Executive incentive compensation in Japan

Incentive compensation

What are the prevalent types and structures of incentive compensation? Do they vary by level or type of organisation?

In current practice, cash compensation linked to the annual net income of a company seems most prevalent. For listed companies, equity-based compensation (see question 17) is also prevalent.

Are there limits generally on the amount or structure of incentive compensation? Are there limits that adversely affect the tax treatment of the compensation relative to the employer or the executive?

There are no limits generally on the amount or structure of incentive compensation, as long as it is within the scope authorised by the shareholders meeting or compensation committee. From a corporate tax perspective, however, with respect to performance-based compensation paid to executives, in order for employers to treat the compensation as a deductible expense under article 34, paragraphs 1 to 3 of the Corporation Tax Act, the following requirements must be satisfied:

1. the company is not a private holding company (except for a private holding company wholly owned by a non-private holding company);
2. the target executive is engaged in the management and operation of the company (a managing executive) and all managing executives receive profit-based compensation in compliance with requirements (1) to (6);
3. the total amount of compensation during the fiscal year is reasonable (considering the contribution of the executive, the size of the company, etc);
4. the compensation is paid, or is expected to be paid, within one month of deciding the amount;
5. the amount is treated as an expense for accounting purposes; and
6. the procedures and calculation method comply with the following:
   • the amount is determined according to an objective method based on indexes related to:
7. profits referenced in the securities reports (eg, earnings before interest, tax, depreciation and amortisation, return on assets and return on equity);
8. stock price in the market (eg, stock price on a specific date, comparison to the Tokyo Stock Price Index, market capitalisation and total shareholder return); or
9. sales referenced in the securities reports (only if this index is used together with any index falling under (a) or (b));
   • the maximum amount is fixed and the calculation method is consistent with that used for other managing executives;
   • the calculation method is determined under appropriate procedures (such as obtaining the approval of the compensation committee within three months of the beginning of the accounting year); and
   • after the calculation method is determined, the method is reported in the securities report without delay.

Is deferral and vesting of incentive awards permissible? Are there limits on the length or type of vesting and deferral provisions?

It is permissible for executive compensation. It is also permissible for employee benefits, as long as such an award is characterised as a discretionary bonus and is outside the scope of wages or base salary under the Labour Standards Act.

Are there limitations on the individuals or groups eligible to receive the compensation? Are there aspects of the arrangement that can only be extended to certain groups of employees?

Executive compensation is governed by the Companies Act, and employee salary is governed mainly by the Labour Standards Act and Labour Contract Act, which provide stricter rules to protect employees. Thus, there are several limitations regarding employee salary (see question 8), which are not applicable to executive compensation.

Can it be held that recurrent discretionary incentive compensation has become a mandatory contractual entitlement? Is this rebuttable?

In general, no. If a fixed amount is routinely paid regardless of the achievements or performance of employees, however, such amount may possibly be deemed a mandatory contractual entitlement. If it is deemed a mandatory contractual entitlement, an employer can discontinue it:

• with the employee’s consent; or
• if the discontinuation is deemed to be reasonable.

Note: its reasonability will be scrutinised by a court if an employee disagrees with the discontinuation.

Does the type or amount of incentive compensation awarded to an executive potentially affect the compensation that must be awarded to other executives or employees?

The type and amount of incentive compensation offered to an executive can affect what is offered to other executives, but not what is offered to employees, because the primary sources of law governing executive and employee compensation are different (see question 1).

With respect to executives, profit-based compensation satisfying the requirements of the Corporation Tax Act (see question 10) will be paid to all managing executives in a consistent manner. Therefore, if an employer intends to treat compensation as a deductible expense, any amount of incentive compensation paid to a managing executive will affect that of the other managing executives. Also, in practice, a company will adopt a common rule or method for determining the incentive compensation offered to all executives.

Is it permissible to require repayment of incentive compensation under certain circumstances? Are there circumstances under which such repayment is mandatory?

Currently, there are no circumstances under which repayment of incentive compensation is mandatory under Japanese laws. Nevertheless, some Japanese finance institutes have adopted clawback provisions regarding executives’ compensation in response to the Financial Stability Board’s ‘Principles for Sound Compensation Practices - Implementation Standards’ (as of 24 September 2009). With respect to employees’ compensation, if the repayment of compensation is characterised as payment of damages, certain restrictions under the Labour Standards Act apply.

Can an arrangement provide that payment is conditioned on continuing employment until the payment date? Are there exceptions?

As to executive compensation, it is possible. As regards salary for employees, it is not possible. However, it is possible for bonuses unless the termination of employment is attributable to an employer.