Collective investment schemes
There are several options available as a vehicle for structuring the fund, including voluntary partnerships based on Civil code (NK), silent partnerships (TK), investment limited partnerships (LPS), limited liability partnerships (LLP) and partnerships under foreign laws.
If such partnership-type vehicles do not meet certain exclusion criteria such as joint ventures, they are collectively referred to as “collective investment schemes”.
In practical use, for business funds such as ship funds or energy funds, “silent partnership” under the Commercial Code of Japan is commonly used, while for securities investments, the investment limited partnership (LPS) is commonly used.
The reason for the predominant use of silent partnerships in business funds is their convenience and ease of use.
Voluntary partnerships other than silent partnerships, investment limited partnership, limited liability partnership, and partnerships based on foreign laws, each have their own legal basis, but there are certain issues as outlined below.
Let’s look at them individually.
Voluntary Partnerships based on Civil Code (Nini Kumiai)
Under Article 667 of the Civil Code of Japan, partnerships become effective when each party promises to make a capital contribution and engage in joint business.
Therefore, since the system itself assumes joint ventures in the first place, it exists as a risk on the investor side that each partner bears unlimited liability.
In the case of borrowing under the name of a partnership, the repayment obligation extends to all partners, thereby theoretically creating unlimited liability and posing a significant risk for the partners as investors.
For example, a power plant was set up and operated by the partnership, and it is conceivable that if the power plant were to cause significant property damage and financial losses to the neighboring area by accidents due to its negligence.
In this case, legal liability to the neighborhood extends beyond the assets of the partnership itself, and reach to the personal assets of all the partner that constitutes the partnership.
On the other hand, in the case of a voluntary partnership, if the business in which the partners invest qualifies for separate taxation, such as securities investment business, individual partners who are members of the partnership can also benefit from separate taxation. This provides a tax advantage for the partners.
For example, in the case of capital gains from securities transfers, the tax rate is 20.42%, and for bond interest income, the tax rate is 20.315%. These rates provide significant tax advantages for individual investors in funds that invest in financial instruments, such as VC/PE funds. This makes voluntary partnerships an appealing vehicle for individual investors from a tax perspective.
Investment Limited Partnership (LPS)
The Investment Limited Partnership is a partnership under the Limited Partnership Act for Investment and consists of both general partners with unlimited liability and limited partners with limited liability.
By having the general investor join the Partnership as a limited partner, the Partners’ liability is limited to the amount of their investment.
As a result, the problem that the general investor has unlimited liability is solved.
However, under the Limited Partnership Act for Investment, the purpose of the Partnership is limited to a certain extent, such as shares, equity, stock acquisition rights, designated securities, monetary claims, industrial property rights, copyrights, or beneficial interest in trust, etc. The Partnership may not be operated other than under laws and regulations.
In addition, it is mandatory to register the Partnership and undergo an accounting audit each fiscal year.
Investments in foreign corporations are also restricted.
Loans of money to foreign corporations are outside the scope of the Limited Partnership Act for Investment. Therefore, such lending cannot be conducted as part of the operations of an Investment Limited Partnership unless they are certified under the Industrial Competitiveness Enhancement Act.
And since the acquisition and holding of shares, stock acquisition rights, and other securities issued by foreign corporations are limited to the extent that the total acquisition price is less than 50% of the total investment of all members of the partnership, this restriction prevents the establishment of fund primarily targeting foreign stocks or securities. However, it has been reported that the Japanese government intends to abolish this 50% limitation in an upcoming legislative revision, which is expected to be implemented in 2024.
The tax treatment of an investment limited partnership is similar to those of voluntary partnerships. If the investment target business is a separate taxable entity, such as a stock investment business, individual members of the partnership can enjoy separate taxation.
Limited Liability Partnership (LLP)
A limited liability partnership is based on the assumption that its members jointly operate business.
In other words, since basically the business must be operated jointly, it is not generally permitted to delegate all business execution to representatives or others on behalf of the investors.
Participation from a fund investor’s standpoint is not considered by law.
With regard to business execution, the Ministry of Economy, Trade and Industry (METI) explains that “the content of business execution includes, for example, activities relating to the business operations of LLP, such as the conclusion of external contracts, negotiations for the conclusion of such contracts, or other important parts of the operations of the union, such as the formulation and design of specific research and development plans, bookkeeping, management of products, and the command and supervision of employees.” It is clear that the commitment of only participating in partner membership meetings without active involvement in these important operational aspects is not acceptable.
As a general rule, business execution requires the consent of all partners. Even if this is excluded by separated agreements, at a minimum, it is necessary to make decisions by unanimous consent or the consent of at least two-thirds of the partners, for significant matters such as disposal and acquisition of important assets and large borrowings.
As a result, it is no longer possible for the fund to be managed independently by the substantive manager.
Silent Partnership (Tokumei Kumiai)
According to Article 535 of the Commercial Code, a silent partnership is established by an agreement between one party who provides capital for the other party’s business and the distribution of profits arising from that business. In other words, a silent partnership is a contractual relationship between the recipient of the investment (operator) and the investor (silent partner).
The term “Silent” means that transactions conducted by the operator of the business are done in the name of the operator, and the silent partners are not disclosed to the trading partners or third parties. It does not imply that the investors are obliged to remain anonymous.
Silent partnerships are not conducted jointly by operator and multiple partners, so the silent partners can invest funds without the need for agreement with other partnership members.
Therefore, it is common to use silent partnership for vehicles, especially in the practice of business funds and real estate securitization (so-called GK/TK).
However, although the silent partnership withholds 20.42% of dividends to its partners, it is not subject to separate withholding tax.
Individual income tax is subject to comprehensive taxation.
In cases where a fund for individual investors engages in an equity investment target business that allows for separate taxation, the Silent partnership may be at a tax disadvantage compared to other vehicles.
Partnership based on Foreign Law
Limited partnership agreements in offshore areas such as Cayman BVI (British Virgin Islands) are frequently used as a vehicle for funds.
In the case of domestically-based asset management firms, this is mainly used when the fund is managed with contributions from overseas investors, when the location of the investee business is overseas, or when the multi-layered structure of the fund is necessary due to regulatory requirements or other reasons.
We are often inquired about setting up overseas funds based on vague assumptions that it may be more advantageous to invest in assets overseas. However, if the operator does not migrate to foreign countries and the investors are primarily residents of Japan, the tax shield expectation is generally limited.
In cases when dealing with residents or where the fund operator has a base in Japan, it is generally required to register as a financial instruments business operator or make a notification of business exceptions for Specially Permitted Businesses for Qualified Institutional Investors, etc. (SPBQII). There is no relaxation of business restrictions based on the Financial Instruments and Exchange Act. Therefore, there is no particular advantage in overseas schemes based on abstract reasons (of course, this does not deny the possibility of structuring based on specific merits).
In the case of an Investment Fund in Stocks, etc.
As seen from the discussion, silent partnerships are generally considered to be the most convenient structure. However, there can be exceptions depending on the content of the fund.
For example, in the case of investments in stocks, when using the silent partnership, individual investors will be subject to comprehensive taxation on the profits generated by the partnership which will be classified as miscellaneous income.
And in investment limited partnerships and partnerships the return attributable to individual investors is subject to separate taxation at a rate of 20.42%.
As partnerships have the aforementioned issue of unlimited liability, most venture funds and other equity investment funds use investment limited partnerships that ensure limited liability.
On the other hand, investment limited partnerships are obligated to undergo audits and registrations, which making them more costly and administratively burdensome compared to other partnerships.
Considerations for Each Investment Business Opportunity
Under Limited Partnership Act for Investment, it says that “it is possible to acquire or hold shares, stock acquisition rights, etc. issued by foreign corporations to the extent that the total acquisition price is less than 50% of the total investment of the partners.” Therefore, an Investment Limited Partnership that solely invests in foreign stocks cannot be formed without obtaining certification from the Ministry of Economy, Trade and Industry (METI) under the Industrial Competitiveness Enhancement Act.
And, although forex margin trading is subject to separate taxation in the case of individuals, the Limited Partnership Act for Investment stipulates that derivative transactions cannot be executed for any other than for hedging purposes.
As a result, investment limited partnerships that primarily engage in forex margin trading cannot be structured.
So that it is necessary to consider the optimal form of a fund in accordance with the investment products, target investors, schemes, and other factors.
What is considered optimal will vary depending on the specific case, so please feel free to consult with us at your convenience.
Note that such partnership type vehicles fall under the collective investment schemes set forth in Article 2(2)(v) and (vi) of the Financial Instruments and Exchange Act unless they satisfy certain exclusion criteria such as joint venture requirements.
Therefore, it should be noted that the procedures in the Financial Instruments and Exchange Act are required for the placement or private placement, and the management of such vehicles mainly through securities or derivative transactions.
