Why Labor Due Diligence Matters in Japanese M&A and IPOs: Differences from Financial and Tax DD and Key Coordination Points

Introduction

For foreign companies and international executives pursuing M&A transactions or IPOs in Japan, it is important to understand not only the financial and tax risks of the target company, but also risks relating to employment and labor management.

In an M&A transaction, the buyer, M&A advisors, or other parties may request labor due diligence (“Labor DD”) to identify employment-related risks and potential liabilities at the target company. Similarly, when preparing for an IPO in Japan, the lead underwriter, audit firm, or other advisors may require the company to review and remediate labor-management issues, including working-hour management and unpaid overtime.

While financial due diligence (“Financial DD”) examines a company’s financial condition and earnings capacity, and tax due diligence (“Tax DD”) focuses on tax-related risks, Labor DD reviews areas such as employment agreements, work rules, time and attendance management, payroll, and social insurance.

A particularly important aspect of Labor DD in Japan is determining not only whether policies and agreements are properly documented, but also whether “the written rules are consistent with actual practice.” If actual practices do not comply with the documented rules, the company may have off-balance-sheet liabilities such as unpaid wages or additional social insurance contributions.

This article is intended for foreign executives and professionals at multinational companies considering M&A transactions involving Japanese companies or IPOs in Japan. It explains the respective roles of Financial DD, Tax DD, and Labor DD, as well as the key points for coordinating the three workstreams.

1. What Is Due Diligence in Japanese M&A and IPO Transactions?

Due diligence (“DD”) is the process of examining a target company from multiple perspectives before making a decision on an M&A transaction, IPO, major investment, or similar transaction. Its purpose is to identify potntial risks and factors that could adversely affect the company’s value.

Due diligence may cover areas such as financial, tax, legal, business, labor and employment, IT, and environmental matters. Not every transaction requires the same scope of review. The appropriate areas are selected based on factors such as transaction size, the target company’s business, employee headcount, and anticipated risks.

In M&A transactions involving Japanese small and mid-sized companies, as well as in IPO preparation, financial, tax, and labor matters are often important areas of review. Because each area involves different information and expertise, they are generally handled by different specialists.
 

2. The Role of Financial Due Diligence

Financial DD is generally conducted by certified public accountants, audit firms, accounting firms, or similar professionals. Its purpose is to assess the target company’s financial condition and earnings capacity from a quantitative perspective.

The main materials reviewed include financial statements such as the balance sheet, income statement, and cash flow statement. Based on this information, the review examines matters such as off-balance-sheet liabilities, contingent liabilities, adjusted net assets reflecting the company’s underlying financial position, and normalized earnings after excluding temporary or exceptional factors.

The findings from Financial DD form an important basis for business valuation and may also be used in purchase-price negotiations and when considering representations, warranties, indemnities, and other provisions in a Share Purchase Agreement (“SPA”).

A review period of approximately three fiscal years is common.

3. The Role of Tax Due Diligence

Tax DD is generally conducted by Japanese tax accountants or other tax professionals. It assesses whether the target company has appropriately complied with Japanese tax requirements and whether there are potential risks of additional tax assessments in the future.

The review may cover corporate income tax, corporate inhabitant tax, enterprise tax, consumption tax, withholding income tax, and other taxes. Areas examined typically include past tax filings, responses to matters identified in tax audits, the treatment of tax loss carryforwards, intercompany transactions, and corporate reorganizations.

The review period is often approximately three to five years, taking into account the relevant periods under Japanese tax law for reassessments and determinations.

Tax risks identified through Tax DD may affect business valuation in the form of estimated future additional tax liabilities. They may also be an important factor when determining the M&A transaction structure, such as whether to use a share acquisition or a business transfer.
 

4. The Role of Labor Due Diligence

Labor DD is generally conducted by Certified Social Insurance and Labor Consultants (sharoshi) or attorneys. It examines the target company’s actual labor-management practices in light of Japanese labor laws and the social insurance system.

Key areas of review include work rules, employment agreements, labor-management agreements, working-hour management, payroll, fixed overtime pay arrangements, the treatment of managers and supervisors, enrollment in social and labor insurance, compliance with equal-pay-for-equal-work requirements, and harassment prevention frameworks.

Japan has a number of employment-related requirements that companies must comply with, including the so-called “Article 36 Agreement,” which is generally required when employees work overtime beyond statutory working hours or on statutory holidays. Foreign companies acquiring Japanese businesses therefore need to pay attention to issues that cannot necessarily be assessed solely by applying the HR policies and labor-management practices used in their home countries.

A key feature of Labor DD is that it reviews not only written policies and agreements but also how they are actually implemented.

For example, even if a company’s work rules establish an appropriate working-hour system, unpaid wages may still arise if attendance management or overtime calculations are not conducted in accordance with those rules. Similarly, if employees who should be enrolled in social insurance have not been properly enrolled, the company may face additional contribution liabilities.

To identify these types of off-balance-sheet liabilities, Labor DD may use approximately the most recent three years as a practical benchmark for review. In Japan, the statutory limitation period for wage claims is five years, although a transitional measure currently provides for a three-year period for the time being.

Labor DD is therefore more than a review of HR policies. It is a process for identifying risks that may lead to future costs, labor disputes, or issues in post-merger HR integration (“PMI”), and for incorporating those risks into management and transaction decisions.
 

5. Differences Among Financial DD, Tax DD, and Labor DD

The main differences among the three types of due diligence are summarized below.

All three types of DD share the same fundamental objective: to identify potential risks at the target company before the transaction and reflect them in investment decisions and transaction terms.

However, Financial DD mainly examines quantitative financial information, Tax DD focuses on tax filings and tax treatment, and Labor DD examines employment systems and actual workplace practices. Combining these different areas of expertise provides a more comprehensive understanding of the target company.

6. Why Labor DD Is Becoming More Important in Japanese M&A and IPOs

Traditionally, employment-related matters were often reviewed as part of Legal DD, particularly from the perspective of contractual and compliance risks. In recent years, however, Labor DD has increasingly been conducted as a separate specialist workstream.

One reason is the growing complexity of labor compliance in Japan. Companies must address a wide range of requirements relating to work-style reforms, equal pay for equal work, expanded social insurance coverage, and amendments to childcare and family-care leave systems.

Another important factor is the impact that off-balance-sheet liabilities such as unpaid wages can have on an M&A transaction. Following an amendment to the Labor Standards Act that took effect in April 2020, the statutory limitation period for wage claims was extended from two years to five years, while a transitional three-year period currently applies for the time being. Because the potential claim period is longer than before, liabilities such as unpaid overtime may have a greater impact on enterprise value.

Investors and management teams are also paying increasing attention to human capital. Workforce composition, employment terms, organizational structure, and human capital management practices are important considerations when planning post-acquisition management and PMI.

In IPO preparation, matters such as working-hour management, fixed overtime pay arrangements, the classification of managers and supervisors, and Article 36 Agreements may also become important areas of review. Labor DD is therefore used to identify issues before listing and implement necessary remediation.

7. Areas Where Financial, Tax, and Labor DD Overlap

Although Financial DD, Tax DD, and Labor DD are separate specialist areas, a single business issue can affect more than one workstream.

Personnel costs are a typical example.

Unpaid overtime, retirement benefit obligations, and deficiencies in social insurance contributions are employment-related issues, but they can also create financial burdens if additional payments are required after the acquisition. Depending on their accounting and tax treatment, they may also require tax analysis.

Independent contractor arrangements are another area requiring attention. Even if an agreement is formally structured as an independent contractor arrangement, the individual may be treated as an employee based on the actual manner in which the work is performed. This may have implications not only under labor law but also for social insurance, withholding tax, consumption tax, and other areas.

Representations, warranties, and indemnities in the definitive M&A agreement are also designed based on an integrated assessment of risks identified through the various DD workstreams. It is therefore important to establish a framework in which financial, tax, and labor specialists can share material findings on a timely basis.
 

8. Risks of Insufficient Coordination Among DD Workstreams

Conducting Financial DD, Tax DD, and Labor DD entirely independently may reduce the efficiency of the review and create issues for the final management decision.

For example, if each specialist separately requests documents, the target company may have to provide the same or similar materials multiple times. This increases the disclosure burden and may extend the overall DD schedule.

In addition, if an issue identified in one DD workstream is not shared with the other specialists, the same potential liability may be counted more than once or, conversely, a material impact may be overlooked.

In particular, if Labor DD identifies unpaid wages or additional social insurance liabilities but the financial impact is not incorporated into the financial analysis or purchase-price negotiations, unexpected costs may arise after closing.

9. Practical Points for Coordinating Financial, Tax, and Labor DD

To coordinate the three DD workstreams effectively, it is important not only to appoint specialists for each area but also to manage the entire due diligence exercise as a single project.

Where possible, conducting the review through a structure in which certified public accountants, tax accountants, Certified Social Insurance and Labor Consultants, and other specialists belong to the same group or can work closely together can make information sharing more efficient.

It is also effective to consolidate document request lists and data rooms to the extent practicable, thereby reducing the burden on the target company. At the kickoff meeting, the teams should share the objectives, scope, key issues, and schedule for each DD workstream, and the timing of interim reporting should be aligned wherever possible.

Ultimately, it is important not merely to review the findings from the financial, tax, and labor workstreams separately, but to integrate them from a management perspective. Key questions include: Which risks affect enterprise value? Which matters should be reflected in the transaction documents? What remediation will be required after closing?

10. Frequently Asked Questions

Q. Do Financial DD, Tax DD, and Labor DD all need to be conducted at the same time?

Not necessarily.

The appropriate scope of DD depends on factors such as transaction size, the target company’s industry, employee headcount, historical management practices, and anticipated risks. In relatively small transactions, the scope of Labor DD may be limited, or only the key issues relating to personnel costs may be reviewed.

On the other hand, a standalone Labor DD workstream tends to be more important for companies with large workforces and for industries such as services, construction, and transportation, where personnel costs and working-hour management are particularly significant.

Q. Is Labor DD necessary when acquiring a small or medium-sized company?

A smaller company does not necessarily have lower employment-related risks.

At Japanese small and medium-sized companies, operational priorities may sometimes result in work rules, attendance management, or other HR systems not being fully developed. As a result, potential liabilities such as unpaid overtime may be significant relative to the size of the company.

Because the available options for addressing issues may become more limited once they are discovered after the acquisition, it is important to assess relevant risks before the transaction.

Q. Is Labor DD unnecessary if Legal DD is conducted?

Legal DD may also cover employment-related matters such as employment agreements and labor disputes. However, Legal DD and Labor DD may differ in both the depth and focus of their review.

Labor DD may involve detailed analysis of Japanese labor and social insurance rules and actual operational practices, such as cross-checking time and attendance data against wage ledgers to identify potential unpaid wages, reviewing social insurance enrollment, and estimating the amount of potential liabilities.

Accordingly, where employment-related risks are significant to an M&A transaction or IPO, it may be appropriate to establish Labor DD as a separate workstream from Legal DD and clearly define the scope of each.

11. One-Stop Due Diligence Support in Japan from RSM Shiodome Partners

RSM Shiodome Partners Group provides one-stop support for Financial DD, Tax DD, and Labor DD involving Japanese companies through collaboration among certified public accountants, tax accountants, and Certified Social Insurance and Labor Consultants.

Rather than conducting each workstream entirely independently, the specialists share material findings within the group throughout the DD process. This helps reduce the target company’s document-disclosure burden while enabling consistent reporting that reflects the interrelationship among financial, tax, and labor matters.

Where issues are identified through Labor DD, support can continue beyond the due diligence process. RSM Shiodome Partners also assists with reviewing work rules, improving payroll calculation methods, considering remediation strategies for unpaid wages, and PMI support, including the integration of employment terms and HR systems after an M&A transaction.

Foreign companies considering the acquisition of a Japanese business, companies planning an IPO in Japan, and companies seeking to assess employment-related risks at their Japanese subsidiaries are welcome to contact RSM Shiodome Partners.

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