treaty partner countries was governed by the treaty's attributable income principle, effectively overriding the broader domestic law "entire income principle."

2. The 2014 Reform: Embracing the "Attributable Income" Principle (Kizoku Shugi)

The 2014 tax reforms fundamentally changed Japan's domestic law approach to taxing PEs. The "entire income principle" for fixed place of business PEs was abolished. Under the new rules, for all types of PEs, a foreign corporation is now subject to Japanese corporate assessment tax only on the income that is properly attributable to its PE in Japan (PE帰属所得 - PE kizoku shotoku). This income is defined as domestic source income under Article 138, paragraph 1, item 1 of the Corporation Tax Act, and the scope of taxable income for PE-possessing foreign corporations is detailed in Article 141 of the same act.

The primary motivations for this shift were:

• Alignment with International Standards: To bring Japanese domestic law in line with the prevailing international standard embodied in the OECD Model Tax Convention and the principles of the Authorized OECD Approach (AOA).
• Elimination of Discrepancies: To reduce the gap between domestic law and the provisions of Japan's tax treaties, thereby simplifying the tax landscape for foreign companies from treaty countries.

3. The Authorized OECD Approach (AOA) as the Guiding Framework

The new "attributable income" principle in Japan is explicitly designed to be consistent with the Authorized OECD Approach (AOA). The AOA provides a framework for attributing profits to a PE based on the fiction that the PE is a functionally separate entity – as if it were a distinct and independent enterprise operating at arm's length from the head office and other parts of the foreign corporation of which it is a part.

This requires a two-step analysis:

1. Functional and Factual Analysis: This first step involves a thorough examination of the PE's operations to identify the economically significant activities it performs, the assets it uses and economically owns, and the risks it assumes in relation to the foreign corporation's overall business.
2. Comparability Analysis (Arm's Length Pricing): The second step involves applying transfer pricing principles (analogous to those used for transactions between separate associated enterprises under Article 9 of the OECD Model) to determine the arm's length compensation or profit attribution for the PE's functions, assets, and risks, including its dealings with other parts of the same enterprise.

4. Calculating PE Attributable Income: Key Considerations

Under the AOA-based kizoku shugi, the calculation of a PE's attributable income (governed by Article 142 of the Corporation Tax Act and further detailed in Cabinet Order Article 184) involves several key considerations:

A. Functions Performed, Assets Used, and Risks Assumed (FAR Analysis):
The amount of profit attributed to a PE will depend heavily on the FAR analysis.

• Functions: What economically significant activities does the PE undertake? This could include manufacturing, sales and marketing, research and development, provision of services, treasury functions, risk management, etc.
• Assets: What tangible assets (e.g., plant, machinery, inventory, office buildings) and intangible assets (e.g., patents, know-how, customer lists, goodwill developed by the PE) are used or economically owned by the PE in performing its functions? Financial assets relevant to its operations are also considered.
• Risks: What business risks (e.g., market risk, credit risk, inventory risk, operational risk) are economically assumed and managed by the PE? The attribution of risk is often linked to the functions performed in relation to that risk.

B. Recognition and Arm's Length Pricing of Internal Dealings (内部取引 - Naibu Torihiki):
A cornerstone of the AOA, and a major departure from Japan's pre-2014 domestic rules for PEs, is the recognition of internal dealings between the PE and its head office or other PEs of the same foreign corporation.

• Previously, Japanese domestic law generally did not recognize profit or loss arising from such intra-company dealings (e.g., notional interest on advances from head office to branch, or notional royalties for the use of head office intangibles by the branch).
• Under the new kizoku shugi and AOA, these internal dealings are now recognized for tax purposes. This means that if a PE, for example, "provides services" to its head office, or "uses" an intangible asset belonging to the head office, or "receives funding" from the head office, these internal transactions must be identified, and an arm's length price (or profit attribution) must be determined for them as if they were occurring between independent enterprises.
• This includes, for example, recognizing notional interest on internal loans, notional royalties for the use of intangibles, or notional service fees.
• There are some specific exceptions. For instance, Cabinet Order may exclude certain internal dealings like guarantees for debt that relate to the PE as a whole rather than specific transactions, or certain internal reinsurance arrangements, from generating a separate profit or loss element, on the basis that these do not involve a true transfer of risk or function in an arm's length sense.

C. Capital Allocation (資本配賦 - Shihon Haifu):
Consistent with the AOA, an appropriate amount of the foreign corporation's "free" capital (equity) must be attributed to the PE, as if the PE were a separately capitalized entity. If the PE's operations are financed by debt from the head office or third parties beyond this notional free capital, the deductibility of interest expense related to that excess debt may be limited (Corporation Tax Act Art. 142-4). This ensures that the PE is not overly leveraged with deductible debt at the expense of an appropriate equity base.

D. Documentation Requirements:
The shift to the AOA and the recognition of internal dealings significantly increases the importance of robust documentation. Foreign corporations with PEs in Japan are required to prepare and maintain detailed contemporaneous documentation supporting their functional analysis, the assets used and risks assumed by the PE, the nature and pricing of internal dealings, and the overall profit attribution methodology (Corporation Tax Act Art. 146-2). This is crucial for substantiating the PE's reported taxable income.

5. Impact on Foreign Companies with Japanese PEs

The 2014 reforms have several practical impacts:

• Elimination of "Force of Attraction": Japan-source income that is not economically attributable to the PE's functions, assets, and risks is generally no longer taxed as part of the PE's income. This is a significant benefit for companies that may have had minor PEs but substantial other, unrelated Japan-source income.
• Increased Complexity in Profit Calculation: While aligning with international standards, the AOA-based calculation is inherently more complex than the previous system. It requires a detailed FAR analysis and the application of transfer pricing principles to internal dealings, which can be data-intensive and require sophisticated economic analysis.
• Potential for Changes in Taxable Income: The AOA can lead to either an increase or a decrease in the taxable income attributed to a Japanese PE compared to the old rules, depending on the specific facts and circumstances. A PE performing significant functions, using valuable assets, and assuming substantial risks will likely be attributed a larger share of the foreign corporation's overall profit related to its Japanese activities. Conversely, a PE with limited functions might see its attributable profit decrease.
• Taxation of Third-Country Income Attributable to the PE: If a Japanese PE of a foreign corporation manages investments or conducts activities that generate income from a third country (i.e., a country other than Japan or the foreign corporation's home country), and this income is economically attributable to the PE's functions and risks, it can form part of the PE's taxable income in Japan. The 2014 reforms also extended Japan's foreign tax credit system to such PEs, allowing them to potentially credit taxes paid to the third country against their Japanese tax liability on that income.

6. Interaction with Tax Treaties

The new domestic rules are now generally more consistent with the profit attribution articles (typically Article 7) of Japan's modern tax treaties that are based on the OECD Model Tax Convention and already incorporate AOA principles (e.g., the current Japan-UK treaty).

However, for PEs of companies resident in countries with which Japan has older tax treaties that do not fully reflect AOA principles (e.g., treaties that might restrict the recognition of certain internal dealings like internal interest or royalties), Japanese domestic law (Corporation Tax Act Art. 139, para. 2) provides that the treaty provisions will prevail to the extent they differ. This means that if an older treaty specifically prohibits the recognition of, say, internal interest payments for PE profit calculation, that prohibition would override the general domestic AOA-based rule that would otherwise allow for such recognition. This ensures that Japan's domestic law changes do not lead to a breach of its existing treaty obligations.

Conclusion

Japan's adoption of the "attributable income" principle (kizoku shugi), guided by the Authorized OECD Approach, represents a significant modernization of its rules for taxing the profits of Permanent Establishments of foreign corporations. This shift brings greater alignment with international standards and the provisions of many of Japan's tax treaties. While it eliminates the outdated "force of attraction" concept for certain PEs, it also introduces a more complex, albeit more economically refined, methodology for calculating PE profits, heavily reliant on functional analysis, risk assessment, and the arm's length pricing of internal dealings. Foreign companies with PE operations in Japan must diligently apply these AOA principles, supported by robust documentation, to ensure compliance and accurately determine their Japanese corporate tax liabilities.