Japan's Foreign Tax Credit System: How Does It Work for Japanese Corporations and PEs of Foreign Corporations?

For businesses operating across international borders, one of the most significant challenges is the potential for double taxation – where the same income is taxed by two or more countries. Japan, like many developed nations, provides a Foreign Tax Credit (FTC) system (外国税額控除 - gaikoku zeigaku kōjo) as a primary mechanism to alleviate this burden for its resident corporations and, more recently, for Permanent Establishments (PEs) of foreign corporations operating within its jurisdiction. This article delves into the key features and mechanics of Japan's FTC system.

1. The Purpose and Conceptual Basis of the Foreign Tax Credit

The fundamental objective of an FTC system is to mitigate international double taxation that arises when a taxpayer is subject to tax on the same income in both their country of residence (or operation, for a PE) and the country where the income is sourced. Japan's system operates on the "credit method," meaning that Japanese taxpayers can generally credit foreign income taxes paid against their Japanese tax liability on that foreign-source income.

This contrasts with the "exemption method," used by some other countries, where foreign-source income is simply excluded from the domestic tax base. Japan primarily employs the worldwide income taxation principle for its resident corporations, making the FTC crucial. Under this principle, a Japanese resident corporation is taxed on all its income, regardless of where it is earned. The FTC then serves to reduce the Japanese tax payable by the amount of foreign tax incurred on income earned abroad. Historically, Japan's FTC system was first introduced in 1953, with major reforms in 1962-63 aimed at supporting the overseas expansion of Japanese businesses. Further significant revisions occurred in 1988, 2009 (which notably replaced the indirect FTC for subsidiary dividends with an exemption system), and 2014.

2. Who Can Claim Foreign Tax Credits in Japan?

Historically, the FTC in Japan was primarily available to:

• Resident individuals (under Article 95 of the Income Tax Act).
• Japanese domestic corporations (内国法人 - naikoku hōjin) (under Article 69 of the Corporation Tax Act).

The 2014 tax reforms marked a significant expansion of eligibility. The FTC system was extended to:

• Non-resident individuals with a PE in Japan (under new Article 165-6 of the Income Tax Act), for foreign taxes paid on income attributable to their Japanese PE that is sourced from a third country.
• Foreign corporations (外国法人 - gaikoku hōjin) with a PE in Japan (under new Article 144-2 of the Corporation Tax Act), for foreign taxes paid on income attributable to their Japanese PE that is sourced from a third country.

This article will primarily focus on the FTC for domestic corporations (under Article 69 of the Corporation Tax Act) and the provisions for PEs of foreign corporations.

3. What Foreign Taxes Are Creditable (Creditable Foreign Corporate Taxes)?

Not all foreign taxes paid can be credited. The FTC is generally available for "foreign corporation tax" (外国法人税 - gaikoku hōjinzei), which is defined as a tax levied by a foreign government (national or local) that is equivalent to Japanese corporate income tax and is imposed on a corporation's income (Corporation Tax Act Art. 69, para. 1; Cabinet Order for the Corporation Tax Act Art. 141, para. 1).

Specifically, creditable foreign corporate taxes include:

• Taxes on specific portions of corporate income, such as excess profits taxes.
• Surtaxes on corporate income tax (but not penalties or interest on tax deficiencies, which are generally non-creditable as they are not taxes on income).
• Taxes levied on a corporation's gross revenue or similar base as a matter of administrative convenience for tax collection, provided such taxes are essentially substitutes for a tax on net income (e.g., withholding taxes on dividends, interest, or royalties).
• Under certain conditions, taxes imposed on a corporation's gross revenue.

However, certain foreign taxes are explicitly excluded from being creditable:

• Taxes for which the taxpayer can arbitrarily request a full refund from the foreign government.
• Taxes for which the taxpayer can arbitrarily determine the period of deferral for payment.
• A portion of foreign tax considered to be "at a high rate" (高率な部分 - kōritsuna bubun). Generally, this refers to foreign corporate tax rates exceeding a certain threshold (e.g., notionally around 35% for general corporate income, or 10% for withholding tax on interest, as detailed in Cabinet Order Art. 142-2). The policy rationale is that Japan will only credit foreign taxes up to a level that reflects its own tax burden; if a foreign country taxes at a much higher rate, that excess is a matter for the taxpayer and the foreign jurisdiction, not something Japan will subsidize through its FTC.
• Foreign taxes levied on income arising from transactions that are not recognized as ordinary business transactions for the Japanese corporation (e.g., certain tax-motivated transactions designed to absorb excess FTC capacity). This provision was strengthened following cases involving schemes to generate artificial foreign tax credits (referencing the Supreme Court judgment of December 19, 2005 in the Risona Bank case context).
• Foreign taxes imposed on amounts that would not be subject to Japanese corporate tax (e.g., if the tax base in the foreign country includes items exempt in Japan).
• If a tax treaty is applicable, any foreign tax paid in excess of the amount that the foreign country is permitted to tax under that treaty is generally not creditable.

The issue of selectable tax rates also arose in a notable case involving taxes paid in Guernsey. A Tokyo High Court judgment on October 25, 2007, initially denied FTC for a tax paid at a rate selected by the taxpayer from a range of options. However, the Supreme Court, in its judgment on December 3, 2009, overturned this, finding the tax creditable. Subsequent legislative amendments (Cabinet Order Art. 141, para. 3, item 3) clarified that if a tax rate is determined by agreement between the taxpayer and foreign tax authorities from multiple options, any portion of the tax resulting from a rate exceeding the lowest possible rate is generally not considered a creditable foreign corporate tax.

4. The Foreign Tax Credit Limitation: Calculating "How Much" Can Be Credited

A crucial feature of Japan's FTC system is the limitation on the amount of foreign tax that can be credited (控除限度額 - kōjo gendo gaku). A domestic corporation cannot simply credit all foreign taxes paid. The credit is capped to ensure that the FTC only offsets the Japanese tax that would otherwise be payable on that foreign-source income.

Japan uses an "overall limitation" method (一括限度方式 - ikkatsu gendo hōshiki). This means that all foreign-source income and all creditable foreign taxes are generally pooled together, rather than applying limitations on a per-country or per-item-of-income basis (though some internal categorizations effectively exist, especially with the dividend exemption).

The basic formula for the FTC limitation under Article 69, paragraph 1 of the Corporation Tax Act is:

FTC Limitation = A × (B / C)

Where:

• A = Japanese Corporate Tax Liability on Worldwide Income: This is the Japanese corporate tax calculated on the company's total taxable income from all sources (before applying the FTC).
• B = Adjusted Foreign Source Income (調整国外所得金額 - chōsei kokugai shotoku kingaku): This represents the company's net income sourced outside Japan, subject to certain adjustments.
• C = Total Worldwide Taxable Income (所得金額 - shotoku kingaku): This is the company's total taxable income from all sources (the denominator for the Japanese tax calculation).

The fraction (B/C) represents the proportion of the company's total worldwide income that is derived from foreign sources. Multiplying the total Japanese tax (A) by this proportion effectively determines the amount of Japanese tax that is notionally attributable to the foreign-source income. The FTC is limited to this amount.

The rationale for this limitation is straightforward: Japan will relieve double taxation, but it will not use the FTC to reduce Japanese tax on purely domestic-source income, nor will it effectively refund foreign taxes that are levied at rates higher than Japan's own effective tax rate on that foreign income.

A key adjustment in calculating "B" (Adjusted Foreign Source Income) involves the exclusion of foreign source income that was not actually subject to foreign corporate tax in the source country (Cabinet Order Art. 142, para. 3). This rule is designed to prevent the artificial inflation of the FTC limitation by including tax-exempt foreign income in the foreign-source income pool, which could otherwise be used to cross-credit high foreign taxes paid on other income (a practice known as "cross-crediting" or 彼此流用 - hishi ryūyō). Initially, only a portion of such untaxed foreign income was excluded, but this has been tightened over the years, and current rules generally require the full exclusion of such untaxed amounts from the numerator of the limitation fraction.

Furthermore, there's a ceiling on the Adjusted Foreign Source Income (B): it cannot exceed 90% of the Total Worldwide Taxable Income (C) (Cabinet Order Art. 142, para. 3, proviso). This 90% cap was introduced to reflect an assumption that at least 10% of a company's income is attributable to activities or contributions from its domestic headquarters, even if a large portion of its income is technically foreign-sourced.

5. Defining Foreign Source Income for FTC Purposes

The 2014 tax reforms introduced a more explicit and positive definition of "foreign source income" (国外源泉所得 - kokugai gensen shotoku) for FTC calculation purposes, moving away from simply defining it as "income other than domestic source income." Article 69, paragraph 4 of the Corporation Tax Act now lists 16 categories of foreign source income.

A central category is "income attributable to a foreign branch or other foreign fixed place of business" (国外事業所等帰属所得 - kokugai jigyōsho-tō kizoku shotoku) (Art. 69, para. 4, item 1). Consistent with the AOA principles applied to inbound PEs, this income is determined as if the foreign branch were a separate and independent enterprise dealing at arm's length with the Japanese head office, considering functions, assets, risks, and internal dealings.

Other categories of foreign source income include income from the operation, holding, or transfer of assets located abroad; consideration for personal services provided abroad; rental income from real estate located abroad; and various types of investment income such as interest, dividends, and royalties received from foreign payers or related to foreign assets/operations.

6. Operational Aspects of the FTC

• Non-Deductibility of Credited Taxes: Foreign corporate taxes for which an FTC is claimed are not deductible as business expenses for Japanese corporate tax purposes (Corporation Tax Act Art. 41). Taxpayers can choose to deduct foreign taxes instead of claiming a credit, but the credit is usually more beneficial.
• Carryforward Provisions: If the creditable foreign taxes paid in a year exceed the FTC limitation for that year, the excess amount can generally be carried forward for 3 years to be credited in a future year where there is an excess limitation (New Corp Tax Act Art. 69, para. 3). Conversely, if the FTC limitation in a year exceeds the creditable foreign taxes paid, this "excess limitation" can also be carried forward for 3 years to potentially allow for the crediting of more foreign taxes in a subsequent year (New Corp Tax Act Art. 69, para. 2).
• Documentation for Internal Dealings: Similar to inbound PEs, Japanese corporations claiming FTC for income attributable to foreign branches must prepare and maintain documentation regarding internal dealings between the head office and the foreign branch to support the AOA-based profit calculations (New Corp Tax Act Art. 69, paras. 19 and 20).
• Transfer Pricing for Internal Dealings: If the terms of internal dealings between a Japanese head office and its foreign branch are not at arm's length, resulting in an overstatement of foreign source income for FTC limitation purposes, Japanese transfer pricing principles (under special taxation measures law) can be applied to recalculate the foreign source income based on arm's length terms (New Act on Special Measures Concerning Taxation Art. 67-18).

7. Interaction with Tax Treaties

Tax treaties also play a role in the FTC:

• Most treaties explicitly obligate the country of residence (Japan, in this context) to provide relief from double taxation, often specifying the credit method. For example, Article 23(1) of the Japan-U.S. Tax Treaty provides for Japan to grant a credit for U.S. taxes paid in accordance with the treaty.
• Treaties generally permit the residence country to apply its domestic FTC limitation rules.
• Treaty source rules can influence the determination of what constitutes foreign source income for the purpose of Japan's FTC (New Corp Tax Act Art. 69, para. 7).
• For foreign branches in countries with which Japan has an older tax treaty that does not fully adopt AOA principles for internal dealings, Japanese domestic law may restrict the recognition of certain internal dealings for FTC calculation to align with the treaty (New Corp Tax Act Art. 69, para. 8).
• Tax Sparing Credits (みなし外国税額控除 - minashi gaikoku zeigaku kōjo): Some of Japan's tax treaties, particularly with developing countries, include "tax sparing" provisions. These allow a Japanese company to claim an FTC for foreign taxes that were "spared" (i.e., not actually paid) due to tax incentives offered by the foreign country. The deemed paid foreign tax is then creditable in Japan, subject to limitations. However, Japan has been phasing out such provisions in its newer treaties and revisions due to concerns about potential abuse and their effectiveness as an aid measure.

8. Foreign Tax Credit for PEs of Foreign Corporations in Japan

The 2014 reforms allowing PEs of foreign corporations in Japan to claim an FTC (under new Corporation Tax Act Art. 144-2) address a specific "triangular" double taxation scenario. This occurs when a Japanese PE of a foreign corporation (e.g., a U.S. company's Japanese branch) earns income from a third country (e.g., dividends from a Singaporean company). This third-country income might be taxed in Singapore (as source country) and also in Japan (as part of the PE's attributable income). The FTC allows the Japanese PE to credit the Singaporean tax against its Japanese corporate tax liability on that income. This measure aligns with the principle of non-discrimination often found in tax treaties, which generally requires that a PE not be taxed less favorably than a domestic enterprise. The mechanics of this FTC for PEs largely mirror those for domestic corporations, including the overall limitation.

Conclusion

Japan's Foreign Tax Credit system is a complex but vital mechanism for Japanese corporations engaged in international business and for foreign corporations with PEs in Japan that earn third-country income. It aims to provide relief from international double taxation, thereby promoting cross-border trade and investment. Key features include the overall limitation method, specific definitions of creditable foreign taxes and foreign source income (now incorporating AOA principles for foreign branches), and detailed rules for calculation and carryforwards. The 2014 reforms significantly modernized the system, particularly by extending FTC eligibility to PEs of foreign corporations and by refining the definition of foreign source income. Effective management of the FTC, including understanding the limitation formula and the nature of creditable taxes, is a crucial aspect of international tax planning for businesses connected with Japan.