Labor Due Diligence in Japan: Key Issues for Foreign Companies in M&A and IPO Transactions

For foreign companies pursuing M&A transactions, an IPO, or stronger governance of their Japanese subsidiaries, identifying human resources and labor-related risks is an important management priority.

Unpaid overtime, improper classification of managers, failure to enroll eligible employees in social insurance, workplace harassment, and deficiencies in rules of employment or labor-management agreements can result in more than additional costs. These issues may also affect the acquisition price in an M&A transaction, the IPO timeline, corporate value, and the company’s reputation.

Japan has a number of country-specific labor regulations and practices. In addition to compliance with the Labor Standards Act and other labor-related laws and regulations, companies need to consider requirements relating to Article 36 Agreements (commonly referred to as “36 Agreements”), rules of employment, and social insurance procedures.

This article explains the key aspects of labor due diligence in Japan for foreign executives and management teams considering investments in or acquisitions of Japanese companies or subsidiaries, as well as IPOs in Japan.
 

1. What Is Labor Due Diligence in Japan?

Human resources and labor due diligence (“labor DD”) is the process of reviewing a target company’s HR and labor management practices in connection with an M&A transaction, IPO, or similar corporate event. Its purpose is to identify potential legal risks, procedural deficiencies, unpaid liabilities, and other HR-related issues.

While financial and tax due diligence primarily focus on financial information and tax risks, labor DD examines how employees actually work and how HR policies and systems are implemented in practice.
The principal areas of review include:
 

Japan’s labor-related regulatory framework is continually evolving, and the level of labor compliance expected of companies has increased accordingly.

Labor DD is therefore important not only for M&A and IPO transactions but also as a form of ongoing labor compliance audit for managing risks at Japanese subsidiaries.

2. Labor Risks to Review When Preparing for an IPO in Japan

Labor compliance is one of the important areas of review for companies seeking an IPO in Japan.

If issues such as unpaid overtime, inadequate working-hour management, deficiencies in Article 36 Agreements, or inappropriate classification of employees as managers or supervisors are identified, the company may need to correct its practices and make retroactive payments.

Such issues may affect not only financial results but also the assessment of the company’s internal controls and corporate governance.

In preparing for an IPO, where the fiscal year in which the listing application is submitted is designated as Year N, it is advisable to begin a labor compliance audit at an early stage, typically around Year N-3 to Year N-2.

Key areas requiring particular attention include:

• Working-hour management: Whether actual working hours are appropriately monitored using timecards, computer login/logout records, building access records, and other relevant data.
• Fixed overtime allowance arrangements: Whether the fixed overtime component is clearly distinguished from base salary and whether any additional overtime exceeding the covered hours is properly paid.
• Managers and supervisors: Whether employees classified as managers or supervisors satisfy the requirements under Japan’s Labor Standards Act based on their actual authority, responsibilities, and working conditions—not merely their job titles.
• Article 36 Agreements: Whether the required agreements have been properly executed, filed, and implemented.
• Differences in treatment based on employment status: Whether there are unreasonable disparities in working conditions between regular employees and fixed-term or other non-regular employees.
• Occupational health and safety: Whether the company has established the required systems and measures based on its size and other applicable criteria.

In Japan, an employee does not necessarily qualify as a “manager or supervisor” under the Labor Standards Act simply because the individual holds a title such as “Manager” or “Department Head.” This is an area that requires particular attention when a foreign company manages a Japanese subsidiary.

3. Why Labor Due Diligence Is Important in M&A Involving Japanese Companies and Subsidiaries

The primary purpose of labor DD in an M&A transaction is to identify HR and labor-related risks before closing that could otherwise materialize after the acquisition.

Management should focus in particular on the following four areas:

Depending on their significance, identified risks may be reflected in the valuation of the target company, the acquisition price, and the representations, warranties, and indemnification provisions of the share purchase agreement (SPA).

For key personnel, the buyer should also review employment terms, incentive arrangements, stock options, and other relevant conditions in order to assess the risk of post-acquisition departures.

Vendor Labor Due Diligence for Sellers

In an M&A transaction, the seller may conduct its own labor due diligence before commencing or completing the sale process. This is generally referred to as “vendor labor due diligence.”

Identifying issues in advance and correcting them to the extent possible can help reduce the likelihood of purchase price adjustments requested by buyers and minimize uncertainty during negotiations.

This can be particularly important when a foreign company is selling a Japanese subsidiary. Japan-specific labor issues that were not known to overseas headquarters may emerge during the transaction process. A pre-sale review can help identify such risks at an earlier stage.

Care Is Required When Changing Employment Terms During PMI

Labor DD is also directly relevant to post-merger integration (PMI).

When integrating rules of employment, compensation structures, employee benefits, and other HR systems following an acquisition, companies in Japan must exercise care when making changes to employment terms that may be disadvantageous to employees.

Rushed changes to HR policies or employment conditions can result in lower employee morale, the departure of key personnel, or labor disputes.

Labor DD should therefore also assess the costs and time required to integrate HR and labor systems following the transaction.
 

4. Key Areas Reviewed in Labor Due Diligence

Labor DD in Japan generally covers the following areas:

An effective labor DD review should go beyond confirming that the required documentation formally exists. It is equally important to determine whether written policies and systems are consistent with the company’s actual practices.

5. Typical Labor Due Diligence Process

Labor DD generally consists of the following five steps:

1. Define the objectives and scope of the review
   Confirm whether the review is being conducted for an M&A transaction, IPO, internal audit, or another purpose, and determine the entities, periods, and areas to be reviewed.
2. Collect and review relevant documents
   Review rules of employment, payroll ledgers, attendance and working-hour records, employment contracts, social insurance documentation, and other relevant materials.
3.  Interview relevant personnel
   Interview HR personnel and management to determine whether actual practices are consistent with the documentation provided.
4. Analyze risks and financial exposure
   Assess the materiality and urgency of identified risks and, where appropriate, estimate potential financial exposure, such as liabilities for unpaid overtime.
5. Report findings to management
   Prepare a report summarizing the findings, explaining the identified risks, and recommending any necessary corrective actions.

6. Cost and Timeline for Labor Due Diligence in Japan

The cost of labor DD varies depending on factors such as the number of employees and business locations, the scope and depth of the review, and the period covered.

Accordingly, fees are generally determined on a case-by-case basis after considering the size of the target company and the purpose of the review, such as an M&A transaction or IPO.

RSM Shiodome Partners offers both fixed-fee and time-based fee arrangements depending on the engagement. Specific fees are quoted after reviewing the circumstances of the target company and determining the required scope of work.

As a general guideline, labor DD typically takes approximately two weeks to one month from the time the required documentation is provided until the final report is issued.

The actual timeline, however, depends on the completeness of the available documentation and how quickly information is provided. If the M&A or IPO schedule has already been established, it is important to begin labor DD sufficiently in advance.

7. Key Risks Requiring Particular Attention in Labor Due Diligence

Typical risks identified during labor DD include the following.

Unpaid Overtime

If a fixed overtime allowance arrangement is improperly structured, or if an employee treated as a manager does not actually qualify as a “manager or supervisor” under the Labor Standards Act, the company may be required to make additional payments, including for prior periods.

Failure to Enroll Eligible Employees in Social Insurance

In some cases, part-time or other employees who are legally required to be enrolled in social insurance may not have been properly enrolled. There may also be deficiencies in required filings or the calculation of insurance premiums.

Employee Status of Independent Contractors and Freelancers

An individual may be classified as an independent contractor under a written agreement but, in practice, work under the company’s direction and supervision.

In Japan, whether an individual is considered an employee may be determined based on the actual nature of the working relationship rather than solely on the title or form of the contract.

Deficiencies in Rules of Employment and Article 36 Agreements

A company’s rules of employment may not reflect the latest legal requirements or actual working practices. Similarly, Article 36 Agreements may not have been properly renewed, filed, or implemented.

Addressing these issues may require not only revisions to policies and systems but also retroactive payments and changes to actual operating practices.

8. Benefits of Engaging a Certified Social Insurance and Labor Consultant for Labor DD

A Certified Social Insurance and Labor Consultant (Shakai Hoken Romushi, commonly known as a “Sharoushi”) is a nationally licensed professional specializing in HR and labor matters and social insurance in Japan.

Effective labor DD requires more than a formal review of contracts and internal policies. It is important to examine actual operations, including attendance and working-hour management, payroll calculations, and social insurance procedures.

Because Certified Social Insurance and Labor Consultants are routinely involved in these practical areas, they are well positioned to identify gaps between documented policies and actual practices.

They can also provide ongoing support with corrective actions following the identification of issues, including:

• Revising rules of employment
• Reviewing compensation structures
• Correcting social insurance procedures
• Addressing unpaid overtime
• Integrating HR and labor systems as part of PMI
   

9. Key Considerations for Foreign Executives

When assessing labor risks in Japan, relying solely on overseas headquarters’ rules or global policies may not be sufficient.

Foreign executives should pay particular attention to the following points:

• An employee classified as a “Manager” by overseas headquarters does not necessarily qualify as a “manager or supervisor” under Japan’s Labor Standards Act.
• Japan has specific rules governing fixed overtime allowances and Article 36 Agreements.
• Even where an individual has entered into an independent contractor agreement, the individual may be regarded as an employee depending on the actual working relationship.
• Social insurance and labor-related procedures for a Japanese subsidiary need to be reviewed separately from systems used by overseas headquarters.
• In M&A transactions, companies need to consider not only existing risks but also the integration of HR systems following the acquisition.

When acquiring a Japanese company or subsidiary, it is therefore important to review actual HR and labor practices alongside financial, tax, and legal due diligence.
 

10. Labor Due Diligence and Labor Compliance Audit Services in Japan by RSM Shiodome Partners

RSM Shiodome Partners’ Certified Social Insurance and Labor Consultants provide labor due diligence and labor compliance audit services in connection with IPOs, M&A transactions, business succession, and cross-border transactions in Japan.

Working together with certified public accountants, tax accountants, administrative scriveners, and a network of attorneys, RSM Shiodome Partners can assess HR and labor-related risks alongside financial, tax, and legal due diligence.

Our support extends beyond identifying risks. We also assist with corrective measures and post-merger integration, including revisions to rules of employment and compensation systems, remediation of unpaid overtime issues, and the integration of HR and labor systems following M&A transactions.

Leveraging RSM’s global network, we also support Japanese subsidiaries of foreign companies and cross-border M&A transactions.

If you are considering an M&A transaction involving a Japanese company or subsidiary, preparing for an IPO in Japan, or seeking to strengthen labor risk management at your Japanese operations, please contact RSM Shiodome Partners.
 

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