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:

1. LLCs are similar to corporations in that the liability of members is limited to the amount of the investment.
2. 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.
3. 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:

1. An organisation formed for the purposes of engaging in commercial acts in conformity with the US laws in the State of its formation,
2. It had the qualification to act as a party to contracts,
3. It was an independent legal entity separate from its members

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 partners.

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.