1. Overview: What Qualifies as Retirement Income Under Japanese Tax Law

Retirement income is a category of income under Japan's income tax system, primarily referring to income received when a lump-sum retirement payment is made. It's treated separately from employment income, and a significant feature is the tax preferential treatment given to retirement payments. In Japan, there's a custom of paying a lump-sum retirement benefit to employees and officers who have served for many years to reward their contributions. The tax system also considers this one-time retirement income.

The calculation method for retirement income is preferential, unlike other income types. Specifically, from the received retirement payment amount, a "retirement income deduction" (a fixed deduction amount determined by years of service) is first subtracted. Then, only half of the remaining amount is subject to taxation. While this system is originally intended to reward long-term contributions, tax authorities are closely monitoring this area as there are cases where it might be inappropriately used for tax avoidance purposes to lighten the tax burden.
 

2. How Retirement Payments Are Taxed in Japan

Japan's retirement benefit system primarily centers on lump-sum payments made by companies to employees as a reward for long service. Especially in Japanese companies, there's a custom of stipulating the calculation method for retirement benefits in work rules and executive retirement benefit regulations, and paying a prescribed amount upon retirement. For tax purposes, retirement benefits are treated as retirement income as mentioned above, and they receive preferential treatment by having half of the amount taxed after the retirement income deduction.

The calculation formula is: "(Retirement Income - Retirement Income Deduction) × 1/2" multiplied by the tax rate. This preferential treatment means that even if a large retirement payment is received, depending on the years of service, the tax amount might be significantly lower than if it were received as regular salary.

However, in recent years, this preferential treatment for retirement income has been reviewed. Specifically, for retirement benefits paid to short-term employees with 5 years of service or less, rules have been introduced that partially or entirely exclude the conventional one-half taxation. This amendment is a countermeasure against schemes to reduce tax burdens by paying high-value retirement benefits over a short period. This applies to cases where officers are seconded to a Japanese subsidiary of a foreign-affiliated company and then retire and return after a few years. Therefore, it's important to note that the expected tax benefits may not actually be received. 
 

3. Risks Arising from Excessive Retirement Payments

While the retirement income system is attractive, if the amount of the retirement payment is excessively large, tax risks arise. Tax authorities may question whether a retirement payment is "reasonable" if it exceeds a conventional amount, and they may deny the application of preferential tax treatment.

Especially large retirement payments to officers may be scrutinized closely. The portion exceeding the appropriate level may not be recognized as a deductible expense under the Corporate Tax Law, and for the individual receiving it, there's a risk that it will be taxed as employment income instead of retirement income.

The main risks caused by large retirement payments are summarized as follows:
 

Risk of Denial in Tax Audits
Unusually high retirement payments are easily checked during tax audits, and in some cases, they may be denied treatment as retirement income on the grounds of being "unreasonably excessive."
 

Increased Taxation on Both Individuals and Corporations
If the preferential treatment for retirement income is denied, that retirement payment will be taxed as regular salary for the individual recipient, potentially subject to the highest tax rates (45% income tax + 10% local inhabitant tax, etc.). Furthermore, for the corporation, the retirement payment that should have been deductible may become non-deductible, potentially increasing the corporate tax taxable income. Unexpected tax burdens thus arise for both the individual and the company.

In other words, it is important that "just because it's a retirement payment doesn't mean it gets tax benefits no matter how high the amount is." Retirement payments exceeding the level deemed appropriate for tax purposes will be considered to deviate from the spirit of the system, leading to unexpected increases in tax costs.
 

4. Common Grounds for Tax Disallowance

Under what specific circumstances can a retirement payment be denied for tax purposes? Cases where a retirement payment is judged as "not appropriate as a retirement payment" include the following:

• Amount is excessive in light of achievements or regulations: This is when the retirement payment amount is clearly too large compared to the company's performance or the individual's contribution. Setting an extremely large amount without objective justification may be deemed "unreasonably excessive" for tax purposes.
• Deficiencies in internal procedures: Under the Companies Act, providing retirement benefits to officers such as directors requires proper approval procedures, such as a resolution at a general shareholders' meeting. Retirement payments made without following this process, even if the amount is appropriate, may be problematic for tax purposes.
• Ambiguity of the fact of retirement: Caution is required if an officer formally retired from the company but is substantially still involved in the company. In such a case, the paid amount may be regarded as executive compensation rather than a retirement payment.

Behind the above is the tax authority's intention to uphold the original purpose of the retirement income system and prevent arbitrary tax avoidance. Japan's tax system provides preferential treatment for retirement benefits to reward long service. However, if this is exploited for short-term high-value payments or tax avoidance through nominal retirement, the fairness of the system is undermined. For this reason, tax authorities check the actual circumstances of retirement benefits and rectify formal retirements or unreasonably excessive payments.
 

5. Navigating Cultural and Regulatory Differences

For CFOs of foreign-affiliated companies and foreign national officers, the differences between Japan's and their home country's retirement benefit systems pose a significant challenge. While retirement benefits as a reward for long service are deeply rooted in Japan, in Western countries, explicit retirement benefit systems are less common, with severance pay and performance-linked incentives being prevalent. This difference in perception can easily lead to misunderstandings if Japan's retirement benefit preferential treatment is not correctly understood and high payments are mistakenly justified.

However, in Japan, excessively high retirement payments that exceed common social norms carry a high risk of tax denial, and under the Companies Act, retirement benefits to officers generally require a resolution at a general shareholders' meeting. While countries like the United States typically have no special tax benefits for retirement payments, it's important to note that in Japan, preferential treatment is only allowed within a reasonable scope. It is crucial to carefully explain the Japanese system and foster mutual understanding.
 

6. Practical Measures to Mitigate Tax Risk

To avoid tax risks related to retirement payments, it is important for the accounting and finance departments of foreign-affiliated companies to take several measures.

First, it is necessary to establish clear retirement benefit regulations and clearly define the calculation method and procedures for payments to ensure their validity. Next, formal approval procedures based on the Companies Act, such as resolutions at general shareholders' meetings or board of directors' meetings, must be observed. Furthermore, payment amounts should be set considering business performance, contribution, and market rates, taking care not to be excessive.

It is also effective to prepare documents that substantiate the basis and procedures for payment in preparation for future tax audits. If the amount is large, consulting with a tax specialist in advance can help mitigate tax risks.
 

7. Case Studies and Lessons Related to Retirement Payments

Here are lessons learned from actual cases concerning retirement payments.
 

[Case 1: Denial of Retirement Payment Due to Nominal Retirement]
Overview: This is a case where a retirement payment made in conjunction with a change in executive role from representative director to director was not recognized as a substantial retirement, and its deductibility was denied.

Points:

• The minutes of the extraordinary general shareholders' meeting or board of directors' meeting were not recognized as genuinely prepared.
• The commercial registration was not completed.
• The individual continued to substantially perform duties as a representative director even after "retirement."

Lesson: To prove a substantial retirement rather than a formal change in position, appropriate procedures and evidence are necessary.
 

[Case 2: Partial Denial of High-Value Retirement Payment]
Overview: This is a case where a retirement payment made to the bereaved family of a deceased representative was partially denied as being unreasonably excessive.

Points:

• It is generally recognized that a larger payment than usual is made to those who retire due to work-related death.
• The appropriate amount was determined by adding 3 years' worth of ordinary salary at the time of death, in accordance with tax law treatment, to the amount of ordinary retirement allowance calculated using the average contribution ratio of comparable corporations, considering the circumstances of work-related death.
• The portion exceeding that amount was deemed an unreasonably excessive executive retirement payment.

Lesson: The amount of retirement payments must be set within an appropriate range, considering work-related circumstances and the actual situation of comparable corporations.
 

[Case 3: Denial Due to Deficiencies in Retirement Payment Procedures]
Overview: This is a case where the deductibility of an executive retirement payment was denied because the approval procedures were not appropriately followed.

Points:

• Although internal regulations required approval from a general shareholders' meeting for the payment of retirement benefits, the retirement benefit was paid based solely on the fact of retirement, without undergoing the required approval.
• Given that no resolution was passed at the general shareholders' meeting, the retirement payment was not automatically deemed to be a confirmed liability merely based on the fact of retirement.

Lesson: It is essential to follow appropriate approval procedures based on regulations for the payment of retirement benefits.
 

8. Conclusion

Japan's retirement income tax system appears attractive for tax purposes, but preferential treatment is not unlimited and requires operation within an appropriate scope. Excessively large retirement payments or nominal retirements carry the risk of denial by tax authorities, and a response that understands the system's purpose and Japanese business practices is crucial.

For CFOs and accounting managers of foreign-affiliated companies, it will be important to provide thorough explanations to headquarters and foreign national assignees, establish internal regulations, and ensure proper procedures are followed to proactively manage tax risks.

Contact us

Complete this form and an RSM Shiodome Partners representative will be in touch.