Statutory definition

Article 161 of the Income Tax Act lists categories of domestic-source income taxable for nonresidents. The category covering salaries and other remuneration for personal services provides:

“Salaries, pay, wages, annual allowances, bonuses, remuneration of a similar nature, and other remuneration for personal services, attributable to employment or other personal services performed in Japan (including employment performed overseas as an officer of a domestic corporation and other personal services prescribed by Cabinet Order).”

This item focuses on whether the employment or personal services giving rise to remuneration were performed in Japan, rather than on the recipient's residential status. It also includes overseas duties of officers of domestic corporations and other personal services prescribed by Cabinet Order. Whether an economic benefit from exercising stock options falls within this item must be examined by reference to that causal connection.

Overview

How are nonresidents taxed?

Article 164 of the Income Tax Act prescribes how income tax on nonresidents is calculated according to permanent establishment status and the domestic-source income category. For categories including salaries and other remuneration for personal services, it provides:

“Where a nonresident listed in any of the following items has domestic-source income specified in that item, income tax imposed on that nonresident shall, in addition to the preceding paragraph, be calculated by applying Section 3 (Separate taxation of nonresidents' income) to the domestic-source income specified in that item.”

Salaries and other remuneration for personal services fall within this separate-taxation category. For the overall scope of domestic-source income, see What is domestic source income; for categories of nonresidents, see Who Is a Nonresident Under the Income Tax Act? will handle.

What withholding obligations arise for the payer?

Article 212 of the Income Tax Act provides for withholding upon payments to nonresidents:

“A person making payment in Japan to a nonresident of domestic-source income listed in Article 161(1)(iv) through (xvi) (Domestic-source income), excluding income prescribed by Cabinet Order, ... must withhold income tax on that domestic-source income upon payment and remit it to the national government by the tenth day of the month following the month of withholding.”

Salaries and other remuneration for personal services are among the categories subject to this withholding obligation. For details, see Payments to Nonresidents and Foreign Corporations and Withholding Tax. Where a tax treaty provides otherwise, Article 162 of the Income Tax Act states:

“Where a tax treaty (...) provides rules for domestic-source income differing from the preceding Article, for persons to whom that treaty applies, domestic-source income shall, notwithstanding that Article, be determined under the treaty to the extent of those differing provisions.”

For whether and how a treaty applies, see What Is a Tax Treaty? will handle.

How do the provisions classify stock options among assets subject to exit tax?

Article 60-2 of the Income Tax Act provides as follows for “securities, etc.” held by residents departing Japan:

“...Where the person holds securities or equity interests in a silent partnership agreement prescribed in Article 174(ix) (Tax base for income tax on domestic corporations) (excluding securities representing rights to acquire shares free of charge or at a favorable price that would generate domestic-source income prescribed in Article 161(1) (Domestic-source income), and other securities prescribed by Cabinet Order; hereinafter referred to as ‘securities, etc.’ in this Article through Article 60-4 (Special provisions for capital gains, etc. where exit tax provisions have applied)) ... those securities, etc. shall be deemed transferred.”

The parentheses exclude from “securities, etc.” securities representing rights to acquire shares free or at favorable prices that would generate domestic-source income. For “other securities prescribed by Cabinet Order,” Article 170 of the income tax Order provides:

“Securities prescribed by Cabinet Order in Article 60-2(1) of the Act (Special provisions for capital gains, etc. upon departure from Japan) shall be the following securities that would generate income listed in Article 161(1)(xii) of the Act (Domestic-source income).”

“Securities representing rights listed in the items of Article 84(3) to which that paragraph would apply if exercised.”

This wording narrows the scope by two conditions: the securities would generate domestic-source income, and they represent rights under Article 84 of the income tax Order that would be covered by that provision upon exercise. Those rights include the following share acquisition rights:

“Share acquisition rights issued pursuant to a resolution under Article 238(2) of the Companies Act (Determination of subscription requirements) (including determination of subscription requirements under delegation by a resolution under Article 239(1) (Delegation of determination of subscription requirements), and a board resolution under Article 240(1) (Special provisions for determining subscription requirements in public companies)), limited to rights deemed granted on particularly favorable terms or for a particularly favorable amount to the subscriber, or deemed to constitute all or part of consideration for services or other acts.”

Whether a particular stock option meets both conditions is a matter of applying the provisions; this article only presents those conditions. Treatment of shares acquired upon exercise must be checked separately under Income Tax Act Article 60-2 and income tax Order Article 170. For the exit tax system itself, see What Is Japan's Exit Tax System? will handle.

How do the provisions address departure while holding tax-qualified stock options?

Article 29-2 of the Act on Special Measures Concerning Taxation provides for notification when a grantee of specified share acquisition rights departs Japan:

“Where a person granted the share acquisition rights under the contract departs Japan (meaning ceasing to have either a domicile or residence in Japan; hereinafter the same in this item and paragraph (5)) between the contract date and the exercise date, the person must notify the stock company with which the contract for those rights was concluded before departure.”

For departure while holding specified shares acquired through exercise, the Article provides:

“Where a person receiving the special treatment departs Japan, of the specified shares (excluding specified shares of directors, etc.) held at departure, ... shall be deemed ... transferred at departure at the value upon exercise ..., and Articles 37-10 and 37-11 and other laws and regulations concerning income tax shall apply.”

Where a person receiving the special treatment departs while holding these specified shares, Article 11-3 of the Regulation for Enforcement of the Act on Special Measures Concerning Taxation specifies the event and information the granting company must notify to the business office, etc. of the financial instruments business operator, etc. This is not a notification to the tax office.

“Departure from Japan (meaning departure prescribed in Article 29-2(1)(vii) of the Act; hereinafter the same in this paragraph, the following paragraph and paragraph (16)(xi)) by a person receiving the special treatment who holds specified shares (excluding specified shares of directors, etc. (meaning those prescribed in Article 29-2(4) of the Act; hereinafter the same in this Article)).”

“The fact of departure and the date of departure.”

For the requirements themselves, see What Are Tax-Qualified Stock Options? will handle.

Points that require care in practice

• Income Tax Basic Circular 23–35 Common-6 classifies stock option exercise gains as employment, business or miscellaneous income according to the relationship between the issuing corporation and the grantee, etc.
• Whether individual stock options meet the two conditions determining their treatment under exit tax must be checked against the rights' terms. Unexercised options and shares acquired upon exercise have different statutory positions.
• Where a tax treaty defines domestic-source income differently from Article 161 of the Income Tax Act, the treaty prevails under Article 162. Whether and how it applies must be confirmed from the particular treaty's provisions.

Legal basis

• Income Tax Act, Article 161(1)(xii)(a) (Domestic-source income) / Quoted wording: “Salaries, pay, wages, annual allowances, bonuses, remuneration of a similar nature, and other remuneration for personal services, attributable to employment or other personal services performed in Japan (including employment performed overseas as an officer of a domestic corporation and other personal services prescribed by Cabinet Order).”
• Income Tax Act, Article 164(2) (Taxation methods for nonresidents) / Quoted wording: “Where a nonresident listed in any of the following items has domestic-source income specified in that item, income tax imposed on that nonresident shall, in addition to the preceding paragraph, be calculated by applying Section 3 (Separate taxation of nonresidents' income) to the domestic-source income specified in that item.”
• Income Tax Act, Article 212(1) (Withholding obligation) / Quoted wording: “A person making payment in Japan to a nonresident of domestic-source income listed in Article 161(1)(iv) through (xvi) (Domestic-source income), excluding income prescribed by Cabinet Order, ... must withhold income tax on that domestic-source income upon payment and remit it to the national government by the tenth day of the month following the month of withholding.”
• Income Tax Act, Article 162(1) (Domestic-source income where a tax treaty provides otherwise) / Quoted wording: “Where a tax treaty (...) provides rules for domestic-source income differing from the preceding Article, for persons to whom that treaty applies, domestic-source income shall, notwithstanding that Article, be determined under the treaty to the extent of those differing provisions.”
• Income Tax Act, Article 60-2(1) (Special provisions for capital gains, etc. upon departure from Japan) / Quoted wording: “...Where the person holds securities or equity interests in a silent partnership agreement prescribed in Article 174(ix) (Tax base for income tax on domestic corporations) (excluding securities representing rights to acquire shares free of charge or at a favorable price that would generate domestic-source income prescribed in Article 161(1) (Domestic-source income), and other securities prescribed by Cabinet Order; hereinafter referred to as ‘securities, etc.’ in this Article through Article 60-4 (Special provisions for capital gains, etc. where exit tax provisions have applied)) ... those securities, etc. shall be deemed transferred.”
• Order for Enforcement of the Income Tax Act, Article 170(1), introductory wording (Special provisions for capital gains, etc. upon departure from Japan) / Quoted wording: “Securities prescribed by Cabinet Order in Article 60-2(1) of the Act (Special provisions for capital gains, etc. upon departure from Japan) shall be the following securities that would generate income listed in Article 161(1)(xii) of the Act (Domestic-source income).”
• Order for Enforcement of the Income Tax Act, Article 170(1)(ii) (Special provisions for capital gains, etc. upon departure from Japan) / Quoted wording: “Securities representing rights listed in the items of Article 84(3) to which that paragraph would apply if exercised.”
• Order for Enforcement of the Income Tax Act, Article 84(3)(ii) (Value of restricted shares, etc.) / Quoted wording: “Share acquisition rights issued pursuant to a resolution under Article 238(2) of the Companies Act (Determination of subscription requirements) (including determination of subscription requirements under delegation by a resolution under Article 239(1) (Delegation of determination of subscription requirements), and a board resolution under Article 240(1) (Special provisions for determining subscription requirements in public companies)), limited to rights deemed granted on particularly favorable terms or for a particularly favorable amount to the subscriber, or deemed to constitute all or part of consideration for services or other acts.”
• Act on Special Measures Concerning Taxation, Article 29-2(1)(vii) (Exemption, etc. for economic benefits relating to acquisition of shares through exercise of share acquisition rights received by specified directors, etc.) / Quoted wording: “Where a person granted the share acquisition rights under the contract departs Japan (meaning ceasing to have either a domicile or residence in Japan; hereinafter the same in this item and paragraph (5)) between the contract date and the exercise date, the person must notify the stock company with which the contract for those rights was concluded before departure.”
• Act on Special Measures Concerning Taxation, Article 29-2(5) (Exemption, etc. for economic benefits relating to acquisition of shares through exercise of share acquisition rights received by specified directors, etc.) / Quoted wording: “Where a person receiving the special treatment departs Japan, of the specified shares (excluding specified shares of directors, etc.) held at departure, ... shall be deemed ... transferred at departure at the value upon exercise ..., and Articles 37-10 and 37-11 and other laws and regulations concerning income tax shall apply.”
• Regulation for Enforcement of the Act on Special Measures Concerning Taxation, Article 11-3(3)(ii)(c) (Exemption, etc. for economic benefits relating to acquisition of shares through exercise of share acquisition rights received by specified directors, etc.) / Quoted wording: “Departure from Japan (meaning departure prescribed in Article 29-2(1)(vii) of the Act; hereinafter the same in this paragraph, the following paragraph and paragraph (16)(xi)) by a person receiving the special treatment who holds specified shares (excluding specified shares of directors, etc. (meaning those prescribed in Article 29-2(4) of the Act; hereinafter the same in this Article)).” “The fact of departure and the date of departure.”

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