Japan’s consumption tax and U.S. technology companies

Japan initiated a number of tax reforms in 2015 to address the challenges created by the growing digital economy. One of the reforms was the application of the Japanese consumption tax (JCT) to the supply of digital services provided by nonresident enterprises. The JCT was implemented as part of the global trend of unilateral tax measures designed to overcome the limitations on taxing e-commerce created by income tax treaties that prevent countries from taxing the business profits of a foreign enterprise that does not have a physical presence (a permanent establishment) in the country.

The application of the JCT to digital services is not a digital services tax (DST) imposed specifically on gross revenue from digital services. Rather, it is an extension of the Japanese consumption tax (similar to a VAT or a GST) to digital services provided by nonresident enterprises. In conjunction with the coordinated effort to develop new taxing rights based on the location of customers under Pillar 1 of the OECD BEPS 2.0 project, the OECD/G20 Inclusive Framework provides for the removal of all DSTs and other similar unilateral measures. However, it is unclear if the requirement that DSTs be removed will extend to other forms of digital taxation, such as the application of the JCT to digital services provided by nonresident enterprises.

In January 2021, the Office of the U.S. Trade Representative (USTR) determined that the DSTs adopted by Austria, India, Italy, Spain, Turkey, and the United Kingdom discriminated against U.S. companies and proposed tariffs on the import of goods from those countries in an apparent attempt to pressure those countries to repeal their DSTs in conjunction with the OECD/G20 two-pillar solution. Earlier, in July 2019, the USTR had taken similar action with respect to the DST in France. The tariffs were subsequently suspended to provide time for the OECD/G20 to complete work on the BEPS 2.0 project. Then, on Oct. 21, 2021, following the OECD/G20 agreement reached by 136 of the 140 OECD/G20 Inclusive Framework members on the principles of the two-pillar solution, the USTR withdrew the proposed tariffs on Italy, Austria, Spain, the United Kingdom, and France. It seems unlikely that similar pressure would be placed on Japan to repeal the application of the JCT to digital services which is not facially discriminatory. However, Japan has been an active participant in the OECD/G20 BEPS 2.0 project, and may amend the JCT in response to the consensus agreed upon by the OECD/G20 Inclusive Framework members.

Original place of supply rule

The JCT is imposed on the supply of goods made in or imported into Japan, and services provided in Japan. Prior to the 2015 reforms, services were considered to have been provided based on where the service provider was located. Consequently, if the services were provided over the internet by a service provider located outside Japan, the services were not subject to the JCT even if the recipient of the services was located in Japan.

Revised place of supply rule

Effective Oct. 1, 2015, the place of supply rule that applies to digital services was changed to the location of the customer (Act for Partial Revision of the Income Tax Act and Other Acts [Act No. 9 of 2015]). Digital services are now considered to have been provided in Japan and, therefore, potentially subject to the JCT, if the customer is located in Japan.

The revised place of supply rule applies to business-to-business (B2B) and business-to-consumer (B2C) transactions. In B2B transactions, the location of the customer is generally based on the location of the head office or principal place of business of the enterprise that is receiving the services. However, if a business receives digital services through a permanent establishment, the customer location may be based on the location of the permanent establishment. In B2C transactions, the location of the customer is normally based on the billing or home address of the individual.

Scope of digital services

Digital services for this purpose include, but are not limited to, online advertising, providing cloud-based services, consulting services provided through the telecommunication network (including phone and email), fees for access to online auction websites (charges for posting goods for sale) and reservation websites (such as booking restaurant and hotel accommodations), providing digital content over the internet (e-books, digital newspapers, videos, music, games, and other software).

The digital services supply rule does not apply to a transaction if the use of the telecommunications network is ancillary or incidental to the transfer of assets. Transactions for which the use of the telecommunications network is ancillary, or incidental may include, for example, e-banking, requests for foreign businesses to collect information, instructions, and correspondence regarding asset management and fund transfers, and communication and transfers of code in conjunction with the development of software.

Remitting the JCT to the National Tax Agency

The procedures for collecting and remitting the JCT to the National Tax Agency (NTA) depend on whether the foreign enterprise is providing digital services to consumers or businesses. If the digital services are provided to a Japanese business (B2B), the foreign supplier must inform its business customer that digital services have been or will be provided, and the business customer must collect and remit the JCT under a reverse-charge mechanism. In such cases, the foreign supplier is not required to file a tax return in Japan to report the JCT. However, U.S. suppliers of digital services to businesses in Japan may want to register with the NTA to allow business customers to claim a credit against the JCT.

In contrast, if the digital services are provided to consumers (or the foreign enterprise cannot distinguish its customers between consumers and businesses), the foreign enterprise may be required to file a consumption tax return in Japan and remit the JCT to the NTA. However, a foreign enterprise may be exempt from collecting the JCT and filing a consumption tax return if its taxable sales for each of the two prior fiscal years (the base period) are less than ¥10 million.

Unlike many other jurisdictions where the classification of a transaction as a B2B or a B2C sale is made by reference to the tax status of the customer, the JCT rules for digital services base this classification on the nature of the service provided and how the service is delivered to the customer. For example, certain digital services, such as the provision of music, apps, games, streaming, etc., are always classified as B2C transactions because they are associated with personal consumption. On the flip side, certain advertising related to digital services is always classified as B2B transactions because they are typically only purchased by business customers.

Complexity often arises when digital services are provided via online checkouts and so-called “click-through” agreements. In these instances, where any person in Japan can make the purchase, the transactions are normally classified as B2C, even if the customer is a business. However, if the same service was provided through an individually negotiated agreement, the transaction would be classified as B2B.

Technology companies selling to Japanese customers

Many U.S. mid-market technology companies that provide digital services to customers in Japan will find they have a JCT reporting obligation given the relatively low reporting threshold of ¥10 million (approximately $100,000). The vast majority of cloud-based services, such as software-as-a-service, platform-as-a-service (e.g., database), or infrastructure-as-a-service, fall within the definition of digital services for purposes of the JCT. Technology companies should carefully review their customer list to identify Japan sales and determine whether they have a reporting obligation.

U.S. companies that provide services to Japanese businesses may be surprised to discover that those services can be recharacterized as B2C sales, creating an obligation to register with the JCT and remit the tax to the NTA (rather than following the reverse charge mechanism).

If a U.S. company fails to remit the JCT to the NTA, the Japanese tax authorities may assess penalties and place liens on certain assets held by the company. Public awareness of such non-compliance in Japan may also negatively affect a brand and have a material impact on the financial position of the business.