Where such offset is not available a taxpayer may find themselves carrying forward a tax loss that they cannot use or losing the benefit of a tax loss altogether, hence paying tax on an amount of income greater than their overall economic gains.
For example, a foreign exchange hedging strategy may not be economically effective for an individual if a tax loss from a hedging derivative transaction cannot offset gains realized on the hedged asset because the losses are treated as having a different source of income where offset against the hedged gain is not permitted.
Particularly for expatriates with assets exposed to foreign exchange risk, understanding the Japanese individual tax rules around the offset of or carry forward of tax losses for different sources of income can be of key importance for a successful hedging or tax planning strategy.
Japanese loss offset
The Japanese individual tax system has a complex series of rules governing the offset of losses between different sources of income (for example income from employment, income from carrying on a business, investment income and so on) and governing the carry forward of tax losses that cannot be offset against other income. These rules reflect both matters of tax policy and also the historical development of the tax system so can sometimes appear arbitrary.
This article outlines the Japanese tax rules relating to the offset of losses between different sources of income, outlines important exceptions to these rules and also explains the order in which the loss set off rules apply.
Following articles will provide examples of the application of the rules concerned.
Before applying the loss set off rules a Japanese individual taxpayer has to first calculate his income or loss from each source of income under the relevant tax rules that apply to that source.
Please see this article for an outline of the tax return preparation process and the different sources of income.
Where a loss arises from Real Estate Income (in Japanese 不動産所得 or `fudousan shotoku’), Business Income (in Japanese 事業所得or ‘jigyou shotoku’), Mountain and Forestry Income (山林所得or shinlin shotoku) or Capital Gains (譲渡所得or ‘jyouto shotoku) such a loss can be offset against income or gains from other sources.
In contrast, losses arising from Dividend Income (in Japanese 配当所得 or ‘haitou shotoku’), Occasional Income (in Japanese 一時所得or ‘ichiji shotoku’) and Miscellaneous Income (in Japanese 雑所得or ‘zasshotoku’) cannot offset income or gains from other sources of income.
There are many exceptions and detailed rules that apply to the basic principles governing the offset of losses for Japanese individual income tax purposes.
In particular, although in principle losses arising from Real Estate Income, Business Income and Capital Gains can be offset against other sources of income, losses arising in the circumstances listed below are treated as not being available for such offset and hence cannot reduce income from other sources:
Assets not normally used in day to day life
Losses arising from defined “assets that are not normally required in day to day life” (below ‘Luxury Assets’) are not available for offset.
The definition of Luxury Assets can include race horses, gemstones, precious metals, pearls and similar above JPY300,000 in value, paintings, antiques, holiday homes and items used for hobbies or other enjoyment. Exceptionally, capital losses from the sale of race horses can be offset against miscellaneous income arisen from their ownership.
Interest to purchase land
Where a loss has arises on Real Estate Income, the amount of that loss attributable to the interest cost of borrowings for the purchase of land cannot be offset against other sources of income. See this article for more details and and example calculation.
Losses from certain trust and partnership investments
In order to address perceived tax avoidance through investments in partnerships that would generate tax losses from depreciation or similar, losses arising to certain partners in civil law partnerships or to beneficiaries of certain trusts cannot be offset against other income. This area is discussed in more detail in the article here.
Excess long term or short term Capital Gains
Where a long term Capital Loss has arisen it can be offset against short term Capital Gains and where a short term Capital Loss has arisen it can be offset against long term Capital Gains.
However, any amount of excess long or short term Capital Loss that could not be deducted after such an offset between long term and short term Capital Gains cannot be offset against other income.
Note, however, as an exception to this rule losses arising from the purchase and exchange of assets used for residential purposes can be offset against other sources of income or carried forward under certain special circumstances.
Capital gains from the sale of shares
Capital Losses from the sale of shares and similar assets cannot be offset against other gains. As an exception however, losses on the sale of listed shares can be offset against dividend income of the same year arising from listed shares.
Futures trading losses
Losses arising as Miscellaneous Income from futures trading cannot be offset against other sources of income.
Order of loss offset
The order in which one source of loss is offset against another source of income is often important in determining the final overall loss offset that is available. Loss offset is carried out in the following sequence of steps for Japanese individual income tax purposes:-
Step 1: Real Estate and Business Losses vs Ordinary Income
Losses arising from sources of Real Estate Income or Business Income (excluding amounts that are not subject to loss offset because of the exceptions listed above) are first set against Ordinary Income for individual tax purposes (in Japanese 経常所得 – for these purposes Ordinary Income is defined as the total of Dividend Income, Real Estate Income, Business Income, Employment Income and Miscellaneous Income).
Note that his rule allows the offset of Real Estate losses and Business Losses against Employment Income. This is often an important offset for an employed individual who also owns property or runs a second business.
Step 2: Capital Losses vs Occasional Income.
Capital Losses (to the extent that they do not fall within the exceptions to offset above) can offset Occasional Income
Step 3: Real Estate, Business Losses vs Capital Gains, Occasional Income
Losses arising from sources of Real Estate Income and Business Income that could not be completely set off at Step 1 above are then set off against Capital Gains, but limited to the amount of Capital Gains included in Comprehensive Income (in Japanese 総合課税の譲渡所得 or ‘sougou kazei no jyouto shotoku’).
Any remainder is then set off against Occasional Income remaining after completing the loss offset in Step 2 above. Where the Capital Losses include long and short term capital losses, short term capital losses deducted first.
Step 4: Residual Capital Gains vs Ordinary Income
Capital Losses that still could not be deducted under Step 4 are then offset against Ordinary Income (defined above in Step 1) to the extent any Ordinary Income remains after the loss offset in Step 1 above.
Step 5: Residual Real Estate Losses and Residual Business Losses
Where any losses from sources of Real Estate Income and Business Income remain after offset under Step 1 above, the residual amount may be offset against Mountain and Forestry income and Retirement Income in that order.
Step 6: Mountain and Forestry Income
Losses arising from sources of Mountain and Forestry income can finally be set off against Ordinary Income (after the deductions under Steps 1 and Steps 4 above.
To the extent any Mountain and Forestry Income remains undeducted it can then be offset against income from Capital Gains, Occasional Income (after the deductions in Steps 2 or 3 above) in that order.
If any losses still remain they can then be offset against Retirement Income remaining after any loss offset in Step 5 above. This circumstance where the Mountain and Forestry Income can be offset against long term and short term Capital Gain, the offset is first against short term Capital Gain.
The above rules are complex and also are not elective but apply automatically. Accordingly a taxpayer who has assets with unrealised losses should consider carefully when to realise those losses in order to maximize their offset against other income or through realizing gains in other assets. Please also see the examples of these rules applying in other articles on this site.