18 March 2019 - Article
Japanese Prime Minister Abe's plan for economic growth and the selection of Tokyo as the site for the 2020 Summer Olympics have created strong demand for real estate in Japan, attracting billions of dollars of investment by global investors in the past few years. Amongst those investors are global investment funds targeting real estate. Many such global funds use foreign limited partnerships established in the Cayman Islands and Delaware as their collective investment vehicle. In the absence of written guidance in the tax rules, Japanese tax practitioners have historically characterized foreign limited partnerships as transparent entities for income tax purposes. However, a recent decision of the Japan Supreme Court rejected that view in the case of a Delaware limited partnership, holding that the entity should be considered a foreign corporation for Japan income tax purposes. The decision has significant tax consequences to foreign funds and their investors investing into Japan.
Global fund structures
Global investment funds investing in private equity and real estate frequently establish their collective fund vehicles in the legal form of limited partnerships in jurisdictions where investors are most comfortable with the legal and regulatory regimes. For United States investors, Delaware, is a popular choice for establishing the fund's limited partnership. For non-United States investors (who are fearful of having a US tax nexus), Luxembourg and the Cayman Islands are favored jurisdictions. A common tax characteristic of such collective investment vehicles is that they do not pay income tax in the jurisdiction of their formation, and are generally treated as pass-through entities by the investor's own tax jurisdictions. How the tax jurisdictions the fund invests characterizes the fund vehicle for purposes of domestic taxation is also of key importance to the foreign investors. If the investment jurisdiction views the fund vehicle as tax transparent, fund investors may find themselves with a permanent establishment in Japan. The tax treatment is also important to fund investors who wish to rely upon their own home jurisdiction tax treaties for capital gain exemptions and reduced withholding taxes.
Japan foreign entity classification rules
Japan tax law does not have a comprehensive body of foreign entity tax classification rules. The National Tax Administration (NTA) has issued formal guidance on the classification of limited liability companies established in the United States, determining that such LLCs are treated as foreign corporations for Japan income tax purposes. However, there is no written guidance on the classification of limited partnerships. In the absence of guidance, the approach used by Japanese tax practitioners has been to analogize the legal rights and obligations of the partners under the foreign governing law to those of partners in a Japanese civil law partnership, known as a Ninen-Kumiai (NK). The NK is treated as tax transparent for Japan tax purposes, with the partners subject to Japan income taxation on their respective share of profits and gains of the NK business. Under the Japan civil law, partners in an NK are liable for the debts and obligations of the NK business, legal title to assets acquired by the NK business are recorded in the names of the individual partners, and the NK is not able to bring legal action or be sued in its own name.
Under such approach, the practice in Japan has been to analogize foreign general partnerships, such as a Delaware general partnership, to an NK, comparing rights and obligations of the partners and characteristics under the law to the NK civil law. If the entity is sufficiently similar, the entity is generally treated as a pass-through for Japan income tax purposes. The same analytical approach has been used in the classification of foreign limited partnerships, with practitioners analogizing the rights and obligations of the entity under local law to those of a NK versus a corporation under Japanese law. That approach has historically led to the view by most Japan tax practitioners that a Delaware limited partnership, as well as limited partnerships established in the Cayman Islands and Bermuda, are treated as pass-through entities for Japan tax purposes. Global funds using foreign limited partnerships as their collective investment vehicle have relied on the view that the foreign limited partners would be entitled to pass through treatment for Japan tax purposes in making hundreds of billions of dollars of investments into Japan. The NTA seemed to not be interested in challenging that characterization of the partnerships, in the context of foreign investment funds investing in Japan. However, the view of the NTA towards such vehicles dramatically changed when Japanese taxpayers began using foreign limited partnerships as collective investment vehicles for the purpose of making investments outside of Japan which generated tax losses claimed by Japanese fund investors back home.
Japan tax shelter funds
In the early 2000s, funds marketed to wealthy Japanese individuals (subject to income tax rates as high as 55%) began to attract the attention of the NTA. These funds invested in foreign real estate which threw off tax losses created by depreciation deductions (playing on the Japan tax rules allowance of depreciation of used structures in as little as a few years). Many of these funds invested in United States real estate, and utilized Delaware limited partnership as the form of collective investment vehicle. Japanese investors in these funds began claiming losses on their individual Japan income tax returns, leading to the NTA to challenge loss deductions. One theory used by the NTA to disallow losses was that the foreign limited partnership is treated as a corporation for Japan tax purposes, thereby precluding the Japanese partner from claiming any losses on its individual return.
Delaware limited partnership cases
Taxpayers began to litigate the NTA's disallowance of their tax losses in the courts throughout Japan, leading to a series of tax cases tried in Tokyo, Nagoya, and Osaka courts examining the Japan tax treatment of Delaware limited partnerships. The cases ultimately resulted in the trial courts, and the intermediary high courts reviewing those decisions on appeal, being split on how they characterized the Delaware LP for Japan tax purposes. The courts holding in favor of the taxpayer generally took the view that under Delaware limited partnership law it was not clear that a limited partnership should be considered to have the status of a juridical person, and therefore should be treated as tax transparent. A trial court in Nagoya decision that the taxpayer's claiming of losses was proper on the grounds that a Delaware limited partnership should be treated as a pass-through was upheld on appeal to the Nagoya High Court. The NTA appealed that decision to the Supreme Court of Japan. In an eagerly awaited decision, the Supreme Court overturned the Nagoya High Court decision, holding that a Delaware limited partnership is treated as a foreign corporation for Japan tax purposes.
The Court's decision is significant for it not only overturns the historical long-held practice of treating a Delaware LP as a pass-thru, but provides guidance on how other foreign entities are to be classified for Japan tax purposes. In testing whether a foreign entity should be treated as a foreign corporation for tax purposes, the Court stated that it was important to first determine whether the foreign entity under its own jurisdiction laws has the status of a 'juridical person' equivalent to a corporation under Japanese laws. If it does, the Court held the entity should be treated as a foreign corporation for Japan tax purposes. However, if it is not clear under the foreign law that the entity is a juridical person, the Court instructed that the inquiry is to then focus on whether or not the entity, under the laws and legislative history of its own jurisdiction, has legal rights and obligations.
Upon examining the Delaware limited partnerships law the Court noted that it could not clearly conclude that a Delaware limited partnership had the status of a legal person equivalent to a Japanese corporation. The Court went on to examine what legal rights and obligations a limited partnership possess under the Delaware Limited Partnership Act. Specifically citing Sections 17-106(b) and 17-701, the Court concluded that a limited partnership was entitled to legally and validly carry on business and act in its own name, and held that the entity should be treated as a foreign corporation for tax purposes.
Impact of decision on foreign investment funds
A fund established as a Delaware LP investing in Japan it to be treated as a corporation for Japan tax law purposes. That treatment suggests that partners in such funds would not be entitled to claim pass through treatment with regard to home country treaty benefits which would reduce its Japan taxation burden. That is certainly true in the case of non-US taxpayer partners (e.g., a Singapore investor in such a Delaware LP fund would not be entitled to claim a reduced withholding tax rate under the Japan – Singapore Double Tax Agreement). However, US taxpayer partners should be entitled to claim benefits under the United States – Japan Double Taxation Agreement (US-Japan Treaty) as if the Delaware LP was treated as a pass-thru for Japan tax purposes. In the case of the US-Japan Treaty, the article 4 states that an item of income derived from a Contracting State through an entity that is organized in the other Contracting State and treated as the income of the beneficiaries, members or participants of that entity under the tax laws of that other Contracting State; shall be eligible for the benefits of the Convention. As a Delaware limited partnership by default is treated as a partnership for US income tax purposes, US partners should be entitled to claim the benefits of the US – Japan Treaty. The tax treaties between Japan and the United Kingdom and the Netherlands contains provisions similar to the US – Japan Treaty. Thus, for example, if a Delaware LP is treated as a pass-through for UK tax purposes, it should be treated similarly for treaty purpses.
How a fund established as a Cayman limited partnership is treated for Japan tax purposes is an open legal question. Following the approach set out by the Supreme Court, the analysis suggests that a Cayman limited partnership should be treated as a pass-through for Japan tax purposes. The view that a Cayman limited partnership is treated as a pass-through for Japan tax purposes also finds support indirectly by reference to another tax shelter fund lower court decision involving a Bermuda limited partnership that was appealed to the Supreme Court by the NTA at the same time as the Delaware LP case. The Bermuda LP case involved another real estate tax shelter fund. In that case, the Japanese individual taxpayer won at the lower trial level and appellate courts, which lead to an appeal by the NTA to the Supreme Court on the grounds that a Bermuda limited partnership should, like a Delaware LP, be treated as a corporation for Japan tax purposes. The Supreme Court denied the NTA's appeal, causing some commentators to interpret the rejection of the appeal as the Supreme Court agreeing with the lower court's decision. If that interpretation is correct, it is important to note that the Bermuda Limited Partnership Act (BLPA) is in many respects to similar to the Cayman Limited Partnership Act.
Withers Japan Zeirishi Hojin is uniquely qualified to advise foreign investment funds and their investors on this recent development.