1. What is a Tax Audit?

A tax audit is an investigation conducted to confirm whether the content of tax returns submitted to the tax office by companies or sole proprietors is correct.

Japan's tax system adopts a self-assessment system, where taxpayers themselves calculate, declare, and pay their taxes. Therefore, tax authorities regularly check to confirm the accuracy of declarations. The purpose is to confirm that there are no errors or irregularities in the declared content, and if there are any issues, to request corrections to the proper declaration.

Tax audits are often conducted as part of a regular, cross-sectional verification process and do not necessarily imply "suspicion of wrongdoing." However, if there are undeclared amounts or calculation errors, it can lead to additional taxation, and if there was intentional concealment or misrepresentation, severe penalties may be imposed. 
 

2. Voluntary vs. Compulsory Audits

There are two types of tax audits: "voluntary audits" and "compulsory audits."

A voluntary audit refers to a tax audit conducted with the cooperation of the taxpayer. The tax office contacts the taxpayer in advance to arrange a visit, during which they review books and vouchers and ask questions to the person in charge. Although it's called voluntary, it generally cannot be refused. The scope of the audit period may be expanded depending on the situation. Most tax audits received by companies fall into this voluntary category.

On the other hand, a compulsory audit refers to a tax audit conducted based on a court warrant when malicious tax evasion is suspected. This is an audit with coercive power, and in some cases, investigations and seizure of evidence may occur. It is rare for sound companies to be subjected to compulsory audits, but accurate bookkeeping and sincere responses are required on a daily basis.  
 

3. Typical Tax Audit Process

Among tax audits, voluntary audits proceed through the following steps:
 

1. Prior Notification
The tax office will send a prior notification of the audit. At that time, the date and time of the audit, location, target tax items, audit period, and required documents will be communicated.
 

2. Scheduling and Internal Preparation
After receiving the notification, you will communicate with the tax auditor to confirm the schedule. Internally, organize necessary documents such as account books, evidentiary materials, contracts, and approval forms for the target fiscal year. If you wish to have your advisory tax accountant present, adjust their schedule as well.
 

3. On-site Audit
On the day of the audit, tax auditors will visit the company and first conduct interviews. Subsequently, they will review books and vouchers, and if there are any unclear points, they will request additional questions or document submissions. Inquiries may also be made to business partners.
 

4. Notification of Results
Once the tax audit is completed, the results will be notified to the company at a later date. If there are no issues, a "Certificate of Approval" will be issued, indicating that the declared content was appropriate. On the other hand, if undeclared amounts or errors are pointed out, a revised tax return and additional tax payment will generally be required.
 

The above is the general flow of a tax audit. If you have any objections to the points raised by the tax audit, careful consideration and consultation with your advisory tax accountant are required.
 

4. What Triggers a Tax Audit?

"How often will my company be audited?" is a major concern for business owners and CFOs. The frequency of tax audits varies depending on the company's size, industry, and the status of its declarations, but it is generally said to be about once every 3 to 10 years. For relatively small companies with low tax risk, an audit may not occur for over 10 years.

On the other hand, large companies with significant sales and employee numbers, or companies with a history of issues pointed out in past audits, tend to be audited regularly at shorter intervals.

Specifically, the following factors can affect audit frequency:
 

Extreme Fluctuations or Abnormal Values in Performance
Companies with significant increases or decreases in sales or profits compared to the previous period are more likely to be selected for audit to confirm the reasons. If the increase or decrease can be explained by temporary economic fluctuations or changes in business structure, it's understandable, but otherwise, there's a possibility of being suspected of incorrect declarations or omitted entries.
 

Industry and Transaction Type
Industries where historical instances of fraudulent accounting have been frequent tend to be targeted for focused audits. For example, industries primarily based on cash transactions are recognized as susceptible to undeclared sales or private use of expenses.
 

Previous Audit Findings
Companies that had issues pointed out in their previous tax audit may be subject to a follow-up audit within a few years. Conversely, companies that had no issues and were approved in their previous audit tend to have a lower audit priority, and the interval until the next audit tends to be longer.
 

As described above, the frequency and timing of audits are determined by various factors. It is important for companies to "be prepared for an audit at any time" and not to let their guard down just because an audit hasn't occurred for many years.
 

5. Business Impact of Tax Audits

Tax audits have a significant impact on companies. First, in terms of operational burden, a lot of time and manpower are required for document preparation and handling on the day of the audit. Not only the accounting department but also related departments need to be consulted, and additional documents need to be prepared. For foreign-affiliated companies, additional tasks such as reporting in English to headquarters and internal coordination also arise.

Furthermore, the monetary impact cannot be overlooked. If undeclclared amounts or errors are found during the audit, additional taxes, penalties, and delinquency charges may be imposed, potentially amounting to tens of millions of yen in some cases. If there is fraud severe enough to warrant heavy additional taxes, there is also a risk of the issue escalating to management accountability or damages.

Moreover, the impact on a company's credibility is also important. If there are large amended returns or heavy additional taxes, listed companies may have disclosure obligations, and negative media coverage could damage the company's image. This can lead to a decline in stock prices or affect credit ratings from financial institutions.

However, on the other hand, if an audit finds no issues, it confirms the appropriateness of tax processing, which has the effect of providing a sense of security both internally and externally. Even if issues are pointed out, they can be viewed positively as an opportunity to review internal rules and business processes, leading to strengthened internal control systems and governance. Appropriate responses and daily preparation are key to minimizing the impact of tax audits.
 

6. Practical Preparation Tips

The following are practical points that corporate accounting personnel and CFOs should be aware of when preparing for a tax audit:
 

Proper Retention of Books and Vouchers
Accurately record daily transactions in accounting books using the double-entry method without omission, and securely retain related evidentiary documents for the prescribed period. While Japanese tax law generally stipulates a 7-year retention period for books and vouchers, a 10-year retention period is necessary considering other regulations such as loss-making fiscal years and the Companies Act. Especially for foreign-affiliated companies, some documents may be managed by the head office, but tax law obliges the preservation of books and documents at the place of tax payment (within Japan). Therefore, caution is required, such as establishing internal rules for storage locations and methods.
 

Self-Check of Financial Statements and Declarations
After preparing annual financial statements and filing tax returns, conduct a self-check of their content. Specifically, it is effective to compare financial figures with the previous year and confirm whether there are reasonable explanations for significant fluctuations in items. Additionally, common points checked in tax audits include omissions or timing differences in sales and purchases, appropriateness of expense accounting, and the presence of mixed private expenses.
 

Collaboration with Tax Professionals
Not limited to foreign-affiliated companies, many businesses operating in Japan have advisory contracts with tax accountants who are well-versed in Japanese tax matters. In such cases, have them jointly review past declarations during the preliminary preparation stage. It is also recommended to have your advisory tax accountant present on the day of the audit whenever possible.
 

Follow-up After the Audit
Even after the tax audit is over, it is necessary to address the points raised and implement measures to prevent recurrence. If a revised declaration was submitted, it is important to report its content to the company's management and headquarters and formulate future improvement measures. By reflecting the lessons learned from the tax audit in internal rules, you can make use of them in subsequent tax audits.
 

7. Real-World Cases: What to Watch Out For

Based on actual cases of tax audits in Japan, here are appropriate response methods that foreign-affiliated companies should take.
 

[Case 1: Fraudulent Consumption Tax Refund]

• Overview: The company falsely inflated the value of export transactions and recorded fictitious export tax-exempt sales and taxable purchases.
• National Tax Agency Audit: Conducted an on-site audit for fraudulent consumption tax refunds, resulting in a large additional tax assessment.
• Response Method: Properly manage vouchers related to export transactions, export sales, and taxable purchases, and confirm consistency with actual transaction conditions.

[Case 2: Undeclared Income Related to Overseas Transactions (Controlled Foreign Company Taxation System)]

• Overview: Despite owning a foreign subsidiary located in a low-tax country, the Japanese corporation failed to apply the Controlled Foreign Company taxation system in its declaration.
• National Tax Agency Audit: Identified undeclared income based on local registration information and instructed correction for non-application.
• Response Method: Comprehensively manage foreign subsidiary information and confirm consistency between the actual situation of the foreign subsidiary and its tax treatment.

These cases suggest that thorough management of vouchers and understanding of the tax system are crucial for responding to tax audits.
 

8. Conclusion

We have explained the overview of tax audits in Japan and practical responses. Tax audits are nothing to fear if handled appropriately, but lack of preparation or mishandling can lead to significant damage such as additional tax burdens and loss of credibility.

Particularly for foreign-affiliated companies, which may be unfamiliar with Japan's unique tax system and practices, prior preparation and support from tax professionals are key.

Referencing the points discussed in this article, regularly ensure thorough management of books and checking of declared content, and be prepared to calmly deal with an audit when it occurs. We hope that appropriate responses will lead to further strengthening of corporate compliance and improved credibility.

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