The Income Tax Law categorizes income into ten types according to its source or nature (Income Tax Law (hereinafter referred to as the “ITL”) Article 21 No.1, Articles 23-35).
“Business income” is one of them.
The amount of business income is basically the remaining amount after deducting necessary expenses from the amount of income, such as sales.
In principle, “how to compute taxable income” for business income is the same for both Japanese and foreigners.
However, depending on whether you are a “resident” or “non-resident” under the Income Tax Law, whether the place where the business was conducted is in Japan or abroad, the “range” of business income that is actually taxed in Japan will vary.
Non-residents are not subject to income tax in Japan for income generated outside the country (i.e., foreign source income).
Only a specific type of Non-Foreign Source Income is taxed in Japan.
In the case of business income, only income related to business conducted through the place of business in Japan is taxed.
Therefore, there is no business income to be taxed if there is no place of business in Japan.
For ordinary residents (Permanent Residents), the total amount of business income (worldwide income) is included in the taxable income regardless of where the business was conducted.
On the other hand, residents who do not have Japanese nationality and who have been having an address or domicile in Japan for five years or less in the most recent ten years are defined explicitly as “Non-Permanent Residents (NPR) ”(ITL Article 2 Item 4).
The taxable scope of NPR is limited to the following three.
Non-Foreign Source Income is taxed in the year it generates regardless of payment location and remittance (immediately taxed). In contrast, Foreign Source Income is not taxed until it is paid in Japan or repatriated to Japan. (Taxed on remittance. Please see the blog “Income tax on remittance to Non-Permanent Residents” for details.)
Therefore, it is necessary to distinguish between Foreign Source Income and Non-Foreign Source Income in order to determine the range of the taxable income of NPRs.
Permanent residents also need to distinguish between Foreign Source Income and Non-Foreign Source Income in order to calculate the capacity for Foreign Tax Credit.
Of business income, “income of business conducted through the foreign place of business” (income attributable to place of foreign business) constitutes Foreign Source Income (ITL Article 95, Paragraph 4, Item 1).
Other business income is included in “Non-Foreign Source Income”.
For a sole proprietor, especially an NPR, doing business in multiple countries, the range of his/her taxable income for Japanese income tax purposes will vary depending on whether the business had been conducted through a “foreign place of business” or not. Therefore this judgment is quite crucial.
Unless otherwise specified by law, income attributable to foreign place of business shall be computed for each country (Basic Income Tax Circulation (hereinafter referred to as “ITBC”) 95-6) by applying the General Rules for computation of Business Income (ITL Article 221-3, Paragraphs 1 and 2).
There is a provision that business conducted through a foreign place of business is deemed as if it had been conducted by a separate enterprise independently from Japan business.
Specifically, income attributable to a foreign place of business shall be determined considering its contribution to and risk assumed for the entire business of the sole proprietor as if they were performed by an independent enterprise (ITL Article 95, Para 4, Item 1).
Necessary expenses are deductible only for those attributable to the foreign business.
Expenses required in common (common expenses) with the other income categories, other places of business shall be reasonably allocated then deducted (ITL Enforcement Ordinance (hereinafter referred to as “ITLEO”) Article 221-3, Para 6).
Internal transactions (such as the transfer of inventory) between places of the business are also regarded as transactions with independent third parties (ITLEO Article 221-3, Para 5).
The above rules provided in the ITL for calculating income attributable to foreign place of business have been drastically modified in response to the Action Plan No.7 of the BEPS project led by the OECD and are relatively new rules applicable to January 2019 onward.
However, the business model that the action plan envisaged is mainly conventional businesses such as manufacturing and wholesale/retail.
As for the case of service providers through the internet where the fixed place of business and actual place of service provision may not match, it is supposed to be subject to further discussion.
Therefore, they would face many difficulties that attributable income cannot be determined by only provisions provided in the ITL.
For example, if a lawyer who works alone but has multiple offices in Japan and overseas, it is unclear how the functions of each office should be defined and weighted.
I suppose the case where legal service is performed in Japan through the internet, but foreign offices are kept for mere registration as an attorney in each country should be treated differently from the case where the service is performed in each office while the lawyer actually worked there.
In the case of lawyers who cannot engage in business without registration in accordance with the law, it can be said that functions performed by each place of the registration are important. On the other hand, the function of an office merely for registration purposes may be viewed as “preparatory or auxiliary activities” (ITLEO Article 1-2, Para 4) and the contribution to the entire business (attributable income) may be valued almost zero.
When non-residents provide services to consumers and businesses in Japan using the Internet (service provision through electronic communications, etc.) as a sole proprietor, such services will be subject to Japanese Consumption Tax.
Besides, in the case of resident sole proprietor, consumption tax implication (domestic transactions = taxable / zero-rated / exempt, foreign transactions = out-of-taxation / in-scope of reverse charge) can be different by the location of business.
Multi-nationalization, globalization of sole proprietor outpace development of taxation.
For the time being, international sole proprietors would have to take discreet for each tax issue in the tax filing.