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Salaried Employees and Necessary Business Expenses


Taxation on salaried employees, the biggest group of Japanese taxpayers, is under review as part of drastic tax reform. This paper discusses the status and position of salaried employees, focusing on the relations between the employment income deduction and necessary business expenses of salaried employees under the Japanese taxation system with respect to income of individuals, as implemented on the principle of self-assessment and taxation on comprehensive income.

Ⅰ Salaried employees, Withholding tax system and , Year-end adjustment

In Japan, employment income is subject to tax withholding at the source. The payers of salaries, wages and other allowance are obliged to withhold the tax when paying salaries, bonuses, etc. to their employees and remit the tax withheld to the national tax authority. Most salaried employees are not required to file a final return. Because if his or her employment income was paid by only one employer and his or her employment income receipt was ¥20,000,000 or less the year-end adjustment of withholding income tax is made in the final payment for the year by the employer, thereby clearing the difference between the finalized tax liability and tax withheld during the year.
With the employment income deduction discussed here and through the tax withholding system, most salaried employees in Japan are able to satisfy their tax obligations and are not required to file tax returns, which means they are almost isolated from the national tax authorities.

Ⅱ The system of employment income deduction

1.Historical development and significance
The history of employment income deduction started in 1913 with the introduction of the earned income deduction. After World War II, the “Shoup Mission’s Recommendation” (*) clarified the rationale of the earned income deduction. In this, they cited that
(1) the deduction represents a sort of depreciation allowance for the exhaustion of working life of individuals; (2) it represents a recognition of the effort and sacrifice leisure involved in “earning”; (3) it is a rough allowance for additional expenses incurred because of the work which nevertheless cannot for administrative reasons be allowed as specific deductions, since they are often almost indistinguishable from normal living expenses; (4) it operates to offset the relatively more adequate assessment of wages and salaries as compared with other form of income.
It deserves note that the Shoup recommendation included abolishing the year-end adjustment.

2. The Supreme Court decision in the case of Prof. Oshima’s litigation
Prof. Oshima of the Doshisha University filed a suit stressing the Constitutional illegality of the taxation scheme whereby necessary business expenses, such as are deductible from business income, are not deductible from employment income. The Supreme Court dismissed this suit quoting the following characteristics of the employment income deduction.
The employment income deduction allows for a predetermined equitable amount for necessary business expenses. It (1) supplements the unstable capability of tax due, which can be seen, for instance, when an employee dies, with income ceasing and (2) the disadvantage that employment income, withheld at the source, is more accurately assessed than other form of income. Moreover, (3) since withheld income tax is paid earlier than other form of income tax that is paid with filing a final return, it compensates for the interest employees could enjoy if their tax were not withheld (Note 1).

In my assessment of the court judgment, the Supreme Court characterizes the employment income deduction as standard deduction for necessary business expenses, but they failed to verify how the above elements are numerically reflected in the employment income deduction. It merits regard that, in reality, ordinary salaried employees tend to overestimate their necessary business expenses.

3. Specific expense deduction for salaried employees
After the case of Prof. Oshima, the income tax reform of 1987 provided for a special arrangement to specific expense deduction for salaried employees. If the amount of specific expense deduction for salaried employees exceeds the amount of the employment income deduction, the excess is allowed as a specific expense deduction (Article 52-2, the Income Tax Law). However, specific expenses are limited, which include; necessary transportation expenses for commuters, ordinary and necessary expenses to move in connection with job transfers, necessary expenses for education and training directly related to qualifying for one’s job (but not for expenses of qualifying as a professional, such as a lawyer, CPA, etc.), travel expenses of a single person starting in a new post (tanshin funin – i.e. visits to family home by a person in a temporary assignment away from home). Owing to such limitations, this scheme applied to only seven individuals in the fiscal year of 2001. In practice, the arrangement does not appear to be functioning well and we cannot but doubt that it is actually a scheme to allow salaried employees to claim a deduction for necessary business expenses (Note 2).

4. Opinions stated in the Government Tax Council’s Interim Report, July 2001
In its Interim Report of July 2001, the Government Tax Council stated
"…employment income deduction is characterized as a ‘standard deduction for necessary business expenses’ and ‘functions to offset a heavier tax burden compared with that of other form of income.’ However, the Council hereafter will consider the employment income deduction necessary business expenses’….”

The Council concluded,
"If the current scheme of employment income deduction is to be reviewed, considering its element as standard deduction for necessary business expenses, application of specific expense deduction for salaried employees will increase, which will provide salaried employees with more chances to personally assess their income and tax amount.”

Although the Council predicted that application of specific expense deduction for salaried employees would increase, they did not review the contents of specific expenses. This implies that the Council suggested lowering the level of employment income deduction as a precondition.

Ⅲ Necessary business expenses for salaried employees

1. Comment by the Government Tax Council
The Interim Report of the Government Tax Council stated,
"…to estimate the actual employee business expenses in Japan, the Council studied the result of the household survey and chose certain expenses deemed necessary in relation to employee business, taking into account the employee business expenses deductible in other countries….”

According to the Council’s studies, the average annual employee income was ¥6,510,000 and the average employee business expenses were ¥433,000, which represents some 6.7% of the gross earned income.
The Council recognized that certain irrelevant items such as haircuts, clothes cleaning, pocket money, etc. are counted as employee business expenses. A few relevant items were omitted. The reason the Council showed no material which distinguishes employee business expenses and household related expenditure might stem from problems in statistical techniques, but the Council seemed unable to establish a clear concept of employee business expenses, which are deductible.

2. The concept of necessary business expenses in Federal income taxation of individuals in the U.S.
(1) Federal income taxation of individuals who have only wages, salaries, etc.
Federal income tax withholding is required for wages and salaries, but without the year-end adjustment as we have in Japan, every individual who has income from wages, salaries is required to file a return.
Adjusted gross income is defined as gross income minus: trade and business deductions, certain trade and business deductions of employees, and others. Taxpayers who do not itemize their deductions are entitled to a standard deduction. Taxpayers have the choice of itemizing deductions or taking the applicable standard deduction amount, whichever figure will result in a higher deduction.
(2) Standard deduction
The amount of the standard deduction varies according to the taxpayers filing status. For example, a husband and wife who file separate returns cannot claim the standard deduction when his or her spouse chooses to apply an itemized deduction.
The amount of standard deduction differs according to the status of taxpayers. For 2002, it is $7,850 for a husband and wife who file a return jointly, $4,700 for an unmarried person, and $6,900 for a head of household.
A taxpayer who chooses to apply the standard deduction cannot apply the itemized deduction such as business expenses, theft or casualty loss, medical expenses, donation to charities, interest on housing loans, state taxes, plus a few others.
Reportedly, about 70% of American wage earners choose the standard deduction.
(3) Itemized deduction
The basic code sections that define what is deductible are Internal Revenue Code section 162 and 262. I.R.C. section 162(a) defines,
“There should be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business….”

This provision applies to a taxpayer, whether a corporation, an individual, a partnership, or a trust or estate. Needless to say, individuals include salaried employees. I.R.C. section 262(a) also provides that
no deduction shall be allowed for personal, living, or family expenses except as otherwise expressly provided.

(4) Ordinary and necessary expenses
Whether an expense is ordinary and necessary is based on the facts surrounding the expense. An expense is necessary if it is appropriate and helpful to the taxpayer’s business. An expense is ordinary if it is one that common and accepted in the particular business activity.
Thus, interpretation of the “ordinary and necessary expenses” concept is given wide latitude. However, it deserves note that legislation places a specific limit on expenses, such as 50% for food and beverages.
(5) Employee business expenses
The performance of service as an employee is considered to be a trade or business. Thus, employee business expenses are deductible, generally. Individuals who are considered to be “statutory employees” may deduct their allowable business expenses from gross income. Statutory employers include a full-time traveling or city salesperson, a full-time life insurance agent, an agent-driver or commission-driver, a home worker performing work on material or goods furnished by the employer.

3. Standard deduction and minimum taxable income
International comparison of the minimum taxable income among various countries whose taxation system, social welfare system, etc. differ from each other requires caution. It would not be appropriate to select salaried employees who belong to a standard type of family in each country as examples, apply the exchange rate to their minimum taxable amount to get the equivalent in local currency and compare them according to country. I also insist it inadvisable to include employment income deduction in the general discussion on calculation of the minimum taxable income (Note 3).

Ⅳ Final tax returns filed by salaried employees

The cost and merit of filing final tax returns by salaried employees
If Japan introduced the principle of allowing salaried employees to choose either the standard or the itemized deduction and file their own final returns, the administrative cost would increase. Salaried employees would be required to keep books of accounts and relevant records or documents, which would impose a new burden and cost on the taxpayers. In addition, the number of taxpayers filing tax returns would increase. Whether the current framework of the certified public tax accountants could cope with such a change remains somewhat debatable.
The merit would be the possibility of introducing negative income tax, such as the earned income tax credit in the U.S. or the GST (Goods and Sales Tax) credit in Canada (Those are refundable.). The introduction of requiring salaried employees’ filing final tax return also would be it possible taxing on fringe benefits, which are one of the biggest loopholes. Then Japanese people would get more conscious about the use of taxes.

Ⅴ Taxation issues for small and medium-scale enterprises

There are more than 2.5 million corporations in Japan. Most of them are small or medium-scale family operations. An obvious reason for the existence of such a large number of small corporations is that they can enjoy a lighter tax burden by using the system of employment income deduction. Everyone knows that by incorporating their business and paying salaries to the proprietor and employees, who are usually their family members, they can apply employment income deduction for salaries paid and can save more taxes than if they file individual income tax returns for their business income.
If Japan introduces the itemized deduction for salaried employees, I suggest considering a scheme of taxation whereby a company below a specific size is treated as group of individuals such as “S Corporation” of the U.S. and individual stockholders are taxed.
Regarding the theory of dual income taxation recently discussed, we should not consider the situation in Japan merely by comparing it with that of Nordic countries: Japanese income taxation of individuals is a kind of schedular one, where separate taxation applies for income from interest, dividends, capital gains, while comprehensive income taxation was norm in Nordic countries. We also must recognize that even by discussing the theory of dual income taxation, as for as taxation on small and medium-scale firms, it is not easy to divide the income derived from finances or assets and that derived from labor (Note 4).


I recommend that salaried employees be given a chance to file their final return with claiming a deduction for necessary business expenses. I also recommend the alternative system so that taxpayers can choose either the standard or itemized deduction. The amount of standard deduction should be determined taking into consideration the minimum taxable income, with its upper limit set.
Introducing a system whereby salaried employees file their final return means that a huge number of taxpayers well aware of their rights will emerge in Japan and that it would be effective in resolving the feeling of unfairness held by many salaried employees. It is highly doubtful that the conventional tax administration in Japan could cope with such a new group of taxpayers. Taxpayers, including the people who earn business income under the current taxation scheme, would be required to keep accurate books of accounts, relevant records, documents, etc. In other words, since it would be a precondition for taxpayers to keep books of accounts, the current system of “blue tax return filing” (**) as a “privilege” would be abolished. At the same time, provisions for the obligation of taxpayers to keep books of account must be prepared, with rules for tax administrative procedures and legislation on taxpayers’ rights required. Those arrangements would be essential since it would be in the nation’s best interests under circumstances where all Japanese citizens must file tax returns.

Note 1:Decision by the Supreme Court, 27 March 1985 (P.5507 “Tax Litigation Materials No. 144”)
Note 2: P. 200 “Tax Laws, 8th edition,” authored by Prof. Hiroshi Kaneko (published by Kobundo in 2001) states different views.
Note 3:“Comparative Studies on Minimum Taxable Income in Japan & U.S.” in “Ten Years’ Implementation of the Consumption Tax Law,” authored by Prof. Takehiro Negishi (published by Horitsubunkasha in 2000) takes the comparative approach by the substantial minimum taxable income.
Note 4:“Economic Policies of Nordic Countries” in “Taxation on Income for Small and Medium-Scale Enterprises,” by Hagen, Kare, Petter, et al. (published by Japan Securities Research Institute in 2001)

- McNulty, John K., Federal Income Taxation on Individuals, West Group, St. Paul, 1999
- Mitsuaki Usui, “Deduction for home office expenses in the U.S.” in “Tax Administration and Remedies for Taxpayers” (Chuokeizaisha 1997)

* “Shoup Mission’s Recommendation”
The mission headed by Dr. Carl S. Shoup was invited from the U.S. in 1949 to review and modernize the structure and administration of the Japanese tax system. After four months’ study, they submitted the recommendation for an overall tax reform plan, which became the foundation of today’s Japanese taxation structure.
** “Blue Tax Return”
Taxpayers who earn income from businesses, real estate or timber and fulfill certain requirements, including keeping books of accounts, are allowed to file blue colored tax returns and enjoy certain privileges such as special deductions, etc.


by nk24mdwst | 2012-10-22 10:12 | 租税法(日本)

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