TAX NEWS - DECEMber 2009
Japanese Tax: Japanese taxation of foreign limited partners of funds investing in Japan
Permanent establishment
Foreign investors (nonresident individuals or foreign corporations) that have a PE in Japan by virtue of their investment in a fund are obliged to file tax returns in Japan and pay tax on their share of the profits attributed to the PE at approximately 41%. Following the tax reform, however, foreign investors can obtain an exemption from having a PE if they satisfy certain conditions. To qualify for the PE exemption, the foreign investor must:
- Be a limited partner (LP) in an Investment Limited Liability Partnership, or its foreign equivalent (collectively ILLP);
- Not be involved in conducting the business of the ILLP;
- Own less than 25% of the assets of the ILLP;
- Not be specially related to the general partner (GP) of the ILLP; and
- Not have a PE in Japan with respect to any other business activities.
A foreign LP that wishes to apply for the permanent establishment exemption must submit an application to the relevant tax office via the GP. The limited partner will be deemed not to have a PE in Japan (by virtue of its investment in the fund) from the date the application is filed. The exemption will lapse, however, from the date of any change to the disclosures reported, unless an amended application is submitted on a timely basis.
The exemption application should be filed together with a copy of the partnership agreement, and must include information such as: the name and address of the foreign limited partner; details of the partnership agreement (including the location of the registered office of the partnership, a description of business and the name of the GP); and the LP's percentage ownership of fund assets. In addition, before filing the application, the GP is required to obtain confirmation of the name and address of the foreign LP in the form of a certificate or document issued by a governmental body within the previous six months. LPs are also required to provide details to the tax authorities on an annual basis of their Japan-source income that is untaxed by virtue of the PE exemption. No format, however, has been specified for this disclosure.
Exempted investors no longer need to file Japanese tax returns in respect of their permanent establishment, but (to the extent not exempted under an applicable tax treaty) in principle remain obliged to file a return and pay Japanese tax (at 30%) on any gains recognized in accordance with the "5/25 Rule." The 5/25 Rule applies if the following conditions are satisfied: (i) the foreign investor, together with its specially related shareholders, has owned 25% or more of the issued shares in the Japanese company at any time during the three years prior to the end of the period in which disposal occurs, and (ii) the foreign investor, together with its specially related shareholders, sells 5% or more of the total number of issued shares in the year of disposal. Separate rules apply in respect of the disposal of shares in companies that are "real estate rich" for Japanese tax purposes.
Tax on gains
Under Japanese tax law, each foreign limited partner investing in a Japanese company through a fund is required to aggregate its ownership share with that of its "specially related shareholders" for the purpose of determining whether it is subject to tax on gains under the 5/25 Rule. The definition of "specially related shareholders" includes the other partners in a fund, and in this way the ownership percentage is effectively tested at the level of the fund. As a result, all partners in a fund that owns 25% or more of a Japanese company would generally be subject to Japan tax on gains on the sale of those shares unless they are exempted under the provisions in a tax treaty.
To address this situation, the 2009 tax reform changed the way the 5/25 Rule is applied to foreign LPs that satisfy certain conditions. More specifically, qualifying foreign LPs are now exempted from the need to aggregate their ownership interest with that of their partners when determining whether they are subject to tax under the 5/25 Rule. As a result, qualifying foreign limited partner investors will no longer be subject to tax on gains (arising on the disposal of portfolio company shares) under Japanese law. This is a significant positive development for investors that are not entitled to an exemption from tax on gains under a tax treaty. Note that the exemption from ownership aggregation does not apply to GPs, and foreign GPs will still need to aggregate their ownership interest with that of all their limited partners in determining whether they are taxable under the 5/25 Rule.
To qualify for the exemption, foreign LPs (that do not have a PE in Japan) must satisfy the following conditions:
- Shares transferred must have been held continuously for at least one year from the day after the fund acquires the shares;
- Shares must not be those of a "distressed financial institution" (defined as a Special Crisis Managed Bank acquired from a Deposit Insurance Corporation under the Deposit Insurance Law);
- The LP must hold less than 25% of the issued shares in the company being disposed of at any time during the three years prior to the end of the year in which the disposal takes place; and
- The LP must not be involved in conducting the business of the fund during the three years prior to the end of the year in which the disposal takes place (see below).
If a foreign LP satisfies these conditions, and wishes to benefit from the exemption from ownership aggregation, it must file an application with the Japanese tax authorities within two months after the end of its accounting period during which the share transfer takes place (corporate investors). The application must include the following information: the name and address of the foreign LP; the percentage of issued shares held by the LP; the name of the company in which the shares are transferred; and the number of shares transferred. Excerpts from the partnership agreement must be submitted with the application as evidence of limited liability and non-involvement in conducting the business of the fund.
As a result of these requirements, there are a number of scenarios in which gains would not be exempt from Japanese tax, such as where shares are held by the fund for less than one year, or where gains arise on the disposal of shares in a specified distressed financial institution, or in a real estate rich corporation.
Conducting the business of a fund
According to the enforcement orders published in connection with the tax reform, a foreign LP will be considered to be "conducting the business" of a fund if it undertakes any of the following actions:
- Executes the business of the fund;
- Makes decisions on the execution of the business of the fund; or
- Gives approval or consent to the above actions.
In an attempt to clarify what kind of activity constitutes "conducting the business" of a fund, the Ministry of Economy Trade and Industry released a Q&A document in July 2009 that addresses the issue. The document examines a number of actions that could conceivably be executed by an LP, and discusses whether or not these would fall under the concept for tax purposes of "conducting the business" of the fund. The list of actions discussed is by no means exhaustive, but includes the following:
- Exercise by an LP of authority in connection with protection of its rights, fund supervision and fund formation, e.g. amendments to partnership agreement, appointment and removal of the GP and rights to inspect financial statements. Such actions are not considered to constitute the conduct of the business of the fund.
- Pre-approval by the LP (exercised in accordance with the terms of the partnership agreement) of investments by the GP. Such approval would be deemed to be conducting the business of the fund.
- Approval of general changes to the GP's authority that are not related to a specific investment, e.g. changes in the general restrictions on investments by amount or asset type. The provision of such approval would generally not be deemed to be conducting the business of the fund.
- Provision of advice to the GP in relation to investments. Provision of such advice by the LP would not be considered to constitute the conduct of the business of the fund provided that the advice is not binding on the GP.
Interaction of PE exemption and 5/25 rule exemption
For a foreign LP that has a PE in Japan by virtue of its fund investment, the relative merits of applying for the PE and 5/25 Rule exemptions will depend on the LP's particular circumstances. Important considerations include whether it can claim an exemption from Japanese tax on gains under a tax treaty, and (if not) the types of investment made by the fund, and whether gains on disposal of these investments will be covered by the new exemption from ownership aggregation under the 5/25 Rule.
An immediate benefit of claiming the PE exemption is that the foreign LP would no longer be obliged to file Japanese tax returns in respect of the PE. This does not necessarily mean though that the LP will not be required to file Japanese tax returns in respect of gains on investments made by the fund – that will depend on whether the gains are taxable under the 5/25 Rule. If the gains are taxable and no treaty exemption is available, the LP may now (if the requirements are met) be able to claim the new 5/25 Rule exemption.
Where the nature of the fund investments means that gains are not covered by the new 5/25 Rule exemption, a claim for PE exemption would at least reduce the effective rate of tax on gains from 41% to 30%. Before determining whether to apply for the PE exemption, however, foreign LPs should carefully consider the impact on any Japanese tax attributes that they have.
In terms of the compliance and information disclosure obligations associated with applications for the exemptions, it should be noted that these are not "one-time" administrative events. In the case of the PE exemption, there is the ongoing requirement to disclose untaxed Japan-source income, together with the need to file amended applications that reflect changes in information previously disclosed. For the 5/25 Rule exemption, the application itself would need to be filed in respect of each year in which taxable gains arise. It is important that investors understand these requirements and the information that will need to be disclosed when deciding whether or not to apply for the exemptions.
© 2009-2012 TaxRates.cc
2011 - 2012 Tax Rate Guide and Tax Help Website
