No Deduction for Deception: Japanese Supreme Court on Expenses for Tax Evasion Schemes

Date of Decision: September 16, 1994
Case Name: Corporate Tax Act Violation Case (平成元年(あ)第28号)
Court: Supreme Court of Japan, Third Petty Bench

In a significant criminal case with direct implications for corporate tax law, the Supreme Court of Japan on September 16, 1994, addressed whether payments made by a company to collaborators for their assistance in a tax evasion scheme could be deducted as expenses or losses when calculating the company's taxable income. The Court's decision firmly established that such expenditures, intrinsically linked to the falsification of accounting records, are not deductible, grounding its reasoning in the principle of "fair and appropriate accounting standards" mandated by the Corporate Tax Act.

The Anatomy of a Tax Fraud: Fictitious Costs and Paid Collaborators

The defendant company, X (formerly S.V.C. Inc.), was involved in real estate sales and other activities. X was prosecuted for violating the Corporate Tax Act by concealing income through the fraudulent recording of fictitious land development costs, thereby significantly under-reporting and underpaying its corporate income tax.

To execute this scheme, X enlisted the help of outside collaborators. These collaborators provided fictitious cost estimates and invoices for purported land development work that never actually occurred. Over two business years, X recorded a total of ¥284,642,200 in these bogus development costs. In return for their "cooperation" in this tax evasion effort, X paid these collaborators "commissions" or "fees" amounting to a total of ¥19 million.

When X's tax evasion came to light, a central issue arose concerning the tax treatment of these ¥19 million in payments: Could X claim these "commissions" as deductible expenses or losses against its corporate income, thereby reducing its taxable profit? The tax authorities, and subsequently the prosecutors, argued against such deductibility.

The Legal Framework: Deductible Expenses and "Fair Accounting"

To understand the Supreme Court's decision, it's essential to consider the relevant provisions of Japan's Corporate Tax Act:

• Article 22, paragraph 3 generally defines the amounts that can be deducted as "expenses" (sonkin) in calculating corporate income. These include the cost of goods sold, sales and general administrative expenses, and other losses (excluding those from capital transactions).
• Article 22, paragraph 4 is crucial. It stipulates that the amounts referred to in paragraph 3 must be calculated in accordance with "generally accepted fair and appropriate accounting standards" (公正妥当と認められる会計処理の基準 - kōsei datō to mitomerareru kaikei shori no kijun, often abbreviated as kōsei shori kijun).

While Japanese tax law, through judicial precedent and prevailing interpretation, generally holds that illegally obtained income is still subject to taxation, the question of whether illegally expended amounts can be deducted is more complex. Prior to this Supreme Court decision, lower courts had taken varied approaches to different types of illegal expenditures. For instance, payments exceeding statutory limits for brokerage fees in real estate transactions had been allowed as deductions by one court, while another denied deductibility for payments made to prevent the exposure of criminal acts. A 1968 Supreme Court en banc decision, sometimes associated with the "public policy/order doctrine," had denied the deductibility of certain shareholder "courtesy payments" that violated company law principles, but its broader applicability to all illegal expenses was considered unclear.

The Supreme Court's Verdict: "Fair Accounting Standards" Preclude Deduction

The Supreme Court dismissed X's appeal, thereby upholding the lower courts' denial of deductibility for the "commissions" paid for tax evasion assistance. However, the Supreme Court's reasoning was specifically and narrowly focused on the mandate of Article 22, paragraph 4.

The Court's logic was as follows:

1. Fictitious Accounting Violates Fair Standards: The act of recording fictitious expenses (the bogus land development costs) to conceal income is, by its very nature, an accounting treatment contrary to fact. Such a practice must be rejected under the "fair and appropriate accounting standards" (kōsei shori kijun) referred to in Article 22(4).
2. Payments Were for Falsification: The "commissions" paid by X to its collaborators were direct payments for their assistance in creating these fictitious expenses—that is, for their cooperation in carrying out this fact-contravening accounting treatment.
3. Nature of the Expense: Therefore, these payments were expenses incurred specifically to evade corporate tax by means of accounting practices that themselves violated kōsei shori kijun.
4. Deduction Itself Would Be Unfair Accounting: Consequently, the Supreme Court reasoned, allowing the deduction of such expenditures (the commissions) as business expenses or losses would also constitute an accounting treatment that fails to comply with "fair and appropriate accounting standards".

In essence, the Court held that if the underlying act facilitated by the payment is a violation of fair accounting principles for the purpose of tax evasion, then the payment itself cannot be treated as a deductible expense under those same principles. The Court found the lower court's judgment denying deductibility to be correct.

Notably, while the lower courts (Tokyo District Court and Tokyo High Court) had also denied deductibility, their reasoning had involved analyzing whether the payments met the definitions of "cost of goods sold," "expenses," or "losses" under the respective sub-items of Article 22, paragraph 3, in addition to considering Article 22, paragraph 4. The Supreme Court, in contrast, based its entire affirmative reasoning for non-deductibility solely on Article 22, paragraph 4 and the kōsei shori kijun. This focused approach suggested that even if such payments might arguably have some remote "business connection" under paragraph 3, their direct link to fraudulent accounting made them non-deductible under the overriding principle of fair accounting in paragraph 4.

Significance and Implications

This Supreme Court decision was a landmark for several reasons:

• Primacy of "Fair Accounting Standards" in Tax Evasion Costs: It was the first Supreme Court ruling to explicitly use the "fair and appropriate accounting standards" provision of Article 22(4) as the specific basis for denying the deductibility of expenses directly incurred to facilitate a tax evasion scheme involving accounting falsification.
• Internal Consistency of Tax Law: By centering its decision on a provision within the Corporate Tax Act itself (Art. 22(4)), the Supreme Court avoided the need to import broader, potentially more ambiguous, "public policy" or "public order" doctrines derived from other areas of law to disallow the deduction. This approach underscores the principle that the Corporate Tax Act should not be interpreted to condone or subsidize expenditures made for the very purpose of violating its own mandates. The lower courts had touched upon the idea that allowing such deductions would be self-contradictory for the Corporate Tax Act, which penalizes tax evasion.
• Scope and Application to Other Illegal Expenses: The PDF commentary suggests that this ruling was quite specifically tailored to the facts at hand—payments made for assistance in a tax evasion scheme that involved the creation of fictitious accounting entries. Its direct and automatic applicability to other forms of illegal expenditures (e.g., bribes that were not yet specifically addressed by subsequent legislation, or fines for non-tax related violations) was not definitively established by this decision alone and remained a subject of academic discussion.

Legislative Clarification and the Evolving Landscape

The issue of deducting illegal payments received further legislative attention later:

• Corporate Tax Act Article 55 (2006 Reform): In response to international obligations such as the UN Convention against Corruption, Japan's 2006 tax reform introduced Article 55 to the Corporate Tax Act. This article explicitly denies the deductibility of certain payments, most notably bribes to domestic or foreign public officials.
• Explicit Non-Deductibility of "Concealment Costs": To prevent a potential misinterpretation that any illegal expense not explicitly listed in the new Article 55 might thereby become deductible, the legislature also included in Article 55, paragraph 1, a provision explicitly denying the deductibility of "expenses required for acts of concealment or disguise" – precisely the type of payments at issue in the 1994 Supreme Court case.
• Official Interpretation and Ongoing Debate: According to explanations from Ministry of Finance officials at the time of the 2006 reform, the inclusion of "concealment costs" in Article 55 was intended as a clarification of existing law rather than a substantive change in the overall approach to other types of illegal expenses not specifically listed. This suggested that the reasoning of the 1994 Supreme Court decision, based on "fair and appropriate accounting standards," might still hold relevance for a broader range of illegal expenditures. However, legal commentators have noted that judicial practice in subsequent years has sometimes continued to examine the "business connection" of various illegal outlays under Article 22, paragraph 3, indicating that the comprehensive framework for assessing the deductibility of all types of illegal expenses remains an area of ongoing legal interpretation and debate.

Conclusion

The Supreme Court's 1994 decision delivered an unequivocal message: expenditures made to procure assistance in tax evasion through the falsification of accounting records are not deductible for corporate income tax purposes in Japan. By grounding this conclusion firmly in the Corporate Tax Act's own mandate for "fair and appropriate accounting standards," the Court reinforced the integrity of the tax system without needing to invoke broader, and potentially less precise, public policy doctrines. While subsequent legislation has specifically codified the non-deductibility of such "concealment costs" and other illicit payments like bribes, this ruling remains a key judicial precedent illustrating the fundamental principle that the tax law will not recognize expenses incurred in its own deliberate subversion. The broader applicability of its core reasoning to other categories of illegal expenses continues to be a subject of legal analysis.