Given that the TKDP is issued through the Japanese Tax College it represents a very useful source of reference when seeking to understand academic thinking around the international taxation of tokumei kumiai agreements. The TKDP reviews both legal issues arising in TK agreements as well as considering a variety of related international tax issues.
Note however that the TKDP is essentially an academic study rather than a straightforward interpretation of the law and hence should be sign as a guide to understanding the issues involved rather than a source of interpretation in itself. This post reviews pages 295 to 299 of the TK Discussion Paper.
Judicial precedents concerning whether a TK contract is formed
The TKDP notes that the legal definition of a TK agreement under the Japanese Commercial Law is somewhat vague and its contours difficult to see. In order to give a more concrete view of the definition the TKDP examines a number of Japanese court cases in which the point of contention was whether or not a TK agreement was formed between parties concerned.
The TKDP notes that there are precedents from tax cases (rather than commercial law cases) concerning TK contracts and gives as one example a case where the issue under dispute was whether or not a contract for entrustment of assets that also allowed their hypothecation (a 消費寄託契約/shouhi kitaku keiyaku) would be treated as equivalent to a TK agreement for Japanese withholding tax at source purposes. The TKDP also refers to another corporate tax case that addressed whether or not the “heavy land tax” (currently suspended) assessed on profits from the sale of land used in a TK business should be assessed on the operator or not. However the TKDP notes that, given that these cases do not address the legal nature of the TK agreement under commercial law, the TKDP will instead consider civil law cases where the contractual terms between the parties was in dispute and in particular where the point at issue was either (a) whether or not the contract was a TK contract or alternatively (b) if the contract was not a TK contract whether it may be deemed to be such a contract. These are discussed in detail below.
Tokyo Local Court 26 July Showa 32
This case concerned a TK agreement under which the operator of a financial business raised investment in the form of TK contributions from a large number of investors but, ignoring the level of profit in the TK business, contracted to distribute to the TK members at periodic intervals amounts calculated at a fixed rate (i.e. very similar to interest). The contract also did not confer on the TK members rights to participate in the TK business such as rights to oversee the business concerned. The contract was not recongised to be a TK agreement.
A factor in a TK agreement is the intention of the TK member to participate in the TK business
In this case the terms of the contract were under dispute and a purported “TK Contract” was deemed not to be a TK Contract but was rather recognised to be a contract for the entrustment of assets that also allowed their consumption (i.e. hypothecation). Two factors relevant to differentiate between these two types of contracts were (1) that the contract ignored the profit arising from the TK business and instead made distributions based on a fixed time period and fixed rate of return; and (2) the existence or otherwise of a right of the TK investor to participate in the TK business (albeit that such participation may be limited to limited rights recognised in the Japanese Commercial Code to review results of the business as a silent partner rather than actively participate in its running).
The TKDP notes in relation to factor (1) above that denial of the status of the contract as a TK agreement based on this item alone may be possible. However the TKDP notes that it may still be difficult to differentiate between a TK agreement and a “participating consumption loan” (共算的消費貸借・kyousanteki shouhi taisyaku – explained in the TKDP to be a contract that allows either a distribution of profit alone or, along with a fixed rate of return, an incremental distribution of profit).
In relation to (2) above the TKDP notes that there is a Japanese Supreme Court Case where, in order for a contract to be regarded as a TK agreement under Japanese Commercial Law, the TK members have to have an intention to participate in the TK business concerned. The TKDP also notes later tax cases that concerned whether or not the TK members possessed rights to participate in the TK business.
Kobe District Court Showa 62.3.31 – the ‘Steak Shop Case’
This case concerned Party A, in whose name legal permission to operate a steak shop existed and who was actually running the steak shop concerned in the case, and Party Y who provided capital at the commencement of the business concerned and whose own name was used for the business. Given these facts and circumstances the case recognised the existence of a TK agreement between Party A and Party Y, with the result that Article 537 of the Japanese Commercial Law applied to allow joint liability in respect of the debts of the operator. (Note Article 537 is a little known Article that says where a TK member permits his name to be used by the operator, then the TK member will bear joint liability for the debts of the operator arising post the establishment of the TK business).
The intention of the TK member to participate in the TK business – cases where a strong co-operative relationship between the TK member and operator is understood to exist
This case is an example where the courts recognised the establishment of a TK agreement between the parties concerned. However this was a case where the point of dispute was whether or not a third party who had transacted with the operator could exercise rights against the TK member to recover debts rather than being a case about the contractual relationship between the TK member and the operator. In this case a TK agreement was recognised as existing between the person operating a business and a person who provided his own capital to the business concerned but who was also closely concerned in the carrying out of the same business. Because the TK member allowed the use by the TK operator of the TK member’s name, Article 537 applied on the recognition of the TK agreement allowing a third party to claim accordingly against the TK member. Note that in this case the Japanese version of the legal doctrine of estoppel (禁反言の法理) is applied by Article 537. This is somewhat rare.
The TKDP notes that this is an example of the recognition of a TK agreement in a case where there is a strong sense that the operator and TK member are carrying out the relevant business in cooperation.
Tokyo District Court Heisei 7.3.28 – the Showa Lease Case
In this case the operator was a paper company that owned a single aircraft subject to lease and where the profit from the lease was used to repay the capital that was provided to purchase the aircraft under a so called “leveraged lease contract” (LL Contract). In the case the LL Contract was recognised to be a TK contract. Also this case is an example of the rejection of an assertion from the TK member of the legal doctrine denying the corporate character of the TK operator on the grounds that the operator was a paper company. [Editors note: The Editor has not read this case and the TKDP does not refer to the reasons for this assertion, but this may be a back up position taken by the TK member in order to achieve fiscal transparency in order to realise the tax benefits that were expected from the TK agreement, the principal benefit being accelerated depreciation on the aircraft itself].
The intention of the TK member to participate in the TK business – cases where there is a very weak intention from the TK member to participate in the business
This is an example of a case where a so called leveraged lease contract was held to be a TK contract. In this case the operator was more of a nominee in owning the aircraft and carrying out the related leasing business. In fact the capital of the operator company was small, there were no employees and – in a physical sense [rather than a legal sense] no office. Rather it was a company run by its directors and by the directors and investment group of the operator’s parent company.
The TKDP notes that in the above circumstances, given the operator was holding the aircraft as a paper company, the operator could be said to earning profits from the lease business and allocating them to the TK member. The TK member was making the operator hold the aircraft and lease it out and then, as a result of the allocation of profit from the business to the TK member, expect to save taxes. Accordingly their intention of the TK member to participate in the business of the TK operator was weak. Furthermore, the parent company of the operator did actually carry out a commercial leasing operation, so rather the arrangement could be said to be nothing more than an arrangement allowing the operator hold the aircraft as an investment.
In the case the court recognised the LL Contract as being a TK agreement. The court noted that the circumstances in which the TK member could not recover his investment were very limited – i.e. limited to cases where the lessee entered bankruptcy (in the case of a crash and complete loss of the aircraft then insurance, in the case of partial loss of the aircraft the cost was borne by the lessee, in the case of earlier termination then related compensation all meant that the lessee would not lose his investment). Accordingly, considering that the lessee was an aircraft operating company, then – as in investment – the TK members interest could be seen to be very safe. The court noted they did not give much credibility to emphasis from the TK member as plaintiff in the case that there was a risk that their original investment may not be repaid. However the contract was still recognised as being a TK agreement despite the court understanding it to be a safe investment with very weak intention to participate in the business concerned.
The next section of the TKDP (top of page 299) comments on the above cases.
The section notes that, in addition to the regulations of the Japanese Commercial Code, the Japanese Supreme Court has identified the intention of the TK member to participate in the TK business as an important factor in forming a TK agreement. The Editor notes that such participation must still be within the limited scope allowed by a silent partner under the Commercial Code, but would seem to exclude cases where the TK member has no rights to information about the investment or whose return on its TK investment is not calculated by reference to the results of a defined business (i.e. this would probably include cases where the return on the investment more closely resemble the return on a conventional loan).
The TKDP then discusses the Steak House case and notes that a TK may still be recognised where there the TK member is closely concerned with the actions of the operator, including cases where a third party may see them as carrying on the business co-operatively. The Editor would note that while a TK agreement may still be recognised as existing under these circumstances for legal purposes, tax issues could still arise especially in relation to a cross border TK investment and the risk of the TK Investor being seen to have a permanent establishment in Japan as a result of activities arising from its relationship with operator.
Finally the TKDP notes in relation to the Showa Lease case that a TK agreement was still recognised for legal purposes in circumstances where the operator was a paper company and the actual operation of the business was entrusted to other parties, the TK investor was expecting a tax benefit and his intention to participate in the business of the operator was very weak.
The TKDP concludes this section by noting that, even when adding the Japanese Supreme Court factor required in a TK contract, – that is the intention of the TK member to participate in the business – the terms of the legal relations between contracting parties that could be regarded as giving rise to a TK agreement are really quite broad in scope.