The Alternative Investment Management Association

Alternative Investment Management Association Representing the global hedge fund industry

Independent Agent Exemption for Discretionary Investment Managers

Stuart Porter, Akemi Kito and Jan-Erik Velse

PricewaterhouseCoopers, Tokyo

Q1 2008

As widely announced, Japan’s 2008 tax reforms introduced an independent agent exemption into Japanese tax law with effect from 1 April 2008. Reaction to the changes by foreign fund managers with business operations in Japan or those contemplating set-up and Japanese fund managers seeking to expand their foreign investor base, has been universally positive. This article summarises the background to the reform and the guidance subsequently issued by the Financial Services Agency (FSA).


On 21 December 2007, the FSA announced the basic concepts of a plan for strengthening the competitiveness of Japan's financial and capital markets. Part of the plan called for encouraging foreign fund managers to participate in Japanese markets by removing taxation risk of the fund, in carrying out business through independent agents in Japan.

Under Japanese law, a non-Japanese resident may cause a permanent establishment (PE) to arise, where it conducted business through an agent in Japan who acted in a discretionary capacity on its behalf, regarding the conclusion or negotiation of contracts (Agent PE). For Japanese fund managers, unlike many other jurisdictions and the Organisation for Economic Co-operation and Development (OECD) Model Tax Convention on Income, and on Capital (Model Tax Convention), Japan had neither a general independent agent exemption nor the equivalent of a safe harbour trading rule or investment management exemption, for the management of foreign registered and domiciled funds (Foreign Funds) by Japanese based advisers. Since many Foreign Funds were not themselves eligible under a double tax treaty with Japan or were not considered qualified for tax exempt status, pursuant to Japanese tax principles, this lack of an OECD standard independent agent exemption, under Japanese law created a tax exposure for Foreign Funds and their investors, where the Japanese based investment advisers acted formally or in practice as decision makers. By comparison, other major fund management centres have safe harbour rules that allow investment managers to invest and trade in securities on behalf of Foreign Funds, within set parameters, without subjecting them to the risk of Agent PE taxation.

In practice, this risk contributed to the restriction of investment management activities in Japan and often the location of regional investment managers in Hong Kong and Singapore, with the Japan team acting as nondiscretionary advisers/researchers. The graph below highlights that whilst the number of licensed investment advisory companies increased significantly, from 195 in 1987 to over 800 by mid-2007, the number of discretionary investment management companies stagnated.

Registered investment advisory companies (IA) and discretionary investment management companies (DIM)


Source: Japan Securities Investment Advisers Association

Change to Japanese Tax Law

The definition of an Agent PE was amended for Japanese tax law purposes to exclude:

“…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”

This exemption is broadly in line with Article 5 of the OECD’s Model Tax Convention and is consistent with many other taxation regimes of OECD member countries. However, the amendment did not contain any language specifically defining the scope of the exception, nor did the change provide a safe harbour for certain activities conducted by an agent in Japan. Rather, a case-by-case analysis as to the independence of each agent is required. Further commentary and the equivalence of a safe harbour rule for Foreign Funds came with the issuance of the guidance following the press release by the FSA on 27 June 2008, outlining a collection of “Reference Cases” and a “Q&A” on practical application together with the “Guidance” and a subsequent joint presentation, entitled “Minimising the PE Risk of Fund Managers” by the FSA, the National Tax Agency (NTA) and the Ministry of Finance (MOF) held on 4 July 2008.

The Guidance: Independent Agent and the Four Tests

Independent Agent

The Guidance starts with the OECD standard in the Model Tax Convention. For an agent to be considered an independent agent, such agent must be legally and economically independent and must be acting in the ordinary course of its business when providing services as an agent.

Whether an agent is independent is a question of facts and circumstances; however, the Guidance provides the following indications of what facts would be relevant in making this determination:

Legal independence • The agent must have sufficient discretion to act as an agent, relying on its own special skill and knowledge in carrying out the role of agent, and not be subject to detailed instructions or to comprehensive control by the principal.
• An agent who is a subsidiary of the principal does not, of itself, preclude the agent from being independent of its parent company.

Economical independence • An element of entrepreneurial risk must be borne by the agent.
• Whilst not determinative, the number of principals represented by the agent is relevant, as is the dependency on a single principal for the agent’s income.

Ordinary course of Business • This is to be considered by examining the business activities that the agent customarily carries out when acting as an agent.

The Four Tests for a Discretionary Investment Manager

The Reference Cases then clarify the meaning of an independent agent in the context of an investment management business, i.e., restricted to where a foreign general partner (FGP) or foreign investment manager (FIM) of a Foreign Fund enters into a discretionary investment agreement with a Japanese discretionary investment manager (DIM) registered under the Financial Instruments and Exchange Law, and the DIM conducts certain investment activities.

These four tests are more of a safe harbour rule where the circumstances apply; since meeting the four tests is taken as satisfying the meaning of an independent agent in the context of a discretionary fund management business.
Where applicable, the DIM will be treated as an independent agent of the Foreign Fund if it satisfies all of the following four tests:

1. “Detailed instruction” testThe FIM may provide broad discretion to the DIM but not detailed instructions; and the DIM must have enough discretion to make decisions when acting as an agent in order to be considered legally independent. The Guidance then states that the DIM should have enough discretion to make decisions on - the kind, issues, amounts or prices of securities to be invested, including the contents and timing of any derivative transactions to be conducted, as well as whether the securities shall be purchased or sold, by what method and at what timing. The Guidance also provides examples of the application of this test in the areas of risk management, asset allocation, investment restrictions (e.g., negative limits), investment policy, investment approvals, exchange of information and oversight.

2. “Shared officers” testOne half or more officers of the DIM should not concurrently serve as officers or employees of the FGP or the FIM.

3. “Remuneration” testThe DIM receives remuneration that adequately reflects its contributions made; and a DIM will fail this test if it does not receive remuneration which corresponds to the amount of the total assets to be invested under the discretion of the DIM or the investment income of the Foreign Fund.

4. “Diversification capacity” testThe DIM should have capacity to diversify its business or to acquire other clients, without fundamentally altering the way the DIM conducts its business or losing economic rationality for its business where the DIM exclusively or almost exclusively, deals with the Foreign Fund or the FIM (with exceptions for a start up period).


Concluding Comments


The Guidance is limited to Foreign Funds that are established as foreign partnerships or foreign corporations without access to any double tax treaty with Japan. Moreover, the Guidance only applies to specific investment activities, by which is meant activities of portfolio investment and these do not extend to the advisory or management of investments particularly of note covering private equity, real estate and non-performing loans where, by comparison with portfolio investment, income is generated through control of the investment. However, the approach to an independent agent in the Guidance should generally assist in principle in the application of the equivalent OECD/treaty based test from the Japanese perspective.


The NTA has been willing to respond to individual enquiries by fund managers, either in the form of an advance confirmation (written responses) or confirmation with a relevant tax office (oral response), in the application of the four tests including where, for certain reasons, a Foreign Fund or FIMs circumstances may not strictly meet all of the four tests and some flexibility is being sought.

Policy Changes and Final Remarks

This tax reform does not eliminate the Agent PE taxation risks for Foreign Funds or the need to manage these risks. However, it does generally align Japan’s taxation policy in this regard with the approach of the OECD and in global fund management centres.

The reform process was notable for the active involvement of the FSA in framing Japanese tax policy in consultation with MOF and the NTA, and also for the collaborative consultation that involved discussions amongst government agencies, industry bodies (including AIMA), advisers, asset managers and other interested parties.

Finally, it does remain to be seen whether this change itself will lead investment managers repatriating to Japan, as moving away from the prevailing model of having the Japan team acting as nondiscretionary advisers/researchers does bring enhanced regulatory oversight, compliance costs, and a higher individual tax burden for portfolio managers residing in Japan and corporate tax costs for the DIM.

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