Seconding Employees to Japanese Subsidiaries: Understanding PE Risks and Tax Implications for the Foreign Parent Company

Japanese Attorney at Law - Bengoshi L.L.

• 9 min read

I. Introduction: Secondment of Employees to Japanese Subsidiaries – Unintended PE Risks for the Foreign Parent

Multinational enterprises (MNEs) frequently second key personnel—managers, technicians, sales staff, and other specialists—to their foreign subsidiaries. This practice, while common for operational, training, or strategic reasons, can carry significant, sometimes unintended, Japanese tax consequences if not structured carefully. Specifically, the activities of employees seconded from a foreign parent company to its Japanese subsidiary can potentially create a "Permanent Establishment" (PE) for the foreign parent company in Japan.

If a foreign parent is deemed to have a PE in Japan as a result of such secondments, a portion of its profits could be attributed to that Japanese PE and become subject to Japanese corporate income tax. This can lead to unexpected tax liabilities, complex compliance obligations, and potential double taxation if not properly managed. This article explores the primary PE risks—Service PE, Fixed Place PE, and Agent PE—that can arise in this context and discusses strategies to mitigate these risks. While examples will draw on general international principles, including logic similar to that applied by tax authorities in jurisdictions like China for outbound secondments, the focus is on the foreign parent's PE risk in Japan.

II. What is a Permanent Establishment (PE) in Japan? A Brief Overview

A PE is a core concept in international tax law signifying a taxable business presence of a foreign enterprise in another country. Under Japanese domestic law and its network of tax treaties, a PE generally arises in one of three main ways:

  1. Fixed Place PE: A fixed location (e.g., office, factory) in Japan through which the foreign parent's business is carried on.
  2. Construction PE: A construction or installation project in Japan lasting beyond a specified duration (typically 12 months).
  3. Agent PE: An agent in Japan (other than an independent agent) acting on behalf of the foreign parent and having/exercising authority to conclude contracts for the parent, or playing a principal role in such conclusions.

Additionally, many of Japan's tax treaties include specific provisions for a Service PE, which is particularly relevant in the context of employee secondments.

III. How Secondment Can Create a PE for the Foreign Parent in Japan

The primary PE risks for a foreign parent company seconding employees to its Japanese subsidiary arise if those employees, while in Japan, are deemed to be conducting the business of the parent company rather than solely the business of the Japanese subsidiary.

A. Service PE (under Tax Treaties)

This is a significant risk. Many of Japan's tax treaties (especially more recent ones or those updated post-BEPS, like the 2019 protocol to the Japan-China treaty) contain a Service PE clause. A Service PE can be triggered if:

  • Employees or other personnel of the foreign parent company furnish services within Japan. These services might be provided directly to the Japanese subsidiary or to third-party customers in Japan on behalf of the parent.
  • These service activities continue (for the same project or connected projects) within Japan for a period or periods aggregating more than a specified threshold – commonly 183 days in any 12-month period.

If these conditions are met under an applicable treaty, the foreign parent company is deemed to have a PE in Japan, and profits attributable to the services performed in Japan by its seconded employees will be subject to Japanese corporate income tax. The key is that the services are considered to be rendered by the parent company through its employees, even if those employees are formally assigned to the subsidiary.

B. Fixed Place PE

A Fixed Place PE for the foreign parent could arise if its seconded employees:

  • Have a fixed place of business at their disposal within the Japanese subsidiary's premises (e.g., a dedicated office space, specific desks, or facilities).
  • This space is used with a degree of permanence and regularity.
  • The seconded employees conduct the parent company's own business from this location, rather than exclusively performing duties for the subsidiary's distinct business operations. For instance, if a team of seconded employees uses an office at the subsidiary to manage the parent's regional sales strategy or oversee other investments of the parent in Asia, this could constitute a Fixed Place PE of the parent.

C. Dependent Agent PE (DAPE)

An Agent PE risk for the foreign parent can materialize in several ways through a secondment arrangement:

  1. Seconded Employees as Agents of the Parent: If the seconded employees, while working at or with the Japanese subsidiary, retain and habitually exercise authority to conclude contracts in the name of the foreign parent company with Japanese customers or partners, or if they play the principal role leading to the conclusion of such contracts for the parent. Their formal status as "seconded to the subsidiary" might be looked through if their substantive role is to bind the parent.
  2. Japanese Subsidiary as an Agent of the Parent: More commonly, the risk arises if the Japanese subsidiary itself acts as a dependent agent for its foreign parent. This can happen if the subsidiary's primary function becomes to solicit orders, negotiate contracts, or perform other core business activities almost exclusively on behalf of and for the benefit of the parent company, rather than conducting its own distinct business. If the subsidiary has little autonomy and essentially acts under the detailed direction and control of the parent for the parent's market activities in Japan, it could be deemed a DAPE of the parent. The 2018 Japanese tax reforms, broadening the definition of Agent PE, make this an area of increased scrutiny.

IV. Lessons from International Interpretations: The "Economic Employer" and Substance Over Form

While specific domestic rules apply in Japan, tax authorities globally, including Japan's NTA, increasingly adopt a "substance over form" approach, often considering concepts like the "economic employer" when analyzing secondment arrangements. Principles seen in other jurisdictions (like China's criteria for assessing PE from secondments, as described in SAT Announcement [2013] No. 19 for outbound secondments from Japan) offer insights into the types of factors that tax authorities may scrutinize to determine for whose business the seconded employees are truly working.

Japanese tax authorities might consider factors such as:

  • Responsibility and Risk: Which entity (parent or subsidiary) bears the ultimate responsibility and risk for the work performed by the seconded employees?
  • Authority and Evaluation: Who has the primary authority to instruct the seconded employees regarding their day-to-day tasks and longer-term objectives? Who evaluates their performance?
  • Remuneration and Reimbursement: How is the parent company compensated for the costs of the seconded employees (salary, benefits, etc.)?
    • Is it a simple cost-recovery recharge from the subsidiary to the parent?
    • Or, does the parent charge the subsidiary a service fee with a markup, suggesting the parent is providing a service (through its employees) for profit? A service fee arrangement could strengthen the argument for a Service PE if services are rendered in Japan.
  • Payroll and Benefits: Do the seconded employees remain on the parent company's payroll and participate in its benefit plans, or are they fully integrated into the subsidiary's HR systems?
  • Purpose and Duration: What is the stated and actual purpose of the secondment? Is it for a specific, temporary project or skill transfer benefiting the subsidiary's own distinct business, or does it represent an ongoing extension of the parent's core business activities into the Japanese market?
  • Direct Benefit to Parent: Does the parent company derive a direct and identifiable benefit from the specific activities performed by its seconded employees in Japan (e.g., developing the Japanese market for the parent's own products, directly overseeing the parent's strategic interests beyond normal shareholder oversight)?

If the overall arrangement indicates that the seconded employees are, in economic reality, performing functions primarily for the parent's business within Japan, or are furnishing services in Japan on behalf of the parent, a PE risk for the parent materializes.

V. Key Japanese Tax Reforms (2018) and Agent PE for the Foreign Parent

The 2018 tax reforms in Japan, aligning with BEPS Action 7, broadened the definition of an Agent PE. This is particularly relevant if the Japanese subsidiary's activities, potentially involving seconded personnel, could be construed as creating an agency relationship for the foreign parent:

  • "Principal Role" Standard: Even if the Japanese subsidiary or seconded employees do not formally conclude contracts in the parent's name, if they habitually play the "principal role" leading to the conclusion of contracts that are routinely finalized by the parent without material modification, this can create an Agent PE for the parent.
  • Narrowing of Independent Agent Exception: A subsidiary acting primarily for its parent is highly unlikely to be considered an "independent agent."

VI. Structuring Secondment Agreements and Arrangements to Mitigate PE Risk for the Foreign Parent in Japan

Careful planning and structuring of secondment arrangements are crucial to minimize the risk of creating a PE for the foreign parent in Japan.

A. Clear Definition of Role, Responsibilities, and Control

  • Secondment Agreement: The agreement between the parent and subsidiary, and any employment agreement between the secondee and the subsidiary (or an amendment to the secondee's parent-level employment), should clearly stipulate that the seconded employee will work under the exclusive direction, supervision, and control of the Japanese subsidiary.
  • Purpose of Secondment: The purpose should be clearly defined and focused on benefiting the subsidiary's own business operations (e.g., transfer of specific skills, temporary management support for the subsidiary).
  • Reporting Lines: Secondees should report to management within the Japanese subsidiary for their day-to-day activities in Japan.

B. Duration and Nature of Activities in Japan

  • Service PE Avoidance: If an applicable tax treaty has a Service PE clause with a day-count threshold (e.g., 183 days), carefully monitor the presence of seconded employees in Japan performing services that could be attributed to the parent. Structure assignments to stay below these thresholds if PE avoidance is critical, or acknowledge and plan for PE if exceeded.
  • Scope of Work: Limit the activities of seconded employees in Japan to those directly related to the subsidiary's business. They should not be performing core business functions of the parent or acting as representatives of the parent for the parent's separate business interests in Japan.

C. Remuneration, Cost Allocation, and Reimbursement

  • Direct Employment by Subsidiary (Ideal but Complex): Ideally, from a PE risk mitigation perspective for the parent, the Japanese subsidiary would directly employ and pay the seconded individuals. However, this can be complex regarding continuity of home-country benefits, social security, and repatriation.
  • Cost Reimbursement: If the parent company continues to pay the secondee's salary and benefits and is reimbursed by the Japanese subsidiary:
    • The reimbursement should be structured clearly as a cost-recovery mechanism without a profit element or service fee markup for the parent. A markup could imply the parent is providing a service (i.e., personnel provision) for profit, strengthening a Service PE argument.
    • Ensure the costs allocated are justifiable and relate only to the period of secondment to the Japanese subsidiary.
    • Avoid characterizing reimbursements as "management fees" or broad "service fees" to the parent unless they genuinely reflect distinct services provided by the parent entity itself (which then triggers separate transfer pricing considerations for those services).

D. Contract Conclusion Authority

  • It must be unequivocally clear that neither the seconded employees (acting on behalf of the parent) nor the Japanese subsidiary has, or exercises, any authority to negotiate or conclude contracts in the name of or on behalf of the foreign parent company in Japan. All such authority should reside with, and be exercised from outside Japan by, the parent company.

E. Documentation

  • Maintain contemporaneous documentation supporting the rationale for the secondment, the specific roles and responsibilities of the secondees within the Japanese subsidiary, the subsidiary's direction and control over their work, and the arm's length nature of any cost reimbursement arrangements. This includes the secondment agreement, relevant board resolutions, and internal communications.

VII. Interaction with Tax Treaties

  • The PE definition in the tax treaty between Japan and the foreign parent's country of residence is paramount. Treaty definitions (including for Fixed Place PE, Agent PE, and any Service PE clause) will generally override Japanese domestic law if they are more favorable to the taxpayer by setting a higher threshold for PE creation.
  • Limitation on Benefits (LOB) clauses in the treaty must be satisfied for the foreign parent to claim any treaty protection related to PE or the taxation of business profits.

VIII. Foreign Tax Credit Considerations for the Parent (If a Japanese PE is Found)

If, despite best efforts, Japanese tax authorities determine that the foreign parent company has a PE in Japan due to the secondment arrangement and assess Japanese corporate income tax, the parent company will typically seek a foreign tax credit (FTC) for this Japanese tax in its home country to alleviate double taxation.

  • However, the parent's home country tax authorities might scrutinize the basis of Japan's PE assessment. If the home country believes that Japan's finding of a PE is broader than what is permitted under the bilateral tax treaty (e.g., if Japan applies its domestic PE rules more aggressively than the treaty allows), the creditability of the Japanese tax could be challenged, limited, or denied in the parent's home country. This can result in unrelieved double taxation on the same profits.

IX. Conclusion

Seconding employees to Japanese subsidiaries is a common and often necessary business practice. However, it carries inherent risks of unintentionally creating a Permanent Establishment for the foreign parent company in Japan if not carefully structured and managed. The PE risks can manifest as a Service PE (under many treaties), a Fixed Place PE (if secondees have dedicated space for parent's business), or a Dependent Agent PE (if secondees or the subsidiary itself act to bind the parent in Japan).

The guiding principle for tax authorities is "substance over form." They will examine the economic realities of the secondment, including who exercises control, who bears risks, how costs are allocated, and for whose ultimate business benefit the secondees are working in Japan. Clear contractual agreements, meticulous management of the secondees' roles and duration of their stay in Japan, appropriate cost allocation methods that avoid a "service" characterization for the parent, and robust supporting documentation are all essential strategies for mitigating PE risk. Given the complexities and potential for significant tax consequences, consulting with experienced tax advisors in both Japan and the parent company's home jurisdiction is crucial before implementing secondment arrangements.