The Japanese tax law concerning Japanese civil law partnerships (in Japanese nin’i kumiai and below ‘NKs’) includes anti-avoidance provisions that can apply to deny the deduction of tax losses arising from an NK under circumstances where, generally speaking, the investment is passive and there are actual or substantive limits to the NK investor’s economic exposure to the underlying NK investments.
These rules are referred to below as the ‘NK Loss Limitation Rules’ or the ‘Rules” (in Japanese the ‘組合事業等による損失がある場合の課税の特例’ or ‘kumiai jigyoutou ni yoru sonshitsu ga aru baai no kazei no tokurei’).
If the underlying business of the NK ultimately gives rise to an overall profit then the NK investor may, if specified conditions are met, be able to set off previously disallowed NK losses in whole or in part from such profits.
This article discusses these rules further as they apply to corporations holding interests in NK Contracts. See this article for the legal background to NKs, this article for an overall description of the taxation of NK Contracts and this article for a discussion of accounting for an interest in an NK Contract. Similar rules, with some modification, also apply to investments in tokumei kumiai or Japanese limited liability partnerships and to individual investors.
Specified Kumiai Members
A key definition in the NK Loss Limitation Rules is the definition of ‘Specified Kumiai Members’ (in Japanese ‘特定組合員’ or ‘tokutei kumiai in’) of the NK as only these NK members are subject to the Rules. The definition depends on the extent of involvement of the NK member in the underlying business, where such involvement would normally depend on the rights of the NK member under the NK Contract, or Japanese civil law if not stated. Typically only some members of the NK would be Specified Kumiai Members as explained further below.
The definition of Specified Kumiai Member is found in the Special Taxation Measures Law Enforcement Order (‘STMLEO’) 39 no 31-2 (link in Japanese) and is defined negatively in that a Specified Kumiai Member is an NK member who is not a NK member identified under either of the two paragraphs explained later in this article.
Activities of Specified Kumiai Members
In order to apply the Specified Kumiai Member definitions in the two paragraphs below two further definitions are required. These definitions relate to the underlying assets and liabilities making up the business of the NK Contract and the NK member’s activities with respect to those assets and liabilities. The definitions are:
‘Material Business’ (in Japanese ‘重要業務’ or ‘juuyou gyoumu’) with respect to the assets and liabilities of the NK: This term refers to the execution of business related to the disposal or succession of material assets of the business of the NK or in relation to the borrowing of material funds financing the business of the NK.
‘Material Execution Part’ (in Japanese ‘重要執行部分’ or ‘juuyou shikkou bubun’). This term refers to a subset of the activity included in Material Business of the NK referred to above and refers to the negotiation of contracts and similar material activities included in the scope of the Material Business.
To given an example, Material Business may include a decision around timing and means of realisation of the underlying investments of the NK assets while the Material Execution Part may include negotiations of the sales price or contract further to such a decision.
Definition of Specified Kumiai Members
A Specified Kumiai Member is any NK member other than one falling into either of the two paragraphs below.
This paragraph identifies NK members who participate in determining the Material Business of the NK or NK members who themselves participate in the execution of the Material Execution Part of the Material Business. NK members who did not participate in determining how to execute the Material Business that has already been carried out (in the case of persons who newly joined the NK or persons who succeeded to another members interest in the NK, the business carried out from the time of their joining the NK or succession to rights under the NK) are excluded from identification under this paragraph, as are NK members who did not themselves participate in the Material Execution Part of the business.
This paragraph identifies members who where all, at the time of commencement of the NK contract, (or, at the time newly joining members or succeeding members joined or succeeded to the NK contract, that time) up until the end of the most recent closed accounting period of the NK, managing as their main business the same type of business as the NK (excluding the NK business itself if, for example, this was the only business of the member).
In concept paragraph 1 identifies NK members who have an active role in the business of the NK, either through determining decisions around how to deal with the NK assets or being involved in negotiation with outside parties around disposal and acquisition of the NK assets or similar. Paragraph 2 seems to allow the exclusion from the definition of Specified Kumiai Members NKs made up of persons who are carrying on a similar business to the NK business as their main business.
Given that the definition of Specified Kumiai Member is critical to the application of the NK Loss Limitation Rules proper professional advice must be obtained from a qualified Japanese tax accountant in this area.
Adjusted Capital Amount
The ‘Adjusted Capital Amount’ (in Japanese ‘調整出資金額’ or ‘chousei shusshi kingaku’) is also a critical concept in the NK Loss Limitation Rules. Conceptually Adjusted Capital Amount is equivalent to partnership outside basis in the US Subpart K partnership tax rules. In outline, it is calculated from the total of initial capital contributions (which may be of both monetary or non-monetary assets) plus accumulated profits of the NK less distributions from the NK (STMLEO 39-32-2) (link in Japanese). As explained below the Adjusted Capital Amount may act as a limit to the amount of deductible loss under the NK Loss Limitation Rules.
It is also important to be aware that the Adjusted Capital Amount may be carried over to the buyer of an interest in an NK. Accordingly the tax basis of such a buyer may be different from the consideration the buyer actually paid to acquire the NK contract.
Schedule 9(2) to the Japanese corporate tax return (link in Japanese) is used to calculate and track the amount of non tax deductible loss arising from an NK Contract. It also includes in the bottom third of the schedule a section to calculate and track the Adjusted Capital Amount. More details on this form and this calculation are planned for later articles.
Disallowance of losses from a nin’i kumiai
Where it can be foreseen that the business of an NK will not be loss making (such an NK referred to be below as a ‘Limited Exposure NK’) then, for a company which is also a Specified Kumiai Member, the whole amount of any loss arising from their interest in the NK contract cannot be treated as tax deductible. When making an assessment of whether or not the business concerned will finally, in substance, not be loss making consideration should be given to factors such as the make up of the business, the contract to repay the liabilities of the business, contracts for compensation of losses and the content of other contracts or relevant conditions.
Tax office interpretation of Limited Exposure NK
Special Taxation Measures Law Tax Instruction 67 no 12-4 (link in Japanese) gives further tax authority interpretation of the meaning of “…it can be clearly foreseen that [the NK Contract] will not be loss making…” (in Japanese 「明らかに欠損とならないと見込めるとき」). This Tax Instruction states that cases where only a relatively small loss may be incurred or where events that could give rise to a loss have a relatively low probability of arising then such contracts may still not be excluded from being contracts where it can be foreseen that the NK Contract is not loss making. Hence exclusion from loss deduction may still apply for such contracts. The Tax Instruction does not provide further explanation around the size of loss or level of probability in assessing this point, perhaps deliberately.
NK Loss Limitation Rules for other nin’i kumiai
Where a Specified Kumiai Member realizes a loss from an NK other than a Limited Exposure NK then the cumulative loss claimed as deductible for corporation tax purposes cannot exceed the amount of the Adjusted Capital Amount.
Recovery of disallowed losses from a nin’i kumiai
Where a company has suffered a disallowance of loss from the NK in excess of the Adjusted Capital Amount of its NK investment but in subsequent financial years earns a profit from the same NK the company can offset the previously disallowed loss up to the amount of the profit.
A practical example of an NK that could be subject to the above Rules might include an NK whose underlying business is investment in real estate financed by a non-recourse loan. In such a transaction a passive investor in the NK not involved in the day to day management of the underlying business may be treated as a Specfied Kumiai Member unable to claim a tax deduction for any excess of interest or operating costs of rent and other income over their initial capital invesment. Tax deduction may therefore be deferred until the underlying real estate is finally sold at a profit.
Limited Exposure NK
The definition of Limited Exposure NK may be intended to capture transactions with a clearer tax avoidance motive. For example, an investment through an NK in an asset that had limited economic risk – for example because it was purchased using a non-recourse loan – but on which accelerated depreciation may be available may be caught by these rules. Care should be taken around whether or not the Rules apply to leasing and similar transactions.