A Thorough, Easy-to-Understand Guide to Consumption Tax When Starting a Business: Focusing on Determining Tax Liability

This time, it is a serious topic.

When establishing a company, the most important decision from a financial perspective is how consumption tax will apply.

Basically, except in special industries that can receive a consumption-tax refund, it is more advantageous to be exempt if an exemption is available.

Consumption tax failed to be introduced many times in the past. To finally get it introduced, the system was designed with consideration for small and medium-sized businesses. The exemption after establishment is the foremost example of this, making it a very advantageous system.

Can the company you are establishing receive a consumption-tax exemption? Or how can it receive one?

I will explain the criteria for making that determination. This is a basic discussion, so I will not explain cases of organizational restructuring involving mergers, acquisitions, and the like.

First, understand how advantageous a consumption-tax exemption can be

Let us review the basics of consumption tax. This is the consumption tax when an ordinary company purchases something for ¥50 and sells it for ¥100 (excluding tax).

• Sales ¥100 (consumption tax collected ¥8)
• Purchases ¥50 (provisional input consumption tax ¥4)
• Profit ¥50 (consumption tax payable ¥4)

This is how it works. You pay the difference between the ¥8 in consumption tax collected and the ¥4 in provisional input consumption tax.

When you become a consumption-tax-exempt business, payment of this consumption tax is waived. In other words, the same transaction is calculated as follows.

• Sales ¥108
• Purchases ¥54
• Profit ¥54

As you can see, you gain the amount of consumption tax that would have been paid! Wonderful. The figures here are small, so you may only think, “Oh.” But if, for example, you earn ¥30 million in profit, taxable and exempt treatment create a ¥2.4 million difference in profit.

Criteria for consumption-tax exemption (whether you become a taxable business)

• Whether taxable sales in the base period exceed ¥10 million
• Whether taxable sales in the specified period (or the total amount of salaries and similar payments) exceed ¥10 million

First, keep these two criteria in mind.

The key points are probably the base period, the specified period, and ¥10 million in sales.

Confirm the meaning of the base period

You can remember that the base period is two years ago.

• For corporations (stock companies, etc.), it is the fiscal year before the preceding fiscal year
• For individuals, it is the year before the preceding year

The terminology differs, but in both cases it means two years ago.

Confirm the meaning of the specified period

Until now, whether a business was taxable or tax-exempt in the current calendar year or fiscal year was determined by whether taxable sales in the “base period”—the year before the preceding year for an individual business operator, or the fiscal year before the preceding fiscal year for a corporation—exceeded ¥10 million.

However, part of the Consumption Tax Act was revised in June 2011, and for years or fiscal years beginning on or after January 1, 2013, a new requirement called the “specified period” was added in addition to the existing “base period” requirement.

That is right. This is a newly created requirement. Why did such an odd and troublesome criterion arise? Understanding that background should make it easier to follow.

Background to the introduction of the specified period

In fact, before the specified period was introduced, tax saving (tax evasion?!) using the consumption-tax exemption was popular.

It was learned on the 10th that the Tokyo Regional Taxation Bureau had filed a criminal complaint with the Tokyo District Public Prosecutors Office against a former president in their 40s of a building-maintenance company (Nerima Ward, Tokyo) and two group companies for allegedly violating the Consumption Tax Act. They were suspected of evading about ¥84 million in consumption tax by abusing the consumption-tax exemption system applied to recently established companies. The former president is believed to have already filed amended tax returns.

According to people involved, the president abused the system under which companies with capital of less than ¥10 million are exempt from paying consumption tax for two years after establishment. The president is alleged to have evaded about ¥84 million in consumption tax over the three years through the fiscal year ending last March by successively establishing dummy companies with small amounts of capital and making it appear that work had been outsourced to them.

¥84 million less tax over three years. You can understand why someone would want to do it if it were not illegal. This time, it was illegal because dummy companies were used, but doing it properly would not be illegal.

The first trial of the president of the barbershop-operating company “Select Management,” who was charged with violating the Consumption Tax Act and other offenses for allegedly evading about ¥28.5 million in consumption tax, was held at the Kofu District Court on the 19th, and the president admitted the charges.
The company operates “Cut House Quick,” a low-cost barbershop where customers can get a haircut for ¥990.
In its opening statement, the prosecution said, “The company evaded taxes to secure operating funds and employees’ wages.” The defense said it would present proof at the next hearing and did not make an argument.
The indictment alleges that the company abused the system under which companies with capital of less than ¥10 million are exempt from consumption tax for two years after establishment, shifting sales over the three years through the fiscal year ending June 2011 to two dummy companies with capital of less than ¥10 million in order to evade taxes.

This one also involved dummy companies. Once a company is identified as a dummy and a criminal complaint follows, it is game over.

Because things like this happen, the National Tax Agency put on the brakes in an effort to impose at least some restraint. Strictly speaking, however, it cannot prevent avoidance of taxation. It can only prevent people from doing it conspicuously.

It was learned on the 17th, in an investigation by the Board of Audit, that “tax avoidance” is occurring frequently through the use of a system that exempts newly established corporations with capital of less than ¥10 million from the obligation to pay consumption tax for two years. According to the Board, 58 cases were referred by tax authorities as tax-evasion cases during the five years through fiscal 2010, with total tax evasion of about ¥4.158 billion. The system will be partially revised next January, but it is said that “tax avoidance” cannot be prevented.

Apart from the cases referred for prosecution, the Board selected and investigated 1,546 corporations newly established with capital of less than ¥10 million, focusing on 2006, when the minimum-capital system that had required at least ¥10 million in capital to establish a stock company was abolished.

As a result, 206 individual business operators who had become liable to pay tax transferred their businesses to newly established corporations and were exempted from paying tax for two years. In addition, among the 24 corporations that dissolved after the exemption and the like, there appeared to be cases in which sales were transferred to separately newly established corporations.

More detail on the specified period

For an individual business operator, the specified period means the period from January 1 through June 30 of the preceding year; for a corporation, it means, in principle, the six-month period beginning on the start date of the preceding fiscal year for that fiscal year.

Until now, if taxable sales in the base period were ¥10 million or less, a business was tax-exempt and its obligation to pay tax was waived. However, with the addition of the specified-period requirement, a business continues to be taxable when taxable sales in the base period exceed ¥10 million; moreover, for years or fiscal years beginning on or after January 1, 2013, a business becomes taxable when taxable sales in the specified period exceed ¥10 million even if taxable sales in the base period are ¥10 million or less.

For the specified-period test, it is also possible to use the total amount of salaries and similar payments instead of taxable sales. The taxpayer may choose which criterion to use. Therefore, even if taxable sales in the specified period exceed ¥10 million, the business can be determined to be tax-exempt if total salaries and similar payments do not exceed ¥10 million.

Thus, there are two criteria for the specified-period test—taxable sales and total salaries and similar payments—but it is not necessary to test both. For example, it is acceptable to omit the aggregation of taxable sales in the specified period and determine the result solely using the total-salaries-and-similar-payments criterion. Here, total salaries and similar payments means the aggregate of salaries, bonuses, and the like that were paid during the specified period and are subject to income tax. Unpaid salaries and the like are not included, so please take care.

Specific examples of the specified period

• The specified period for individual business operators and corporations with one-year fiscal years

For an individual business operator, the specified period is the period from January 1 through June 30 of the preceding year; for a corporation, it is, in principle, the six-month period beginning on the start date of the preceding fiscal year for that fiscal year.

Therefore, for example, if an individual who was not operating a business opened one on March 1 of the preceding year, the determination is made based on taxable sales or total salaries and similar payments from March 1 through June 30. If the business was opened between July 1 and December 31, there are no taxable sales or total salaries and similar payments for the specified period, so no determination is required.

1. Specified period for a newly established corporation (a corporation whose preceding fiscal year is not one year)

1-1. When the first fiscal period after establishment is eight months or more [specified period exists]

　For example, if a corporation was established on May 1 of the preceding year and its preceding fiscal year was the eight-month period from May 1 through December 31, the six-month period beginning on the start date of the preceding fiscal year—that is, the six months from May 1 through October 31—is the specified period.

1-2. When the first fiscal period after establishment is less than eight months [there may or may not be a specified period]

1-2-1. A corporation established during a month, whose preceding fiscal year (seven and a half months) ends on the last day of a month [specified period exists]

 If, for example, a corporation was established in the middle of a month, on May 15 of the preceding year, and its fiscal year-end is the last day of a month, December 31, its preceding fiscal year is seven and a half months. The six-month period beginning on the first day of the preceding fiscal year ends on November 14 because the establishment date is May 15. But when the preceding fiscal year ends on the last day of a month, the last day of the month before the date six months later (November 14)—that is, October 31—is the last day of the specified period. Therefore, in this case the specified period is May 15 through October 31 of the preceding fiscal year, and the determination is made based on taxable sales or total salaries and similar payments during that period.

1-2-2. When the first fiscal period after establishment is seven months [no specified period]

 For example, if a corporation was established on June 1 of the preceding year and its fiscal year-end is December 31, its preceding fiscal year is seven months. Although there is a six-month period from the date of incorporation to the end of the preceding fiscal year, when the preceding fiscal year is seven months or less, that period does not qualify as a specified period. Therefore, no determination based on taxable sales in the preceding fiscal year is required.

Even where there is no specified period and the corporation would not otherwise be a taxable business, a corporation whose amount of capital or capital contributions at the start of the fiscal year is ¥10 million or more (a newly established corporation as defined in Article 12-2, paragraph 1 of the Act) is a taxable business for the first two years after establishment, so please take care. From the third year, the general rule returns, and tax liability is determined by the base period and specified period.

Several examples were given above, but the specified period may differ in other cases as well, such as newly established corporations that have changed their fiscal year-end, depending on when the corporation was established and when the fiscal year-end was changed.

The explanation is long, but to summarize it simply, at the risk of misunderstanding:

“The specified period is the first six months of the preceding year. With the addition of the specified-period criterion, determinations of whether the first and second fiscal periods after establishment are exempt have also increased.”

That is what it means. In the past, if you met the conditions, exemption for two fiscal periods was certain and easy, but...

The reason for the incomprehensible criterion of the first six months is consideration for practical operations. If the latter half were also a criterion, confirmation of whether a business was taxable would come too late for operations to function.

Now that you understand it, use the chart to check whether you are exempt from consumption tax

If you proceed according to the decision diagram, it is not that difficult. The desired goal is the “Election of taxable or exempt treatment” or “Exempt” box at the lower right.

Reviewing the key points of consumption-tax exemption to check carefully when starting a business

A newly established company has no base period

A newly established company did not exist two years ago. Therefore, a newly established company is treated as having no base period. Since it does not exist, the first criterion—“Do taxable sales in the base period exceed ¥10 million?”—is cleared on the determination that they do not exceed it.

Therefore, the company is tax-exempt for up to two years (24 months).

Let us examine the requirements in a little more detail.

Both 1 and 2 must be met.

An important point here: When starting a business (or launching a venture), keep capital below ¥10 million whenever possible. It means “below,” so ¥10 million puts you out!

A collection of every trick in the book for somehow securing exemption at startup

Regarding condition 1 above, “the amount of capital must be less than ¥10 million,” one approach is to make part capital and part borrowings or capital reserves. For example, if you are starting a business that needs ¥30 million in funds, rather than treating the whole amount as capital, you could use ¥9 million in capital and borrow ¥21 million (such as a loan from the founder). It may be a somewhat rare case, but care is needed if you increase capital partway through. If capital is increased to ¥10 million or more before the beginning of the second fiscal period, the exemption does not apply from the second fiscal period.

Likewise, to meet condition 2 above—that “taxable sales in the specified period are ¥10 million or less, or total salaries and similar payments are ¥10 million or less”—one method is to set a fiscal period of less than one year. Close the books before sales or salary payments reach ¥10 million. If sales are ¥1 million per month, close the books after nine months. Then first-period sales are ¥9 million, so you are safe.

There is also an aggressive method concerning “taxable sales in the specified period are ¥10 million or less, or total salaries and similar payments are ¥10 million or less.” Use it when business is going too well. It is to set a fiscal period of seven months or less. There is an exception for the specified period: the law provides that “where the period is seven months or less, it is a short fiscal year (Consumption Tax Act 9-2(4)) and is not determined based on sales in the preceding fiscal year.” Therefore, if the first fiscal period after establishment is seven months or less, the business can remain tax-exempt in the second year even if taxable sales and the amount of salaries and similar payments paid during that period exceed ¥10 million! A business whose exemption would end after a normal one-year first fiscal period can extend it to one year and seven months.

As an extra, somewhat detailed method, regarding the point that “total salaries and similar payments in the specified period are ¥10 million or less,” there is the method of paying wages on the fifth day of the following month after closing the month-end (for example). This makes 12 months of wages effectively count as 11 months for the determination. For wages, the amount is based on “payment,” not “accrual.” Therefore, there will relatively often be cases that can be managed by adjusting payment. Items included in wages include “officer compensation, employee wages (including part-time workers), overtime allowances, holiday allowances, bonuses, retirement benefits, and the like,” and you should note that various allowances are also included. Conversely, transportation expenses and commuting allowances are not included.

Be careful with subsidiaries of large companies

There is also the concept of a specified newly established corporation (Article 12-3(1) of the Consumption Tax Act), under which special determinations are needed for subsidiaries of companies with taxable sales exceeding ¥500 million. Basically, you can assume that it is difficult for a subsidiary of a large company with taxable sales exceeding ¥500 million to be exempt. This criterion is difficult to determine, so consult a tax accountant when it actually becomes necessary.

(Extremely Important) Avoid the pitfall of losing out by being exempt

When newly establishing a business at startup or incorporation, satisfying the conditions basically makes it exempt automatically, but you can also elect taxable-business status and file a notification yourself. In fact, being a taxable business can be more advantageous in some cases. These are cases where:

・A large capital investment and the like is required in the first fiscal period after establishment
・Almost no sales arise in the first fiscal period after establishment

Put simply, at the risk of misunderstanding, consider taxable-business status when expenses exceed income. In that case, you can often receive a refund. The consumption tax you paid comes back. It does not come back if you are a tax-exempt business, so you have paid it for nothing. When the consumption tax a company has paid exceeds the consumption tax it collected from customers upon making sales, the company can receive a consumption-tax refund from the government by declaring the difference. Research-and-development businesses, for example, often fall into this category. One more detail: among large capital investments, equipment costing ¥1 million or more excluding tax qualifies as “fixed assets subject to adjustment” (Consumption Tax Act 2(1)(xvi)), in which case adjustments to the consumption-tax amount may be made for about three years after establishment. It is best to consider this carefully with a tax accountant.

So, what did you think? I hope you now have a sense that when considering starting a new business, you have to think through complicated matters. This kind of thing continues throughout company management. A two-year exemption when starting a business has a major effect on company management and cash on hand, so adjust sales, salaries, and the start date as much as possible and make the most of the consumption-tax exemption system.