Introduction
The Japanese personal income tax system consists of various income categories, a progressive tax rate structure, social insurance premium deductions, a withholding tax system, determination of filing obligations, and criteria for residency in international taxation, among other multifaceted elements. Compared to other countries, it is more complex, and taxpayers with international relationships, such as expatriates, foreign residents, employees of multinational corporations, and overseas investors, need to pay careful attention to tax processing.
For companies, the management burden is significant due to payroll calculations, withholding tax, handling of overseas dependents, year-end adjustments, support for tax returns, and responses to tax audits.
This paper provides a comprehensive overview and explanation of the structure of Japan's individual income tax system and basic tax procedures from the perspective of an international tax expert.
1. The Basic Structure of Japan's Income Tax
The Japanese individual income tax is levied as a national tax based on the Income Tax Act, and the basic method is comprehensive taxation calculated by type of income; however, for certain types of income, separate declaration taxation and withholding taxation are also adopted.
The process for calculating income tax is as follows:
(1) Calculation of income amounts by income category
(2) Application of Necessary Expenses or Income Calculation Methods
(3) Total of each income
(4) Application of Income Deductions
(5) Calculation of Taxable Income
(6) Application of Tax Rates and Calculation of Tax Amount
(7) Application of Tax Credit
(8) Special Reconstruction Income Tax Surcharge
(9) Calculation of Resident Tax
Income categories are classified into 10 types, with representative examples including employment income, real estate income, business income, dividend income, capital gains, and miscellaneous income.
2. Progressive tax rates and special reconstruction income tax
Income tax is based on a progressive tax system, where the tax rate increases as income rises. The tax rates are set in a range from 5% to 45%, and an additional 2.1% is added as a special reconstruction income tax.
The resident tax is basically a flat 10% tax, and since this is supplemented by equalization levies and other factors, the effective tax rate varies significantly depending on income.
In international comparisons, Japan's highest tax rate tends to be higher than the OECD average, which also affects the migration and compensation design of high-income earners.
3. Resident Classification and Tax Scope
The most important aspect of taxation in Japan is the determination of the taxpayer's residency classification. Individuals are classified into one of the following three categories:
・Resident (Permanent Resident)
・Resident (non-permanent resident)
・Non-resident
Residents are subject to taxation on all income, both domestic and foreign.
Non-permanent residents are taxed only on the portion of foreign-sourced income that is remitted to the country.
Non-residents are only subject to taxation on income sourced within Japan.
The determination of residency is based on actual circumstances such as address, location, and length of stay, which differs from the criteria used by corporations. In the treatment of expatriates, short-term travelers, and remote workers, incorrect determinations can lead to significant tax risks.
4. Withholding Tax System and Year-End Adjustment
The Japanese salary income system adopts a withholding tax system, whereby the company is obligated to deduct and pay income tax at the time of monthly salary payment.
Additionally, while many salaried employees are exempt from filing a tax return due to year-end adjustments, there are also many cases where filing obligations arise, such as multiple sources of income, high medical expenses, the first year of mortgage deduction, stock income, and overseas asset holdings.
When foreign employees return to their home country or arrive for work, additional procedures such as tax adjustment for overpayment or underpayment, withholding tax obligations on retirement income, and the appointment of a tax representative are required.
5. Practical Implications of Income Deductions and Tax Credits
Income deductions include the basic deduction, spouse deduction, dependent deduction, social insurance premium deduction, medical expense deduction, and donation deduction, which all affect the calculation of taxable income.
On the other hand, tax credits have the effect of reducing the tax amount itself, with examples including mortgage interest deductions, foreign tax credits, and dividend deductions.
In particular, foreign tax credits are a central area of international taxation, aimed at eliminating double taxation on foreign income. On the other hand, the calculation of the deduction limit is complex, and there is a growing trend of tax audits pointing out application errors.
6. Individual Taxation for Expatriates and Foreign Workers
In personal taxation involving international transfers, it is necessary to coordinate residency determination, application of tax treaties, taxation of foreign income, and handling of social insurance. The following are particularly representative issues:
・Taxability of overseas salary incurred after returning to Japan
・Whether withholding tax is required for salary earned abroad
・Determination of Taxing Country for Salary Payments from Foreign Corporations
・PE risks due to secondment contracts and salary burden structure
・Evaluation and Taxation of In-Kind Benefits
・Determining Stay Duration and Misunderstanding the 179-Day Rule
The provisions on employment income in tax treaties (Article 15 of the OECD Model) include issues of consistency with Japan's withholding tax system, representing a significant area of tax management burden for companies.
7. Handling of Dependents Living Abroad
For dependents living abroad, strict documentation requirements have been established for the application of the dependent exemption.
To apply, objective evidence such as remittance certificates and proof of family relationships is required, and there is a growing trend of tax denials due to insufficient documentation.
In companies with a particularly high number of multinational employees and foreign students, managing the risks associated with the excessive application of dependent deductions becomes important.
8. Retirement Income and Stock Compensation
Retirement income is taxed separately from other types of income, and it has the characteristic of a lower effective tax rate due to special deductions and half taxation.
On the other hand, there are many practical issues such as the deductibility of executive retirement benefits, allocation based on the period of employment, taxation of non-residents, and the relationship with tax treaties.
Additionally, with the proliferation of stock compensation systems such as stock options, RSUs, and ESPPs, the determination of tax timing from grant to vesting and sale has become more complex. While salary taxation is fundamental in Japanese tax law, there are systems in countries like the United States that treat it as capital income, necessitating adjustments for double taxation.
9. Overseas Asset Holding and Reporting System
The disclosure systems regarding overseas assets, such as the foreign asset report, the asset and liability report, and the CRS reporting system, are being strengthened.
In particular, the following systems have a significant impact on the wealthy, investors, and expatriates:
・Foreign Asset Reporting System
・Exit Tax (Taxation System upon Leaving the Country)
・Financial Information Coordination through the Introduction of My Number
Due to the exit tax, when holders of financial assets exceeding 100 million yen move abroad, they are taxed on unrealized gains from stocks, which significantly impacts their migration strategy.
10. Impact of International Tax Changes and Residency Status
The type of residency status can affect tax risks. For example, depending on the type of residency status such as Technical, Humanities and International Services, Management, Highly Skilled Professionals, or Diplomatic/Public Affairs, the tax relationships and the applicability of tax treaty exemptions may vary.
Additionally, changes in status such as visa renewal, permanent residency, or short-term stay can affect tax management and the content of submitted documents.
11. Tax Audits and Personal Tax Risks
The focus of individual tax investigations has traditionally been on the wealthy and real estate income earners, but the scope has expanded to include areas such as international salaries, cryptocurrency, overseas investments, dependent deductions, and retirement benefits.
The typical examples of tax denial are as follows：
・Error in tax-exempt treatment of the overseas portion of salary
・Insufficient Dependent Deduction Documentation
・Incorrect application of mortgage loan deduction
・Stock option tax omission
・Incorrect Non-Resident Determination
・Failure to report cryptocurrency transaction income
In multinational corporations, errors in employee tax processing can also affect the company's transfer pricing tax matters.
12. Summary
The personal income tax system in Japan has a diverse structure that includes payroll calculations, deduction systems, stock income, foreign income, retirement benefits, and dependent deductions, and its complexity has been increasing year by year. Particularly in cases involving international transactions or overseas assignments, the combination of residency determination and taxation of foreign income can pose significant tax risks for both businesses and individuals.
The personal income tax in Japan is not just a matter of tax calculation; it is closely linked to corporate strategy, human resource strategy, and international tax strategy. As globalization progresses, its importance is further increasing. Companies must focus on withholding tax, payroll design, tax cost management, compliance with regulations, and strengthening internal controls, while individual employees need to ensure accurate reporting and secure documentation with the advice of tax professionals.