The Tokyo District Court (in Japanese commonly referred to as ‘東京地裁’) recently issued a decision in a case involving a plaintiff that had improperly capitalized costs into inventory in a prior financial year and then claimed a tax deduction for the write off of those costs in the subsequent financial year under appeal.
Although the facts of the case involved deceptive or inappropriate accounting (below ‘Inappropriate Accounting’ and in Japanese ‘粉飾決算’ or ‘funshoku kessan’) the decision involves fundamental issues on the timing of recognition of inventory expenses. The case is also quite straightforward and hence may be seen as having broader application. It seems likely the case will be appealed to the Tokyo High Court.
On the 10 September 2010 the 38th Division of Tokyo’s Local Civil Court denied an appeal from a Japanese company (the ‘Plaintiff’) against an assessment the Plaintiff had received from their jurisdictional tax office that disallowed the deduction of a loss claimed as a result of reversing Inappropriate Accounting of inventory costs of a prior financial accounting period.
The judgment noted that “…the losses arising from excessive capitalization of costs into inventory were deductible expenses of a prior financial accounting period, and accordingly are not costs of sales related to the revenue of the accounting period concerned…” and hence were not-deductible in period in which the tax deduction was orginally claimed.
Cost of sales under corporation tax law article 23-3-1
Article 23-3-1 of the Japanese Corporation Tax Law (link in Japanese) defines the tax deductible cost of sales (in Japanese ‘売上原価’ or uriage genka) for a given financial year end as the balance of inventory at the beginning of the financial year plus inventory purchased during the financial year less the balance of inventory at the end of the financial year.
The write off of the costs of prior year’s Inappropriate Accounting were not costs of the current year falling within this article. Article 23-3-1 clearly states that the amount of tax deductible cost of sales is the “…cost of sales related to the revenue of the financial year concerned…”.
Given that the losses arising from the Inappropriate Accounting were costs of prior years that were capitalized, they did not fall within the terms of the above article as being costs of sales relating to revenues of the current year as required. This was the case notwithstanding that the company had corrected the previous Inappropriate Accounting in the current period when restating its accounts.
A practical problem faced by taxpayers in Japan in circumstances where a restatement of their accounts is required (as a result of Inappropriate Accounting or more straightforward error) is that it is only possible to submit a revised tax return for a repayment of tax within a year of submission of the original tax return.
Note though that it may be possible under some rare circumstances – such as during corporate insolvency proceedings – to petition the authorities to exercise discretion in opening prior years to facilitate repayment of taxes arising from Inappropriate Accounting.
Therefore given the practical problems arising from this very short, one year deadline the practice of some taxpayers may have been to claim a tax deduction for the correction of an error in a prior year in the year in which the error is identified. The taxpayer may then seek to agree an appropriate treatment of the item with the tax authorities at the audit stage.
This case implies that – at least for circumstances with similar facts – the tax authorities’ may have less discretion in dealing with cases such as these in future.