Japan’s Supreme Court says Delaware limited partnerships are corporations for tax purposes

by Masao Yoshimura

The Supreme Court of Japan has ruled that Delaware limited partnerships should be classified as corporations for tax purposes and, as a result, the entities’ partners may not deduct the partnerships’ losses on their tax returns.

The case, decided July 17, is the first Supreme Court decision to establish criteria for foreign entity classification and is of great significance to tax planning for cross-border investment.

In the case, Japanese residents owned limited partnership interests in two partnerships arranged by Commerz Securities Japan that were established under the Delaware Revised Uniform Limited Partnership Act (DERULPA). Both partnerships invested US real estate.

The partners reported huge paper losses on their income taxes, claiming depreciation and other costs associated with the investments.

However, Japan’s National Tax Agency (NTA) contested the deductions, claiming that the limited partnerships should be treated as corporations whose losses cannot be directly allocated among the members for tax purposes.

The dispute reached the Supreme Court, which has agreed with the NTA, concluding that the Delaware partnerships at issue should be treated as corporations.

In reaching its decision, the Supreme Court noted that Japan’s Corporate Tax Act and (Individual) Income Tax Act do not provide a statutory definition of a foreign corporation.

The Court said that to determine if an entity is a corporation, one must determine if the entity has the legal attributes of a separate taxpayer, focusing on the entity’s legal relationships and the rights and obligations associated with the entity’s activities.

The Court said first question is whether the entity is clearly defined by the law of incorporation as a corporation, or other type of body corporate equivalent to a Japanese corporation, or as just an aggregate of the members.

If the entity is clearly defined, the classification should be respected, the Court said.

Otherwise, the relevant test is whether the entity can separately have a proprietary interest in its assets and be liable for the debts and obligations incurred as a result of its legal acts under the law of incorporation, the Court said.

Applying these criteria, the Supreme Court noted that while DERULPA regards a limited partnership as a “separate legal entity” under sec. 201(b), no provisions define that as a “body corporate.” So, the Supreme Court did not find a clear definition for entity classification in DERULPA.

The Court then concluded that the Delaware partnerships should be treated as corporations because DERULPA provides, in section 106, that a limited partnership may exercise powers and privileges as are necessary or convenient to the conduct, promotion, or attainment of the business and because it further provides, in section 701, that a partner has no interest in specific partnership property.

— Masao Yoshimura is an Associate Professor of Tax Law at Hitotsubashi University’s Graduate School of International Corporate Strategy in Tokyo, Japan, where he focuses on corporate and international tax.