Japan Puts Off Vote on Controversial Tax

TOKYO-Lawmakers here postponed a vote last Wednesday on controversial legislation that could significantly increase tax rates for U.S.-based private equity firms and other foreign-owned businesses doing business in Japan. The regulation would also force them to re-incorporate to continue operations in Japan.

While repeated media reports say that Japanese bureaucrats are unwilling to back down in the face of intense lobbying by foreign financial firms, that may in fact be what is happening. During a debate on the passage of the bill in the Japanese Diet’s House of Councillors – which took place before the vote was postponed – a member of the House is reported to have asked Ministry of Justice officials whether they had considered the consequences of the new legislation upon the 40-plus foreign financial firms doing business in Japan.

The Diet rescheduled the vote on the controversial legislation for June 29. The proposed law, which contains more than 1,000 articles, has caused an uproar in much of the American and European financial community in Japan. Law firm Baker & McKenzie has said the legislation would produce “the most sweeping changes to corporate law in Japan in the last half century.”

Foreign financial firms in this country are most furious about “Article 821” of the new code, which if passed, will take effect on April 1, 2006. That article would require foreign-owned businesses operating through branches in Japan to re-incorporate as subsidiaries of foreign-owned companies.

Of the 40-plus foreign financial firms in Japan, about 30 are expected to have to re-incorporate if the legislation is passed. One source in Japan says that the article appears to have crept up on many firms operating here and does indeed pose “enormous issues” for them

The tax implications for foreign-owned companies doing business here are substantial, says Yasuko Masaki, a partner at Shin Nihon Ernst & Young in Tokyo. She says that once foreign forms re-incorporate they will be subject to a 42% tax rate on their profits. Masaki says that few firms will end up paying the full rate, even if the bill eventually becomes law, because they can amortize profits against losses or against goodwill over a five-year period. But Masaki says that it would be hard for firms such as Ripplewood to avoid paying hefty taxes on windfall deals. Ripplewood recently sold part of its holdings in Japan’s Shinsei Bank for $5.4 billion, earning a 4x return. It paid no taxes in Japan.

Until Japan’s tightly knit community of bureaucrats provides details and guidance on the new law, almost no one in this country is willing to talk about the issue in fear of either educating regulators about their fears or of receiving reprisal by regulators. In fact, only one representative from nearly two-dozen law firms, investment banks, accounting practices, private equity firms and non-governmental agencies agreed to speak on the record to PE Week about Article 821.

The Financial Times of London has published several stories recently that claim passage of the article will cost foreign businesses hundreds of millions of dollars in administrative costs relating to re-incorporation. The article’s passage would also require between six to 18 months of re-incorporation work, and may cause foreign financial firms to withdraw from doing business in Japan.

The new commercial code, which has been in the works for three years, was introduced into the Diet on March 22, shortly before the Diet’s March 30 passage of the so-called “Shinsei Tax,” a 20% levy on the profits of foreign private equity firms. The Shinsei Tax regulation was accompanied by other taxes on minority investors, including LPs in private equity funds, which were previously immune to taxation on their PE investments.

Previously, a representative from a leading investment bank in Japan told PE Week that the bank hoped to avoid taxation under the Shinsei Tax because it operated as a branch in Japan. But if approved, the new commercial code will effectively close that loophole.

Nine different private equity firms and investment banks – including JP Morgan Partners and The Carlyle Group – were reported to have worked, unsuccessfully, to lobby the Japanese government against passage of the Shinsei Tax. But as the date for the final vote on the new commercial code approached, the American and European chambers of commerce in Japan were reported to be intensively lobbying Japan’s Ministry of Finance, Ministry of Justice and government representatives to prevent passage of Article 821, as part of the new code, apparently with greater success.

One source says that while investment banks and private equity firms are screaming foul, in part over having to pay taxes, they do have a valid point about the issue of being forced to re-incorporate. The source says that Japan’s Ministry of Finance told the banks and private equity firms to set up their businesses here as branches, which they did. But having done that, they are now being told by another governmental branch, that they must reincorporate and do business in another form.

Given the deliberate pace of legal and governmental processes in this country, foreign firms are rightly concerned that the switch is going to be a slow, costly procedure that will cause considerable harm to their ongoing business in this country.

After the new law is implemented it will no longer be possible to incorporate as a Yugen kaisha (YK), and YKs will automatically convert into KK (Kabushiki Kaisha). Converted companies will be allowed to continue to trade under the YK name for the time being.

YK is a limited liability company analogous to the German GmvH, and are typically used by small “mom and pop” business operations in Japan, but US investors sometimes use the YK as a pass-through vehicle for U.S. tax purposes.

One senior attorney suggested that the changes in the commercial code relating to KK and YK companies were written not to further penalize foreign financial firms operating in Japan, but to bring more effective oversight of companies formed by either high net worth individuals or “Yakuza” groups in Japan, who have used the YK structure to hide their assets overseas from Japanese tax authorities.

Chris Hodges, a senior partner in Baker & McKenzie’s Tokyo office and author of a summary of the new corporate law, was one source willing to go on the record with comments about the new commercial code.

He said that there are many improvements being introduced, including, “a simplification of the incorporation procedures, a simplification of the asset valuation process that [PE firms need] in making purchases in Japan,” and other features that “add up to a lot of good news for PE firms.”