Posted on 05 October 2020

Taking a Closer Look at Fund Structures in Japan

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Japan is an established and vibrant market for international fund managers across a wide range of asset classes. For managers interested in investing Japan, however, the unique types of structures used in the market can prove daunting.


In this roundtable conversation, we turned to several industry experts to capture their unique insight on the market – as well as their advice for managers interested in investing in Japan. Our expert panel includes: Steven Wheeler, Partner, Real Estate at Withers; Naoki Ueyama, Partner Real Estate at Withers; Scott Reynolds, Country Executive Japan at Alter Domus; and Hironori Tsujinaka, Tax and Accounting Manager Japan at Alter Domus.


Opening the discussion with a brief overview of upstream structures, Reynolds says, “Coming into Japan, Cayman structures are most commonly used. We generally see a Cayman General Partner and investors in Japan being Limited Partners. In July, Hong Kong’s OSC regime was introduced, which created a number of advantages, but also a number of restrictions as well. In Luxembourg, the most commonly used fund coming through into Japan for asset acquisition is the RAIF (Reserved Alternative Investment Fund).”


According to Reynolds, “All of these share a few strengths – they all claim to be strong with compliance on OECD and FATF (Financial Action Task Force), as well as AML and data protection requirements. This is a real driver for investors – fund structures need to be strong in these areas in order to attract large numbers of investors who form the backbone of their money coming into Japan.”


Investment structures at the asset level

Turning to investment structures at the asset level, Reynolds notes, “Fund structures tend to differ based on the underlying asset class. For real estate we will usually see structures utilising Special Purpose Companies (SPCs). Vehicles like the TMK (Tokutei mokuteki kaisha) or GK-TK (Godo kaisha – tokumei kumiai) arrangements, a form of silent partnership, or a combination of both, are the most commonly used investment structures. Infrastructure funds are usually structured similar to a REIT, however there are certain exceptions such as solar energy – which tends to use GK-TK, and wind – which favours KK (Kabushiki kaisha) or GK (Godo Kaisha) structures due to substance requirements. For debt funds, we may see an SPC used at the asset level, especially for distressed debt.”


Ueyama adds, “For real estate, usually GK-TK structures or TMK structures are used. GK-TK structures are more flexible and costs are cheaper; however, many larger transactions utilize TMK structures. Decision making processes are clearer in TMK structures than GK-TK structures. A TK investor needs to be passive and cannot be involved in GK's decision making process, while investors can participate in its decision making process for a TMK through shareholding. On the other hand, TMKs tend to have higher costs due to filing requirements and other procedures necessary for the TMK to receive the desired tax benefits. On the distressed debt side, theoretically, TMKs can be used, but – at least recently – I haven’t seen TMKs used for acquiring NPLs. Whenever you acquire a property by enforcing collateral, you need to amend the ALP (Asset Liquidation Plan). In the case of a TMK, this would be troublesome. As a result, managers may choose to use the GK-TK structure, which is more flexible than TMK.”


“A private equity fund can invest, as a limited partnership, in stocks, warrants and bonds in a corporation, as well as individual property rights – so the nature of private equity investments makes them conducive to the use of a limited partnership. As a TMK cannot hold more than 25% equity in another company, this could pose problems for a leveraged buyout, for example,” notes Reynolds.


Wheeler brings up an important point concerning the structure of real estate funds. “Specific to real estate, the main drivers for deciding which onshore holding structure to use are the nature of the underlying assets, the cost and timing of setting up the structure and tax benefits of the structure. Most of the funds that we see investing into Japan’s real estate space tend to use either Cayman/BVI structures or Luxembourg structures. The Cayman/BVI structures tend to come in through either Hong Kong or Singapore if the fund or its managers have sufficient substance in those jurisdictions, presumably due to the double tax treaty between Japan and those jurisdictions, which drives down the effective tax rate.”


Wheeler continues, “Generally speaking, there is no restriction on foreign direct ownership of property in Japan. A fund could acquire on its balance sheet and be the direct owner of a property, for example. However, generally, the tax rate is going to be higher for a direct owner than holding through the more tax efficient GK-TK or TMK structures.”


“The TMK structure can drive taxation down even further – especially if you make your investment through Hong Kong, Singapore or Luxembourg. In the case of Hong Kong, you can drive the blended tax rate for the whole structure down to 17% - 17.5%. If you come through Singapore, you’re looking at around 13%. As you can see, funds are always going to use one of these tax-efficient structures in order to increase their returns,” adds Tsujinaka.


He explains, “If a TMK distributes more than 90% of its profits, dividends can be treated as a loss, subject to satisfaction of other requirements under tax law. However, in this case the TMK needs to be more than 50% owned by a Japanese company. Distribution from the TMK to offshore, for example through Singapore, can take advantage of a lower tax rate – less than 20.42%.”


Key considerations for real estate structures

Identifying two major issues with the GK-TK structure for use in real estate, Ueyama notes, “For GK-TK structures, the GK is the owner of the asset, while the TK investor cannot have any control over the asset – they only have the contractual right to participate in the profits and losses of the venture. That tends to be a problem for funds that have to explain to investors that they don’t own the underlying asset.”


“The other issue in using the GK-TK structure is that under the Real Estate Syndication Law, you are technically not allowed to use the proceeds of TK investments to acquire fee simple property. If you retain a Type 3 licensed manager and a Type 4 licensed manager you can do it, but it’s complicated and there aren’t that many of them in the market that will do it for third parties. So funds will typically need to set up their own Type 3 licensed manager and Type 4 licensed manager, making it difficult to acquire fee simple properties in the GK-TK structure.”


Ueyama notes an additional consideration that is often overlooked, “If you are buying or selling real estate you must have a broker’s license. GKs must have the broker license by themselves, however TMKs are not required to obtain the broker license under the law. Instead they can retain an asset manager who has the broker license. Notably, it is generally prohibited for the TMK to acquire additional fee simple properties after its establishment.


Going into further detail about the differences between the two structures, Reynolds explains, “One of the main differences between the GK-TK and TMK structures is the Asset Liquidation Plan (ALP). The ALP is legally required to be prepared and filed prior to the TMK conducting any business, and it’s essentially the governing document specifying what assets can be bought and details of its finance that really plans out the life cycle of the TMK.”


“Once you go down the path of using a TMK to hold your assets, you’re going to incur greater cost in preparation of the ALP, as well as in relation to distributions. If you are using a GK-TK, you can pretty much do a calculation of distributable profits at any time throughout the year. As long as you have the right amount of cash and distributable profits, you can make a distribution. However with a TMK, it’s not so flexible. You must do a full financial close and divide your year into hard closes for each reporting period. This adds a lot of extra administrative work – as well as the related cost,” says Reynolds.


He adds, “Startup costs are generally higher for a TMK than a GK-TK. For that reason, smaller investments are more likely to use a GK-TK structure, whereas larger investments will usually choose a TMK for better economies of scale.”


Wheeler amplifies this point, “Not only is it the cost, which is definitely more for a TMK vs a GK-TK, but it’s also the time it takes to set it up – which often prevents funds from using the TMK structure. It can take several months to actually set up a TMK structure, to file the ALP, and to get it to the point where the TMK can accept funds through the issuance of preferred shares. Unless managers have TMKs sitting on the shelf-or can purchase one in the market- it’s not something they can quickly employ to make an investment.”


Choosing the right structure

Asked about the process for guiding clients towards a particular structure, Wheeler observes, “For a fund coming into Japan to make investments, we would want to know what the investment is, what the objective of the fund is, and what the expected profits/returns on the investment are. Smaller investments typically don’t justify the time and heavy cost of putting in place and maintaining a TMK structure. Even for a 5 to 8-year fund, there is a significant cost involved in maintaining that structure.”


He concludes, “For new fund managers who haven’t invested in Japan before, I would highly recommend consulting with their tax and legal advisors prior to making investments in Japan because it’s both time consuming and costly to change structures. To go from direct ownership to a TMK structure will require the owner to sell the asset to the TMK- which must be funded in cash-  and pay the acquisition taxes and registration taxes again. Too frequently, we see managers come in and really like a property, so they buy it with the idea that they’ll put their structure in place later. It’s only later that they discover they’re going to have to double fund in order to put a TMK structure into place.”



This article was originally published in Sensus Magazine. Download the latest issue below.