For Japanese tax purposes Japanese civil law partnerships (in Japanese nin’i kumiai, referred to below as ‘NK’s) are treated as fiscally transparent.
NKs themselves are not taxed as separate entities. Instead, the members of the NK are subject to taxation on the income treated as attributable to them.
This article explains in more detail how NK investments are taxed including some of the choices available to a taxpayer. See the article here for legal aspects of NK agreements. See this page for commercial law tokumei kumiai partnerships.
Taxation of investors: Timing of income recognition
Corporate or individual members of an NK in principle have to recognize the income or loss arising to them under their NK Contract as the income or loss accrues. Whether or not income has been distributed from the NK is not relevant to the timing of NK income recognition for tax purposes. (Tax Instruction 14-1-1 for corporations, 36, 37-19 no 2 for individuals, links in Japanese).
However under TI 14-1-1, and as an exception to the above principle, where:
- A calculation of its income or loss from the NK interest is made at least once per year
- The calculation is made at set, specified periods (below for an ‘NK Accounting Period’)
- where attribution of income or loss is made to each NK member within one year or less from the time under which the income arose;
- and, where the income or loss is calculated based on an NK Accounting Period (rather than, for example, being an apportionment of income from more than one NK Accounting Period)
Where the above criteria are met the NK investor can be taxed on the income or loss for the NK Accounting Period that ends during the corporation tax year end of the corporate investor (or that ends in the calendar year for the individual investor) instead of applying the default NK income recognition treatment of taxation at the time the income accrues.
The above treatment is regulated by Tax Instruction 14-1-1 and hence is non-statutory. The Tax Instruction recognizes that this treatment has the potential to be used abusively to defer taxation over a longer period, for example where an NK has invested in another NK with a different accounting period end that applied the same rule. In such circumstances the TI makes it clear that, if taxation of underlying income was to be deferred for more than one year, the non-concessionary recognition of income at the time it accrues should be applied.
Different approaches to taxation of income from a nin’i kumiai
In principle an NK is treated as a pass-through entity for Japanese tax purposes and hence the income from the NK retains its nature when attributed to and taxed at the investor level.
In practice investors can choose between three different methods of taxation to apply to income from the NK that match the three accounting treatments described in the NK accounting article. The three methods, described below, are increasingly complicated, but along with this complexity allow the investor additional tax benefits.
Net Method taxation
Under this method the investor is taxed only on his net gain or loss from the NK. This method is administratively convenient for an investor, but the investor cannot apply tax benefits such as the Japanese Dividends Received Deduction, credit for income taxes withheld or a deduction for tax deductible provisions or reserves.
The investor is still required to add back permanent items, such as donations and entertaining expenses, on the basis that the NK is deemed to be a corporation without any capital (the add back of these permanent items can be reduced by an amount that increases with the amount of a company’s capital). Costs of writing down depreciable assets may however be deducted, provided there is no inappropriate loss of tax.
Compromise Method taxation
Under this approach the investor grosses up items of gain or loss in the profit and loss account but does not gross up the investment in the NK on the balance sheet, instead reporting only the net investment amount. The investor can apply the Japanese Dividends Received Deduction and a credit for Japanese withholding taxes suffered by the NK. However the investor cannot claim a deduction for items that would involve balance sheet recognition, such as claiming a deduction for establishing provisions or reserves.
Gross Method taxation
Under this method the investor recognizes all income, expense, assets and liabilities for tax purposes and is entitled to the full range of tax benefits that a company would normally receive.
In its tax return the NK investor may aggregate the items of NK income and expense and assets and liabilities with their own corresponding intrinsic items or may analyze them separately.
Anti-avoidance rules and nin’i kumiai
The regulations around NK taxation include ant avoidance regulations that restrict the recognitions of losses from an NK under certain specified circumstances where the NK investor’ economic exposure to the NK business may in substance be limited. These circumstances may arise, for example, when the only or main liability of the NK is a non-recourse loan secured on the NK’s main asset or when other arrangements exist that in substance limit or prevent the NK member being exposed to economic loss. These will be discussed in more detail in a later article.
Implications for the nin’i kumiai contract
Given the above methods for taxing income from an NK it is important for investors to make sure they can receive the information they require for the method if taxation that they want to adopt. The best approach would be to specify this information in the NK Contract at the time it is negotiated.
Withholding tax on distributions of income arising from NK contracts
The principal of fiscal transparency of the NK extends to the treatment of Japanese withholding tax. The members of the NK are treated as paying or receiving the income concerned directly and withholding taxes applied accordingly.
Regrettably however there seems to be limited practical guidance on the practical aspects of how the payor of income to an NK should calculate how much tax should be withheld when some members of the NK are liable to withholding tax and some are not.
In theory withholding should reflect the treatment of the underlying income as it is allocated to each member in the NK, but in practice a payor of income may not know how the income is allocated without access to the TK Contract and may also find it difficult to prove that he met his obligations to properly withhold tax on a subsequent withholding tax audit (see this article for more details on legal aspects of withholding and this article in errors in withholding).
Given the above the payer of income subject to WHT to an NK would be wise to address potential problems with under-withholding in their contract with the NK.
Japanese withholding taxes and nin’i kumiai
It is, under some circumstances, possible for a foreign corporation to be deemed to have a taxable presence (a permanent establishment or ‘PE’) in Japan by virtue of his being an NK member. A 20% withholding tax (‘WHT’) applies to distributions to such a foreign corporation.
If the only business of the foreign corporation is the business of the NK that gives rise to the deemed PE concerned then it is not possible for the foreign corporation to apply for an exemption from the application of the withholding tax.
However if the foreign corporation has a PE in Japan carrying on business activities separate from the deemed PE arising from the business of the NK, then such a PE can apply to the tax office for a certificate conferring exemption from the WHT on the NK distribution. This certificate would routinely be obtained by a Japanese PE registered by foreign company and must be shown to the person paying the income in order to permit them to exempt the payment from withholding tax. Note that in these circumstances the PE will be filing a tax return and paying the full corporation tax rate on income attributable to its PE.