Statutory definition

“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).”

Article 28 of the Income Tax Act defines employment income in these terms. Whether exercise gains on stock options granted by foreign parent companies constituted employment income or occasional income (Article 34) was litigated in the early 2000s.

Overview

What did the Supreme Court classify as “employment income”?

On January 25, 2005, the Supreme Court's Third Petty Bench ruled on gains realized by the representative director of a Japanese subsidiary upon exercising stock options granted by its U.S. parent (2004 (Gyo-Hi) No. 141). The stated holding was:

“A case in which gains realized by the representative director of a Japanese subsidiary of a U.S. corporation upon exercising so-called stock options granted by the U.S. parent were held to constitute employment income under Article 28(1) of the Income Tax Act.”

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 by the parent to incentivize diligent service by certain executive officers and key employees of the parent and its subsidiaries ... and that rights granted under the plan were exercisable only by the grantee during the grantee's lifetime and could not be assigned or transferred—the gains realized by the representative director upon exercise constitute employment income under Article 28(1) of the Income Tax Act.”

The summary says the gains constituted employment income “under the circumstances stated in the judgment.” It does not state that all exercise gains are employment income irrespective of those facts.

How were “justifiable grounds” recognized for additional tax?

In cases where exercise gains on stock options granted by a foreign parent of the taxpayer's Japanese employer were reported as occasional income and later subjected to upward reassessment as employment income, the existence of “justifiable grounds” under Article 65 of the General Act of National Taxes was separately disputed. The Supreme Court's Third Petty Bench judgment of October 24, 2006 (2005 (Gyo-Hi) No. 20) and First Petty Bench judgment of November 16, 2006 (2005 (Gyo-Hi) No. 96) have identically worded holdings and summaries. The stated holding was:

“A case in which ‘justifiable grounds’ under Article 65(4) of the General Act of National Taxes were found for a taxpayer's reporting, in the final income tax return for 1999, exercise gains on stock options granted by the foreign parent of the taxpayer's Japanese employer as occasional income.”

The court's published summary reads:

“...Under the circumstances stated in the judgment, including that (1) no special statutory provisions governed taxation of stock options granted by a foreign parent to employees, etc. of a Japanese subsidiary, and the tax authorities had formerly treated exercise gains as occasional income, a view also expressed in publications supervised or otherwise overseen by tax officials; (2) from the filing season for 1998 income tax returns, the authorities changed to uniform treatment as employment income, but did not expressly announce the change in a circular at that time, first doing so in the June 2002 amendment to the Income Tax Basic Circular; and (3) the interpretation classifying these exercise gains as occasional income had reasonable grounds, there were ‘justifiable grounds’ under Article 65(4) of the General Act of National Taxes for the taxpayer's reporting the gains as occasional income and not including them as employment income in the basis for calculating tax.”

How does the Income Tax Act distinguish employment income from occasional income?

Article 34 of the Income Tax Act defines occasional income as follows:

“Occasional income means income other than interest income, dividend income, real estate income, business income, employment income, retirement income, timber income and capital gains, which is occasional income other than income arising from continuous profit-seeking activities and does not have the nature of consideration for labor or other services or the transfer of assets.”

Occasional income presupposes that the income does not fall within the other listed categories, including employment income. Point (1) of the 2006 judgments' summary states that, for 1999, there were no special statutory provisions governing stock options granted by foreign parents. Article 84 of the income tax Order provides for revenue amounts where certain rights are granted by an issuing corporation.

When and what did the circular state?

The summaries of the 2006 judgments state that the tax authorities did not expressly announce their changed treatment in a circular when making the change, and “first expressly stated the changed treatment in a circular through the June 2002 amendment to the Income Tax Basic Circular.” Immediately after the introductory wording of Income Tax Basic Circular 23–35 Common-6 appears this amendment history:

“(Amended by 1974 Chokusho 2-23; 1996 Kaho 8-2, Kasho 4-5; 1998 Kaho 8-2, Kasho 4-5; 2002 Kako 2-5, Kashi 3-3, Kaho 8-3, Kashin 3-118; 2006 Kako 2-18, Kashi 3-10, Kashin 4-114; 2016 Kako 2-22, Kashin 5-18; 2019 Kako 2-22, Kaho 11-3, Kashin 5-12; 2020 Kako 2-12, Kaho 11-3, Kashin 5-6).”

This history includes “2002 Kako 2-5, Kashi 3-3, Kaho 8-3, Kashin 3-118.” Here we merely present that entry alongside point (2) of the judgment summary. This article does not definitively identify the entry as the June 2002 amendment mentioned in the summary.

What do the current statute and circular provide?

Income Tax Basic Circular 23–35 Common-6 provides:

“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.”

“(a) Where the rights are found to have been granted by reason of an employment contract or similar relationship between the issuing corporation and the grantee: employment income. ... (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.”

“(b) Where the rights are found to have been granted in connection with the grantee's business activities: business income or miscellaneous income.”

“(c) In cases other than (a) and (b): miscellaneous income in principle.”

The current circular divides the relationship with the issuer into three categories: employment or similar relationship (a), business-related relationship (b), and other relationships (c). The note to (a) expressly states that “directors, etc.” under the Act on Special Measures Concerning Taxation have an employment or similar relationship. For taxation specific to foreign-parent stock options, see Taxation of foreign parent company stock options will handle.

Points that require care in practice

• The January 25, 2005 judgment is a fact-specific ruling that the gains were employment income “under the circumstances stated in the judgment.” Whether an individual case shares those circumstances must be checked against the facts in the judgment.
• The two additional-tax judgments are likewise fact-specific, based on three factors: absence of statutory provisions, timing of express circular guidance, and grounds for the interpretation. Their reach in other cases requires examining the circular's wording and the filing date individually.
• To determine which specific amendments correspond to each entry in the amendment history of Income Tax Basic Circular 23–35 Common-6, consult the National Tax Agency's amendment documents.

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) / Quoted wording: “Occasional income means income other than interest income, dividend income, real estate income, business income, employment income, retirement income, timber income and capital gains, which is occasional income other than income arising from continuous profit-seeking activities and does not have the nature of consideration for labor or other services or the transfer of assets.”

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: “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.”
• Income Tax Basic Circular 23–35 Common-6 (Income classification where rights to acquire shares, etc. are granted), (a) / Quoted wording: “Where the rights are found to have been granted by reason of an employment contract or similar relationship between the issuing corporation and the grantee: employment income. However, where exercise occurs after retirement and the benefits are found mainly unrelated to performance of duties—for example, rights granted to a person expected to retire shortly after grant that mainly provide benefits corresponding to share appreciation over a long period after retirement—the income shall be miscellaneous income. (Note) For example, 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.”
• Income Tax Basic Circular 23–35 Common-6 (Income classification where rights to acquire shares, etc. are granted), (b) / Quoted wording: “Where the rights are found to have been granted in connection with the grantee's business activities: business income or miscellaneous income.”
• Income Tax Basic Circular 23–35 Common-6 (Income classification where rights to acquire shares, etc. are granted), (c) / Quoted wording: “In cases other than (a) and (b): miscellaneous income in principle.”
• Income Tax Basic Circular 23–35 Common-6 (Income classification where rights to acquire shares, etc. are granted), amendment history / Quoted wording: “(Amended by 1974 Chokusho 2-23; 1996 Kaho 8-2, Kasho 4-5; 1998 Kaho 8-2, Kasho 4-5; 2002 Kako 2-5, Kashi 3-3, Kaho 8-3, Kashin 3-118; 2006 Kako 2-18, Kashi 3-10, Kashin 4-114; 2016 Kako 2-22, Kashin 5-18; 2019 Kako 2-22, Kaho 11-3, Kashin 5-12; 2020 Kako 2-12, Kaho 11-3, Kashin 5-6).”
• Supreme Court, Third Petty Bench, judgment of January 25, 2005 (2004 (Gyo-Hi) No. 141) / Quoted holding: “A case in which gains realized by the representative director of a Japanese subsidiary of a U.S. corporation upon exercising so-called stock options granted by the U.S. parent were held to constitute employment income under Article 28(1) of the Income Tax Act.”
• 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) / Quoted holding: “A case in which ‘justifiable grounds’ under Article 65(4) of the General Act of National Taxes were found for a taxpayer's reporting, in the final income tax return for 1999, exercise gains on stock options granted by the foreign parent of the taxpayer's Japanese employer as occasional income.”
• Supreme Court, Third Petty Bench, judgment of October 24, 2006 (2005 (Gyo-Hi) No. 20) / Quoted summary: “Where a taxpayer reported exercise gains on stock options granted by the foreign parent of the taxpayer's Japanese employer as occasional income in the final income tax return for 1999, and an upward reassessment was subsequently made on the basis that the gains were employment income, under the circumstances stated in the judgment—including that (1) no special statutory provisions governed stock options granted by foreign parents to employees, etc. of Japanese subsidiaries, the authorities had formerly treated exercise gains as occasional income, and publications supervised or otherwise overseen by tax officials expressed that view; (2) the authorities changed to uniform treatment as employment income from the filing season for 1998 income tax returns, but did not expressly announce the change in a circular at that time, first doing so through the June 2002 amendment to the Income Tax Basic Circular; and (3) the interpretation classifying these exercise gains as occasional income had reasonable grounds—there were ‘justifiable grounds’ under Article 65(4) of the General Act of National Taxes for reporting the gains as occasional income and not including them as employment income in the basis for calculating tax.”
• Supreme Court, First Petty Bench, judgment of November 16, 2006 (2005 (Gyo-Hi) No. 96) / Quoted holding: “A case in which ‘justifiable grounds’ under Article 65(4) of the General Act of National Taxes were found for a taxpayer's reporting, in the final income tax return for 1999, exercise gains on stock options granted by the foreign parent of the taxpayer's Japanese employer as occasional income.”
• Supreme Court, First Petty Bench, judgment of November 16, 2006 (2005 (Gyo-Hi) No. 96) / Quoted summary: “Where a taxpayer reported exercise gains on stock options granted by the foreign parent of the taxpayer's Japanese employer as occasional income in the final income tax return for 1999, and an upward reassessment was subsequently made on the basis that the gains were employment income, under the circumstances stated in the judgment—including that (1) no special statutory provisions governed stock options granted by foreign parents to employees, etc. of Japanese subsidiaries, the authorities had formerly treated exercise gains as occasional income, and publications supervised or otherwise overseen by tax officials expressed that view; (2) the authorities changed to uniform treatment as employment income from the filing season for 1998 income tax returns, but did not expressly announce the change in a circular at that time, first doing so through the June 2002 amendment to the Income Tax Basic Circular; and (3) the interpretation classifying these exercise gains as occasional income had reasonable grounds—there were ‘justifiable grounds’ under Article 65(4) of the General Act of National Taxes for reporting the gains as occasional income and not including them as employment income in the basis for calculating tax.”