Due to (or, considering the results, thanks to, though I hate to say thanks to) COVID-19, many business events have been going online so we can participate any seminars (or webinars) all over the world (as far as you can manage your sleeping hours), to learn and catch up with recent regulations changes at any jurisdictions, regardless of onshore or offshore, as well as promotions of brand new investment vehicles and real cases such as VCC – Variable Capital Company – in Singapore and OFC – Open-ended Fund Company – in Hong Kong, by ear: what a wonderful world for learn!
Among others, Omori-sensei, who is a partner of Withers Japan and game me his brand-new book for Japan domestic limited partnership and Koji, another famous partner counsel of Withers Japan and my long-time friend organised their webinar in late July to present to overseas (hence all in English, unlike Japanese lawhouse) how you conduct fund business into Japan from both placement and portfolio management aspect. Figuring out the average audience which their contents targeted, who have neighbour successful peers with Japanese investors so thought that we can go better, I could not stop give some laugh and smiles and scratching my heads when Koji and Omori-sensei honestly commented to current business environment in Japan, which I suspect it discourages (oops, I have to stop it).
One of take-out from their webinar here was:
“If you want to sell your fund in Japan, you need unit trust form, as…”
In principal, I do agree with his explanation then: At that time, I also made some researches to local taxation rule as well as backdrop for product design to a certain country, so those made me agreed as his explanation has same root with my research. In addition, I have some more words to explain, as I have a business track record to raise and manage USD 4 billion of AUM from Japan market and I also had experiences with various obstacles which his explanation did not mention but I have to share from non-legal aspect.
And, as you may know, a month ago (since I wrote Japanese edition of this article) Nick Harrold, a (good-looking with pleasant personality) partner at Maples Hong Kong, who I also knew him for more than 10 years, uploaded his webinar why Japan loves Unit Trust so I am getting to a point that now is another time to explain JID – Japan is Different.
So, this article, my virgin blog in English, is to present my edition of “Why Japan loves mutual funds / unit trust” from another aspects than legal professionals, as both product structuring and business customs aspect, to respond to legal analysis by those webinars. This article has Japanese edition of article as well as my presentation desk uploaded to slideshare in August 2020. I hope this assists you when you start working with Japanese investors.
Very basic – we have three fund structures
Wherever we establish funds, we can choose fund structure from 3 types: the simplest one is company form, which can issue variable capital shares in a timely manner, namely, Singapore VCC, Hong Kong OFC, Protect Cell Company in Jersey and Segregated Portfolio Company in Cayman Islands. Next one is partnership form to provide joint investment and ownership between sponsor of the investment and investors, such like investment business limited partnership in Japan, Cayman Islands Exempted Limited Partnership, Limited Partnership in Delaware, US, and Limited Liability Limited Partnership in some states of US. And the last one is so call-ed contractual form which the investors delegates acquisition, holding and disposal of asset to third pary by law: mutual fund in Japan, unit trusts in Cayman Islands and Ireland and FCP – Fonds Commun de Placement – in Luxembourg.
In a few words, we see in the world of investment, many company forms and partnership forms for investments exist, considering the way of sponsorship to investment and taking risks to downside risks, as well as sharing the upside risks i.e., success fee / carried interests. But, it is quite unique when you want to bring your fund into Japan investors market: you should be asked to set up in unit trust form, or you have to find a local mutual fund house to wrap your fund by their Japan local mutual fund. I knew you want to insist on direct investment to existing fund, to avoid additional cost due to additional layer as Japan mutual fund or (Cayman) unit trust, or to avoid additional working party to cause refusal by trustee of Japan mutual fund or Cayman due to the asset nature or investment strategies of your fund.
Why Japanese insists on trust?
They also have some good reasons, though they cannot tell you exactly why by themselves, so I can tell you below.
- Simply tax reason: mutual funds and foreign unit trusts have the lowest tax-related downside risk for Japanese investors.
- Securities brokers, who are the fund distributors in Japan, use a dedicated and fully-automated distribution system highly connected to eco-system of mutual fund industry in Japan.
Having said, as Koji (or Yamamoto-sensei) stressed in his webinar, this rule is _only_ applicble to taxable investors in Japan, such as retail investor and institutional investors (while I say “only”, this is still big enough as market). If you deal with non-taxable investors, that is pension funds, wherever they belong to public or private, this tax-related argument is not relevant so you had better identidy the tax profile of your target / potential clients.
In other words, it is essential and one of the first steps that you should consider the tax status of your clients when you structure your funds. Why? If you love to leverage your purchasing power of your fund admin fee to reduce from 0.15% p.a. to 0.10% p.a., or if you are happy to give up some of your management fee as 1.5%, it is quite trivial amount comparing to 30% of withholding tax on the capital gain or 20% of withholding tax on dividend from portfolio companies to impact to performance once you mis-design your fund for your clients.
Again, unless you miss anything for tax exemption filing to tax bureau, your non-taxable investor clients never be disturbed with this tax arguments.
To walk through all those schemes
First of all, partnerships. As partnership is deemed to have no legal personality but share the assets and liabilities among partners, partners, as investor, has to incorporate allocated profits and losses from the partnership into his/her own proprietary account for tax filing every year. With this annual process, he/she cannot enjoy one, but quite important, tax merit to push any capital gain as taxable profit until the redemption / repurchase of their interests like mutual funds or corporate forms as they have to declare such capital gain during the tax year.
Having said that, if we deal with investments through partnership, reinvestment is quite rare and most investors collect cash as distribution to be ready for for tax payment so partnership investors will not fall into trouble due to cash shortage by reinvestment within the open-ended fund. However, it is indeed hard enough to step back for individual investors especially to take allocated profits and losses from partnerships into his/her tax account every year.
As for trust forms, roughly speaking, it is same taxation rule as listed equity as
- 20.315% of capital gain tax to individual, and subject to corporate income tax to corporate investors, and
- as for distributions, 3 choices of 20.315% of withholding tax, treatment of individual income tax or separate declaration for individual, and 15% of withholding tax for corporate investors
And, as mentioned above, trust form investors can enjoy tax deferral of capital gain and reinvestment of portfolio investments as capital gain tax on repurchase or redemption of units, i.e., as far as he/she holds unit of trusts and portfolio makes capital gains for reinvestments, he/she will not be subject to capital gain tax on individual capital gain in the portfolio of trust. This is a beauty of the fund, as you know.
And taxation on company form is same as unlisted equity as
- 20.315% of capital gain tax to individuals and subject to corporate income tax to corporate investors, and
- 20.42% of withholding tax on dividends to both individual and corporate investors.
Then you may say, well, no big difference between trust and company forms so no issues to hire company form. The story does not end with company form for tax argument, i.e., much harder taxation issue is hidden behind.
Have you heard about “Tax consolidation with foreign subsidiaries”?
If you set up a fund in company form, you need a suitable legal framework for company which allows issuance and cancellation in active manner. However, Japan does not have such company related laws. In Japan you cannot establish unlisted companies or limited liability companies which can issue or cancel its equity shares by its net asset value (on daily manner or less frequently) or transfer freely (i.e., without consent by issuer) to anonymous third party, while VCC and Segregated Portfolio Company can. Hence, it is most likely that arguments related to company scheme applies to non-Japan jurisdictions, and taxation is no exception. So when you think of company form bringing into Japan, you need to take it into account for one of Japanese heavy taxation rules; “Tax consolidation with foreign subsidiaries”.
This is also known as “Tax Haven taxation” (and typical Japanese cannot distinguish “Haven” from “Heaven” so not-a-few call it as “Tax Heaven taxation”). This comes from a global trend of BEPS (Base Erosion and Profit Shifting), which pursues realignment of _proper_ taxation for _nations_ (not companies or individuals). Consequently, this taxation rules is so bad to tax on overseas net profit with overseas subsidiaries in jurisdictions with low corporate income tax which business is leasing, managing patents or software rights, or holding companies for overseas subsidiaries to seek tax avoidance in a reasonable manner, that Japanese government should have had no rights for taxation on.
And… if this rule applies to funds, which are also deemed as paper-company, in a nutshell, once equal or more than 50% of interests / equity shares of such fund is held by investors in Japan directly or indirectly, this taxation is applied to the fund so that your holding shares should be consolidated to your proper account if you have equal or more than 10% of interests / equity shares. As results, the net profit of the fund is also taxable even if it is NOT distributed hence you need to file and pay tax on that profit. Again, you will not enjoy the tax deferral and, even more you have to pay tax to unpaid profits. Do you see any merits to invest into this scheme?
Okay, you may say “how about avoiding 50% investment from Japan” or “capping their holding up to 9.9% all the time” even if Japanese investors holds more than 50%. Good guess but who cares to manage their holding once it hits 10%? Who monitors the holding ratio all the time to trigger force selling? Is it worth to be invested? Or how do you manage and _keep_ sources of your non-Japanese investors holding more than 50%? Remember, Japanese investors are the last group to leave from your funds, so do you have any ideas who can stay your funds until the last minutes? It is not practical, obviously so we always end up with avoiding company form.
So, the last scheme: trust. But, not all the trust is treated as mutual funds. Only “Securities Investment Trust” can enjoy the tax benefit mentioned above. The “Securities Investment Trust” requires to hold equal or more than 50% of securities defined in Article 2-1 of Financial Instruments and Exchange Act, such like equity, bonds and notes and mutual funds (both domestic and overseas).
As reverse side, if your trust is designed to hold equal or more than 50% of “deemed” securities defined in Article 2-2 of Financial Instruments and Exchange Act, such as lands and buildings, trust certificate of real estate trusts, partnership interests or more than 50% of cash, your trust cannot apply for “Securities Investment Trust” but corporate trust taxation.
Corporate trust taxation is, simply, taxation to individual trust account so that your trustee needs tax filing and, consequently, oblige for tax payment for such trust account. Again, this taxation is not allowing the beneficiary of such trust account for tax deferral hence you cannot leverage your asset management with more efficient reinvestments.
After all of considering taxation and its impact, it is quite natural to fall your answer down to Japanese mutual funds and overseas unit trusts to let them invest into equities, bond and notes, and other unit trusts, mutual funds and company formed funds (as securities). I.e., Japan feeder is mutual funds or unit trust, while your master fund can be company form.
Lights and shadows of business infrastructure for mutual fund in Japan
Even after this argument, you may still say: there are many UCITs in SICAV (“Société d’Investissement à Capital Variable”, another company form) in Luxembourg with more than 50% of European investors, or 40-Act Company vehicles in US with majority investors from US. Why not bringing minority portion of such products to Japan?
Rest assured, your logical sense is good enough (or superb enough to be appreciated by yourself), but we are still living in the real world and there is another higher barrier of “practice”, a business infrastructure for mutual fund in Japan, discouraging Japanese distributors to handle your overseas company form funds, finally.
Perfect system infrastructure for Japanese securities brokers, only for domestic products
If we list up financial instruments sold at securities brokers in Japan in order, listed domestic equity should come first, bonds and notes (including structured ones and convertible bonds) next, and then publicly-offered domestic mutual funds. And depending on the brokers, foreign equities, insurance and publicly-offered foreign mutual funds (i.e., our beloved unit trust) come after.
As for the booking systems for domestic listed equity, bonds and notes and publicly-offered mutual funds, they are connected to securities infrastructures, i.e., among, brokers, exchanges, securities depository, trustee as registry of shareholders as well as trustee of mutual funds, and mutual fund houses for STP (straight-through processing) to avoid securities incidents. In this sense, it is quite natural to deem human as most possible factor to create incidents so this neural network for securities dealing and settlements is built without intervention of human as much as possible, and to achieve this, settlement cycle of securities (namely, domestic equity, notes and bonds and publicly-offered domestic mutual funds) are standardized: hence as flipside, non-standard securities cannot be handled through this system.
As we all know, listed equities and bonds/notes have standardized settlement schedule so it is easy to handle. But as for the domestic mutual funds, it depends on the settlement schedule of its underlying asset, and moreover publicly-offered domestic mutual funds are subject to liquidity restriction, which reflect to the selection of underlying asset to narrow down to liquid assets like listed equity and bond/notes, so that we can still assume the settlement schedule of those type of mutual funds as listed equity plus one business day or two, as basic design of the mutual fund system.
Now we are living in 21st century, an era of diversity: why not offering more flexible system to them all?
After a story and history as above, some brilliant and smart guys (like you!) may say simply and casually, hey why not offering much more flexible system for them to replace, or much simpler, why not give a simple and dedicated system for _our_ products?
I had experiences for both stories: as for the latter one, once we give them another tablet (like shiny iPad) with a dedicated app for ordering your product, they, I mean, the branch staff of securities brokers, have to input _twice_ for ordering your product, one for your system and the other for their system to manage their clients account. And there seems no direct point to confirm automatically so each branch may have to reconcile the orders, settlement amount and cash movement, between two system _manually_. See, there is a big hole of securities incidents by human error!
As for the former, you also need to think how the company replaces the system: data replication from existing one to new, to perform parallel testing to confirm the stability of system at least equivalent to existing one before turn off the switch of old one. And more flexible system means more parameters they have to learn and input, and this means more operating time as cost to add. And finally, existing vendors of securities systems are subsidiaries of mega securities brokers so you also have to consider the unique formats and protocol to adapt for replacement… Not as easy as you think in your brain.
What if my product is not applicable to their system?
For instance of publicly-offered foreign mutual funds, first, securities brokers should have their system to handle, to cover all the branches across the country and online channel, which should also connects to their clients booking system. This means such system is a subset of securities system costs like half a million dollars for installment. Too expensive for even middle size brokers to start a new business. So, only mega brokers and some 2nd tiers, and some banks (I.e., SMBC Trust and SMBC) have the dedicated system to offer publicly-offered foreign mutual funds. And, worse and worse, such systems are more or less replicated from domestic mutual fund system so settlement cycle is only adaptable to T+5 to 7. So monthly settlement like hedge funds or structured products with settlement cycle as T+20 cannot be handled. Good old days, though, before GFC, they were kind enough to handle with care by hands, but now no one would take business risk so no such products can be found in the market.
And, thank you for waiting. Publicly-offered foreign company funds is, as the nature of company share, heard to be handled at the foreign stock system, another subset of securities system. Having said that, considering another unique settlement system from ordinary US equities, it is yet hard to be sold.
To conclude, system capabilities talk to product nature in Japan, so publicly-offered domestic mutual funds are the first choice for fund products in Japan, with those reasons.
Another fact: diversification of investment needs is also there.
If you only focus to professional investors, you may consider private placement. In this space, some small teams like financial institution marketing team in the headquarter of securities brokers and boutique placement agent type of distributors are active and those guys are not using a nation-wide system, as no depository or STP required.
But, as for HNW clients business, for instance, I was told in the past that, though the number of solicitation may be smaller, it is better to put the same operations as publicly offering, so it depends on the trade-off between cost of handling and profitalility.
Moreover, investment needs shifts to private assets
Hence, recent market talks more about partnership scheme, which manages both investment opportunities and capital control. Then, investment managers can call the capital to meet funding needs for investment opportunities, and capital will be return to investors each investment project ends. This means the investment team do not have to keep investing to something all the time like open-ended funds. So you cannot handle the subscription and redemption systematically any more. Of course, this type of investment is selective to the investors, but investment needs with both capable and non-capable investors increase and more sellers appetite raise so, both buy-side and sell-side may consider and find more suitable way to investments.
To wrap up
So, hope you could understand why Japan loves unit trust as “greatest common divisor” in Japan market, and after knowing this, if you still want to promote something new and different, hope you can find much smarter solution which is less stressful to anyone in the ecosystem of securities industry (and tax friendly). But, I also see it difficult until basic taxation rule and legal framework for vehicle establishment should change or become more flexible first, and this should be driven by needs (and voices) from local investors for change. Maybe.