Providing Services from an Overseas Subsidiary to its Japanese Parent Company: Strategies to Avoid Creating a PE for the Subsidiary in Japan

Japanese Attorney at Law - Bengoshi L.L.

• 8 min read

I. Introduction: The Complexities of Intercompany Services and PE Risk in Japan

In today's interconnected global economy, multinational enterprise (MNE) groups frequently utilize specialized subsidiaries located in different jurisdictions to provide various services to other group members, including the parent company. When a foreign subsidiary provides services to its Japanese parent company, a key tax consideration for the MNE group is whether the foreign subsidiary's activities could inadvertently create a "Permanent Establishment" (PE) for that subsidiary in Japan.

The creation of a PE in Japan for the foreign subsidiary would mean that the profits attributable to that PE become subject to Japanese corporate income tax, leading to additional tax liabilities and compliance burdens for the group. While the Japanese parent is already taxable in Japan on its worldwide income, having its foreign service-providing subsidiary also trigger a taxable presence in Japan complicates intra-group dealings, transfer pricing considerations, and overall group tax efficiency. This article explores how such PE risks can arise for the foreign subsidiary and outlines strategies to mitigate them.

II. Understanding Permanent Establishment (PE) in Japan: A Recap

A PE is a concept in international tax law that signifies a sufficient business presence of a foreign enterprise in another country (the source country) to warrant taxation of profits derived from that presence by the source country. Under Japanese tax law and its network of tax treaties, a PE can generally take three forms:

  1. Fixed Place PE: A fixed place of business (e.g., an office, factory, workshop) through which the business of the foreign enterprise is wholly or partly carried on in Japan.
  2. Construction PE: A building site, or a construction, assembly, or installation project (or related supervisory activities) that exists in Japan for more than a specified period (typically 12 months).
  3. Agent PE: Arises when a person in Japan (other than an independent agent acting in the ordinary course of their business) acts on behalf of the foreign enterprise and habitually exercises authority to conclude contracts in the name of the foreign enterprise, or plays a principal role in concluding such contracts.

This article will focus on how a foreign subsidiary's service provision to its Japanese parent could lead to the creation of a Fixed Place PE or an Agent PE for the subsidiary in Japan, and also touch upon the concept of a "Service PE" often found in tax treaties.

III. PE Risks for the Foreign Subsidiary Providing Services to its Japanese Parent

While services provided by a foreign subsidiary entirely from outside Japan to its Japanese parent generally do not create a PE for the subsidiary in Japan, the risk can arise if the service provision involves activities or a presence within Japan.

A. Service PE under Tax Treaties

Many of Japan's modern tax treaties, or those updated in line with OECD/BEPS recommendations, include provisions for a "Service PE." A Service PE can be created if:

  • Employees or other personnel of the foreign subsidiary are present in Japan to furnish services (including consultancy services) to the Japanese parent (or other clients in Japan).
  • These services continue (for the same or connected projects) within Japan for a period or periods aggregating more than a specified threshold (commonly 183 days in any 12-month period) within any 12-month period.

If a treaty with a Service PE clause exists between Japan and the foreign subsidiary's country of residence, and these conditions are met, the foreign subsidiary will be deemed to have a PE in Japan, and profits attributable to those services performed in Japan will be taxable in Japan.

B. Fixed Place PE through Service Provision

A Fixed Place PE could potentially arise for the foreign subsidiary if its employees use an office or a specific space within the Japanese parent company's premises in Japan to perform services for the parent, and this use meets certain criteria:

  • Fixed Location: There must be a distinct place of business.
  • At the Disposal of the Subsidiary: The foreign subsidiary must have the space effectively at its disposal. Simply visiting the parent's office may not be enough, but having dedicated, continuous access to and use of an office space or facility could qualify.
  • Duration: The presence must have a certain degree of permanence.
  • Business Activity: The services performed through this fixed place must be part of the foreign subsidiary's business.

If the foreign subsidiary's personnel are continuously using a dedicated area within the Japanese parent's office to provide core services for the parent (and these services are not merely preparatory or auxiliary to the subsidiary's main business), this could be viewed as a Fixed Place PE of the subsidiary in Japan.

C. Agent PE for the Foreign Subsidiary

An Agent PE risk for the foreign subsidiary arises if another person or entity in Japan acts as its dependent agent. While it might seem counterintuitive for the Japanese parent to be an "agent" for its own foreign subsidiary, certain scenarios could lead to this, or related, concerns:

  1. Japanese Parent Acting for the Foreign Subsidiary with Third Parties: If the foreign subsidiary provides services not only to its Japanese parent but also to other Japanese customers, and the Japanese parent company's employees or representatives in Japan habitually play the principal role in negotiating and concluding service contracts on behalf of the foreign subsidiary with these third-party Japanese customers, the Japanese parent could be considered a dependent agent, creating an Agent PE in Japan for its foreign subsidiary.
  2. Recharacterization or Substance-Over-Form Concerns: Even in direct service provision from the foreign subsidiary to the Japanese parent, if the foreign subsidiary lacks genuine substance (e.g., it's a "letterbox company" with no real employees or capacity to perform the services it bills for) and the services are, in reality, substantially performed by the Japanese parent's own employees or directed in minute detail by the parent, tax authorities might, under transfer pricing principles or general anti-avoidance rules, seek to disregard the arrangement or reallocate profits. While not strictly creating a PE for the subsidiary through the parent acting as an agent, it could lead to adjustments that effectively tax the intended service income within the Japanese parent. However, the more direct PE risk for the subsidiary arises from its own activities or its own agents in Japan.

IV. Key Japanese Tax Reforms (2018) and Their Impact on Agent PE

The 2018 Japanese tax reforms, largely reflecting BEPS Action 7, significantly broadened the definition of an Agent PE under domestic law. These changes are relevant if the foreign subsidiary has any form of representation or conducts activities in Japan that could fall under agency principles:

  • Commissionnaire Arrangements: An agent in Japan concluding contracts in its own name but for the economic benefit of the foreign subsidiary can create a PE for the subsidiary.
  • "Principal Role" Standard: A person in Japan who habitually plays the "principal role" leading to the conclusion of contracts that are routinely concluded without material modification by the foreign subsidiary can create a PE, even if that person lacks formal authority to conclude contracts. This means focusing on the substance of who is actually driving the contractual process.
  • Narrowing of Independent Agent Exception: An agent acting exclusively or almost exclusively for the foreign subsidiary (and its related parties) is less likely to be considered an independent agent, even if legally separate.
  • Deletion of Specific Agent Categories: While old categories like "stock-holding agent" or "order-securing agent" were removed from the explicit PE definition, the activities they described can still be caught under the broadened "principal role" or commissionnaire-type rules if they contribute significantly to contract conclusion or core business functions.

These reforms emphasize a substance-over-form approach, looking at the actual functions performed in Japan.

V. Strategies to Mitigate PE Risk for the Foreign Subsidiary in Japan

When a foreign subsidiary provides services to its Japanese parent, the following strategies can help mitigate the risk of the subsidiary creating a PE in Japan:

A. Structuring Service Agreements and Operations

  1. Clarity on Service Location: The intercompany service agreement should clearly define the scope of services and, crucially, specify that services are to be rendered by the foreign subsidiary from its location outside Japan to the greatest extent possible.
  2. Managing Personnel in Japan (if unavoidable):
    • Limit Duration and Frequency: If the foreign subsidiary's personnel must visit Japan to provide services to the parent, carefully track their days of presence to stay below Service PE thresholds in applicable tax treaties (often 183 days).
    • No Fixed Place at Disposal: Ensure that visiting personnel do not have a dedicated office, desk, or facility within the Japanese parent's premises that is continuously at their disposal and from which they conduct the subsidiary's business. Ad-hoc use of meeting rooms is generally less risky than a permanent, designated space.
    • Limited Scope of Activities in Japan: The activities of visiting personnel should be clearly defined, directly related to the specific contracted services, and should not extend to negotiating or concluding contracts with third parties on behalf of the foreign subsidiary, or performing core, ongoing business functions of the subsidiary in Japan.
  3. Decision-Making Authority: Ensure that key decisions related to the foreign subsidiary's business (including the services provided to the parent and any third parties) are made by the subsidiary's management outside Japan. The Japanese parent should not exercise day-to-day control over how the subsidiary performs its services in a way that makes the subsidiary appear to be merely an extension of the parent's Japanese operations.

B. Ensuring Genuine Substance of the Foreign Subsidiary

  • The foreign subsidiary must be a genuine operating entity with its own qualified employees, resources, and capacity to perform the services it is contracted to provide. It should not be a mere "letterbox" or shell company set up primarily for tax purposes.
  • It should bear appropriate business risks associated with its service provision.

C. Transfer Pricing Compliance

  • While distinct from PE determination, ensuring that the service fees charged by the foreign subsidiary to the Japanese parent are at arm's length is vital for transfer pricing compliance.
  • Having a robust transfer pricing policy and documentation also supports the argument that the foreign subsidiary is a legitimate, independent service provider conducting bona fide intercompany transactions, rather than merely a conduit or an artificial arrangement.

D. Avoiding Actions by the Japanese Parent that Could Implicate Agency

  • If the foreign subsidiary also serves (or intends to serve) other Japanese customers, the Japanese parent company should not act in a manner that could constitute it as a dependent agent for its foreign subsidiary in Japan. This means the parent should not:
    • Habitually conclude contracts in Japan on behalf of the foreign subsidiary.
    • Habitually play the principal role in securing orders or negotiating essential terms of contracts for the foreign subsidiary with third parties in Japan.
    • Hold itself out as having authority to bind the foreign subsidiary.

E. Contractual Negative Covenants (Where Parent Supports Subsidiary's Third-Party Business in Japan)

If the Japanese parent company provides any support services in Japan related to its foreign subsidiary's business with other Japanese customers (a scenario distinct from the subsidiary servicing the parent), it's crucial that the scope of the parent's activities is clearly limited to preparatory or auxiliary services. The contract between the foreign subsidiary and its Japanese parent (for these support services) should explicitly state that the parent has no authority to conclude contracts in the name of, or on account of, the foreign subsidiary. However, substance will always prevail over form.

VI. The Role of Tax Treaties

  • Service PE Clauses: If the tax treaty between Japan and the foreign subsidiary's country of residence contains a Service PE article, its specific terms (e.g., type of services covered, duration threshold) will be paramount in determining if services performed by the subsidiary's personnel in Japan create a PE.
  • Fixed Place PE and Agent PE Definitions: Treaty definitions for Fixed Place PE and Agent PE will override Japanese domestic law definitions if they are different and more favorable to the taxpayer (i.e., if they set a higher threshold for creating a PE). Japan's 2018 domestic law reforms clarified this principle.
  • Limitation on Benefits (LOB) Clauses: If treaty benefits are invoked (e.g., to argue that a certain activity does not constitute a PE under a more lenient treaty definition, or to determine the taxation of profits if a PE is found), the foreign subsidiary must satisfy any LOB provisions in that treaty.

VII. Conclusion

When a foreign subsidiary provides services to its Japanese parent company, the MNE group must be vigilant about the risk of the subsidiary inadvertently creating a Permanent Establishment for itself in Japan. This risk is heightened if the subsidiary's personnel perform services within Japan for extended periods (Service PE or Fixed Place PE risk) or if the Japanese parent (or another entity in Japan) undertakes activities that could be construed as creating a dependent agency relationship for the subsidiary's business with third parties in Japan.

Careful structuring of intercompany service agreements, ensuring genuine operational substance in the foreign subsidiary, managing the presence and activities of subsidiary personnel in Japan, and maintaining arm's length transfer pricing are all critical steps in mitigating this PE risk. Given the fact-intensive nature of PE determinations and the evolving international tax landscape influenced by BEPS, MNE groups should regularly review their intercompany service arrangements involving Japan and seek expert tax advice to ensure compliance and avoid unwelcome tax surprises.