Executive remuneration practices, and the relevant legal regulations and taxation regimes, have begun to change dramatically in Japan in recent years. Available data clearly shows that the compensation paid by Japanese companies to management and executive-level employees tends to be significantly lower than that paid by western companies. The data is particularly clear in demonstrating that long-term incentives constitute a much smaller portion of overall compensation in Japan.
The Tokyo Stock Exchange implemented the Corporate Governance Code on 1 June 2015. Inter alia, the Corporate Governance Code encourages listed companies to:
- a provide incentives that reflect the mid to long-term performance and potential risks of a company, and incentivise management to engage in healthy entrepreneurship; and
- b provide appropriate mid to long-term performance or equity-based incentives (or both) to promote sustainable growth.
These Corporate Governance Code provisions have encouraged companies in Japan to show greater interest in designing compensation packages for their officers or executives, particularly long-term incentives such as equity benefits. Many companies are actively pursuing globalisation and are considering ways of better incentivising key talent outside Japan.
In connection with this drive, mechanisms capable of providing long-term incentives to officers and directors have been discussed. In one major development in relation to long-term incentive schemes, it is now legal to issue restricted stocks in Japan. In order to do so, the officers and directors must first be compensated by a company with monetary claims which they then contribute to the company in return for the issuance of restricted shares.
Under the former interpretation of the Companies Act of Japan, restricted stocks could not be issued without contributions. However, based on discussions between the Ministry of Economy, Trade and Industry and the Ministry of Justice, it is now generally considered permissible to issue restricted stocks in the above-described manner.
The tax implications of restricted stocks were also clarified in the 2016 tax reforms, and additional broader changes were made in relation to various types of long-term incentive schemes in the 2017 tax reforms.
We are seeing more companies introduce, or consider introducing, long-term incentive programmes, particularly J-ESOP (which uses the stock trust mechanism) and ¥1 stock options (stock options that can be exercised at the minimal price of ¥1), as well as the restricted stocks explained above.
Traditionally, the payment of remuneration to directors has been subject to a stringent tax deductibility threshold. Directors’ bonuses (i.e., non-periodic payments to directors) had, for example, been treated as per se non-deductible expenditures. In addition, amounts by which a director’s regular (periodic) remuneration and retirement payments are considered unreasonably high have been and continue to be treated as non-deductible.
ii 2006 tax legislation
Directors’ bonuses were deregulated under the 2006 tax legislation to the effect that:
- a directors’ bonuses are paid in fixed amounts determined in advance and subject to the provision of prior notice to the tax office; and
- b in the case of public corporations with remuneration committees, which are required to disclose annual reports under securities law, ‘profit-based’ remuneration has been treated as a deductible expense subject to the satisfaction of certain requirements.
Under the same legislation, the stock options granted to directors under non-qualified stock options plans are also treated as deductible, so long as certain requirements are satisfied. In other words, remuneration paid to directors is deductible in Japan provided that certain conditions are met and the remuneration is categorised as (1) fixed periodic payments, (2) fixed payments with advance notice or (3) performance-based bonuses determined in proportion to profits.
iii 2016 tax legislation
The 2016 tax legislation also characterises restricted stock granted on or after 1 April 2016 as ‘fixed payments with advance notice’ and deductible for corporate tax purposes. Under the relevant tax provisions, only restricted ‘shares’ that satisfy certain requirements are eligible for treatment as fixed payments with advance notice. An advance ‘delivery of shares’ as consideration for a director’s services ‘before the vesting date’ is one such requirement. The other requirements that must be satisfied in order for restricted shares to be eligible for treatment as fixed payments with advance notice under Articles 34 and 54 of the Japanese Corporation Tax law are as follows:
- a The shares must be restricted shares (RSs) that are not transferable for a certain period.
- b If the target performance is not achieved, a forfeiture provision is triggered, under which the shares do not vest and are returned to the issuing company free of charge.
- c The RSs must be issued as consideration for services.
- d The RSs must be issued by a ‘domestic’ employer company or its direct or indirect 100 per cent parent company (not limited to domestic companies).
- e The RSs must be delivered to the director in exchange for monetary claims (i.e., notionally granted but not a taxable event for income tax purposes) for payment for future director services in amounts fixed before the commencement of such director services. However, if the monetary claim amounts fluctuate in connection with performance after the director services commence, they are not categorised as a ‘fixed payment’ of the director’s remuneration (and are therefore non-deductible).
The amount of the deduction is the amount of the monetary claims exchanged, and is not necessarily equal to the taxable income realised by the director upon the vesting of the RSs. The deduction will be made at the employer level when the director recognises taxable income from the RSs. Taxation at the director level takes place when the restriction is deleted (i.e., when the stock becomes transferable, normally on the vesting date). In the case of a director who is not a resident of Japan, it is generally considered that since the income upon vesting in such a case is not categorised as remuneration income for income tax purposes, no deduction is available for the employer company.
Where both of the following conditions (in relation to the RS approval and delivery process) are met, advance notice is not required.2
- a A resolution is passed by a shareholders’ meeting regarding the amount of each director’s remuneration (or by a board meeting where the board is authorised by a shareholders’ meeting to determine the remuneration amounts) within one month of the date on which the director services commence (most often the date of the ordinary general shareholders’ meeting).
- b The RSs are delivered within one month from the date of the above resolution in exchange for the monetary claims for remuneration for director services (the monetary claim amount is also determined at the time of the resolution in (a) above).
The corporate law procedures regarding the timing of shareholders’ meetings and board meetings are also relevant.
As explained above, the tax deductibility requirements rely on a unique Japanese RS legal mechanism: the fact that an employee must contribute his or her claim to the company in advance. This arrangement is a technical (in a sense, virtual) means of circumventing the Companies Act requirement that something be contributed in order for stock to be issued. Such grants of monetary claims are merely ‘notional’ in an economic sense (‘synthetic’ grants carried out solely to nominally satisfy the requirements of the Companies Act). Indeed, for Japanese income tax purposes, such grants are not taxable events.3 In other words, from a Japanese tax perspective, because employees do not actually receive or retain any economic benefit from such monetary claims, receiving such a monetary claim is not recognised as a taxable event. The RSs (and thus the monetary claims exchanged for them) become taxable only upon the expiration or deletion of the transfer restriction.
In the case of foreign restricted stock ‘units’ prevailing in other countries, it is understood that the delivery of shares is optional, cash payment may be made in lieu of the delivery of shares, and the ‘restricted shares’ may be fictional or notional until vesting. Thus, the new Japanese tax treatment would not be available for such restricted stock units.
Furthermore, profit-based remuneration factors also expanded under the 2016 tax legislation. Earnings before interest, taxes, depreciation and amortisation, return on equity, return on assets and other similar parameters can now be used as the profit-based factors.
iv 2017 tax legislation
The 2017 tax legislation made the following changes in order to establish consistent tax treatment for similar but different stock incentive plans, expand the persons or entities eligible for tax deductible treatment for RSs, and expand the scope of performance-based bonuses.
(1) Fixed periodic payments
(2) Fixed payments with advance notice
(3) Performance-based bonuses determined in reference to fixed parameters
‘Net’ fixed payments after deduction of withholding tax and social insurance premiums have been included in this category.
Compensation in the form of grants of a fixed number of listed shares and/or stock options (upon exercise of which listed shares are obtained) at a fixed time has been included in this category.
In the case of RSs, if the number of shares is determined based on performance-based parameters, they are outside the scope of this category.
In addition to (1) the profit-based parameters, (2) parameters reflecting the fair market value of shares or (3) parameters reflecting sales proceeds (if used in combination with (1) and/or (2)) can be used.
Parameters can also be used for multiple future years or for a fixed future time/period.
Compensation in the form of grants of a fixed maximum number of listed shares and/or stock options (upon exercise of which listed shares are obtained) based on performance-based parameters has been included in this category.
Compensation in the form of stock options (upon exercise of which listed shares are obtained) for which the number that may be exercised is determined based on performance-based parameters has been included in this category.
Under the 2017 tax legislation, where the number of RSs is determined based on performance-based parameters, it is not tax deductible. In addition, stock options that do not constitute ‘fixed payments with advance notice’ or ‘performance-based bonuses determined in reference to fixed parameters’ are not treated as tax deductible. Finally, while directors’ retirement payments were outside the scope of these requirements before the 2017 tax legislation (tax deductible as long as the amount was considered reasonable), under the 2017 tax legislation, if a director’s retirement payment is calculated based on performance-based parameters, the requirements for ‘performance-based bonuses determined in reference to fixed parameters’ must be satisfied to receive the tax deduction. These changes are not favourable to taxpayers, but the government believes them to be necessary to maintain tax treatment consistency. These unfavourable changes are effective from 1 October 2017. The other changes, which are favourable to taxpayers, are effective from 1 April 2017.
The 2017 tax legislation narrows the scope of the ‘fixed payments with advance notice’ category while widening the scope of the ‘performance-based bonuses determined in reference to fixed parameters’ category. This means that opportunities will increase to introduce various tax-deductible profit/performance-based directors’ compensation plans, such as stock-delivery trust plans and other performance-based stock incentive plans.
III TAX PLANNING AND OTHER CONSIDERATIONS
In the past, the structuring of the incentive elements of a director’s remuneration (i.e., integrating incentives into fixed periodic payments) has been a tax-planning consideration. However, doing this dilutes the incentive effect, leading to a conflict between a company’s tax treatment and corporate governance goals. On the other hand, since the scope of director bonus tax deductibility expanded under the 2016 and 2017 tax legislation, it should be possible to provide appropriate incentives to directors in the future.
IV EMPLOYMENT LAW
In principle, representative directors and other directors who act solely as directors are not categorised as employees under Japanese law. Such directors do not enjoy labour law protections, and matters relating to them are generally governed by the Companies Act. Unless otherwise indicated, this section is based on the assumption that the labour laws apply to executives.
i Changing working conditions
From a legal perspective, one of the most important factors to consider when offering compensation or benefits is the difficulty of reducing compensation and benefits once granted. Generally, the consent of each employee must be obtained in order to change working conditions. The work rules can be changed via certain procedures provided under the Labour Standards Act. Procedurally, the individual consent of each employee is not required. However, under Articles 9 and 10 of the Labour Contract Act and the relevant court precedents, an amendment to the work rules that involves a detrimental change to working conditions can be valid only where (1) each affected employee consents to the change, or (2) the change is reasonable and the amended work rules are sufficiently communicated to the employees.
ii Signing bonuses
A common difficulty faced by international companies in Japan is that Article 16 of the Labour Standards Act does not permit the payment of a signing bonus that an employee is required to repay it if he or she resigns before a certain period elapses. Article 16 of the Labour Standards Act prohibits a company from concluding a contract with an employee that requires the employee to pay predetermined compensation in the event of a breach of the employment contract. ‘Predetermined compensation’ basically means a fixed amount that the employee has to pay to the employer for breach of contract – a type of liquidated damages. The purpose of this prohibition is to prevent companies from imposing undue burdens on their employees by financially penalising them for breaching their employment contracts.
Requiring an employee to repay a signing bonus can be seen as an agreement on predetermined compensation. Once the signing bonus is paid, it becomes the employee’s sole property and there should be no strings attached to funds already paid to an employee. Requiring an employee to repay a signing bonus later is essentially equivalent to requiring the employee to pay compensation in a predetermined fixed amount.
iii Restrictions on termination or severance
Assuming that an executive is classified as an employee for labour law purposes, under Article 16 of the Labour Contract Act and the relevant court precedents, unilateral termination of the executive will be invalid if it is found to have been conducted in a manner which is an ‘abuse of the employer’s right of termination’. Generally speaking, courts are more sympathetic to the positions of employees in wrongful termination cases, and it is quite difficult to establish a justifiable reason for such termination.
However, if an individual can be classified purely as a director, and not an employee for labour law purposes, the company can generally terminate such a director at any time. Such a director could not bring a claim for reinstatement. However, the company may be required to pay compensation for any damages caused to the director as a result of the termination if there is no ‘just cause’ for the termination.4 The amount of the damages could be as large as the amount of compensation and benefits the director would have earned for the portion of his or her term of office remaining at the time of his or her wrongful termination.
No statutory severance requirements exist for employees or directors. However, many companies have rules or policies regarding retirement benefits to be paid to employees or directors when they leave the organisation. If such rules or policies exist, such retirement benefits must be paid accordingly. In the absence of such rules, payment of retirement benefits is not legally required. However, where the company wants to terminate employees or directors, it is quite common to ask the employees or directors to resign voluntarily as a result of the aforementioned difficulty in justifying unilateral termination. In such cases, it is usually necessary to offer a certain amount of ex gratia severance in order to induce such employees or directors to resign.
iv Non-competition covenants
In determining whether a non-competition covenant is enforceable, the court balances:
- a the employer’s right to protect its trade secrets;
- b the disadvantages imposed on the employee and the degree to which the employee’s constitutional right to choose an occupation is restricted; and
- c the impact on the interests of society (or the community).
The court considers many factors when balancing these three elements, including (1) the nature of the employee’s position and responsibilities (e.g., degree of exposure to confidential information), (2) whether additional compensation has been paid for the non-competition covenant and (3) the length and scope (geographical and type of business) of the restriction. The court will examine these factors comprehensively.
If the non-compete can be strongly justified by factors (1) and (2), a court would enforce a long-term (e.g., two-year) non-competition covenant, which is broad in scope in terms of both the geographical area and the types of employment restricted. However, if the justification is not strong, the company would need to consider limiting the length of the non-compete period (e.g., six months or one year) or the scope of the restricted geographical area and types of employment.
V SECURITIES LAW
i Public offering
Under the Financial Instruments and Exchange Act of Japan (the FIEA), solicitation for the subscription of securities in a company made to 50 or more persons in Japan generally constitutes a ‘public offering’. This triggers an obligation on the part of the issuing company to file a securities registration statement (SRS) or securities notice (depending on the total issue price) with the local finance bureau prior to the commencement of the solicitation.
Stocks, restricted stock and stock options fall under the definition of ‘securities’ under the FIEA. However, it is generally understood that a stock-based incentive to be paid to directors, officers or employees in cash in accordance with appreciation in the market value of the issuing company’s stock does not fall within the definition of securities. Thus, disclosure requirements will not generally be an issue in such cases.
Offering securities to fewer than 50 persons in Japan is considered a private offering, which generally requires no securities filing. However, an offer of securities will be deemed a public offering even if the securities are offered to fewer than 50 persons where the securities are listed on any stock exchange in Japan or the issuer has filed an SRS in Japan with respect to the securities.
Notwithstanding the foregoing, the offering of stock options in Japan will generally be exempt from the disclosure requirements when the transfer of the stock options is restricted and the stock options are offered only to officers or employees (or both) of the issuing company or certain wholly owned subsidiaries of the issuing company.
ii Statutory prospectus
Where the relevant offering triggers an SRS filing, the issuing company will be required to deliver a statutory prospectus to the offerees prior to or at the same time as the solicitation of offers in Japan either in hard copy or electronic format (e.g., via email). The format of the statutory prospectus is substantially the same as that of the SRS.
iii Continuous disclosure
Once an SRS is filed, the issuing company must comply with the continuous disclosure requirements set out in the FIEA, under which the issuing company is required to file an annual securities report and semi-annual report with the local finance bureau (a company listed on a securities exchange in Japan must comply with quarterly disclosure requirements as well). Additionally, in the event of certain material changes in the issuing company’s financial, economic or other corporate conditions prescribed under the FIEA, the issuing company must file an extraordinary report without delay. The annual securities report, semi-annual report and extraordinary report are substantially equivalent to Forms 10-K and 10-Q submitted to the SEC under US securities laws, and must be filed via the Electronic Disclosure for Investors’ NETwork (EDINET) administered by the Financial Services Agency (FSA) of Japan and disclosed to the public for the purpose of informing investors about the issuing company. In principle, these continuous disclosure documents must be written in the Japanese language. However, if the issuing company publicly discloses certain continuous disclosure documents written in the English language in accordance with foreign securities laws or foreign stock exchange rules (e.g., Forms 10-K and 10-Q) and the FSA of Japan approves after taking the public interest and investor protection into consideration, these continuous disclosure documents can be partly written in the English language.
iv Prohibition of insider trading
The FIEA contains a rule prohibiting insider trading under which directors, officers and employees, etc., of a company listed on a securities exchange in Japan who become aware of material information in relation to the listed company through certain means are prohibited from buying or selling certain securities, including stocks, restricted stock and stock options of the listed company before said material information is made publicly available by the listed company. The insider trading prohibition rules apply to dispositions of securities by directors, officers and employees, etc., but not to the exercise of stock options.
The FIEA provides certain exceptions from the insider trading rules, which include the buying or selling of securities based on a plan or contract that (1) was established or entered into and (2) confirmed by a securities company before the director, officer or employee became aware of the material information. In order to utilise this exception, the terms and conditions of the disposition of the securities must be fixed in the plan or contract.
v Disclosure obligation of directors or officers
A director or officer of a company listed on a securities exchange in Japan must file a report with a local finance bureau when he or she purchases, sells or enters into certain derivative transactions in relation to certain securities relevant to the listed company, including stocks and restricted stock issued by the listed company. If the transaction is entrusted to a securities company in Japan by the director or officer, the report must be filed via the securities company.
vi Short swing rule
A director or officer of a company listed on a securities exchange in Japan who personally profits from the sale of certain securities relevant to the listed company, including stocks and restricted stocks, within six months of the purchase may be requested by the listed company to disgorge his or her profits to the listed company.
i Type of filing document
In the case of a public offering of securities in Japan, the type of filing document required is determined by reference to the ‘aggregate of the total issue prices’ of the securities offered to offerees in Japan. For stock options, the aggregate of the total issue prices is determined by reference to the aggregate of the total issue prices of the stock options (usually zero) and the expected maximum total exercise prices of the stock options. The expected maximum total exercise prices of the stock options is determined by the total estimated amount required to be paid if all of the stock options granted to offerees in Japan are exercised.
The total estimated issue price filing requirement thresholds are as follows:
- a ¥10 million or less: no disclosure or filing requirements are imposed on the issuing company;
- b greater than ¥10 million but less than ¥100 million: the filing of a securities notice by the issuing company is required; and
- c ¥100 million or more: the filing of an SRS by the issuing company is required.
A further aggregation rule exists regarding these monetary thresholds under which the issue prices of certain other offerings must also be aggregated.
Please note that restricted stocks issued by a Japanese company need to be issued in exchange for the provision of monetary claims to the issuing company, while Western companies can generally issue restricted stock without consideration without it being treated as an offering of securities requiring registration or disclosure. As such, for purposes of the above calculation, the total issue price of the restricted stocks issued by the Japanese company will be the total amount of said monetary claims.
The two main types of filings under the FIEA are (1) securities notice filings and (2) SRS filings. A securities notice filing is a less onerous filing obligation than an SRS. Its contents are not disclosed to the public, and are limited to information concerning the securities involved and the securities issuance history of the issuing company – general corporate information concerning the issuing company does not need to be reported. A securities notice must be written in the Japanese language and filed no later than one day prior to the commencement of solicitation in Japan.
An SRS, by contrast, must be filed via EDINET. It is a statement that must be disclosed to the public for the purpose of informing investors about the issuing company, especially its financial condition and other relevant information useful in making investment decisions. The corporate information portion of an SRS is equivalent to Forms 10-K and 10-Q, which are submitted to the SEC under US securities law. In principle, an SRS must be written in the Japanese language, but if the issuing company publicly discloses certain documents written in the English language in accordance with foreign securities laws or foreign stock exchange rules (eg, Forms 10-K and 10-Q) and the FSA of Japan approves after taking the public interest and investor protection into consideration, the SRS can be partly written in the English language. Also, the SRS must disclose a summary of the conditions of the securities offering, including a summary of the transfer restrictions and the number of securities to be offered to each executive. Disclosure of offerees’ personal information will not be required for the offering of restricted stock or stock options with transfer restrictions. After an SRS is filed, a 15-day waiting period must be observed prior to the granting of securities in Japan.
iii Relaxed filing requirements
A company that has complied with certain conditions, including the obligation to engage in at least one year of continuous disclosure, may utilise the reference-style SRS. This permits the company to incorporate documents it has continuously disclosed into the SRS by reference. Under this method, the company is not required to update all of its corporate and financial information in the SRS each time a new SRS is filed and the above waiting period may be shortened to seven days.
iv Timely disclosure
In addition to filing a securities notice or SRS, if the issuing company is listed on a securities exchange in Japan, the issuing company must, based on the regulations of the relevant securities exchange, disclose its decision to issue stock or stock options. In the case of companies listed on the Tokyo Stock Exchange, such disclosure will then be released to the Japanese media and to investors via the internet and the TSE’s online disclosure system (TDnet).
VII CORPORATE GOVERNANCE
For a stock company, compensation to be paid by the company to directors must be approved by the articles of incorporation or a shareholders’ resolution under Article 361.1.1 of the Companies Act. However, it is more common in practice and permissible under the relevant court precedents to pass a shareholders’ resolution on the maximum total amount of compensation to be paid to all directors and leave the precise allocation of compensation to each director to be resolved by the board of directors.
Also, with regard to retirement benefits, the relevant court precedents hold that they can be paid without the approval of a specific amount by a shareholder’s resolution. As long as the retirement benefits are objectively calculated and paid based on certain standards or criteria, they may be paid based on a board resolution.
Turning to variable incentives or bonuses paid based on performance indicators, the specific calculation formulas under which the incentives or bonuses are calculated must be approved by a shareholders’ resolution under Article 361.1.2 of the Companies Act. The directors are required to explain why they consider the incentives calculated based on the calculation formulas to be reasonable under Article 361.4 of the Companies Act.
The Companies Act does not generally require the appointment of any outside directors. However, certain large, public companies are required to explain why it would not be appropriate for them to have outside directors if they lack outside directors. Also, the Corporate Governance Code provides that listed companies should appoint at least two independent directors.
A company with a nominating committee, etc., as defined under the Companies Act has a different corporate governance structure, and a majority of the members of each committee must be outside directors under Article 400.3 of the Companies Act. For companies of this type, the compensation committee determines the compensation to be paid to executive officers and directors under Article 404.3 of the Companies Act.
VIII SPECIALISED REGULATORY REGIMES
No notable regulations exist regarding executive compensation for particular industries. However, industry-specific rules or standards exist concerning various matters. It would be advisable to confirm whether such rules or standards exist in each particular industry.
IX DEVELOPMENTS AND CONCLUSIONS
As explained above, executive compensation practices in Japan have begun to change greatly in recent years. Executive compensation within Japanese companies was formerly very different from that of western companies, and it has become an obstacle to the globalisation of Japanese companies. There have been some changes, and will likely see further changes over the mid to long term, in the legal and tax regulations relating to executive compensation.
1 Tomohisa Muranushi and Shinichi Kobayashi are partners and Kosuke Yatabe is an associate at Baker McKenzie (Gaikokuho Joint Enterprise).
2 Under Article 34(1)(ii) of the Japanese Corporation Tax Law and Article 69(2) of the Japanese Corporation Tax Law Enforcement Order.
3 Under Article 84(1) of the Income Tax Law Enforcement Order.
4 Article 339.2 of the Companies Act.