A ‘taxing’ situation in Japanese private equity

These firms are fueled chiefly by local pension and corporate funds, with only a small percentage of capital coming from foreign LPs or fund-of-funds. Even Japanese LPs are finding it difficult., and are looking to invest in emerging markets such as China and India because of the complicated and stiff tax laws and the recently unfavourable economic climate. One local LP told AVCJ that its annual allocation to private equity is about JPY20 billion ($2.1 billion), but it made only one commitment to a local fund last year.

The reality is that until 2009, international LPs faced double taxation in Japan. To improve this situation and promote much-needed investment in the domestic private equity market, the Ministry of Economy, Trade and Industry (METI) worked with the Financial Services Agency (FSA) to improve the existing tax policy for foreign LPs. On April 1, 2009, Japan introduced new regulations granting tax exemptions for foreign investors in local funds. Although there are still restrictions on eligibility, the Japanese government is clearly interested in opening up the market further to international LPs.

PricewaterhouseCoopers (PWC) noted that the 2009 Tax Law introduced provisions that liberalize the application of the so-called 25/5 rule – which makes an investment company liable for tax if it sells 5% or more of an investee’s shares in a fiscal year, and owns 25% or more of its shares for a given period – for certain transactions, and provides a safe harbor rule to allow foreign investors to invest directly in certain Japanese domestic partnerships without creating a “permanent establishment.”

Old(ish) law, new implications

The reason for focusing on a year-old tax policy here is that local GPs have of late been telling AVCJ that foreign institutional investors are still not clear about the changes, and consequently are still holding back potential investment. They have instead gone the route of committing capital to pan-Asian-focused funds that allocate some of their capital to Japan, rather than look exclusively at the country.

Under the pre-2009 rules, foreign partners investing in an onshore limited partnership faced the risk of a permanent establishment tax. However, the 2009 Tax Law allows a foreign partner to avoid this tax, provided certain criteria are met. It is a step in the right direction, though the requirements still make it cumbersome in some circumstances for certain foreign partners to claim the exemption.

The conditions for exemption are as follows:

• The investor is a limited liability member of an Investment Business Limited Liability Partnership (Toshi Jigyo Yugen Sekinin Kumiai), or similar foreign partnership 
• The investor should not be involved in the business of the partnership
  
• The holding ratio of the partnership assets for investors should be less than 25%
• The investor does not have a special relationship with the GP - neither family relationships nor more than 50% shareholding
• The investor does not have a permanent establishment in Japan other than the one related to the investment partnership business

In addition, an applicant who is a non-resident individual or foreign corporate member of a Japanese general partnership targeting investment in local companies by holding no more than 25% of the investee’s shares could enjoy the tax-free policy on capital gains providing:

• The investor should be a limited liability member of an investment partnership
• The investor should not be involved in the business of the partnership
• The shareholding ratio of each investor should be less than 25%
• The investor should not have a permanent establishment in Japan

Set out in this way, the guidelines for the new tax policy for overseas LPs seem fairly straightforward. Even so, according to AVCJ research, the majority of investors in local private equity and VC funds are still domestic.

Implications for GPs

Although the tax laws are not yet widely understood by international investors, some foreign LPs have invested in firms under the new policy and have thus already been enjoying the new tax exemption. The government is hopeful that greater numbers of foreign LPs will use this tax system to their advantage and reconsider allocations to Japanese funds. It is a welcome move, and one the industry hopes will continue.
One AVCJ industry source said, “We think that the tax policy should be even simpler than the current one in order to attract foreign LPs. Stimulating and activating funds – particularly mid-sized funds – needs foreign capital as well as increased allocation from local LPs.”

Another source said, “Investment capital from foreign LPs is very important for further fundraising for Japanese private equity and VC firms, but it does not mean that Japanese LPs will be squeezed out of local investments.” He added there is more than enough bandwidth for many more participants.

METI has been working to make this a reality, consulting with both GPs and LPs in local and foreign markets, to introduce new the tax policy and bring comments to the government about further easing conditions for foreign LPs.

Combining both local and offshore capital, Japan’s private equity and VC firms could make remarkable changes in the local industry and in Japan’s corporate base. The Japanese government has launched state-run investment funds that could spur a greater acceptance of financial investors, if they can prove the model of making sick companies healthier and bringing them back to the market.  But in addition to the government efforts, sources have told AVCJ that local Japanese funds should be doing more footwork as well, actively kick-starting dialogue with foreign LPs and fund-of-funds. 

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• Topics
• North Asia
• LPs
• Regulation
• Performance