This post focuses on the taxation of TK Distributions under domestic Japanese law.
Japanese Withholding Tax on TK Investments
In the past whether or not Japanese withholding income tax applied to distributions under TK Contracts depended on whether or not the TK Investors where domestic corporations or Japanese residents or whether or not the the TK Contract had ten or more members. However in the tax reform of 2007 this was simplified such that from 1 January 2008 onwards a 20% withholding tax applies to distributions of income from TK Contracts.
Note that the withholding tax element only applies to distributions of profit from the TK Contract and not from returns of capital. Also, for Japanese corporations the withholding tax can be either offset against corporation tax or repaid.
Also, in cases where a loss arises in a particular accounting period, then such a loss is not recognised in the period concerned for individual tax purposes. The logic is that the loss will not be finally determined until the end of the TK Contract where the obligations to bear losses among the TK Investors and TK Operator is finally determined. Any necessary expenses of the individual TK Investor relating to the loss making TK Contract are also not deductible for the period concerned. If in the following period a profit arises from the TK Business then, to the extent that such a profit is not used to supplement the previous periods loss, the excess is taxable as income following the normal rule above.
Calculation of the amount of TK Distribution; TK Distributions to Japanese corporate TK Investors
In understanding the taxation of TK Distributions it is helpful to compare them with NKs. While both TKs and NKs are from a Japanese legal perspective both assoociations without a legal personality, in the case of the TK Contract assets and liabilities are both legally attributed to the TK Operator. Accordingly for tax purposes, unlike for NKs where the NK member may report the results of the underlying assets in various levels of detail including full gross up of assets, liabilities, income and expenses, the TK Investor will only report the net income from the TK Contract, being the TK Distributions. Note that this may not be the same result as for accounting purposes.
Given the above a TK Investor cannot directly benefit from certain tax treatments that may be available to an owner of an underlying business, such as dividends received deductions, establishment of tax deductible reserves etc although these benefits would be available to the TK Operator and recognised in its tax filings. Accordingly the TK Investor should consider carefully how these benefits may economically impact the return from its investment and the TK Distribution formulae. For example, if the TK Business included shares in a company for which the TK Operator could apply a dividends received deduction then the TK Investor should consider whether the related tax benefit should be shared with the TK Operator in determining the level of the TK Distribution.
On a historical note, in the past consideration was given in TK context as to whether disallowances such as entertainement expenses or donations should be disallowed at the TK Investor level similar to the treatment under an NK. The TK Investor had to add back their pro-rata share of any addbacks. However from the reform of the CTL Tsutatsu in 2005 such non-deductible expenses are considered the intrinsic espenses of the TK Operator and are adjusted at the TK Operator level only, which is the treatment one would expect from the nature of a TK Contract. The amount of TK Distribution (or allocation of loss from a TK Contract) them becomes a matter of the TK Contract itself.
Income Taxation of TK Distributions for Japanese Resident Investors
For individuals TK Distributions first suffer a withholding tax at 20% and the income is included in the comprehensive income of the TK Investor for taxation at marginal tax rates, with a credit for the withholding tax. For individuals such income would normally be Miscellaneous Income (zasshotoku/雑所得). However if the individual TK Investor is seen as being involved in decisions around the important parts of the execution of the TK Business (which is not what would normally be expected of a silent TK Investor) then the income would be reported in line with the underlying activity of the TK Business, that is as business income or other categories of income as appropriate. Also, some part of the distribution may be treated as income from the lending of money under some circumstances.
The NTA homepage includes guidence on the timing of taxation of distributions from TKs (in guidance under the abbreviated name kumiai tsutatsu kaisetsu/組合通達解説 – Explanation of Tax Instructions Related Partnerships). This guidance makes it clear that the time under the TK Contract that the TK Investor can require the distribution of income is the time that such income should be included in income of the individual TK Investor. This is regardless of whether any cash distribution is made or whether funds are retained by the TK Operator to increase capital of the TK Business. Given this treatment it is advisable to draft the TK Contract so that the time that TK Investors can receive distributions is unambiguous – for example, setting the time that a TK Investor can require such a distribution one or two months after the accounting period for the TK Contract to allow a grace period for settling the accounts and calculating the distributions due.
Taxation for non-resident individual or foreign corporation TK Investors – domestic Japanese tax law
For the above classes of TK Investor the 20% withholding tax discussed above applies. For foreign corporations that do not have a permanent establishment in Japan then this is final taxation under domestic law – although as discussed in further posts tax treaties can alter this taxation.