Changes in tax treatments of directors' and officers' liability insurance premiums

Insurance Update


On 24 February 2016, the National Tax Agency (NTA) announced a new tax treatment of premiums of directors' and officers' liability insurance (D&O Insurance). Under the new tax treatment, a company will not need to treat the amount of insurance premium for shareholder derivative actions as salary income of each director, although the amount of such premium has been recognized as salary income before, provided that the company bears the cost of premium, pursuant to corporate approvals such as resolutions by a board of directors.

Directors, accounting advisors, statutory auditors, officers, and accounting auditors (collectively, 'Directors') owe duty of care of a good manager to their company, and directors and officers also owe "duty of loyalty" under the Companies Act. Directors are liable to their company and third parties for damages as a result of fraud or negligence of such Directors. To cover this liability, D&O Insurance is becoming common in Japan in recent years. It is reported that about 90% of listed companies are enrolled in D&O Insurance as at March 2015[1].

However, conflict of interests may arise if a company bears the cost of D&O Insurance premiums in cases where the Directors are sued for damages in a shareholder derivative action, and it would impair the functions of shareholder derivative lawsuit (ie, coverage of company's damage and repression of illegal activity) if a company bears such cost. As a consequence, it has been common practice among insurance companies providing D&O Insurance to exclude shareholder derivative actions from the general agreement and execute a separate agreement under which the Directors pay the premium for coverage of such actions by themselves. In response to this practice, the premium for shareholder derivative actions was historically treated as a fringe benefit and taxed as a salary income of the Directors, if the company bears the cost of such premium[2]. This practice had deterred Directors candidates from accepting office.

In recent years, discussion about corporate governance has been active in Japan. Various reforms have been made so far such as amendments to the Companies Act, which took effect in May 2015. One of the trends reflecting those discussions is increase of necessities of appointment of external directors. However, it has been pointed out that the above practice regarding coverage of the insurance premium for shareholders derivative actions had made it difficult to appoint external directors and been a deterrence to the enhancement of corporate governance in Japan. In a report published by the Corporate Governance System Study Group organized by the Ministry of Economy, Trade and Industry (METI) on 24 July 2015, it was stated that payment of the D&O Insurance premium for shareholder derivative actions by a company should be allowed if conditions such as below are fulfilled[3], [4]:

  1. approval by board of directors has been obtained: and
  2. consent by: (i) a discretional committee made up of a majority of external directors; or (ii) all external directors, has been obtained.

In response to the inquiry by the METI about tax treatment of the new D&O Insurance in which a company covers the premium for shareholder derivative actions, which is expected to be soon available in the market following the METI's above report, the NTA has responded that it will not treat such insurance premium as salary income of Directors subject to the fulfillment of the conditions above.

[1] METI, "Survey Report on Directors Remuneration in Japan and Foreign Countries" (as at March 2015)" (only in Japanese)
[2] NTA, Tax on D&O Insurance Premium (Referral) (only in Japanese)
[3] METI Corporate Governance System Study Group "Implementation of Corporate Governance - Incentives and Reforms toward an Increase in Corporate Value," Appendix 3 "Guidance on Interpretation of Legal Issues"" (only in Japanese)
[4] This is applicable to companies with boards of statutory auditors only. Requirements for other types of companies have not been cleared.