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Investing in Japan via Tax Efficient Silent Partnerships

By Andrew H. Thorson
Partner, Dorsey & Whitney LLP (Tokyo)

Companies investing, acquiring or operating subsidiaries in Japan should consider using the “silent partnership” or “TK” (known in Japan as a Commercial Code tokumei kumiaia) as a tax efficient vehicle for their transactions. By using the TK vehicle, in certain circumstances investors can realize substantially reduced Japan-side tax burdens which would otherwise set up a road block to viable returns on an investment.

In the typical scenario, the sole-shareholder of a Japanese company might fund the company solely via additional share purchases. In such cases, the shareholder could be paying an effective tax rate of up to 47.8% including combined Japanese local and national taxes plus the 10% withholding tax on dividends paid to the U.S. shareholder. What if the shareholder could reduce the tax burden in Japan to 20%? Depending upon the circumstances, financing the Japanese company via a TK could result in such a reduction.

What is a TK? A TK is not a business entity. TKs are contracts between silent “investors” and business “operators”. The investor contracts to provide an asset (cash or other property) for use by the operator in its business. In exchange, the operator pays the investor an agreed percentage of the business’s pre-tax profits.

Under the TK contract, the investor receives no ownership right in the business. The investor receives only a right to profits. Furthermore, while the TK contract may provide the investor with certain investigatory and informational rights, the investor receives no management rights. TK contracts are simple and often require little more than an agreement upon scope of the subject business, the allocation of profits and losses, and terms relating to termination/expiration.

A TK is not a loan agreement or a leasing agreement. However, the operator deducts payments to the investor on a pre-tax basis. Usury limitations do not apply on payments of profits to the investor. This is one advantage of the TK when contrasted to inter-company loan financing.

Potential Tax Efficiencies. As indicated above, if properly established and monitored, use of a TK structure for a Japan investment could reduce the effective Japanese tax rates for certain Japan investments.

Take the simple example of financing a wholly-owned subsidiary. When a U.S. investor purchases or establishes a wholly-owned corporation in Tokyo the effective tax rate on profits can be estimated at 47.8% (approximate combined corporate tax rate of 42% plus a 10% withholding on dividends to U.S. companies under the Japan – United States tax treaty).

If properly structured, the tax burden in Japan could be reduced to a 20% withholding tax on TK profits paid to the U.S. investor. TK structures have been used in more complicated structures as well, for example in aircraft and other asset leasing arrangements wherein they lawfully reduce tax burdens in Japan.

Freedom of Contract and Limitations on TK Uses. The Commercial Code of Japan prescribes the fundamental legal foundation of the TK structure but TK structures are generally subject to the principle of “freedom of contract”.

The TK structure is, however, not without limitations. An investor is at risk and does not receive fixed payments as a lender might. The investor also has no right to payment when the business has no profits. If the asset is fully consumed by the business, then the investor receives nothing upon termination or expiration of the TK.

Furthermore, a silent investor may enjoy certain contractual rights of investigation and access to information, but participation in the management of the entrepreneur’s business could result in the silent investor being treated as an ordinary shareholder for tax purposes. Such participation could also result in joint and several liability, or the nullification of the legal validity of the TK. For this reason, the TK investor should not be a shareholder of the TK business, but could be an affiliate of the TK business’s shareholder – and could be an affiliate domiciled in a tax haven.

Potential scrutiny by Japanese tax authorities is perhaps the material concern in structuring a TK. Generally speaking, however, the material concern of tax authorities relates to treaty shopping.

Consider, for example, the case in which US Parent Inc., a U.S. corporation, establishes an entity, X Inc., in country X where the tax treaty between country X and Japan provides that TK profit distributions to companies of X are entirely free from Japanese taxation. If X Inc. was established for the sole purpose of taking profits from Japan Sub K.K. via a TK to avoid Japanese taxes, then this is the type of case wherein Japanese tax authorities might consider issuing an assessment notice. Under such circumstances, X Inc. lacks real substance and could be considered a treaty shopping vehicle established to avoid Japanese taxes otherwise payable by a U.S. corporation. Some commentators indicate generally the importance of being able to demonstrate to Japanese tax authorities a rational basis for entering into a TK before taking into account associated tax benefits.

Scrutiny of TKs. The TK is a typified form of commercial code contract, which is used by some well-known Japanese corporations in various capacities. Use of a TK in and of itself is not generally considered suspect activity or harmful to the reputation of an investor.

In recent years the tax authorities have found TKs widely used in business practice, yet until somewhat recently, aircraft leasing has been perhaps the only major transaction in which TKs were regularly utilized. We understand that rumors of a disallowance of TK tax benefits have been surfacing annually for several years now, but based upon informal discussions with officers of related authorities, believe there is no impending move within the tax authorities to eliminate such benefits. There have been quasi-governmental study groups formed to research the current uses of the TK structure in Japan, however, a change in law to prohibit the use of TKs could be difficult for the government. Tax authorities are perhaps more likely to crack down on misuses of the form (such as in treaty shopping) rather than abolish it.

As discussed above, a TK must be used appropriately. In structuring a TK for a Japan investment, particular care must be taken to ensure that the intended benefits are supported by sound commercial rationale and will achieve the intended benefits. The ultimate decision of whether or not a TK is suitable for a Japan investment will rest upon the results of a comprehensive review of all of the relevant facts and associated tax concerns.