Japan

Eric Roose and Michael Shikuma
White & Case
Japan

Tax reform measures promote foreign direct investment and repatriation, explain Eric Roose and Michael Shikuma of White & Case

The 2009 Japanese Tax Reform contained two significant measures which promote investment in Japan. 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 February 27 2009 and became effective from April 1 2009.

The first is designed to promote foreign direct investment (FDI) by reducing the potential Japanese tax burden on foreigners investing in private equity funds. This is accomplished through an exemption from permanent establishment (PE) treatment for foreign limited partners in certain kinds of Japanese limited partnerships (or similar foreign partnerships). In addition, there is 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% or more) in the company.

The second provides an incentive to Japanese companies to repatriate earnings of foreign subsidiaries by creating a participation exemption regime, similar to that adopted by the UK this year.

Permanent establishment 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 (toshi jigyo yugen sekinin kumiai) (Investment LPS).

Under the first measure, a foreign limited partner-a nonresident individual or a foreign corporation-which has concluded an investment partnership agreement, (an FLP) will not be deemed to have a PE in Japan (PE exemption), even if otherwise it 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: (a) an investment LPS agreement; or (b) a foreign partnership agreement which is similar to an investment LPS agreement as prescribed under the LPS Act.

Requirements for permanent establishment exemption

To qualify for the PE exemption, all of the following must be satisfied:

Passive role. 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);
Less than 25% interest. FLP owns, directly or by attribution through a "specified relationship," an interest of less than 25% 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);
No relationship to general partner (GP). 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);
No other PE. FLP does not otherwise already have an existing PE in Japan during the period that the PE exemption is claimed; and
Reporting requirements. Certain reporting requirements are met.

Engaging in the investment LPS business.

The cabinet order provides that 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.

Specified relationship.

The cabinet order provides that, in determining whether an FLP owns less than 25% of the assets of the investment LPS formed under an investment LPS agreement, the interests in the investment LPS assets of , for example, certain persons, such relatives, controlled companies and partnerships, with a specified relationship to the FLP are attributed to the FLP.

Reporting requirements

To obtain the PE exemption, an FLP must apply by filing certain forms through the GP of the investment LPS. The 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 nonresident individual or foreign corporation, unless: (a) the foreign shareholder owns directly or through attribution 25% 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 (b) that foreign shareholder disposes of 5% 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%, then any gains from the disposition of such shares would avoid taxation in Japan.

In determining whether either the 25% ownership or 5% disposition of outstanding shares threshold is met, a rule was adopted in 2005 which 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, 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 these additional requirements and limitations:

Minimum period as an FLP. The FLP must have been an FLP of the investment LPS (or similar foreign investment LPS) for the lesser of: (i) the period starting from the second fiscal year before the year in which the disposition occurs until the end of the year in which the disposition occurs; or (ii) the period in which the FLP was an FLP of the investment LPS before the disposition until the end of the year in which the disposition occurs;
Not engaged in the investment LPS business. The FLP, directly or by attribution, must not have been engaged in the investment LPS business for the lesser of: (i) the period starting from the second fiscal year before the year in which the disposition occurs, until the end of the year in which the disposition occurs; or (ii) the period in which the FLP was an FLP of the investment LPS before the disposition until the end of the year in which the disposition occurs;
FLP owns less than a 25% interest in the Japanese company shares being sold by the investment LPS. 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% 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);
Holding period for shares disposed of. The Japanese company shares disposed of must have been held by the investment LPS for at least one year; and
Certain distressed financial institutions. 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 the first two requirements 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 which meet the requirements above, it continues to apply to attribute ownership from any other partners for purposes of computing the 25% ownership and 5% disposition of outstanding shares thresholds under the 25/5 rule.

Combined impact of permanent establishment 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: (i) 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 (ii) 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% ownership and 5% disposal of outstanding shares thresholds.

Participation exemption for Japanese companies

Generally, Japanese companies are subject to corporation tax (up to about 42%) on worldwide income, including dividends from foreign subsidiaries. To minimise double taxation, foreign tax credits are generally permitted for both direct taxes assessed on the Japanese parent and indirect taxes assessed on certain foreign subsidiaries. However, because of the high corporate tax rates, many Japanese companies have deferred repatriation of foreign profits by accumulating such profits in their foreign subsidiaries. In an effort to promote repatriation of overseas profits, the 2009 tax reform creates a participation exemption regime (participation exemption) which significantly lowers Japanese tax upon repatriation.

Under the participation exemption, a Japanese company may claim a 95% deduction on profits repatriated from foreign subsidiaries that it owns not more than 25% of. The 25% ownership threshold is based on either voting control or the number of shares, and may be reduced under an applicable tax treaty. Because of the 95% deduction, neither direct nor indirect foreign tax credits will be allowed. However, the tax on repatriated profits is effectively reduced to about 2% (5% of repatriated dividend subject to tax x 42% Corporation Tax rate).

In addition, the advent of the new participation exemption also resulted in certain changes to the anti-tax haven rules, which subject Japanese tax residents to Japanese income tax on certain profits of controlled foreign corporations (tax haven company), even if no profits are repatriated to the Japanese shareholder. A tax haven company is a foreign company in which less than 50% (by vote, number of shares, or dividend rights) of it is held by (or attributed to) Japanese tax residents; the income of which is not subject to any income tax in its home jurisdiction or the effective income tax rate imposed on it is equal to or less than 25%; and which does not conduct an active business in its place of incorporation.

In calculating the taxable profits of a tax haven company, any distributions paid to the Japanese shareholder were generally deductible (because the shareholder would be subject to Japanese tax on the receipt of the distribution). Under the 2009 Tax Reform, no deduction is permitted with respect to foreign companies that are 25% or more owned by Japanese taxpayers (because the Japanese shareholder will receive a 95% deduction on the distributions received). In addition, dividends from 25% or more owned lower-tier foreign subsidiaries are fully deductible in computing the tax haven company's taxable income. This measure generally permits foreign holding companies to accumulate profits from lower tier subsidiaries without subjecting the Japanese parent to Japanese tax under the anti-tax haven rules.

Under the new participation exemption regime, it is important for Japanese companies to minimise any withholding tax on the repatriation of profits from 25% or more owned foreign subsidiaries because no foreign tax credits are allowed with respect to such withholding tax.

Eric Roose (eroose@tokyo.whitecase.com) and Michael Shikuma (mshikuma@tokyo.whitecase.com)