Structuring the investment
When choosing an investment structure, the legal, accounting and tax implications must be considered, because each can be a driving factor for the choice. The most popular structures and investment vehicles used for real estate investments in Japan are the GK-TK structure, the TMK structure and the J-REIT. The Real Estate Specified Joint Enterprise Act (REJEA) was amended in 2013 to enable a GK-TK structure (see below) to invest in real estate without requiring the limited liability company (GK) as the contractual anonymous partnership (TK) operator vehicle itself to obtain a licence.i GK-TK structure
A GK is one type of corporate entity under the Companies Act. In some respects, it is similar to an LLC in the United States; however, it is not itself a pass-through entity for tax purposes. When a GK is used as an asset investment vehicle, typically an investor leverages its investment by third-party loans and makes its own investment in the GK through a TK arrangement. The TK arrangement is a bilateral (not multilateral) contractual partnership relationship created for the investment purposes by the TK interest holder, called the TK investor. The other party to the contract is called the TK operator. Under the GK-TK structure, the TK operator is the GK. A TK arrangement qualifies for favourable tax treatment if the TK investor is a passive investor with minimal control over the management of the GK and the contributed funds under the arrangement. If the TK arrangement qualifies, the GK is permitted to deduct distributions to the TK investor from its taxable profits in addition to deducting debt payments. This tax-efficient combination of a GK and a TK arrangement is called a GK-TK structure.
Typically, a GK-TK structure has been used to make investments in trust beneficial interests in real estate, and loans backed by real estate. If a GK holds real estate directly, by raising funds from TK investors, it will generally be subject to a licensing requirement under the REJEA. Therefore, the GK-TK structure has usually been structured to invest in trust beneficial interests in real estate, not in real estate itself. An exemption from the licensing requirement under the REJEA (newly introduced in 2013) allows the GK-TK structure to invest in real estate itself if certain requirements are satisfied.
A GK-TK structure that is used to invest in a trust beneficial interest in real estate will subject the GK to the strict registration requirement under the Financial Instruments and Exchange Law (FIEL), unless an exception applies. One of the exceptions available under the FIEL is the QII exemption, which essentially requires that:
- there is at least one qualified institutional investor (QII) under the FIEL among the TK investors (the requirements to qualify as a QII are now stricter after the amendment to the relevant cabinet order and cabinet office ordinance under the FIEL, which became effective on 1 March 2016);
- the number of non-QII TK investors (if any) is 49 or less (non-QIIs are limited to certain categories, which includes a foreign corporation, after the 1 March 2016 amendment to the relevant cabinet order and cabinet office ordinance under the FIEL, while there were no limitations imposed on non-QIIs before the amendment);
- none of the TK investors is a disqualified investor as detailed in the FIEL; and
- the GK, as the operator of the TK arrangement, files with the government authority a notification regarding the QII exemption (the requirements for the notification to be filed by the GK are now more complex, compared to the previous simple requirements).
As noted above with respect to the relevant requirements, the requirements of the QII exemption were amended in 2016.
Another exception available under the FIEL is the exemption by outsourcing to a registered discretionary investment manager. Under this exemption, the GK retains a registered discretionary investment manager (a 'registered financial instruments operator' under the FIEL) as its asset manager to manage its trust beneficial interest in real estate on a discretionary basis. This exemption requires, among other items, that:
- the GK enters into a discretionary asset management agreement with the registered discretionary investment manager that authorises the manager to make a discretionary investment decision on behalf of the GK on its trust beneficial interest in real estate;
- the TK agreement provides that under the asset management agreement described above, the GK authorises the manager to make a discretionary investment decision on its behalf on its trust beneficial interest in real estate;
- the TK agreement provides an outline of the asset management agreement described above, including the fees (or the fee arrangement) to be paid to the asset manager from the assets managed under the GK-TK structure;
- both the TK agreement and the asset management agreement described above provide certain duties of the asset manager, such as the asset manager's duty of loyalty and duty of care of a prudent manager, both owed to the TK investor in carrying out the investment management of the trust beneficial interest in real estate held by the GK;
- the GK manages its assets of the GK-TK separately from its own assets (and its other investment assets managed for other investors, if any) and the asset manager supervises such separate management; and
- the asset manager files a notification to the authority of the outsourcing by the GK prior to the GK entering into the TK agreement.
Since the 2013 amendment to the REJEA, the REJEA allows a GK-TK structure to invest into real estate directly, without the GK as the TK operator vehicle needing to obtain a licence, if certain requirements are met. It is hoped that this GK-TK structure under the REJEA will enhance investment into real estate without the need to involve a trustee in respect of a trust beneficial interest at the underlying real estate level. The most recent amendment in 2017 to the REJEA has also made certain changes to the GK-TK structure and its requirements.
The GK-TK structure under the REJEA essentially requires that:
- the GK must be established for the sole purpose of distributing proceeds and profits from transactions related to the subject real estate;
- the GK as the TK operator delegates (1) the management of transactions related to the subject real estate to a real estate specified joint enterprise business operator (REJEB operator) that is licensed to conduct its business under Article 2, paragraph 4, item 3 or Article 2, paragraph 6, item 2 of the REJEA, and (2) the solicitation of investments into the TK operator by the TK investor (or investors) to a REJEB operator that is licensed to conduct its business under Article 2, paragraph 4, item 4 of the REJEA;
- only investors falling into one of the categories of 'special investors', which include a licensed REJEB operator and a QII (as defined under the FIEL), make TK investments in the TK operator, if the TK operator is to conduct the development of land as a site for buildings, construction of a building, or repair or renovation of a building, the cost of which exceeds 10 per cent of the value of the real estate held by the TK operator (or exceeds ¥100 million if the REJEB operator retained by the GK is an operator of a 'small-sized real estate specified joint enterprise' as described in Article 2, paragraph 6, item 2 of the REJEA); and
- the agreement for (1) as described in (b) above to be entered into between the GK and the REJEB operator must stipulate certain items specified under the REJEA.
Under these requirements, the REJEA allows a licensed REJEB operator to be involved in a TK arrangement investing into real estate, not as a TK operator itself, but as a manager for the TK operator vehicle, as long as the delegation of the management covers (1) and (2) as described in (b) above. To enhance the use of this GK-TK structure under the REJEA, a GK-TK structure satisfying the above-mentioned requirements will benefit from reduced registration and licence tax, and real estate acquisition tax. For more details on the reduction of these taxes, see Section V, below.
With respect to the 2017 amendment to the REJEA. The REJEB operator mentioned in (b) above can be an operator of a small-sized real estate specified joint enterprise, newly introduced under the 2017 amendment to the REJEA. After the 2017 amendment to the REJEA, the GK-TK structure can also be set up using the framework of the investment arrangement to be invested only by 'super professional investors', not the GK-TK framework as described above that has been available since the 2013 amendment to the REJEA.ii TMK structure
A TMK incorporated under the Asset Liquidation Law (ALL) is another type of corporate entity often used as a real estate investment vehicle. This entity may only be used to liquidate or securitise certain assets. This investment platform is used to make investments in real estate, trust beneficial interests in real estate, and loans and TMK bonds that are backed by real estate. A TMK is typically funded by issuing TMK bonds and preferred shares that meet certain tax qualifications required for the preferential tax treatment of the TMK. If a TMK, its bonds and its preferred shares are properly structured, and the TMK meets certain other requirements under the Tax Code, it is permitted to deduct distributions to the preferred shareholders from its taxable profits in addition to deducting debt payments.
One of the requirements for the preferential tax treatment is that its TMK bonds be purchased by an institutional investor or other similar person or entity (a Tax II or equivalent investor) as defined in the Tax Code. Certain QIIs under the FIEL and certain other QIIs meeting additional requirements fall under the definition of a Tax II or equivalent investor. One of the important steps in setting up a TMK structure is to find a TMK bondholder that is a QII and is a Tax II or equivalent investor.
When using a TMK structure, it is also important for the TMK to comply with strict regulations under the ALL. These regulations include a requirement to file an asset liquidation plan with the government authority. The asset liquidation plan of a TMK outlines how its assets are to be liquidated or securitised. A TMK structure requires close attention being paid to the regulations regarding the asset liquidation plan.iii J-REITs
A J-REIT is a type of investment fund formed under the Law concerning Investment Trusts and Investment Companies (ITL). A J-REIT established to invest in and manage real estate assets uses investors' funds to purchase real estate assets, in return for which investors receive investment units. The investment units of a J-REIT can be listed and traded on the stock exchange. If a J-REIT's investment units are listed, the J-REIT must comply with the rules of the stock exchange in addition to the ITL. Under the ITL, a J-REIT must retain an asset management company (a registered financial instruments operator under the FIEL) to manage its investment. In practice, all investment decisions for a J-REIT are designed to be made by its asset management company.
Unlike an ordinary corporation, which is subject to corporation tax on its profits, a J-REIT is exempt from taxation if certain requirements are satisfied, including:
- the J-REIT is not engaged in any business other than that permitted for J-REITs;
- the J-REIT would not be classified as a family corporation as defined in the Tax Code at the end of its fiscal period;
- the J-REIT distributes more than 90 per cent of its profits as dividends to the holders of its investment units for each fiscal period; and
- more than 50 per cent of the investment units on an aggregate issued amount basis have been offered in Japan.
The basic concept underlying the J-REIT legislation is that unlike a GK-TK structure or a TMK structure, a J-REIT's investments are not limited to certain assets specified at the time of its start-up. By raising long-term funds through a combination of debt and equity financing, a J-REIT can continue to accumulate and replace its investment portfolio for a longer term. At the same time, however, it would distribute most of its profits (more than 90 per cent) to the holders of its investment units for each fiscal period as described above, and therefore may not have sufficient internal reserve funds. When structuring a J-REIT, it is important to mitigate the potential risks of not having sufficient funds to deleverage its debt during an economic downturn. Because a J-REIT would practically be restricted regarding the amount of reserves it may retain, it should adopt another financial strategy to mitigate the potential risks, such as keeping its debt-to-asset ratio at a conservative level.
There are no direct restrictions on acquisitions of commercial or residential real estate in Japan by foreign investors, either directly or through a vehicle. Similarly, establishment of a corporation by foreign investors to invest in commercial or residential real estate is not restricted. In theory, under the provisions of the Alien Land Law, a cabinet order may limit the rights of foreign investors related to land in Japan on the grounds of reciprocity or national security. At the time of writing, however, there has been no such limitation, as no such cabinet order has been issued.
Under the Agricultural Land Act, an authorisation by the relevant authority is required to acquire certain agricultural land. This authorisation can only be granted if the purchaser is qualified as a farmer or a qualified corporation for owning agricultural land. It would not be easy for foreign investors to be granted such an authorisation.
After a foreign investor's acquisition of shares or equity of a corporation, or acquisition of real estate or a right related to real estate, a post-transaction report to the government authority may be required pursuant to the Foreign Exchange and Foreign Trade Law (FEFTL). A post-transaction report of payment or receipt of payment may be required in the case of cross-border payments or payments between a foreign investor and a Japanese resident in accordance with the FEFTL.