Prior to the 2008 tax reform act passed by the Japanese Diet, Japanese domestic tax law did not contain an independent agent exception within the legal definition of a contracting agent permanent establishment. Japan's extensive network of double tax agreements did contain the independent agent concept, as the tax treaties are predominantly based on the OECD model tax treaty. However, non-Japan resident taxpayers were often counseled by Japan tax practitioners that strong reliance upon the treaty based exception for purposes of avoiding having an agent permanent establishment (PE) status in Japan was somewhat risky because Japanese tax examiners, having no practical experience in applying the independent agent concept under the local tax law, may have difficulty applying the treaty based exception in accordance with the OECD commentary on permanent establishments.
The absence of an independent agent PE exception under the local law has made structuring the investments of non-Japan resident funds (Offshore Funds) into Japan who are relying on the expertise of related or unrelated Japan resident fund managers challenging, as many Offshore Funds and their investors are established or resident in jurisdictions which have not entered into at a tax treaty with Japan. To protect against having a PE, most Offshore Funds structured their Japan resident investment advisor relationship to fall under the auxiliary and liaison exception contained in the local tax law definition of a PE. This meant that the Japan resident investment was limited to activities on behalf of the Offshore Fund in an advisory nature only, with no discretionary decision making authority. This factor was recognized by Japanese government policymakers a couple of years ago as a key reason why the total number of discretionary investment managers based in Japan remained virtually unchanged for the past twenty years.
At around the same time, the National Tax Administration (NTA) began to systematically audit Japan resident investment managers of Offshore Funds, focusing on the issue of whether the activities of the manager created an agent PE for the Offshore Fund and its non-Japan resident investors. Those audits were thought to be motivated in part by the large increase in hedge funds investing into Japan capital markets. Because of the high speed and large volume of sophisticated trades executed by offshore hedge funds in the Japanese markets, the sub-advisor structure was difficult for the funds and their advisors to implement in practice without creating PE risk to the hedge fund and its foreign investors. One consequence of the audit activities of the NTA was that many Japan resident fund managers, concerned about creating an agent PE for the Offshore Funds they were advising, began to move their operations from Japan elsewhere within Asia, primarily to Singapore or Hong Kong, whose tax laws not only made it easier to avoid creating PE status for the Offshore Funds, but which, at least in the case of Singapore, provide attractive tax incentives for fund managers to locate there.
Japanese government policymakers involved in the financial services sector believed that the flight of investment managers from Japan to other financial centers in Asia posed a serious national competitiveness issue. Not only was it contrary to Japan's long stated objective of making Tokyo a global financial center, but the fact that the managers were moving to Hong Kong and Singapore only worsened the perception, since both jurisdictions have the same objective of becoming the leading financial center in Asia.
To address this issue, the Ministry of Finance (MOF) and the Financial Services Agency (FSA), the regulatory body in Japan responsible for oversight of the capital markets and funds advisors, requested that the Japanese Diet adopt the independent agent PE exception into the local law. The request was part of the plan announced by the FSA in its December 2007 report entitled "The Four Pillars of the Better Market Initiative". The report cited as its second pillar, to "put into place a business environment [in Japan] that vitalizes the Financial Services Industry and Promotes Competition". The report identified as an important objective in implementing the second pillar, "minimizing the PE risk to attract foreign fund managers to Japan's markets", and calls for measures that ensure "foreign funds or foreign investors are not deemed to have a PE in Japan under domestic tax law when they carry out their business in Japan through an independent agent".
The Independent Agent PE Exception
In response to the request by the FSA, the Japanese Diet, amended the Japan tax law to introduce the independent agent exception. Effective, April 1 of 2008, Article 186 of the Cabinet Order of the Corporation Tax Act, and Article 290 of the Cabinet Order of the Income Tax Act, were both amended to exclude from the definition of a contracting agent permanent establishment a "person who conducts business activities associated with the business of the foreign corporation independently of the foreign corporation…. and in the ordinary course of his business".
Generally, formal interpretations of the Japan income tax laws, as well as revisions to the laws, are set forth in tax circulars (Circulars) issued by the NTA. In the case of the new independent agent PE exception, the NTA, despite announcing earlier this year that it would issue guidance, has yet to issue a Circular interpreting the new tax rule. However, the FSA, which sponsored the law change, has issued guidance in the form of a document which sets forth a "safe-harbor" for investment fund managers, and also contains information on how the exception is to be interpreted more generally through case studies and Q&As.
On June 27, 2008, the FSA issued two documents entitled "Reference Cases" and "Q&A" providing that agency's interpretation of the "independent agent exception" (collectively, the "Guidelines"). Although the FSA clearly consulted with the NTA in drafting the Guidelines, it is important to note that the NTA is not officially a co-author of the documents. With that said, it is understood that the NTA is generally in agreement with the interpretation of the exception as set forth within the Guidelines for the reason that high level officials of the NTA participated in a public joint presentation on July 4, 2008, with officials of the FSA and the MOF, to explain the scope and application of the new exception (July Presentation). However, it is not clear that the views of the FSA and the NTA are completely aligned on every interpretive point. Some tax practitioners in attendance at the presentations noted that oral comments of tax officials sometimes seemed inconsistent with the oral comments of the FSA officials. Thus, the NTA may have its own views regarding how particular aspects of the independent agent exception are to be applied within a particular factual context. Only time will tell of course if that is the case. Hopefully, the NTA will soon issue a Circular interpreting the new independent agent exception to provide guidance and certainty to taxpayers.
The main purpose of the FSA issuing the Guidelines is to set forth how the new exception is to be applied to Offshore Fund portfolio management activities in Japan performed by Japan investment managers. The Guidelines also importantly set forth a "safe harbor" for determining the "independence" of a discretionary fund manager resident in Japan. Presumably, the FSA felt that, given the highly factual nature of an independent agent inquiry, creating a "safe harbor" under the tax law for Japan investment managers to structure within would provide certainty to Offshore Funds that they would avoid creating a PE for themselves and their investors in Japan. The Guidelines are also important in establishing that the exception is to be interpreted in line with the commentary to the OECD model tax treaty with regards to the independent agent exception.
Consistency with OECD commentary approach Consistent with the OECD Model Tax treaty Commentary on Article 5 (concerning the definition of permanent establishments) (OECD Commentary), the Guidelines provide that for an agent to be considered as performing activities within the scope of the exception, it is necessary that the agent be "legally" and "economically" independent from the principal, and that the business activities conducted by the agent for the principal are conducted in the "ordinary course of the agent's ordinary business".
The Guidelines state that the question of whether an agent is "legally" independent from the principal depends upon the scope of the responsibility of the agent to the principal. If the commercial activities of the agent taken on behalf of the principal are under detailed instructions or comprehensive control of the principal, the agent is not considered to be independent. Legal independence of the agent therefore requires that the agent have sufficient discretionary authority to act as an agent.
The Guidelines note that the fact that the principal relies upon the special skills or knowledge of the agent is an indicia of independence.
The Guidelines also confirm the principal set forth in the OECD Commentary that the control exercised by a parent company to its subsidiary in its capacity as a shareholder is not a factor in determining the independence of a subsidiary acting as an agent for its parent company. In addition, the fact that the operations of the business of the subsidiary is managed by the parent company does not mean that the subsidiary is not independent from the parent company.
Under the Guidelines, consistent with the OECD Commentary, for the agent to be independent they must have economic independence from the principal. This determination is based on all of the facts and circumstances. In determining such economic independence, relevant factors include the presence of entrepreneurial risk, and the number of principals the agent acts for.
Ordinary Course of Business
The Guidelines provide that the agent must perform activities within the ordinary course of its own business. In contrast, if an agent performs activities within the business field of the principal as opposed to its own course of business, the agent will fail to satisfy this condition. The comments in the Guidelines in this regard are consistent with the OECD Commentary.
Assuming the NTA is in agreement with this aspect of the Guidelines, it appears that in applying the independent agent PE exception, the tax authority will apply and interpret the exception consistently with the OECD Commentary. One hopes that is the case, as it will significantly reduce uncertainty and give taxpayers a well established body of written guidance to plan its affairs, and to use as support for positions in the case of a tax audit.
The safe harbor for fund industry independent agents
The Guidelines set forth in the Reference Cases document a "safe harbor" which allows a Japan resident investment manager (Japan Investment Manager) of the general partner (General Partner) of an Offshore Fund or of an offshore investment manager to the general partner of such Offshore Fund (Offshore Investment Manager) to be treated as an independent agent with respect to the Offshore Fund and the offshore investment manager as follows:
"Where an offshore general partner of an offshore fund established under a partnership agreement executes a discretionary investment contract with a domestic investment manager for non-residents, etc. who are members of such partnership agreement (including cases where an offshore general partner executes a discretionary investment contract indirectly with a domestic investment manager through an offshore investment manager), if such domestic investment manager conducts specific investment activities in Japan on behalf of such member, unless there are any of the following circumstances, such domestic investment manager is considered an independent agent….
(a) The portion of the investment decisions entrusted to a domestic investment manager under a discretionary investment contract is small, and the offshore general partners (and members) or offshore investment managers are considered to be substantially conducting investment activities directly
(b) One-half or more of the officers of the domestic investment manager concurrently serves as an officer or employee of the offshore general partner or offshore investment manager
(c) The domestic investment manager does not receive compensation proportional to the total amount of management gains or managed assets entrusted from an offshore fund
(d) Where a domestic investment manager places all or a considerable portion of its business activities on transactions with offshore general partners or offshore investment managers, such domestic investment manager is not capable of diversifying its business or acquiring other customers without changing its business activities radically or having a big impact on its profit."
The four criteria of the safe-harbor are worded as negative conditions, meaning that, if the Japan Investment Manager does not satisfy any of these conditions, then it will be deemed to be an independent agent of the General Partner or the Offshore Investment Manager of the Offshore Fund, as the facts may be, under the Guidelines. It is important to note that the Guidelines do not suggest the opposite is true, meaning that the Japan Investment Manager is not automatically treated as a dependent agent if it satisfies any one of the conditions; rather, that the Japan Investment Manager will not be within the safe-harbor rule. In such case, presumably, the activities of the Japan Investment Manager on behalf of the General Partner or Offshore Investment Manager of the Offshore Fund are still tested under OECD commentary principles, and could, depending on the facts, still be treated as an independent agent.
Each of the four criteria is discussed in more detail below, and illustrated through case studies set forth in the Guidelines.
Detailed Instructions Test
The Guidelines provide that if the decision making authority of the Japan Investment Manager is limited in a manner such that decisions are in substance being made offshore by the General Partner or the Offshore Investment Manager, the Japan Investment Manager is not considered to be sufficiently independent of the General Partner. In determining whether the Japan Investment Manager meets this test, whether the manager applies specialist knowledge and expertise in carrying out its activities on behalf of the General Partner is considered an important fact in measuring its independence.
Five case studies set forth in the Guidelines illustrate how the FSA, and possibly the NTA, interprets this factor, indicating its importance in the analysis.
In Case 1, the General Partner of the Offshore Fund enters into a discretionary investment contract with the Japan Investment Manager entrusted with the management of the funds of the Offshore Fund in the Japanese capital markets. The contract sets out certain parameters which the Japan Investment Manager must satisfy with regard to asset allocation ratios and risk limits, but leaves the investment decisions solely to the discretion of the Japan Investment Manager. The case concludes that because the General Partner does not give detailed instructions or comprehensively controls the Japan Investment Manager, the Japan Investment Manager satisfies the Detailed Instructions Test.
The facts of Case 2 are essentially the same in Case 1, except that the contracting party with the Japan Investment Manager is an Offshore Investment Manager which has entered into a discretionary investment contract with the General Partner. The case states that in determining the independence of the Japan Investment Manger from the Offshore Fund, it is necessary to analyze both (1) whether the Japan Investment Manager is independent from the Offshore Investment Manager, and (2) whether the Offshore Investment Manager is independent from the General Partner. The Guidelines conclude that because the Japan Investment Manager has been granted discretionary authority to invest in the Japan capital markets under its management contract, and the Offshore Investment Manager has been granted discretionary authority by the General Partner to manage the funds of the Offshore Fund globally, the Japan Investment Manager is considered to be an independent agent of the Offshore Investment Manager and the Offshore Fund.
Reading Case 2, it appears that as long as the Offshore Investment Manager is treated as an independent agent of the Offshore Fund, the Japan Investment Manager should automatically be treated as being independent from the Offshore Fund, even if it is not independent from the Offshore Investment Manager. Even if the Offshore Investment Manager is not treated as being independent of the Offshore Fund, if the Japan Investment Manager is viewed as independent of the Offshore Investment Manager, the Japan Investment Manager is viewed as being independent of the Offshore Fund.
Case 3 illustrates a situation where the Detailed Instructions Test is not satisfied. In that case, the General Partner enters into an investment contract with a Japan Investment Manager which is considered to be discretionary under the Japan Financial Instruments and Enforcement Law (FIEL), and authorizes the General Partner to designate asset allocations, and give instructions to the Japan Investment Manager on the selection of investments and timing of trades. And in fact, the General Partner actually gives such instructions to the Japan Investment Manager. The Guidelines conclude that instructions regarding the selection of investments and timing of trades sufficiently limit the Japan Investment Manager's discretionary authority that they are to be considered "detailed instructions" which destroy the independence of the Japan Investment Manager.
Case 3 highlights that under the FIEL an investment contract may be classified as being a discretionary contract even if a part of the investment decisions are entrusted to the Japan Investment Manager. However, the fact that the contract is classified under the FIEL as being discretionary does not mean that the Detailed Instructions Test is also automatically satisfied.
Reading Case 1 and Case 3 together, it appears that the General Partner or Offshore Investment Manager may designate asset allocation limits without violating the Detailed Instructions Test, but selecting investments or timing the trades crosses the line.
Case 4 follows the facts of Case 1, except that the Japan Investment Manager is a 100 percent subsidiary of the General Partner. Consistent with the OECD Commentary, the Guidelines conclude that the fact that the Japan Investment Manager is a subsidiary of the General Partner does not make it lose its independence. Further, the fact that the operations and business performed by the Japan Investment Manager is "managed" by the General Partner as its parent or is controlled by the General Partner in its capacity as a shareholder is viewed as "unrelated" to the question of independence.
Shared Officers Test
Under the Guidelines, if fifty percent or more of the officers of the Japan Investment Manager concurrently hold positions as an officer or employee of the General Partner or the Offshore Investment Manager, the Shared Officers Test is not satisfied. There is no indication in the Guidelines what type, level or functions of the officer or employee is relevant, and it appears that every type of position is counted for purposes of applying the test. At the July Presentation, an FSA official explained that the meaning of officer is as defined under the corporate laws. In that presentation, it was also confirmed by the FSA official that a member of the investment committee for an Offshore Fund would not be viewed as an officer of the general partner or offshore investment manager of the Offshore Fund unless the corporate law actually defined them as such. Since investment committee members are not officers within a corporate law context, this would seem to allow considerable leeway in structuring. One wonders, however, whether the NTA is of precisely the same view. At a presentation separate from the July Presentation with the FSA official, an NTA official stated that officers include "deemed officers", suggesting that the definition of officers is broader than the FSA interpretation.
Remuneration of Investment Manager Test
The Guidelines note that the Japan Investment Manager must bear a degree of entrepreneurial risk to be considered independent, and the fact that it is compensated by reference to assets under its management and/or investment profits indicates that it bears such risk. The various cases in the Guidelines evidence that the FSA believes that payment of management fees to the Japan Investment Manager which are calculated as a percentage of assets under management combined with an incentive or performance fee calculated as a percentage of the gains satisfy the test. In contrast, one can presume that if the Japan Investment Manager is compensated on a cost plus basis, the test would not be satisfied as they would be guaranteed to make a profit and therefore not bear any entrepreneurial risk.
How large of a percentage of assets under management or gains must the Japan Investment Manager be entitled to in order to satisfy the test? The Guidelines do not specifically state the appropriate amount of compensation, but provide useful guidance on the question. In Case 5, where the Japan Investment Manager is paid a performance fee and assets under management percentage-based management fee, the Guidelines provide that the compensation must not be less than an arm's length amount, noting that compensation based on arm's length pricing principles is an "important factor" indirectly supporting that the Japan Investment Manager is an independent agent.
Diversification Capacity Test
The Guidelines discuss the diversification capacity test in Case 5, which relates to whether the Japan Investment Manager is treated as being economically independent from the Offshore Fund. The case notes that the number of principals the agent act son behalf of is a factor to be considered in determining economic independence. In discussing that factor, we are told that if the activities of the agent is conducted through the duration of the business or solely or mostly for just one principal, the Guidelines note that it is inconceivable that the agent has independent status. Further, all of the facts are to be considered, and in particular, whether the agent bears risk through entrepreneurial skills and knowledge and receives compensation.
On this first point, the case notes that if the Japan Investment Manager depends in considerable part of its business activities on transactions with the Offshore Fund, it is necessary that the Japan Investment Manager have special skills and knowledge, and the ability to diversify its business activities. The ability of the Japan Investment Manager to diversify its business activities or to acquire other customers without changing its business activities radically or without a big impact on its profitability indicates that is has special skills and knowledge. Regarding the second point, whether the agent bears entrepreneurial risk, the fact the amount of compensation of the Japan Investment Manager is based on the total managed assets and gains is cited as evidence of entrepreneurial risk. Thus, even if the Japan Investment Manager only deals exclusively with one Offshore Fund, one FSA's official view is that it can still be treated as an independent agent if it has a DIM license, and receives a fee based on the total managed assets and gains. Whether the NTA shares the same view as the FSA official is unclear. At a presentation, one NTA official noted that whether an agent has special skills and bears entrepreneurial risk needs to be looked at based on all of the facts and circumstances.
The introduction of the independent agent exception into the definition of an agent permanent establishment under Japan domestic tax represents a significant policy shift by the Japanese government, and will prove useful to foreign taxpayers structuring their investments into Japan through non-treaty jurisdictions. In particular, offshore funds investing into the Japan capital markets can now structure their advisory relationships with Japanese discretionary investment managers without creating a PE under a new "safe-harbor" announced by the FSA. The Guidelines confirm that the new exception should be interpreted in line with the OECD Commentary, but formal guidance by the NTA on how to interpret the exception in other contexts would be welcomed.
[This article appeared in the October 27, 2008 issue of Tax Notes International and is reprinted here with permission from Tax Analysts.]