The source of income is a critical concept for international tax purposes given it will usually define the extent to which a particular country taxes the income of foreign persons. A foreign company which has Japanese source income as defined under Japan’s domestic law may be subject to Japanese tax, through either suffering Japanese withholding tax on such Japan source income or having an obligation to file a Japanese tax return. Such a foreign company should look to see whether it can apply a tax treaty with Japan which may reduce the scope or rate of tax on its Japan source income.
The table here lists up the different types of Japanese source income found in the two key articles in Japanese tax law which define Japan source income, articles 138 and 161. These are discussed further below.
Following posts will discuss in greater detail the different types of income outlined in this table and this article explains the scope of Japanese taxation of foreign corporations, when they will suffer withholding tax and when they will have a tax filing obligation.
Corporation tax law article 138 and income tax law article 161
Japanese domestic law includes two key articles that define the scope of Japanese source income, Articles 138 in the Corporation Tax Law and Article 161 in the Income Tax Law. Article 138 applies to foreign corporations and Article 161 applies to non-resident individuals and also, rather confusingly, to foreign corporations in relation to imposing withholding taxes (for example, on interest).
Both articles 138 and 161 subdivide income into different types and it is common to refer to the paragraph within the article when referring to the type (e.g. Type 4 income is interest and similar).
Interaction of article 138 and article 161
It is helpful to think about how the above two articles overlap. Whether or not a foreign company has a Japanese tax obligation also depends on the nature of the relationship of the foreign company with Japan and the type of income concerned. In particular, whether income that has a Japanese source is taxable for the foreign company and if taxable whether subject to withholding tax or corporate tax on net income, will depend on whether or not the foreign company has a permanent establishment in Japan, the type of any such permanent establishment (whether a branch, a construction project or an agent PE) as well as the type of income. This relationship is shown in this diagram.
Article 138 applies to define the source of income for Japanese corporate tax purposes and Article 161 defines the source of income for Japanese withholding income tax purposes. Both articles apply to the income of a foreign corporation but if a foreign corporation which has a PE in Japan suffers Japanese income tax through withholding on income attributable to such a PE (under Article 161) then such income tax would normally be recoverable through credit against its corporation tax liability (arising under article 138) or through repayment.
Given that such Article 161 income tax is recoverable in the above circumstances there are administrative procedures within the Japanese tax system for the foreign company to certify to a payor of the income concerned that it has a PE in Japan and hence avoid the cash flow disadvantage of suffering the withholding income tax. Be warned however that these procedures are complex, involving a range of different forms and different times limits, and seemed designed to allow slip ups and so provide a chance for tax auditors to assess fines and penalties, a chance which they often take much to the extreme annoyance of many foreign investors given the fines will often be quite out of proportion with the economic loss to the tax authorities.
Gross and net income
Japan source income under Articles 138 and 161 is basically a gross income concept. When net income is being referred to a slightly different Japanese term will generally appear in the legislation “国内源泉所得に係る所得”/kokunai gensen shotoku nikakaru shotoku or still rather confusingly in literal translation, “income related to Japanese source income”. Watch out for this term.