In early 2008, the Ministry of Economy, Trade and Industry (METI) created a study group to investigate the historically low level of foreign direct investment (FDI) through investment funds and to provide recommendations for increasing such FDI.
Based on these efforts, METI proposed two measures to encourage foreign investment by reducing the potential Japanese tax burden on foreigners investing in private equity funds.
Specifically, the first provides an exemption from local tax nexus (that is, treatment as a permanent establishment – PE) for foreign limited partners in certain kinds of Japanese limited partnerships (or “similar” foreign partnerships). The second provides an exception for such partners from the partnership attribution that otherwise would combine their individual partnership interests with those of the other partners to determine whether the partner is subject to Japanese tax on capital gains from the sale of shares of a Japanese company due to holding a “substantial participation” (25 per cent or more) in the company. The proposals, embodied in statutory amendments and related cabinet orders, were successfully incorporated into the 2009 tax reform, which was passed by the House of Representatives of the Diet on 27 February 2009 and became effective beginning 1 April 2009.
PE EXEMPTION FOR LIMITED PARTNERS
In 1998, the Act Concerning Investment Business Limited Liability Partnership Agreements (the LPS Act) created an entirely new partnership, the “investment business limited liability partnership” (Investment LPS).
Under the METI proposal, a foreign limited partner, that is, a non-resident individual or a foreign corporation, and that has concluded an “investment partnership agreement” (FLP), will not be deemed to have a PE in Japan (PE Exemption), notwithstanding that it otherwise is considered to have a PE in Japan concerning its business activities conducted pursuant to the investment partnership agreement; provided, however, that certain requirements are satisfied and certain procedures are followed. For this purpose, an “investment partnership agreement” is limited to either: an Investment LPS agreement; or a foreign partnership agreement which is “similar” to an Investment LPS agreement as prescribed under the LPS Act.
Requirements for PE Exemption
To qualify for the PE Exemption, all of the following must be satisfied:
i FLP does not in fact engage, directly or by attribution through another partnership, in the performance of the business carried on pursuant to the Investment LPS agreement at any time from the date the FLP concludes the Investment LPS agreement (basically, from the time the FLP became a partner in the Investment LPS);
ii FLP owns, directly or by attribution through a “specified relationship,” an interest of less than 25 per cent in the assets of the Investment LPS at any time from the date the FLP concludes the Investment LPS agreement (basically, from the time the FLP became a partner in the Investment LPS);
iii FLP does not have a “specified relationship” with any GP of the Investment LPS at any time from the date the FLP concludes the Investment LPS agreement (basically, from the time the FLP became a partner in the Investment LPS);
iv FLP does not otherwise already have an existing PE in Japan during the period that the PE Exemption is claimed (Even if the FLP previously had a PE(s) in Japan, the requirement is satisfied; provided that such other PE(s) are terminated prior to the period for which the PE Exemption is claimed); and
v Certain reporting requirements must be fulfilled.
With respect to i, ii, and iii above, it is important to note that an FLP, which at some time in the past (even if for only a brief period) did not meet these requirements during the period the FLP was a partner in the Investment LPS, will not generally be able to satisfy these requirements. Thus, such FLP, having once failed to meet any of requirements i, ii, or iii, will never be able to qualify for the PE Exemption with respect to the FLP’s interest in the Investment LPS.
Engaging in the Investment LPS Business
Pursuant to a cabinet order any of the following activities constitute the performance of the business carried on pursuant to the Investment LPS agreement (Engaged in the Investment LPS Business):
• Carrying out the business of the Investment LPS;
• Making decisions with respect to carrying out such business;
• Providing approval or consent with regard to such decisions; or
• Activities similar to the above.
In addition, the cabinet order provides that, if an FLP is a partner in another partnership which itself conducts any of the above activities, then the FLP itself is deemed to conduct such activities.
The cabinet order provides that, in determining whether an FLP owns less than 25 per cent of the assets of the Investment LPS formed under an Investment LPS agreement, the interests in the Investment LPS assets of the following persons with a “specified relationship” to the FLP are attributed to the FLP:
• A relative within six degrees of relationship (three degrees by marriage), a common law spouse, an employee of an individual FLP, other individuals economically supported by the FLP, a relative (within six degrees of relationship (three degrees by marriage)) of any of the foregoing individuals who live together with any such foregoing individual; or with respect to a corporate FLP, any director and any of the foregoing with respect to such director (for example, relatives of the director).
• Any company which the FLP and any related individuals: hold, directly or indirectly, more than 50 per cent of the total amount of shares or voting rights; or comprise more than 50 per cent of the shareholders or members of such company.
• Any partnership, other than the Investment LPS, in which the FLP is a partner. Any Investment LPS interests of other partners in the “other partnership”, which are not held through the other partnership, are not counted for this attribution purpose.
The interest in the “assets” of the Investment LPS is determined based on the higher of the total interest in the Investment LPS assets, or total of the profit allocation ratios, of the FLP and other partners with whom the FLP has a specified relationship.
In addition, the cabinet order provides that an FLP has a “specified relationship” with the GP if the GP is either a related individual or controlled company.
To obtain the PE Exemption, an FLP must apply by filing certain forms through the GP of the Investment LPS, which forms include information which demonstrates that the FLP satisfies all the requirements for the PE Exemption. The law also requires that an FLP report all Japanese source income which would be included in the computation of the taxable income of a Japanese tax resident, but which income is not so treated (as taxable income) because of the PE Exemption.
Similar Foreign Investment LPS
Neither the statute nor the cabinet order specify the circumstances under which a foreign investment partnership agreement will be considered to be “similar” to an Investment LPS agreement (Similar Foreign LPS Agreement).
EXCEPTION FROM PARTNERSHIP ATTRIBUTION RULE
Except with respect to certain holdings in a Japanese real property holding company, Japan does not generally impose tax on capital gains from the sale or other disposition of shares of a Japanese company by a non-resident individual or foreign corporation, unless: the foreign shareholder owns directly or through attribution 25 per cent or more of the outstanding shares of the Japanese company at any time during the three-year period ending in the year of the sale or other disposition; and that foreign shareholder disposes of 5 per cent or more of such shares, taking into account any shares disposed of by related parties, in the same tax year. This is referred to as the “25/5 Rule,” which is a kind of substantial participation rule. Consequently, as long as the foreign investor owns less than 25 per cent, then any gains from the disposition of such shares would avoid taxation in Japan.
In determining whether either the 25 per cent ownership or 5 per cent disposition of outstanding shares threshold is met, a rule was adopted in 2005 that attributes all shares held by the partnership to the foreign partner (Partnership Attribution Rule). This significantly increased the potential for foreign partners to be subject to Japanese tax, especially in the private equity context, where such funds often take substantial or majority ownership stakes in the companies in which they invest. However, under the second of METI’s proposals, the cabinet order creates an exception from the Partnership Attribution Rule, subject to certain requirements and limitations, for FLPs in an Investment LPS or “similar” foreign Investment LPS, which would generally result in the FLP being deemed to own shares in the Japanese company equal only to the FLP’s interest in the Investment LPS or “similar” foreign Investment LPS (Partnership Attribution Exception). That is, the FLP is not deemed to own all the shares held by the Investment LPS or similar foreign Investment LPS. The Partnership Attribution Exception is subject to the following additional requirements and limitations:
i the FLP must have been an FLP of the Investment LPS (or similar foreign Investment LPS) for the lesser of: the period starting from the second fiscal year prior to the year in which the disposition occurs until the end of the year in which the disposition occurs; or the period in which the FLP was an FLP of the Investment LPS prior to the disposition until the end of the year in which the disposition occurs;
ii the FLP, directly or by attribution, must not have been engaged in the Investment LPS Business for the lesser of: the period starting from the second fiscal year prior to the year in which the disposition occurs, until the end of the year in which the disposition occurs; or the period in which the FLP was an FLP of the Investment LPS prior to the disposition until the end of the year in which the disposition occurs;
iii with respect to the shares of a Japanese company held by an Investment LPS and which are sold or otherwise disposed of, the FLP cannot have owned, directly or by attribution through a specified relationship, 25 per cent or more of the shares of such company at any time during the three-year period ending in the year of the sale or other disposition (in determining the FLP’s share ownership by attribution through a specified relationship, shares held by the Investment LPS, which are allocable to the other partners of the Investment LPS, are not attributed to the FLP);
iv the Japanese company shares disposed of must have been held by the Investment LPS for at least one year; and
v the shares disposed of cannot include shares of a “distressed financial institution” (a special crisis management bank (Tokubetsu Kiki Kanri Ginkou) as defined in the Deposit Insurance Law (Yokin Hoken Hou)).
Alternatively, if the partnership meets all the requirements for PE Exemption (as discussed above), then requirements i and ii above do not have to be satisfied.
It is important to note that the Partnership Attribution Rule itself was not repealed and, as a result, except with respect to partners of an Investment LPS or similar foreign Investment LPS that meet the requirements above, it continues to apply to attribute ownership from any other partners for purposes of computing the 25 per cent ownership and 5 per cent disposition of outstanding shares thresholds under the 25/5 Rule.
COMBINED IMPACT OF PE EXEMPTION AND PARTNERSHIP ATTRIBUTION EXCEPTION
The combined effect of the PE Exemption and the Partnership Attribution Exception will potentially be to enable foreign investors in certain private equity and other investment funds to avoid or significantly reduce Japanese tax on their allocable share of certain income and capital gains from the disposition of the fund’s Japanese investments. This is because: under the PE Exemption, each FLP would not be deemed to have a PE in Japan, even though the fund, through the GP itself, were to be considered as conducting business activities in Japan; and under the Partnership Attribution Exception, the likelihood that each LP would be able to avoid being subject to the 25/5 Rule (and thus, be exempt from Japanese tax on capital gains on dispositions of shares) would be increased because all shares held by the Investment LPS (or similar foreign Investment LPS) would not be attributed to the FLP in determining the 25 per cent ownership and 5 per cent disposal of outstanding shares thresholds.