Failure to pay executive compensation appropriately can be costly.

If you are new to Japan, you may not be familiar with some of the tax laws. Therefore, I would like to explain how the Japanese corporate tax law regulates compensation for directors.

Under the tax law, remuneration for directors is not deductible. However, it is deductible only in the following three cases. If this rule is not followed, the company may have to pay unnecessary taxes.

There are three cases in which executive compensation is deductible.

1 Fixed and periodic remuneration

If a company pays fixed executive compensation at regular intervals of one month or less, it can be included as a deductible expense for tax purposes.

2 Pre-reported rewards

Tax deductions are available by submitting the schedule and payment amount to the local tax office in advance.

3 Performance-based compensation

Tax deductions are available when compensation is based on the company’s profits. Certain requirements are set forth in the tax law. A relatively limited number of companies, mainly listed companies, are eligible.

In practice, many small and medium-sized companies pay fixed and regular remuneration to their directors. In order for executive compensation to be deductible, the amount paid to each director must be fixed for a certain period of time as described above. In addition, any revision of executive compensation must be made within three months of the start of each fiscal year. If the executive remuneration is revised, the revised fixed remuneration must be paid until the re-revision is made.

You may think that this rule may not be flexible enough to run a company. However, the first priority of the Japanese tax authorities is to “eliminate arbitrariness” in order to achieve fairness in taxation. From the standpoint of the tax authorities, by increasing or decreasing executive compensation, companies are free to adjust their taxable income. Specifically, if a company’s performance is good and profits increase, it can increase executive compensation to reduce taxable income. To prevent this, the tax authorities require that the amount and schedule of executive compensation be determined in advance.

Companies should also be aware that excessive executive compensation is not deductible under tax law, even if it falls under any of the three categories above.