By Takato Masuda, Nishimura & Asahi, Tokyo
Reforms to Japanese corporate income tax, income tax and inheritance tax, as well as new laws to remove barriers for Japanese asset managers to appoint foreign fund managers, were passed by the state assembly on March 26th and came into effect the same day.
The motivation for these reforms is believed to be Japan’s ambition to outperform Hong Kong as the leading financial center in Asia, given the growing instability in Hong Kong related to the passage of the National Security Law in 2020.
Japan’s reforms therefore appear to be an example of a country’s use of tax competition to improve its status as an international financial center and attract investment. While there is growing consensus that the race to lower corporate tax rates should be moderated, as in the OECD’s Pillar 2 proposal (GloBE), other types of tax competition appear to persist.
According to the new tax law, a performance-based remuneration that an asset management company pays to executives is, under certain conditions, deductible from corporate income tax.
Under current law, performance-related remuneration paid to executives in unlisted companies – which is often the case with asset managers – was not deductible. It was believed that this rule should be changed as it is inconsistent with the typical executive compensation package of investment management companies, which is primarily performance-based compensation.
With regard to inheritance tax, if a non-Japanese fund manager resided in Japan for more than 10 years, a high inheritance tax of up to 55% was levied not only on the manager’s domestic assets but also on foreign assets, even if the inheritance was outside of the country.
This made Japan a less attractive place to work than other non-inheritance tax countries like Singapore. Under the new rules, certain foreign nationals residing in Japan for work purposes will not be subject to inheritance tax on their foreign property regardless of how long they have been in Japan.
With regard to income tax for fund managers, the Japan Financial Services Agency and the national tax authority issued guidance to clarify the tax-friendly treatment of so-called “carried over interest” (a common form of profit-share-based remuneration for fund managers). .
Generally, when carried over interest received by a resident is considered compensation for services, it is taxed at a progressive rate of up to 55%. However, it is believed that this will deter foreign professionals from getting into the Japanese financial business. Accordingly, under the new guidelines, certain transferred interest will be taxed separately from other income at a flat rate of 20% as financial income and not as consideration for services.
The reforms also expand the scope of tax exemption for those investing in Japan from abroad through limited partnerships that have (or are considered to be) permanent establishments in Japan.
If a foreign investor is a limited partner in such a limited partnership, the income tax payable on the permanent establishment is exempt under certain conditions, for example if the foreign investor holds less than 25% of the partnership shares.
Similarly, under current law, if the limited partner was not a natural person but a so-called “fund of funds”, the stake held by the fund of funds had to be less than 25%. After the revision, the threshold of 25% applies to interest held by a fund of funds for the interest that is essentially held by the respective investors in the fund of funds.