Introduction
Tax audits in Japan are an essential tax process that cannot be avoided, regardless of the size or industry of the corporation. Particularly in recent years, as international transactions and the number of global companies with bases in Japan have increased, issues related to international taxation, such as transfer pricing with foreign parent companies, transfer pricing regulations, permanent establishment (PE) recognition, withholding tax, foreign tax credits, and intercompany service fees, have become key focus areas for tax authorities.
For foreign-affiliated companies' Japanese subsidiaries and branches, appropriate responses to tax audits not only help avoid unnecessary tax risks but also present an important opportunity to demonstrate the compliance level of the entire group. This article systematically organizes the general flow of tax audits in Japan, issues specific to foreign-affiliated companies, necessary documents to prepare, points that are often overlooked in practice, and the processes following the audit. Drawing on insights as an international tax expert, the content is compiled to be immediately useful in practice.
1. The Basic Structure and Types of Tax Audits in Japan
The tax audits in Japan are broadly classified into "voluntary audits" and "mandatory audits (inspections)." Foreign-affiliated companies typically experience voluntary audits, which are further divided in practice into "on-site audits (so-called tax audits)" and "counter audits."
Voluntary field investigations typically involve several inspectors visiting a company after prior notification, where they conduct a question-and-answer session while reviewing books, contracts, transaction records, and so on. Conversely, a reverse investigation is conducted by the tax office to verify the actual transactions with business partners or affiliated companies, and it is carried out when it cannot be determined solely based on the company's internal documents.
In the case of foreign-affiliated companies, there is a tendency to require more documentation than usual due to the need to explain international transactions with parent companies and group companies. Additionally, if there is insufficient understanding of the overall accounting policies and internal controls of the group, it can lead to difficulties in explanations and potential miscommunication with tax authorities. Therefore, it is important for the company to prepare its structure in advance, having understood the basic framework of tax audits.
2. Notification of Tax Audit and Preliminary Preparation
Voluntary investigations typically begin with a scheduling notification received 1 to 2 weeks in advance. The period following the notification is very important, and it is necessary to ensure the following three points are addressed.
First, it is important to organize the financial statements, general ledgers, subsidiary ledgers, contracts, transfer pricing documents, internal regulations, and correspondence with the parent company for the fiscal year under investigation. Particularly in the case of foreign-affiliated companies, it often takes time to obtain materials provided by the parent company, and there are instances where the collection cannot be completed before the investigation begins.
Secondly, it is the preparation of anticipated questions and answers. Tax audits are not just about verifying documents; they primarily involve a question-and-answer session with the auditor. If the person in charge is not proficient in Japanese, it is advisable to seek support from an expert.
Thirdly, it is important to clarify the flow of movement and the division of roles among responders on the day of the survey. By deciding in advance on the internal meeting rooms, methods for reviewing materials, and how to compile questions, the survey can be conducted smoothly.
3. Research Issues Unique to Foreign-affiliated Companies
In the case of foreign-affiliated companies, the points of interest for tax authorities differ from those of domestic companies. The typical ones are as follows.
Transfer pricing regulations are the most typical issues, and they involve the methods for calculating services provided within the group, the reasonableness of profit allocation, and the selection of comparable data. Additionally, the determination of a permanent establishment (PE) is subject to investigation to see whether activities conducted by a Japanese branch or expatriates in Japan generate profits attributable to the parent company in their home country.
Furthermore, the proper handling of withholding income tax is also important, and any omissions in withholding tax deductions will be checked when payments to foreign corporations fall under categories such as usage fees, service provision, or lease payments. The reasonableness of intercompany service fees and cost-sharing agreements is also a matter for which detailed explanations may be requested by investigators.
International transactions emphasize the consistency of the contract's form, substance, and economic rationality, so it is necessary to organize the business model in a way that can be explained for tax audits.
4. Procedure for the Day of the Investigation and Practical Considerations
The first day of the investigation typically begins with an opening meeting, where the company overview, business activities, organizational structure, summary of international transactions, and accounting policies are explained. Investigators, having grasped the overall picture, narrow down the key points for verification.
What is important in practice is to avoid giving definitive answers to questions from investigators without careful consideration and to respond based on facts. If the person in charge answers unclear points with assumptions, it increases the risk of contradictions in subsequent explanations and prolongs the investigation.
It is also advisable to keep a log of the materials provided, clearly stating the date of provision, content, and reasons. In the case of foreign-affiliated companies, it often takes time to obtain materials from the headquarters, so there are many situations where "submission at a later date" is chosen. In such cases, it is important to clearly communicate the location of the supporting materials, the expected submission date, and the accountability for the explanation.
5. Points Raised After the Investigation and the Decision on Amended Tax Returns
After the investigation is completed, the tax office will provide an explanation of the points raised. The company will carefully examine whether the content is reasonable in light of laws, notifications, and precedents, and if there are points to contest, they will negotiate with the tax authorities.
In foreign-affiliated companies, it is often the case that identified issues impact global tax policies, making close collaboration not only with domestic entities but also with overseas headquarters essential. Additionally, when transfer pricing is a point of contention, it is necessary to consider the multi-year impacts and the risk of double taxation with the tax authorities of the other country.
Ultimately, if a company agrees with the tax office's view, it will file a corrected tax return; if it disagrees, it will wait for a correction notice and consider procedures such as filing an objection or engaging in mutual consultation.
6. Building a Strong Internal System for Tax Audits
It is important not only to respond to tax audits on a case-by-case basis but also to establish internal controls in preparation for the future. In particular, documentation is essential in the area of international taxation, and by systematically organizing and storing contracts, transfer pricing documents, internal policies, approval processes, and transaction evidence, the efficiency of audit responses can be significantly improved.
Furthermore, it is desirable to share insights gained from tax audits with the global headquarters to optimize risks across the entire group. Tax audits are not merely a burden; they also present an opportunity to strengthen internal controls and enhance transparency. By combining internal structural improvements with ongoing support from experts, foreign companies can build more robust and explainable tax governance.