Securities and Tax Implications for Hedge Fund Managers in Post-FIEL Japan

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1 This article first appeared in ComplianceAsia June 1, 2007 Securities and Tax Implications for Hedge Fund Managers in Post-FIEL Japan by Yukinori Machida and Jay Gould Investment Funds & Investment Management Yukinori Machida Jay Gould Pillsbury Winthrop Shaw Pittman LLP. All rights reserved. For more information about us, please visit Market Practice and the New FIEL On June 7, 2006, the Japanese governing legislative body, the Diet, approved comprehensive legislation that amended a total of 89 existing laws, including the Securities and Exchange Law of Japan and abolished four other financialrelated laws to create the Financial Instruments and Exchange Law (the FIEL ). This sweeping action was intended to update and modernize Japan s securities laws and disclosure standards, enhance investor protection, and promote capital formation by creating cross-sectoral rules for the sale and management of investment products. The FIEL has been rolling into effect over the past year, with the last regulatory mandates implementing the new law having been published for public comment on April 13, Public comments were due by May 21, 2007, after which the Japanese Financial Services Agency (the FSA ) is expected to finalize such regulations by September Among Japanese hedge funds, and hedge funds located outside of Japan with a Japanese investment focus, one of the most anticipated aspects of the FIEL implementation is how the FSA will treat investment advisers to hedge funds. A little background may be useful in understanding how Japanese hedge funds have operated prior to the FIEL and why the FSA is concerned that certain hedge fund advisers may be operating illegally in Japan. Prior to the adoption of the FIEL, the FSA, upon the submission of a proper application, granted the discretionary investment manager license to investment advisers operating within Japan. These discretionary managers were often advisers or sub-advisers to hedge funds, the funds themselves often organized outside of Japan, typically in the Cayman Islands. To the extent a licensed discretionary manager operated its business from within and paid taxes to Japan on income derived from operating as a permanent establishment in Japan, the FSA and the National Tax Authority (the NTA ) appeared to be satisfied. Over the past several years, a different type of investment manager has emerged in Japan. These investment advisers are typically non-japanese and operate without obtaining a discretionary investment manager license or subjecting themselves to any other governmental regulation on the theory that they are operating only a research office in Japan. It is from this office that the bottom-up research is conducted and the recommendations formulated that become the trading strategy of the Japanesefocused fund. This research office often has a counterpart offshore of Japan, typically owned by the same individuals, from which actual trades are executed on behalf of the fund. The research office typically claims no economic activity in Japan and therefore does not subject its fee income

2 Securities and Tax Implications for Hedge Fund Managers in Post-FIEL Japan When organizing its business, a fund manager should consider the different tax implications between traveling frequently to Japan and establishing a place of business in Japan. from the fund to taxes in Japan. The employees themselves often do not claim any income in Japan, thereby completely skirting both Japanese securities and tax law. Many of these research offices believe that they are flying below the radar of the Japanese securities and tax authorities, and often rely on advice from U.S. or other non-japanese advisers with no background in or understanding of Japanese laws and regulations, that this activity constitutes responsible business conduct. However, the FSA and the NTA are well aware of these practices. FSA Registration for Financial Instruments Firms The FIEL was intended to identify discretionary fund managers and capture their activities within its registration regime, in no small part, in response to this market practice. Accordingly, fund managers that conduct activities within Japan are now required to register as Financial Instruments Firms, with certain exceptions. Furthermore, as a result of the increasing investment by pension funds and financial institutions in hedge funds and the growing role of hedge funds in capital market generally, the FSA believes that there is a substantial need to monitor the activities of funds and fund managers in Japan when the funds either operate from Japan or are sold to Japanese investors. The FSA maintains this concern whether such funds are sold to qualified institutions or individuals, and whether these funds are organized domestically or offshore. The FIEL has effectively expanded the types of businesses that are required to register with the FSA, and as of September 2007, investment advisers that operate from within Japan or sell their fund units to Japanese investors must register in Japan, or risk the targeted enforcement that is expected to follow shortly thereafter. Tax Status Determinations When organizing its business, a fund manager should consider the different tax implications between traveling frequently to Japan and establishing a place of business in Japan. Pursuant to the Japanese taxation system, all individuals, regardless of nationality, are classified as either residents or non-residents. Moreover, residents are classified as either permanent residents or non-permanent residents. Permanent Residents Permanent residents are persons domiciled in Japan and who maintain a residence in Japan. A domicile is generally regarded as the principal base of one s life, while a residence is considered to be a location where a person continually resides for a certain period of time, but is not necessarily the base of one s life. The residency requirement is met if a person resides in Japan for one year consecutively or more and is NOT classified as a non-permanent resident. The worldwide income of permanent residents, regardless of the location of the source of income, is subject to Japanese income tax. Permanent residents are persons; regardless of intention of permanent settlement, maintain a domicile or residence in Japan for five years or more in total within the period of ten years; or with an intent of permanent settlement and who maintain a domicile in Japan for less than five years in total within the period of ten years; or 2 with an intent of permanent settlement and who maintain a residence in Japan for one year consecutively or more but less than five years in total within the period of ten years.

3 Non-Permanent Residents Non-permanent residents are persons that are not Japanese citizens and who maintain a domicile or residence in Japan for less than five years in total within the period of ten years. (As a result of the tax system revision of 2006, the requirement concerning non-permanent residents prescribed as consecutive five years has been abolished and replaced by a new provision, five years in total. ) The scope of taxation for non-permanent residents corresponds to that for residents, but tax is not assessed in Japan on income sourced outside of Japan as long as that income is not paid within Japan or is not remitted to Japan. Non-permanent residents are persons; with no intent of permanent settlement and who maintain a domicile in Japan for less than five years in total within the period of ten years; or with no intent of permanent settlement and who maintain a residence in Japan for one year consecutively or more but less than five years in total within the period of ten years. Non-Residents Non-residents are persons not qualifying as residents (neither permanent nor non-permanent). Japanese income tax for non-residents is assessed on income sourced within Japan. The scope of taxable income for withholding tax on non-residents is covered under the provisions for domestic-sourced income, so, except in special cases, taxation for non-residents is often completed through withholding at source procedures.... a non-resident who frequently visits for a series of short stays in Japan, could be treated as a resident by the tax authorities after one year has lapsed. Investment Managers who spend a significant amount of time in Japan or operate an office, whether a research office or a legitimate Financial Instruments Firm in Japan, should determine their status under these rules and their implications to the overall business. And Tax Consequences As described above, once an individual is held to have a domicile in Japan by Japanese tax authorities, the person will become classified as a resident from the first day of his or her residence in Japan and be at least subject to taxation assessed not only on domestic-sourced income, but also on income sourced outside Japan as long as that income is paid within Japan or is remitted to Japan. In addition, the Japanese Supreme Court held that whether an individual has a domicile or not should be determined by examining objective facts, such as ownership of a house and bank deposits, location of assets, living together with a spouse or other family members, occupation and so forth. As the above determination is not made solely by the length of stay, an individual could be deemed resident even though such person stays in Japan less than 183 days a year or registers as a resident in another country. Moreover, a hotel room could be deemed to be a residence, and therefore, a non-resident who frequently visits for a series of short stays in Japan, could be treated as a resident by the tax authorities after one year has lapsed. In the event an individual s base or center of life were held to be located in Japan without any interruption for example, if the person left Japan with the intent of reentry solely to evade Japanese taxation, if an apartment is continuously rented for use after reentry, or if family members other than the person remained resident in Japan the fact that the person had left 3

4 Securities and Tax Implications for Hedge Fund Managers in Post-FIEL Japan U.S. and other non-japanese fund managers that seek to follow a Japanese investment strategy should respect and follow the laws of Japan. Japan would not alter such person s status from resident into non-resident. Again, a fund manager who visits Japan frequently for short periods, could be treated as a resident on a case-by-case basis and face the possibility of paying taxes on income sourced outside of Japan even though such income was not paid within Japan, or was not remitted to Japan. Conversely, non-resident individuals and foreign corporations (i.e., legal entity status) with no certain fixed place of business or permanent establishment, are not subject to income/corporate tax for their income from business activities. Japanese tax law provides that a physical facility, the function of which is restricted to the kind of preparatory or auxiliary character, such as market research, advertising, provision of information, fundamental research, or marketing support, is not included within the category of a permanent establishment. However, there is little guidance with respect to what constitutes a preparatory or auxiliary activity, and such determination can only be determined on a case-by-case basis. Thus, the firms purported to be conducting only research in Japan for offshore-domiciled funds may be held to have created a permanent establishment because such activities could fairly be regarded as a substantial and material part of an investment advisory business. Furthermore, in the event that a Japanese sub-adviser conducting a substantial business is only paid cost plus a small portion of the fee income derived from the fund ( cost plus ), such a payment structure could be denied in accordance with the transfer pricing taxation system in Japan. How to Proceed Requiring registration of firms conducting research and providing advice from within Japan will place these firms on equal footing with other investment firms that are established and fully regulated and taxed in Japan. The perils of non-compliance with the FIEL and its regulations are significant. These fund managers may find themselves not only in violation of Japanese securities laws, but also subject to Japanese tax on that portion of their income that has been derived from their Japanese activities and beyond. The NTA could seek taxes due not only from the fund manager, but from the assets of the fund itself in order to satisfy a tax obligation. The possibility of these types of reprisals are significant enough that certain Japanese-based funds of hedge funds will not allocate to Japanese-focused hedge funds that are not properly registered and which do not conduct their activities fully above board. Certainly, any U.S. investor, institutional or otherwise, would be deficient in its due diligence process if they were to allocate assets to a Japanese hedge fund that flouted the laws of the country in which it invests. U.S. and other non-japanese fund managers that seek to follow a Japanese investment strategy should respect and follow the laws of Japan. These managers should obtain the best available advice on Japanese securities and tax matters, and be able to assure their investors that they are operating legally in Japan and not subjecting their investors and themselves to undue risk as a result of ignorance or arrogance. 4

5 About Pillsbury Winthrop Shaw Pittman LLP Pillsbury Winthrop Shaw Pittman is a dynamic full-service law firm with market-leading strengths in the financial services, energy, technology and real estate sectors. We combine the vigor and entrepreneurial spirit that today s evolving market requires with the experience and insight of a firm that dates back to the early days of Wall Street. We are client-focused, centered on teamwork, collaboration and practice excellence, to deliver innovative and pragmatic business solutions consistent with our clients objectives, regardless of company size. For more information, please contact Pillsbury s Investment Funds & Investment Management Team: San Francisco Jay B. Gould jay.gould@pillsburylaw.com Timothy P. Burns timothy.burns@pillsburylaw.com Michael G. Wu michael.wu@pillsburylaw.com John M. Dick john.dick@pillsburylaw.com New York David G. Odrich david.odrich@pillsburylaw.com Brant K. Maller brant.maller@pillsburylaw.com Jeffrey R. Zuckerman jeffrey.zuckerman@pillsburylaw.com Los Angeles Dulcie D. Brand dulcie.brand@pillsburylaw.com Washington, DC Richard M. Rosenfeld richard.rosenfeld@pillsburylaw.com Kimberly V. Mann kimberly.mann@pillsburylaw.com\ Robert B. Robbins robert.robbins@pillsburylaw.com Kurt L.P. Lawson kurt.lawson@pillsburylaw.com Tokyo William R. Huss william.huss@pillsburylaw.com Yukinori Machida yukinori.machida@pillsburylaw.com London Simon Fielder simon.fielder@pillsburylaw.com Caroline Grange caroline.grange@pillsburylaw.com Clifford C. Hyatt clifford.hyatt@pillsburylaw.com 5