Part 1: The Non-Permanent Resident Taxation System (I)
What is the Non-Permanent Resident Taxation System?
Japan has a unique income taxation system, rarely used in other countries, called the non-permanent resident taxation system.
In many countries, tax systems distinguish between “residents” and “non-residents,” applying worldwide income taxation to residents and taxing only domestic-source income of non-residents. However, under Japan’s tax system, a sub-category called “non-permanent resident” is created under the category of resident. Non-permanent residents are taxed as residents, but the scope of their taxable income is narrower than worldwide income.
Definition of Non-Permanent Resident
A non-permanent resident is defined as an individual who:
1. Is a resident,
2. Does not hold Japanese nationality, and
3. Has had a domicile or residence in Japan for an aggregate period of five years or less within the past ten years.
For example, this refers to a foreigner who receives an assignment requiring them to stay in Japan for several years and then returns to their home country after the assignment ends.
Scope of Taxation for Non-Permanent Residents
The taxable income of non-permanent residents consists of:
(1) Income other than foreign-source income (“Non-foreign-source income”), and
(2) Foreign-source income that is either paid in Japan or remitted to Japan.
The difference compared to other residents subject to worldwide taxation is that foreign-source income paid abroad and not remitted to Japan is not subject to taxation.
For example, a foreigner who is assigned to Japan for more than one year but is expected to eventually return home will not be taxed in Japan, during the first five years, on foreign-source income paid abroad and not remitted to Japan, such as income from assets owned in their home country (and/or a third country).
However, because they are residents who would otherwise be subject to taxation on foreign-source income, the system taxes such income when it is remitted to Japan. This is why it is sometimes referred to as a “remittance basis” taxation system.
There is even a ruling of the National Tax Tribunal that once a remittance to Japan from abroad is made, taxation applies even if the funds are later returned abroad.
Types of Non-Foreign-Source Income Subject to Taxation
The Controlled Foreign Company (CFC) rules, also known as the anti-tax haven rules, apply to individuals as well. If a wealthy foreigner comes to Japan and qualifies as a non-permanent resident while owning an overseas asset management company, would income attributed under the CFC rules escape taxation unless remitted to Japan?
The answer is: such income is taxable. This is because CFC-attributed income is classified as non-foreign-source income under (1), above. Since the Income Tax Act enumerates a limited list of “foreign-source income” and CFC-attributed income is not included in that list, it falls under the category of income other than foreign-source income.
This point requires careful attention when filing tax returns, otherwise there is a risk of underreporting.
On the other hand, although not included in the exhaustive list of “foreign-source income” under the Income Tax Act, there is a certain item that is nevertheless treated as “foreign-source income” in relation to the taxation scope applicable to non-permanent residents. That is a capital gain arising from the transfer of foreign shares, where the transfer takes place on a foreign exchange, except for those acquired during the preceding 10-year period in which the individual was a non-permanent resident. Accordingly, such gains are not subject to taxation, unless they are paid in or remitted to Japan.
