By Takato Masuda, Nishimura & Asahi, Tokyo
Reforms to Japan’s corporate tax, income tax, and inheritance tax, and new laws aimed at removing obstacles for Japanese asset management companies to appoint foreign fund managers were passed by the Diet on 26 March and enacted into law the same day.
The motivation for these reforms is believed to be Japan’s ambition to surpass Hong Kong as a leading financial center in Asia, considering the growing instability in Hong Kong related to the enactment of the national security law in 2020.
Thus, Japan’s reforms seem to be an example of a country’s use of tax competition to enhance its status as an international financial hub and attract investment. While there is a growing consensus that the race to the bottom on corporate tax rate reductions should be mitigated, as in the OECD’s Pillar 2 proposal (GloBE), other types of tax competition seem to remain.
Under the new tax law, performance-based compensation paid by an asset management company to executives is now deductible from the corporate tax under certain conditions.
Under prior law, performance-based compensation paid to executives by non-listed companies – which asset management companies often are – was not deductible. It was thought that this rule should be amended because it was inconsistent with the typical remuneration package for executives of investment management companies, which is mainly performance-based compensation.
With respect to inheritance tax, if a non-Japanese fund manager resided in Japan for more than 10 years, a heavy inheritance tax of up to 55% was imposed not only on the manager’s domestic assets but also on foreign assets, even if the heir resided outside the country.
This made Japan a less attractive place to work than other countries without inheritance tax, such as Singapore. Thus, under the new rules, certain foreign nationals who reside in Japan for work purposes will not be subject to inheritance tax on their foreign assets, regardless of the length of stay in Japan.
Regarding income tax for fund managers, the Japanese Financial Services Agency and the National Tax Agency issued guidance to clarify the tax-friendly treatment of so-called “carried interest” (a common form of compensation for fund managers based on a share of profits).
In general, if carried interest received by a resident individual is considered as compensation for services, it is taxed at a progressive rate of up to 55%. However, this is believed to discourage foreign professionals from entering the Japanese financial business. Accordingly, under the new guidance, certain carried interest will be taxed separately from other income at a flat rate of 20% as financial income rather than as consideration for services.
The reforms also expand the scope of tax exemption for those who invest in Japan from abroad through limited liability partnerships that have (or are deemed to have) a permanent establishment in Japan.
If a foreign investor is a limited partner in such a limited partnership, tax on income attributable to the permanent establishment is exempted under certain requirements, such as when the foreign investor holds less than a 25% partnership interest.
Similarly, under prior law, if the limited partner was not an individual but a so-called “fund of funds,” the equity interest held by the fund of funds had to be less than 25%. After the revision, in the case of an interest held by a fund of funds, the 25% threshold applies to the interest substantially held by the respective investors in the fund of funds.
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