Statutory definition

Income classification for exercise gains on stock options granted by foreign parents to officers and employees of Japanese subsidiaries also starts with the definition of employment income in Article 28 of the Income Tax Act.

“Employment income means income from salaries, pay, wages, annual allowances and bonuses, and remuneration of a similar nature (hereinafter referred to as ‘salaries, etc.’ in this Article).”

Whether exercise gains from foreign-parent stock options are employment or occasional income was long disputed, with cases reaching the Supreme Court.

Overview

How did the Supreme Court classify exercise gains on options granted by a foreign parent?

The Supreme Court judgment of January 25, 2005 (2004 (Gyo-Hi) No. 141; Third Petty Bench; appeal dismissed; Minshu Vol. 59, No. 1, p. 64; prior instance: Tokyo High Court 2003 (Gyo-Ko) No. 235) classified gains from exercise of options granted by a U.S. parent to the representative director of its Japanese subsidiary. The referenced provisions were Income Tax Act Articles 28 and 34. The court's published summary reads:

“Where the representative director of a Japanese subsidiary of a U.S. corporation was granted by the parent a right to acquire the parent's shares at a predetermined exercise price (so-called stock options), exercised it, and obtained an economic benefit equal to the difference between the parent's share price at exercise and the stipulated exercise price, under the circumstances stated in the judgment—including that the rights were granted under a plan established to incentivize diligent service by certain executive officers and key employees of the parent and its subsidiaries; that the parent owned 100% of the subsidiary's issued shares and effectively controlled matters such as officer appointments, the representative director performed duties under the parent's oversight, and the parent granted the rights precisely because of that performance; and that the rights were exercisable only by the grantee during the grantee's lifetime and could not be assigned or transferred—the exercise gains constitute employment income under Article 28(1) of the Income Tax Act.”

The summary states that the gains are employment income “under the circumstances stated in the judgment.” It does not say that exercise gains from foreign-parent options always constitute employment income.

How does the circular address foreign issuing corporations?

Income Tax Basic Circular 23–35 Common-6 opens as follows:

“Where rights listed in the items of Article 84(3) of the Order are granted by the issuing corporation (...), income from acquiring shares (...) through exercise of those rights shall be classified as follows according to the cases listed below.”

The circular then provides:

“(1) Where a person granted rights listed in Article 84(3)(i) or (ii) of the Order exercises them, treatment shall be as follows according to the relationship between the issuing corporation (including foreign corporations) and the grantee, etc.”

Foreign corporations are expressly included here, rather than in the introductory wording.

After stating that rights granted by reason of an employment contract or similar relationship give rise to employment income, the circular adds this note:

“For example, note that the relationship of ‘directors, etc.’ prescribed in Article 29-2(1) of the Act on Special Measures Concerning Taxation ((Exemption, etc. for economic benefits relating to acquisition of shares through exercise of share acquisition rights received by specified directors, etc.)) constitutes an employment contract or similar relationship.”

This note indicates that the “directors, etc.” relationship required for tax-qualified stock options constitutes an employment contract or similar relationship.

What does the National Tax Agency Q&A say about grants by controlling parents and similar entities?

The National Tax Agency's “Taxation of Stock Options (Q&A)” states that gains on nonqualified options “...are subject to income tax as employment income (note) for the year in which the options are exercised (income tax Order, Article 84(3)).” Note 1 then explains:

“Economic benefits relating to stock options granted as consideration for labor by a controlling parent or similar entity are also classified as employment income.”

Both a grant by a controlling parent or similar entity and a grant as consideration for labor are elements of this explanation.

How did the two 2006 judgments address additional tax?

The Supreme Court judgments of October 24, 2006 (2005 (Gyo-Hi) No. 20; Third Petty Bench; Minshu Vol. 60, No. 8, p. 3128) and November 16, 2006 (2005 (Gyo-Hi) No. 96; First Petty Bench; Shumin No. 222, p. 243) considered “justifiable grounds” for additional tax where exercise gains on foreign-parent options were reported as occasional income in 1999 returns and reassessed upward as employment income. Both summaries use identical wording. The full summary and the amendment history immediately after the opening of Income Tax Basic Circular 23–35 Common-6 are presented in Stock option lawsuit (employment income or miscellaneous income / temporary income).

Can the options qualify for tax-qualified treatment?

Article 29-2 of the Act on Special Measures Concerning Taxation provides as follows:

“Where an individual who is a director, executive officer or employee ... of the stock company whose resolution ... under Article 238(2) of the Companies Act (Act No. 86 of 2005) designated the person to receive share acquisition rights ... (hereinafter referred to as the ‘grant resolution’ in this Article) ... acquires shares relating to specified share acquisition rights by exercising, in accordance with the contract, rights ... granted under a contract concluded pursuant to the grant resolution between the stock company and the directors, etc. or specified service providers, the economic benefit relating to that share acquisition shall be exempt from income tax.”

This introductory wording starts with the stock company whose resolution under Article 238 of the Companies Act designated the recipients of the share acquisition rights. For all requirements, see What Are Tax-Qualified Stock Options?.

Points that require care in practice

• Applying the circumstances listed in the judgment summary requires examining each case's plan incentives, the parent's ownership percentage and personnel authority, actual performance of duties, and exercise and transfer restrictions.
• The two 2006 judgments recognizing “justifiable grounds” for additional tax relied on circumstances surrounding the 1999 returns. Whether the same grounds extend to later years requires individual examination.
• Whether options qualify requires individually checking the requirements of Article 29-2 of the Act on Special Measures Concerning Taxation. For withholding where the gains are employment income, see Stock options, tax withholding, and statutory reports; for treatment when the grantee becomes a nonresident, see Non-residents, departure, and stock options.

Legal basis

• Article 28, Paragraph 1 of the Income Tax Act (Employment Income) / Quoted text: “Employment income means income from salaries, pay, wages, annual allowances, bonuses, and remuneration of a similar nature (referred to in this Article as ‘salaries, etc.’).”
• Income Tax Act, Article 34(1) (Occasional income) / Only the location of the provision is indicated; its text is not quoted.
• Act on Special Measures Concerning Taxation, Article 29-2(1) (Exemption, etc. for economic benefits relating to acquisition of shares through exercise of share acquisition rights received by specified directors, etc.) / Quoted wording: “Where an individual who is a director, executive officer or employee ... of the stock company whose resolution under Article 238(2) of the Companies Act (Act No. 86 of 2005) (including determination of subscription requirements delegated under a resolution pursuant to Article 239(1) and a board resolution under Article 240(1)) designated the person to receive share acquisition rights (limited to those prescribed by Cabinet Order; hereinafter ‘share acquisition rights’ in this paragraph) (hereinafter the ‘grant resolution’ in this Article), or of a corporation in which that company directly or indirectly owns shares with voting rights or capital contributions exceeding 50% of the total number or amount of issued voting shares or capital contributions, or having another relationship prescribed by Cabinet Order, exercises rights granted under a contract concluded pursuant to the grant resolution between that company and the directors, etc. or specified service providers (limited to rights whose contracts stipulate the following requirements, or items (i) through (vi) for grants to directors, etc.; hereinafter ‘specified share acquisition rights’ in this Article) in accordance with that contract and thereby acquires the related shares, the economic benefit relating to that acquisition shall be exempt from income tax.”

Relevant administrative guidance, Q&A, and cases

• Income Tax Basic Circular 23–35 Common-6 (Income classification where rights to acquire shares, etc. are granted) / Quoted wording: “Treatment shall be as follows according to the relationship between the issuing corporation (including foreign corporations) and the grantee, etc.” “For example, note that the relationship of ‘directors, etc.’ prescribed in Article 29-2(1) of the Act on Special Measures Concerning Taxation ((Exemption, etc. for economic benefits relating to acquisition of shares through exercise of share acquisition rights received by specified directors, etc.)) constitutes an employment contract or similar relationship.”
• National Tax Agency, “Taxation of Stock Options (Q&A),” last revised November 2024, common introduction to Questions 1, 2, 3 and 6, Note 1 / Quoted wording: “Salary in kind received from an employer is subject to income tax as employment income upon receipt. However, if it consists of transfer-restricted stock options (nonqualified stock options), income cannot be realized by transferring them, so income is not recognized at grant; it is taxed as employment income (note) for the year of exercise (income tax Order, Article 84(3)).” “Economic benefits relating to stock options granted as consideration for labor by a controlling parent or similar entity are also classified as employment income.”
• Supreme Court, Third Petty Bench, judgment of January 25, 2005 (2004 (Gyo-Hi) No. 141) / Quoted summary: “Where the representative director of a Japanese subsidiary of a U.S. corporation was granted by the parent a right to acquire the parent's shares at a predetermined exercise price (so-called stock options), exercised it, and obtained an economic benefit equal to the difference between the parent's share price at exercise and the stipulated exercise price, under the circumstances stated in the judgment—including that the rights were granted under a plan established to incentivize diligent service by certain executive officers and key employees of the parent and its subsidiaries; that the parent owned 100% of the subsidiary's issued shares and effectively controlled matters such as officer appointments, the representative director performed duties under the parent's oversight, and the parent granted the rights precisely because of that performance; and that the rights were exercisable only by the grantee during the grantee's lifetime and could not be assigned or transferred—the exercise gains constitute employment income under Article 28(1) of the Income Tax Act.”
• Supreme Court, Third Petty Bench, judgment of October 24, 2006 (2005 (Gyo-Hi) No. 20) / The judgment summary is not quoted.
• Supreme Court, First Petty Bench, judgment of November 16, 2006 (2005 (Gyo-Hi) No. 96) / The judgment summary is not quoted.