Why is tax residency so important?
Under Japanese domestic law a Japanese resident is obliged to pay tax on their worldwide income. In order to meet this obligation, the resident has to either file an annual Japanese tax return or suffer Japanese withholding tax on their income and apply an exemption from filing a Japanese tax return.
Most Japanese company employees not to have to file an annual Japanese tax return given that, in many cases, their only source of income is from employment in Japan on which withholding tax has been imposed and their total annual employment income is below the threshold requiring a tax return to be filed. In contrast, a non Japanese expatriate individual coming to Japan may often have income from overseas (from rent or overseas investments) and such an individual would likely have to file a Japanese tax return once they become Japanese resident.
Note that unlike the US, Japanese tax residency and the obligation to file a Japanese tax return is not related to citizenship. A Japanese individual who is resident outside Japan would not have a Japanese tax filing obligation, although may still be taxed on his Japanese source income similar to other non-residents.
Three types of Japanese tax residency
Japan is unusual in defining three types of individual tax residency: resident, non-resident and non-permanent resident. Residents are taxed on worldwide income regardless of source country and non residents are taxed only on their Japanese source income. Non-permanent residents are taxed on (a) their Japanese source income; and (b) their non-Japanese source income to the extent that it is remitted to Japan.
Benefits of non-permanent resident status
Given the definition of the scope of the income on which non-permanent residents are taxed there are two main ways that non-permanent resident status can be of benefit to an individual. The first, most obvious of these benefits is that the non-permanent resident is only taxed on foreign income to the extent that it is remitted to Japan.
Income from offshore deposits of non-permanent residents, for example, is not subject to Japanese tax provided the amounts concerned remain offshore and are not remitted into Japan. Remittance into Japan in this context could include transferring funds to an account maintained at a Japanese bank or Japanese branch of a foreign bank or possibly constructive remittance, such as the use in Japan of a credit card that was settled with funds kept outside Japan.
Japan source income and “days in, days out”
The second less obvious way in which non-permanent resident status can be of benefit to an individual is through the favorable manner in which the scope of Japanese source income may be defined and calculated under certain circumstances. In particular, a non-permanent resident individual who is employed and paid on an overseas payroll and who spends part of the year working outside Japan may be able to apply a “days in, days out” approach to calculate his Japan source income. Provided that his salary for his “days out” is not remitted into Japan it may not be treated as Japan source income and hence Japanese tax would not apply while non-permanent resident status is maintained.
Given the complexity in this area a Japanese tax attorney should be consulted for more details. Later articles will look at this and other expatriate tax issues in more detail.
Definition of a resident under Japanese domestic law
When working out his residency status an individual should first consider his tax residency position under Japanese domestic law. If he is not resident in Japan under domestic law then the analysis is finished – he has non-resident status. However if he is resident under Japanese domestic law he should then consider whether any tax treaties may apply to his particular circumstances.
Tax treaties are agreements between Japan and other sovereign states that override domestic law with the intention of preventing double taxation (which, for example, might occur if an individual was found to be resident in Japan and another tax jurisdiction at the same time). A tax treaty may therefore under, some circumstances, override the expatriate’s residency status under domestic law, rendering him non-resident in Japan.
An expatriate who was resident in a country that has a tax treaty with Japan prior to his coming to Japan can probably apply the terms of tax treaty of the country in which he was so resident to establish whether or not he becomes resident in Japan.
Resident is defined in Japanese domestic law in Income Tax Law (ITL) Article 2-1-3 as a person who has an “address” in Japan or who has until the time of determination of resident status spent continuously a year or more in Japan. The term “address” (in Japanese「住所」) is interpreted according to the Japanese Civil Code Article 22 as a “base to carry on one’s life” (in Japanese「生活の根拠」).
The Japanese Tax Authority (NTA) web site interprets this definition in their question and answer section (link in Japanese). The NTA interpretation notes that in determining whether an “address” is a “base to carry on one’s life” giving rise to Japanese tax residence, they will consider the objective facts of the matter to determine where the “…center of that person’s life…” (in Japanese, 「生活の中心」 actually resides. The NTA note that where an individual stays in two or more countries, then in order to establish where his “address” is they will consider the nature of the work that he does, his employment contract and similar matters in order to make an initial assessment of his “address”.
Residence under tax treaties
The definition of residency is changed under Japan’s tax treaties (some of which can be found in English here). As an example, below is Article 4 of the Singapore Japan double taxation agreement which addresses residency. This section lists up in (a) to (c) below three tests used to determine residency in priority order. If none of the tests can be effectively applied then the two tax authorities will apply paragraph (d) to agree the country of residence between them.
It is worth noting that the term “…centre of vital interests…” in paragraph (a) is similar to the “address” and “base to carry on one’s life” residency concept used in Japanese domestic law. Treaties will however differ in their precise terms, as may the approach to interpret them. The terms of each treaty should be checked and appropriate advice taken.
Singapore Japan residency article
2. Where by reason of the provisions of paragraph 1 an individual is a resident of both Contracting States, then this case shall be determined in accordance with the following rules:
(a) he shall be deemed to be a resident of the Contracting State with which his personal and economic relations are closest (centre of vital interests);
(b) if the Contracting State in which he has his centre of vital interests cannot be determined, he shall be deemed to be a resident of the Contracting State in which he has an habitual abode;
(c) if he has an habitual abode in both Contracting States or in neither of them, he shall be deemed to be a resident of the Contracting State of which he is a national;
(d) if he is a national of both Contracting States or neither of them, the competent authorities of the Contracting States shall settle the question by mutual agreement.
Non resident and non permanent resident
A non-resident is the default category for any individual who is not held to be a resident of Japan under the rules described above.
Non-permanent resident is defined as a subcategory of Japanese residency. A non-permanent resident is, out of resident individuals, an individual who does not have Japanese citizenship and for whom, within the past ten years, a total of five years or less has been spent as a resident in Japan. Note that the definition of non- resident has changed in the recent years to this “five years out of ten” test to prevent potential abuse of non-permanent resident status by individuals who had been in Japan just under five years but who would leave the country to establish non-residence for a short period before returning.
Points to watch for
There are a couple of practical points to consider in relation to residency.
The Japanese tax authorities are likely to look at the employment terms of an expatriate sent to Japan. If the contract suggests that the period he is expected to be in Japan is a year or more then it is likely that the individual would be seen as resident from the time he arrives in Japan to start the performance of the contract.
Facts around the above residence test should be considered carefully. For example, if an individual leaves Japan but has an intention to return and also leaves his family behind, perhaps in a rented apartment in which they live continuously then it is possible that the authorities may assert the individual’s “..centre of vital interests…” or “…base to carry out their life…” has not changed and hence they have not broken their Japanese residence status.