#12 Key Takeaways from US-Japan Tax Treaty

The US-Japan Tax Treaty was first signed in 1971 and significantly revised on November 6, 2003, to reflect evolving business needs. Further updates have strengthened the treaty’s framework, with amendments implemented over the years. Among its 31 articles, several provisions are particularly relevant to companies starting or expanding their businesses in Japan— especially those concerning dividends, interest, and capital gains.

1. What is the US-Japan Tax Treaty?

The US-Japan Tax Treaty is a bilateral agreement aimed at preventing double taxation and combating tax evasion. In addition to the United States, Japan has similar agreements with over 50 countries, including the United Kingdom.

Originally signed in 1971, this treaty has undergone several updates and revisions, with the latest amendment in 2019.

For further details, you can access the full text of the treaty here:

English: US-Japan Tax Treaty
Japanese: 日米租税条約

2. Key Provisions of the US-Japan Tax Treaty

The treaty consists of 31 articles, covering a range of tax-related topics that are essential for businesses operating across borders.

In this article, we will look into detailed on Articles 5 through 17, which are further categorized into three key areas:

Day-to-day transactions between parent companies and subsidiaries
Transactions with third parties
Social insurance and employee-related provisions

2.1 Tax Treaties Related to Day-to-Day Transactions

Several treaty provisions are particularly important for companies conducting transactions between parent entities and subsidiaries, covering permanent establishments, business profits, transfer pricing, dividends, interest, and capital gains.

Articles 5 & 7: Permanent Establishment and Business Profits

The right to tax business income largely depends on whether the company has a permanent establishment (PE) in the country where it operates. The PE concept is crucial as it determines whether business profits are taxable.

If a company has a PE in Japan, Japan can tax its business profits.
If a company does not have a PE in Japan, its profits are generally not taxable in Japan.

The treaty defines PE as including:

Branches, factories, or similar fixed places of business (Branch PE).
Construction or installation sites exceeding a specified duration (Construction PE).
Persons authorized to conclude contracts on behalf of the company (Agent PE).

Understanding the PE status is critical for determining the tax obligations of foreign companies in Japan.

Example: A U.S.-based IT company that sets up a permanent office in Japan to directly engage with clients would likely create a Branch PE, subjecting its business profits to Japanese taxation.

Article 9: Associated Enterprises (Transfer Pricing)

Transfer pricing plays a vital role in preventing income shifting between related companies and tax avoidance. Article 9 ensures that transactions between a parent company and its subsidiary adhere to the arm’s length principle, meaning they should reflect market-based pricing.

To mitigate tax risks, the Advance Pricing Arrangement (APA) system allows companies to agree in advance with tax authorities on pricing methodologies, reducing the likelihood of double taxation.

Example: If a Japanese subsidiary purchases components from its U.S. parent company at a price below market value, the Japanese tax authorities may require an adjustment to reflect a fair market price, to prevent profit shifting.

Article 10: Dividends

Dividends paid by a Japanese subsidiary to a U.S. parent company are subject to reduced withholding tax rates under the treaty:

0%: If the parent company holds more than 50% of the voting shares for at least six months.
5%: If the parent company holds more than 10% but less than 50%.
10%: For all other cases.

To enjoy these benefits, companies must submit the "Application for Income Tax Convention" to the Japanese tax authorities.

Example: A U.S. company holding 60% of shares in its Japanese subsidiary was able to qualify for the 0% withholding tax rate by submitting the required documentation, resulting in significant tax savings.

Article 11: Interest

Interest payments from a Japanese subsidiary to a U.S. parent company are generally exempt from withholding tax under the treaty. However, companies should also consider:

Thin capitalization rules: Ensuring the debt-to-equity ratio is within acceptable limits.
Earnings-stripping rules: Limiting excessive interest deductions.

Example: A Japanese subsidiary borrowed funds from its U.S. parent company but ensured compliance with Japan’s thin capitalization rules to maintain full deductibility of interest expenses.

Article 13: Capital Gains

Gains on asset transfers are generally taxed in the transferor’s country of residence. However, there are a few exceptions, and they include:

Real estate located in Japan.
Shares in entities deriving significant value from Japanese real estate.
Business assets related to a permanent establishment.

Example: A U.S. real estate investment firm sold property in Japan and was taxed under Japanese regulations due to the asset’s physical location.

2.2 Tax Rules for Transactions with Third Parties

In the tax treaty, there are several articles that govern transactions between companies and third parties. The key areas include real estate income, shipping, royalties, and entertainers.

Article 6: Income from Real Property

A U.S. company earning income from real estate in Japan is subject to taxation in Japan on that income.

Article 8: Shipping and Air Transport

Profits from international shipping or air transport are taxable only in the company’s country of residence.

Article 12: Royalties

Royalties paid by a Japanese company to a U.S. entity are generally taxable only in the U.S. and exempt from Japanese withholding tax upon proper documentation.

Example: When a Japanese company paid royalties to a U.S. company for the use of proprietary technology. After filing the necessary forms, the payment was exempt from Japanese withholding tax, leading to tax savings.

Article 16: Artists and Sportsmen

Entertainers earning less than $10,000 from performances in Japan are exempt from Japanese taxation. If income exceeds this threshold, they are subject to taxation in Japan.

Example: A U.S. musician performing a one-time concert in Japan with earnings below the $10,000 limit was exempt from Japanese taxes.

2.3 Employee-Related Provisions

Article 14: Income from Employment

Salary earned by a U.S. resident for work performed in Japan is taxable in Japan, unless the individual stays in Japan for less than 183 days and other conditions are met.

Article 15: Directors’ Fees

Directors’ fees received by a U.S. resident from a Japanese company are taxable in Japan.

Article 17: Pensions and Social Insurance

Retirement pensions paid to U.S. residents from Japanese sources are generally taxable only in the U.S.

3. Required Documentation

To claim tax benefits under the US-Japan Tax Treaty, companies and individuals must submit the following forms:

Certificate of Residency (issued by tax authorities)
Notification Form Concerning Tax Treaty
Application for Relief from Japanese Income Tax (for withholding tax exemptions)
IRS Form 8833 (for treaty-based return positions in the U.S.)

4. Conclusion

The US-Japan Tax Treaty provides essential guidance for businesses engaged in cross-border transactions. Key provisions such as permanent establishment rules, transfer pricing, and withholding tax reductions can significantly impact tax planning.

To fully benefit from the treaty:

Companies must understand their PE status and tax liabilities.
Proper documentation and filings are crucial to securing tax benefits.

Seeking professional tax advice can help mitigate risks and ensure compliance with both U.S. and Japanese regulations

If you are considering expanding your business to Japan, please contact Quantum Accounting Inc. for a free consultation during the planning phase or general consultation (available in both English and Japanese). Quantum Accounting's professionals are experts in accounting, tax, legal, and labor issues. Our goal is to provide you with a one-stop professional firm for all the services you need to expand your business into Japan. We are confident that we can help you.