TAX & PE ISSUES IN JAPAN

Whilst deregulation and deflation have improved the operating environment for foreign businesses in Japan, the cost of doing business in Tokyo remains high by global standards. Costs can be measured in a variety of ways including the costs of establishing a business presence in Japan. More significantly the hidden costs and consequences of breaching regulatory and tax regulations can be substantial.

Tax Issues

A detailed discussion of Japanese tax is beyond the scope of this website. Teneo Partners is not a licensed tax agent and provides this information only for general information purposes. However, it is worthwhile to note a number of issues that may not be clear or fully understood by foreign investors looking to establish a presence in Japan.

Permanent Establishment (PE)

Under the Corporation Tax Law, a foreign corporation is subject to Japanese tax only on the income it derives from sources in Japan. For foreign corporations located in countries that have a tax treaty with Japan, e.g. the U.S., local income may be exempt from tax liability, depending on the terms of the agreement. The taxable amount is greatly affected by whether the foreign corporation is deemed to have established a permanent establishment (PE) in Japan, such as a branch office. If, an offshore fund were to create a taxable business presence through the use of their own Tokyo-based researchers or asset managers, the income generated by these individuals for the fund may be taxed at a rate as high as 42 percent.

Under the current U.S. tax treaty Japanese tax on interest from a Japanese source is no more than 10%. Gains on the disposal of Japanese assets (capital gains) are exempt from Japanese taxation unless the investor has a PE in Japan and the assets giving rise to the gain are materially connected with the PE. In practice the issue is rather opaque. It appears as if the Japanese tax authorities decide on a case-by-case basis whether the pass through nature of a fund is to be allowed. Even internationally experienced firms can fall victim to the uncertainties surrounding the tax regime. Once such case is Lone Star.

A similar front-page article in The Financial Times on July 18th 2003 made the following points:

• Lone Star was judged by the Japanese tax authorities as having established a PE in Japan through the use of its affiliates.
• Japan’s tax authorities were investigating foreign investment groups operating in Japan
• Lone Star the private equity company is facing fines and additional taxes of Yen14bn for alleged tax evasion after failing to declare income of Yen40bn.
• Bankers were concerned about the risk of being exposed to Japan’s murky tax rules. They worried about the power of the tax authorities to interpret the rules according to their own whim.

LLC’s may not provide the kind of tax protection that many expect. A National Tax Tribunal Judgment in 2001 ruled that a LLC had a legal qualification and substance and was thus defined as a foreign corporation for the purposes of Japan's tax law. Following this decision the National Tax Agency ("NTA") made the following statement: "LLCs formed pursuant to the LLC laws of a US State will be treated as a foreign corporation for Japanese tax purposes irrespective of whether said LLC elects to be taxed as a corporation or elects pass-through taxation” Lone Star had argued that a U.S. LLC structure was not a corporation so it was exempt. It is somewhat unclear how the NTA will view other forms of limited partnerships created under Cayman or BVI jurisdictions and whether they will be seen as foreign corporations and as such subject to PE.

Moreover, the National Tax authorities are becoming more focused on cross border fund flows and are devoting considerable resources to this and related issues. Regional Taxation Bureaus in Tokyo, Osaka, Nagoya and Kanto-Shinetsu set up project teams in 2001 in order to investigate cross-border transactions for the existence of tax avoidance schemes. They primarily attacked structures, which involved fund transactions outside of Japan and those transactions involving the use of entities in tax-haven jurisdictions to shift Japan source income to foreign jurisdictions. They examined over 400 transactions in 2002 as potential tax avoidance cases and assessed additional taxes on approximately Yen 20.5 billion of income. The new teams are comprised of staff from various tax divisions, including the corporate tax, individual tax, withholding tax, inheritance tax and tax collection divisions. The members of the teams have experience in examining foreign corporations and financial institutions, criminal investigations, and are knowledgeable of international taxation concepts and the use of tax treaties and financial transactions.

When foreign partnerships active in Japan were small in number, influence and size, they were not a priority for the tax authorities. However as recent deal size and their influence in Japanese industry grew, the National Tax Agency increased its scrutiny of these firms, launching a series of investigations. Given the rapid growth in the number of hedge funds based in Japan, their ever-increasing size and the disproportionate impact they have on equity markets, we believe it is only a matter of time before the NTA focuses on this investor group.

Even hedge funds with just an analyst on the ground in Japan can be subject to PE issues.
Under Japanese law, even locally based research analysts who provide investment recommendations in connection with securities products to an offshore fund need to be licensed as Investment Advisors. Additionally licenses to source deals for Private Equity and other investment strategies including distressed debt investments are required.