Update on the Japanese investement environment

To the point

Providing tax exemptions to permanent establishment and applying the 25/5 rules should increase foreign investors access to the Japanese market while enabling alternative structuring opportunities, without triggering unforeseen tax exposure in Japan. In addition, recent legal reforms on unlisted stock incorporation and limited partnership agreements—including the shift to fair value measurement of non-marketable equity securities—aim to channel more capital into startups and offer investors a broader range of diversified opportunities.

Introduction

Tax reforms and evolving accounting standards are helping attract inbound fund investments into the Japanese market and are expected to drive an even greater influx of foreign capital in the years ahead.

Ⅰ. Japan tax considerations for offshore fund investments

1. Permanent establishment rules and exemptions

Under Japanese domestic tax law, a non-resident —whether a corporation or an individual—with a permanent establishment (PE) in Japan is subject to Japanese tax on all income attributable to that PE.

In context of inbound investments, PE rules typically apply when a non-resident investor participates in either: (1) a Japanese Investment Business Limited Partnership (IBLP), or (2) a foreign fund that is directly managed from Japan, such as through a resident general partner, a resident limited partner with decision-making authority or dependent resident agents.

i. Permanent establishment

If a fund or any of its limited partners are deemed to have a PE in Japan, both the income recognized by the fund and any other income attributable to that PE would generally be subject to full Japanese tax rates.

Where the fund is treated as tax transparent and a PE is determined to exist, the applicable Japanese tax rate would be approximately 31%–34% if the fund and/or its limited partners are regarded as corporate entities, or up to 55.945% (including income surtax) for individual limited partners.

In addition, distributions from the fund to limited partners of profits allocable to the PE would generally be subject to Japanese withholding tax at a rate of 20.42% (including income surtax). Partners may claim a credit for their share of any such withholding tax against their Japanese tax liabilities related to the PE when filing their Japanese tax returns.

ii. Permanent establishment exemptions  

A non-resident investor may invest in an IBLP without creating a Japanese tax liability arising from a PE in Japan, provided certain requirements are met and a domestic PE exemption application is filed on time. These requirements include: the non-resident investor is a limited partner in the fund; does not participate in the fund’s management; holds less than 25% in the fund assets, based on the higher of ownership interest or share in profits and losses; has no other PE in Japan (apart from any PE attributed through the limited partner interest); and is not a related party of the general partner.

2. 25/5 Rule and exemption:

In principle, a non-Japan resident investor (corporation or individual) is generally not subject to taxation in Japan unless the investor has a PE in the country, or, without a PE, becomes taxable under the 25/5 rule or the real estate holding company (REHC) rule.

i. 25/5 Rule

A non-Japan resident investor without a Japan PE is generally not subject to tax on capital gains from the sale of shares in a Japanese company unless the investor, together with its special related parties, sells 5% or more of the company’s shares in any fiscal year and has owned, or previously owned, 25% or more of its shares at any time during the fiscal year of sale or the preceding two fiscal years (the 25/5 Rule). Where the seller is a flow-through partnership for Japanese tax purposes, these 5% and 25% ownership thresholds are assessed at the partnership level (e.g., the fund) rather than at the level of each individual partner.

ii. 25/5 Rule exemption

The 25/5 Rule is, however, liberalized under the “25/5 Rule Exemption” for the sale of shares in Japanese companies by an IBLP or another foreign partnership fund similar to an IBLP, provided specific qualifying criteria are met. The exemption applies to transactions (“Covered Transactions”) that (i) satisfy a one-year holding period requirement and (ii) do not involve the disposal of shares in certain distressed financial institutions or a REHC.

If a fund’s investment in a Japanese company qualifies as a covered transaction, the 25% and 5% ownership threshold are tested at the investor level—if the following conditions are met:

(a) The investor (i) does not have a permanent establishment in Japan; (ii) is a limited partner in the fund; (iii) does not own 25% or more of the shares of the Japanese company sold; and (iv) is not involved in the fund’s management or operation; and

(b) The investor files the required qualifying documentation with the Japanese tax authorities.

Ⅱ. Transition from book value evaluation to fair value evaluation

1. Amendment of the Financial Instruments and Exchange Act and the Act on Investment Trusts and Investment Corporations (Unlisted Stock Incorporation) (May 2024):

In May 2024, amendments to the Financial Instruments and Exchange Act and the Act on Investment Trusts and Investment Corporations introduced a framework allowing mutual funds to invest in unlisted stocks.

(i). Mutual funds can invest in unlisted stocks, with a limit of maximum 15%

The Financial Services Agency has stated that the framework is intended to enhance funding for startup companies, while also ensuring necessary safeguards and audit measures to address the higher risks and illiquidity involved. Although it allows a direct inclusion of unlisted stocks in retail investment trust products in Japan, most funds currently maintain only a very small allocation (typically less than 1%) to unlisted equities due to liquidity risk.

(ii). Fair value measurement to non-marketable equity securities

On 21 December 2023, the Investment Trusts Association, Japan, amended its rules to include audit considerations for investments in non-marketable stocks and other securities. Unlisted stocks held by mutual funds are now evaluated at fair value in accordance with IFRS Accounting Standards and US GAAP. Fair value is generally determined using methods such as net asset value, comparison with similar listed companies, or guidance from the International Private Equity and Venture Capital Valuation (IPEV)guidelines.

2. Amendments to the Limited Partnership Act for Investments (LPS Act) (September 2024) and Practical Guidelines on Accounting for Financial Instruments (March 2025):

A limited partnership agreement (hereinafter, LPS) for investment in Japan is a legal contract that establishes an investment limited partnership under the LPS Act. This structure is commonly used for private equity and venture capital funds in Japan.

(i). Deregulation of investment restrictions for foreign corporations

Investment in foreign corporations by LPS, previously limited to 50% of the total capital contribution of all partners, is exempted for foreign corporations effectively controlled by domestic business. This is expected to encourage capital inflows from overseas investors and promote the global business expansion of domestic Japanese business.

(ii). Fair value measurement to non-marketable equity securities

In Japan, non-marketable equity securities were traditionally valued at cost under Japanese GAAP. However, with the recent rise of financial products incorporating unlisted stocks into funds, more growth capital is expected to flow into venture capital investments. The revised Practical Guidelines on Accounting for Financial Instruments now allows investors to choose whether to value all non-marketable equity securities at fair value, depending on their accounting policy.

Conclusion 

• From a tax perspective, the Government of Japan has updated regulations to make the local asset management market more attractive to foreign investors. Exemptions from permanent establishment and 25/5 rules should provide greater access and alternative structure opportunities without triggering unexpected tax liabilities.
• While the exemption requirements are not overly complex, they can affect fund structured operations, limiting limited partners’ authority to decision-making. Investors should consider carefully both qualifying conditions and their impact on partners’ intended roles.
• Additional legal reforms aim to channel more capital into startups and expand investment options.
• Due to the lack of market transactions, fair value for non-marketable securities must be determined using guidelines and valuation models, presenting unique challenges compared to listed stocks.