Benjamin Franklin once said "in this world nothing is
certain but death and taxes." Unfortunately in recent
times in Japan no longer can it be said that taxation is certain.
There have been developments in the tax arena over the past
couple of years that cause hedge fund managers much concern.
This article discusses two of those developments.
What is on the hedge fund wish list? First, that investors
are taxed only in their country of residence. Secondly, that
the fund itself is not taxable and is in a territory with
flexible company law. Thirdly, that the investment manager
is taxable at a low rate only. To optimise the position in
these three wish areas a typical structure will be a Cayman
Island LLC or LP as the fund, with the investment manager
a Special Purpose Vehicle also in the Cayman Islands. The
investment manager will appoint a Japanese investment advisor.
Investors in the fund will typically invest through one or
more feeder funds dependent on their residence and tax status.
For the purposes of illustration this article will address
the position of US investors in a fund set up in the Cayman
Islands. Furthermore it is assumed that the fund is a limited
partnership ("LP") or limited liability company
("LLC"). For US tax purposes both a limited partnership
and an LLC are treated as pass-through entities. As such neither
will be subject to US taxation in their own right. It was
the case that the Japanese tax authorities did not challenge
this pass-through status in considering taxation of the investors.
Thus a US investor in the fund could expect to enjoy the benefits
of the double taxation treaty between the US and Japan.
In the case of dividends from Japanese companies the treaty
provides that both states have taxing rights. However, Japan's
taxing right is restricted, generally, to 15% of the gross
amount actually distributed, but may be reduced to 10% of
the gross amount distributed where the recipient is a corporation
and when certain conditions are satisfied. This is the applicable
treatment where the investor does not have a permanent establishment
("PE") in Japan.
In the case of interest, again both the US and Japan have
taxing rights. Absent the US investor having a PE in Japan
the treaty restricts the Japanese tax on interest from a Japanese
source to 10%.
For capital gains, in general terms, the treaty provides
that gains on the disposal of Japanese assets shall be exempt
from Japanese taxation unless the investor has a PE in Japan
and the property giving rise to the gain is effectively connected
with the PE. This general position does not apply to gains
on the disposal of real property or certain assets that have
been giving rise to royalties.
It can be seen from these treaty provisions that it is of
paramount importance that US investors are entitled to the
benefits of the treaty. Whether they are so entitled is dependent
upon the pass-through nature of the fund being respected by
the Japanese tax authorities. There is, as a consequence of
a National Tax Tribunal Judgment on February 26, 2001, some
doubt. The tribunal concerned a Japanese individual who had
established an LLC in the US that carried on a real estate
rental business in the US. The LLC incurred losses and the
Japanese individual sought to offset against his other real
estate income and salary income in Japan an amount of those
losses corresponding to his equity investment in the LLC.
The uncontested facts included:
- LLCs are similar to corporations in that the liability
of members is limited to the amount of the investment.
- In taxation, however, they are similar to partnerships
inasmuch as the income of the LLC flows through to the members,
who are then taxed on the income.
- The LLC can elect to be taxed either at the level of
the LLC or at the member level. Pass-through treatment applied
in this case.
The tribunal found as a fact that the members of the LLC
had no equity whatsoever in the individual assets owned by
the LLC, and noted that among Japanese and US experts and
scholars there were many who took the position that an LLC
has a corporate personality. It took the view that the treatment
of an LLC under the laws of Japan is as follows:
- An organisation formed for the purposes of engaging in
commercial acts in conformity with the US laws in the State
of its formation,
- It had the qualification to act as a party to contracts,
- It was an independent legal entity separate from its
Accordingly it was held that the LLC had legal qualification
and substance and falls under the definition of a foreign
corporation for the purposes of Japan's tax law. Consequently
relief in Japan for losses attributable to the member were
denied, that is the pass-through nature of the LLC was denied.
Following this decision the National Tax Agency, ("NTA")
made the following statement:
"LLCs formed pursuant to the LLC laws of the 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."
Whether LLCs formed under the laws of other jurisdictions,
for example the Cayman Islands, are similarly to be treated
as foreign corporations by the Japanese tax authorities is
not clear. It is equally unclear as to what position they
might take in the case of LPs. Such uncertainties are, however,
extremely troublesome from the perspective of existing hedge
funds that may be affected, or, indeed, from the perspective
of the structuring of new hedge funds. It is to be hoped that
the proposed new treaty between Japan and the US will make
the position less uncertain.
The second troublesome area is that of PE. As mentioned,
a hedge fund investing in Japanese assets may well employ
an investment advisor in Japan, usually appointed by the Cayman
Islands general partner. This may be a direct investment advisory
role, or an appointment in an indirect capacity, as sub-advisor
to an offshore primary advisor. A general partner has authority
to bind the limited partners in the conduct of its investment
activity. In the circumstances that the feeder funds are themselves
LPs there is a theoretical argument that the fund general
partner is acting as agent on behalf of the feeder fund limited
Article 9 of the US/Japan tax treaty defines PE as a fixed
place of business through which a resident of a Contracting
State engages in industrial or commercial activity. A person
acting in Japan on behalf of residents in the US will be considered
a PE of the US person if he has, and habitually exercises,
an authority to conclude contracts in the name of the US resident,
unless the agent is of independent status acting in the normal
course of his business. In the case of a Japanese investment
advisor that acts solely for the hedge fund, the question
of independence is an issue that must be considered. The commentary
on the OECD Model treaty says, inter alia, the following:
"Another factor to be considered in determining independent
status is the number of principals represented by the agent.
Independent status is less likely if the activities of the
agent are performed wholly or almost wholly on behalf of only
one enterprise over the lifetime of the business or a long
period of time."
Under Japanese domestic tax law there is no distinction between
an agent of independent status and an independent agent. The
Japan Securities Investment Advisors Association issued guidance
to its members in April 2002 based on confirmations it had
received from the NTA. That guidance says that where there
is discretionary asset management with a Japanese advisory
company, under which the advisor has and habitually concludes
contracts on behalf of a non-resident, the asset manager in
Japan is a PE of the non-resident. Although not part of the
guidance given, this would not be the position where the primary
asset management contract is with an offshore entity, and
the asset manager in Japan is acting in a sub-advisory capacity,
provided the offshore advisor is an advisor of substance.
The guidance note goes on to say that there will not be a
Japanese PE, and therefore Japanese taxation of the non-resident,
where a double taxation treaty applies, and the agent is of
independent status acting in the normal course of business.
This means, of course, that in the case of a non-treaty protected
principal, even an independent agent will be a taxable PE
of that principal. In practice this last point does not appear
to have been taken up by the tax authorities as an audit issue
in the case of independent agents.
Times have moved on since the famous words spoken by Benjamin
Franklin, it seems now that the desire to increase the tax
take seems all that is certain about taxation in Japan.