Japan's Proposed Deregulation

It has recently been reported that the Japan Ministry of Justice has decided to revise its Practicing Attorney Law to allow a foreign law firm to conduct its law practice in Japan through a Legal Professional Corporation (“LPC”). These revisions may be submitted to the Extraordinary Diet session this autumn for introduction in 2012.

Effective April 1, 2002, Japanese law firms were permitted to practice through an LPC. However, most medium- and large-sized Japanese law firms located in Tokyo have not opted to use an LPC, and instead have remained Partnerships (“Nin-i-Kumiai”). In many of these cases, tax considerations have been, and continue to be, a significant aspect in this decision-making process.

The following is a summary of the main points to be considered when deciding between operating as a Partnership and an LPC from a Japan tax viewpoint.

Partnership (Nin-i-Kumiai)

• As a Japan partnership, all partners, including non-resident partners, are taxed on their share of income attributable to the firm's Japan office. All partners, including non-resident partners, must file returns in Japan. However, if they qualify each partner can take a 1,030,000 yen personal exemption (380,000 yen basic plus 650,000 yen [roughly $12,245 USD] blue form deduction if applicable), which reduces overall taxable income.
• Income generated by the Japan office is spread over many individuals, including non-resident partners, resulting in a lower tax rate (often about 5% for non-residents), than if computed on income attributable to one entity or only a few individuals (i.e., only firm partners resident in Japan).
• The business enterprise tax, which is calculated at a flat rate of 5%, could be reduced after applying a statutory deduction of 2.9 million yen (approximately $34,500 USD) deduction per partner after allocation.
• The Consumption Tax could be reduced due to the application of the 10 million yen (approximately $118,900 USD) threshold per partner. Thus, the more partners there are in a partnership, the greater the decrease in tax overall. (Business entities, whose taxable supplies during the base period ' generally the year beginning two years before the tax year concerned ' are 10 million yen or less, are generally exempt from filing a Consumption Tax return and paying net Consumption Tax. However, a corporation with paid-in-capital of 10 million yen or more would automatically become a taxable enterprise for its initial two accounting years period from its establishment.)

Legal Professional Corporation

There are a number of advantages associated with operating in Japan as an LPC:

• Assuming fees are locally billed by the LPC to Japanese clients, the LPC may avoid revenue withholding tax liabilities. Please note, however, that this is merely a cash flow timing issue and does not provide permanent tax savings. A 20% withholding tax on dividends is required only when remitted to Shareholders (assuming Shareholders are Resident Partners registered with the Japanese Bar Association).
• Salaries and fringe benefits paid to resident partners are tax deductible (except for certain director's bonuses). Fee costs for non-resident partners and associates (including those who are on temporary assignment in Japan) are tax deductible on an arm's length basis.
• The period of tax loss carry-forward is seven years rather than three years.
• Ability to establish branch offices is available.
• Various tax benefits can become available for directors, such as company housing (“shataku”), home leave and scholarship programs.
• LPC eliminates the requirement of a personal guarantee from the managing partner when signing off on company housing or other contracts.
• As compared with a partnership, non-resident law firm partners need not file in Japan (as long as they are not shareholders in the LPC).

However, there are several factors that may be a disadvantage for law firms, such as:

• The effective corporate tax rate is approximately 42% (in the case of an LPC with a paid-in-capital of 100 million yen or less) and the corporate tax on net worldwide income for the LPC would be assessed on the LPC entity level, rather than spread over the individual partners as is done with a partnership.
• The Japan Consumption Tax is more likely to be fully payable by the LPC (when compared with the 10 million yen exemption per partner that is available under a partnership).
• Japanese tax costs for resident partners may increase since Foreign Tax Credit relief is generally not available.
• Comparatively higher costs relating to the payment of mandatory health and welfare pension insurance premiums would be incurred under the LPC as compared with a partnership (summarized in Table 1, on page 3).

Conclusion

In general, the use of a partnership (Nin-i-Kumiai) structure for international law firms operating in Japan can be substantially more tax efficient than an LPC if the Japan practice is profitable. However, an LPC also has certain non-tax advantages that would make it an attractive option under certain circumstances. Firms should consider undertaking a thorough and detailed analysis of the two different structures, including an examination of cross-border issues, to determine which structure would be most beneficial.

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Stanley Kolodziejczak is co-chair of the Law Firm Services group of PricewaterhouseCoopers LLP and has more than 25 years of business, tax and accounting experience. His current experience is working with law firms that are facing the challenges of growth in a changing global market. He can be reached at 646-471-3160 and [email protected]. Nancy Regan is a director in the Law Firm Services group of PricewaterhouseCoopers LLP with 14 years of experience as an attorney in and around global law firms. She can be reached at 646-471-6104 and at [email protected].

It has recently been reported that the Japan Ministry of Justice has decided to revise its Practicing Attorney Law to allow a foreign law firm to conduct its law practice in Japan through a Legal Professional Corporation (“LPC”). These revisions may be submitted to the Extraordinary Diet session this autumn for introduction in 2012.

Effective April 1, 2002, Japanese law firms were permitted to practice through an LPC. However, most medium- and large-sized Japanese law firms located in Tokyo have not opted to use an LPC, and instead have remained Partnerships (“Nin-i-Kumiai”). In many of these cases, tax considerations have been, and continue to be, a significant aspect in this decision-making process.

The following is a summary of the main points to be considered when deciding between operating as a Partnership and an LPC from a Japan tax viewpoint.

Partnership (Nin-i-Kumiai)

• As a Japan partnership, all partners, including non-resident partners, are taxed on their share of income attributable to the firm's Japan office. All partners, including non-resident partners, must file returns in Japan. However, if they qualify each partner can take a 1,030,000 yen personal exemption (380,000 yen basic plus 650,000 yen [roughly $12,245 USD] blue form deduction if applicable), which reduces overall taxable income.
• Income generated by the Japan office is spread over many individuals, including non-resident partners, resulting in a lower tax rate (often about 5% for non-residents), than if computed on income attributable to one entity or only a few individuals (i.e., only firm partners resident in Japan).
• The business enterprise tax, which is calculated at a flat rate of 5%, could be reduced after applying a statutory deduction of 2.9 million yen (approximately $34,500 USD) deduction per partner after allocation.
• The Consumption Tax could be reduced due to the application of the 10 million yen (approximately $118,900 USD) threshold per partner. Thus, the more partners there are in a partnership, the greater the decrease in tax overall. (Business entities, whose taxable supplies during the base period ' generally the year beginning two years before the tax year concerned ' are 10 million yen or less, are generally exempt from filing a Consumption Tax return and paying net Consumption Tax. However, a corporation with paid-in-capital of 10 million yen or more would automatically become a taxable enterprise for its initial two accounting years period from its establishment.)

Legal Professional Corporation

There are a number of advantages associated with operating in Japan as an LPC:

• Assuming fees are locally billed by the LPC to Japanese clients, the LPC may avoid revenue withholding tax liabilities. Please note, however, that this is merely a cash flow timing issue and does not provide permanent tax savings. A 20% withholding tax on dividends is required only when remitted to Shareholders (assuming Shareholders are Resident Partners registered with the Japanese Bar Association).
• Salaries and fringe benefits paid to resident partners are tax deductible (except for certain director's bonuses). Fee costs for non-resident partners and associates (including those who are on temporary assignment in Japan) are tax deductible on an arm's length basis.
• The period of tax loss carry-forward is seven years rather than three years.
• Ability to establish branch offices is available.
• Various tax benefits can become available for directors, such as company housing (“shataku”), home leave and scholarship programs.
• LPC eliminates the requirement of a personal guarantee from the managing partner when signing off on company housing or other contracts.
• As compared with a partnership, non-resident law firm partners need not file in Japan (as long as they are not shareholders in the LPC).

However, there are several factors that may be a disadvantage for law firms, such as:

• The effective corporate tax rate is approximately 42% (in the case of an LPC with a paid-in-capital of 100 million yen or less) and the corporate tax on net worldwide income for the LPC would be assessed on the LPC entity level, rather than spread over the individual partners as is done with a partnership.
• The Japan Consumption Tax is more likely to be fully payable by the LPC (when compared with the 10 million yen exemption per partner that is available under a partnership).
• Japanese tax costs for resident partners may increase since Foreign Tax Credit relief is generally not available.
• Comparatively higher costs relating to the payment of mandatory health and welfare pension insurance premiums would be incurred under the LPC as compared with a partnership (summarized in Table 1, on page 3).

Conclusion

In general, the use of a partnership (Nin-i-Kumiai) structure for international law firms operating in Japan can be substantially more tax efficient than an LPC if the Japan practice is profitable. However, an LPC also has certain non-tax advantages that would make it an attractive option under certain circumstances. Firms should consider undertaking a thorough and detailed analysis of the two different structures, including an examination of cross-border issues, to determine which structure would be most beneficial.

[IMGCAP(1)]

Stanley Kolodziejczak is co-chair of the Law Firm Services group of PricewaterhouseCoopers LLP and has more than 25 years of business, tax and accounting experience. His current experience is working with law firms that are facing the challenges of growth in a changing global market. He can be reached at 646-471-3160 and [email protected]. Nancy Regan is a director in the Law Firm Services group of PricewaterhouseCoopers LLP with 14 years of experience as an attorney in and around global law firms. She can be reached at 646-471-6104 and at [email protected].