Executive Compensation Taxation in Japan and Key Considerations

1. Basic Overview of Executive Compensation and Japanese Rules

Executive compensation refers to remuneration paid to officers of a company, such as directors. In Japan, strict tax rules govern the amount and method of executive compensation payment.

The background to these rules is to prevent profit manipulation using executive compensation (for example, reallocating profits to executive remuneration to avoid corporate income tax). While salaries for general employees typically fluctuate during the fiscal year, executive compensation generally cannot be freely increased or decreased during the fiscal year to be deductible as an expense for corporate income tax purposes. The determination of executive compensation is usually made by the articles of incorporation or a resolution of the shareholders' meeting, and once an amount is decided, it must generally be maintained throughout the year, barring special circumstances.

Under Japan's Corporate Income Tax Act, only certain types of executive compensation paid by a company are deductible as expenses for tax purposes; other expenditures are treated as non-deductible (not recognized as tax expenses). Non-deductible executive compensation does not reduce the company's taxable income, thereby increasing its corporate income tax burden. Therefore, if executive compensation is not set appropriately, the company may incur unnecessary tax burdens and risks.

The following sections explain in detail the main tax rules and considerations regarding executive compensation settings.
 

2. Three Main Rules Regarding Remuneration Settings

Under Japanese tax law, for executive compensation to be deductible as an expense, it must generally be paid in one of the following forms:
1.  Fixed-Amount Compensation (定期同額給与 - Teikidōgaku Kyūyo)
2.  Pre-determined Severance/Bonus Compensation (事前確定届出給与 - Jizen Kakutei Todokede Kyūyo)
3.  Performance-Linked Compensation (業績連動給与 - Gyōseki Rendō Kyūyo)
 

It is important to note that executive compensation paid in forms not falling under these three categories is generally not recognized as a deductible expense under the Corporate Income Tax Act. Furthermore, for non-listed companies, including small and medium-sized enterprises, only Fixed-Amount Compensation or Pre-determined Severance/Bonus Compensation are permitted under the Corporate Income Tax Act. The overview and requirements for each are as follows:

Fixed-Amount Compensation
This is the most basic form, where the same amount is paid monthly to executives. Monthly fixed executive remuneration falls into this category. For example, if JPY 1 million is paid on the 25th of each month, and the payment amount is the same for each payment period (monthly) throughout the fiscal year, it qualifies as Fixed-Amount Compensation. When revising Fixed-Amount Compensation, the remuneration amount for the fiscal year must generally be determined within three months from the beginning of the fiscal year, and then the same amount must continue to be paid throughout the fiscal year.

Pre-determined Severance/Bonus Compensation
This refers to executive compensation paid after reporting the amount and payment date to the tax office in advance. It applies to compensation that does not fall under either Fixed-Amount Compensation or Performance-Linked Compensation. For example, if a company wishes to pay a bonus to an executive, it must submit a prescribed notification form to the competent tax office within a certain period from the beginning of the fiscal year, declaring the pre-determined amount and its payment date. If the compensation is paid exactly as declared in the notification, the amount is recognized as a deductible expense.

Performance-Linked Compensation
This is remuneration whose amount is determined in linkage with the company's performance indicators (e.g., profit amount, stock price). It can be described as incentive compensation that fluctuates based on the achievement of performance targets. However, its application is generally limited to listed companies and their wholly-owned subsidiaries, etc., and various requirements, such as disclosure in the Annual Securities Report, are stipulated for performance-linked compensation to be recognized as a deductible expense.

Executive compensation that falls into one of these three categories is recognized as a deductible expense under the Corporate Income Tax Act. Conversely, monetary or economic benefits paid to executives in ways other than these categories, even if they are in substance salaries or bonuses, will be non-deductible for tax purposes. It is also important to note that even if executive compensation falls into one of the three categories above, any portion that is deemed "excessively high" will not be included in the amount of deductible expenses. When deciding the amount and timing of executive remuneration, it is imperative to plan in advance to comply with one of these frameworks, while also considering tax law provisions.

3. Cases Requiring Individual Income Tax Returns

Next, let's focus on the tax procedures for individual executives who receive compensation. In Japan, most salary earners have their annual tax determined by year-end adjustment, so they do not need to file their own income tax returns. However, in cases of high-income earners or those with special income circumstances, such as foreign national executives, year-end adjustment alone may not suffice, and an individual income tax return may be required.

Even for foreign national executives, an individual income tax return is mandatory under Japanese tax law if they fall into the following situations:

• Annual employment income exceeds JPY 20 million:
  Salary earners with annual income exceeding JPY 20 million are excluded from year-end adjustment, so they must file an income tax return and pay income tax.
• Non-salary income exceeds a certain amount:
  If the total of income other than employment income and retirement income exceeds JPY 200,000 annually, an individual income tax return is generally required.

Foreign national executives need to check whether they should file an individual income tax return, considering not only the existence and amount of employment income in Japan but also their residency status in Japan, and income and payment methods from overseas.

4. Executive Compensation and Pension Payment Mechanisms

Executives working in Japan are not only subject to income tax on their compensation but also face the obligation to join social insurance (Employees' Pension Insurance and Health Insurance). Even executives, if they are full-time and receive remuneration, must generally join the company's social insurance. This rule applies regardless of Japanese or foreign nationality.

Specifically, if full-time executives, including representative directors, are paid remuneration, the company must report them as insured persons for Employees' Pension Insurance and Health Insurance. As a result, Employees' Pension Insurance premiums and Health Insurance premiums will be deducted from executive compensation. Executives enrolled in Employees' Pension Insurance contribute premiums based on their monthly salary and bonuses while employed and are entitled to receive a pension in the future.

Even foreign national executives can generally receive a Japanese pension after age 60 if they meet a certain enrollment period (generally 10 years or more). However, many foreign national executives may be temporarily assigned to Japan and may return to their home countries without long-term enrollment.

In such cases, the "Lump-sum Withdrawal Payment" (脱退一時金 - Dattai Ichijikin) system should be known. The Lump-sum Withdrawal Payment is a pension refund system designed for foreign nationals who return home with a short period of pension enrollment in Japan. Since social insurance contributions are unavoidable while working in Japan, the company's CFO or head of accounting must design the compensation package taking these costs into account.

It is also important for the executive themselves to understand the Lump-sum Withdrawal Payment they can receive upon leaving their position and to complete the procedures within the designated period.

5. Tax Considerations for Foreign National Executives

Particularly important for the tax treatment of foreign national executives working in Japan are their residency classification and the scope of their taxable income. Under Japan's Income Tax Act, individuals are classified as "residents" or "non-residents," and residents are further subdivided into "non-permanent residents" and "residents other than non-permanent residents." The scope of taxable income differs significantly depending on this classification, so foreign national executives must understand which category they fall into.

• Resident (居住者 - Kyōjūsha)
  An individual who has a domicile (center of living) in Japan or has continuously resided (continuous stay) in Japan for one year or more up to the present is generally considered a resident. Foreign national executives who stay in Japan long-term for assignments, etc., are usually regarded as "residents." Among residents, those who have Japanese nationality or have lived in Japan for more than five years within the past ten years are classified as "residents other than non-permanent residents," and their worldwide income, both domestic and foreign, is subject to Japanese taxation. On the other hand, a non-permanent resident refers to a resident who does not have Japanese nationality and has stayed in Japan for five years or less within the past ten years, and their taxable scope is limited to domestic source income and certain foreign source income brought into Japan.
• Non-Resident (非居住者 - Hikōjūsha)
  Individuals who do not meet the above resident criteria are classified as non-residents. For example, individuals residing overseas, as well as short-term visitors without a domicile in Japan for less than one year, are generally considered non-residents. For non-residents, only Japan-source income is subject to taxation.

In summary, the taxable scope for foreign national executives differs depending on whether they are a "resident or non-resident" and "non-permanent resident or otherwise."
 

6. Tax Risks and Avoidance Strategies Based on Amount

When setting executive compensation, it is important to be aware of the tax risks that arise from the amount. As mentioned, excessively high executive compensation will be denied deductibility under the Corporate Income Tax Act. However, since tax law does not provide clear criteria for what constitutes "excessively high," it is judged by comprehensively considering the executive's job duties, the company's performance scale, and the compensation amounts of similar executives in competitor companies. Moreover, compensation significantly exceeding a reasonable amount can appear unnatural to shareholders and other stakeholders, potentially leading to not only tax risks but also governance issues.

As avoidance strategies, it is important to clarify the basis for setting executive compensation amounts and keep them within a reasonable range in light of the company's profit level and industry standards. For example, determine a reasonable level of remuneration before the start of the fiscal year, and if bonuses are necessary, file for Pre-determined Severance/Bonus Compensation. Furthermore, by documenting the compensation decision process and the basis for the amounts in the minutes of board meetings or shareholders' meetings, you can be prepared to explain appropriately if inquiries are made by the tax office.
 

7. Learning from Case Studies: Practicing Appropriate Compensation Setting

Let's examine appropriate executive compensation settings through a real-world example. The case in question is Nomura Holdings, Inc.'s executive compensation system.

The company emphasizes transparency and governance in compensation and has introduced a remuneration system composed of three pillars: "base salary," "performance-linked remuneration," and "stock-based remuneration." For the fiscal year ending March 2025, as a result of achieving performance exceeding targets such as ROE (Return on Equity), the compensation for the Representative Executive Officer and President was significantly increased.

The majority of the breakdown was performance-linked bonuses based on pre-set indicators, and appropriate procedures, including disclosures required by law and those by the remuneration committee, were carried out. This serves as a valuable practical example of balancing a tax strategy that meets the deductibility requirements under tax law with an incentive design.

Reference material: Nomura Group's Initiatives for Governance (May 2025)

8. Conclusion

Japan's tax rules for executive compensation are detailed, ranging from laws to notifications, and may be unfamiliar to many foreign national executives.

First, as a general rule, executive compensation will not be recognized as a deductible expense under the Corporate Income Tax Act unless it is paid in one of the following forms: Fixed-Amount Compensation, Pre-determined Severance/Bonus Compensation, or Performance-Linked Compensation. Additionally, individual executives must understand the criteria for whether they need to file an individual income tax return and the differences in the scope of taxation based on their residency classification.

Appropriate setting and operation of executive compensation not only avoid tax risks but also contribute to strengthening corporate governance and maintaining executives' long-term motivation. Fully understanding the tax system and constructing the best compensation scheme in compliance with laws, possibly with the cooperation of tax professionals such as certified public tax accountants, will yield the best results for both foreign national executives and companies.
 

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