Statutory definition

“A partnership agreement takes effect when each party promises to contribute and conduct a joint business.”

A Civil Code partnership is formed by an agreement among multiple parties to contribute and jointly conduct business. Contributions may consist of labor.

Overview

Can contributed partnership property be used freely as one's own?

Contributions to a Civil Code partnership and other partnership property are “jointly owned by all partners” under Article 668. Article 676 states that a partner disposing of an interest in partnership property “cannot assert that disposal against the partnership or third parties dealing with it,” and cannot demand division before liquidation. Individual partners' creditors also cannot enforce rights against partnership property (Article 677).

What proportion of profits and losses belongs to me?

Partnership profit and loss allocation first follows the parties' agreement. Civil Code Article 674 provides that, where no ratios are specified, they follow contribution values; where only a profit or loss ratio is specified, it is presumed to apply to both. The applicable rule depends on whether and how the parties agreed, so first check the contract's allocation provisions.

Can an individual offset partnership real estate losses against other income?

Article 41-4-2 of the Act on Special Measures Concerning Taxation provides that, for an individual who is a “specified partner” or “specified beneficiary,” prescribed real estate losses from partnership business or a trust are deemed not to have arisen for income tax purposes. A specified partner is a partner under a partnership agreement, including similar persons prescribed by Cabinet Order, other than one who participates in decisions on disposal or acquisition of important property or substantial borrowing and personally conducts contract negotiations or other important parts of that business. Partners meeting both active-participation requirements are excluded; others are specified partners. The scope and calculation of losses are delegated to Cabinet Order and cannot be settled from this Article alone.

Can a corporation deduct all partnership business losses?

Article 67-12 restricts deductions where a corporation is a specified partner or beneficiary and liability for partnership or trust debts is substantively limited to partnership property value (for silent partnerships, business property) or trust property value, or another prescribed case applies. The portion exceeding an amount calculated under Cabinet Order based on contribution value or trust property book value is nondeductible. Where the Order prescribes a case in which no substantive loss is expected, the entire partnership or similar loss is covered. “Specified partners” are partners, including prescribed similar persons and, for silent partnerships, contributors and successors to their positions, other than partners who participate in decisions on important property disposal or acquisition or substantial borrowing and personally conduct contract negotiations or other important parts, and other partners prescribed by Cabinet Order. This parenthetical wording includes silent partnership investors among partners; a separate definition includes silent partnership agreements within “partnership agreements.” The same Article permits corporations filing final returns and other prescribed documents to deduct accumulated excess losses up to prescribed profits. Article 67-13 imposes similar restrictions on corporate LLP partners. Article 27-2 separately restricts necessary-expense deductions for individual LLP partners.

How does the partner's identity change the applicable provisions?

When considering taxation of a Civil Code partnership's partner, first establish the partner's category. Income Tax Act Article 2 divides individuals into residents and nonresidents, while Corporation Tax Act Article 2 divides corporations into domestic corporations and foreign corporation. The applicable statutory framework depends on which of these four categories the partner belongs to.

Where partners are nonresidents or foreign corporations, Income Tax Act Article 161 lists as domestic-source income prescribed profits allocated under Civil Code Article 667(1) partnership agreements, including similar agreements prescribed by Cabinet Order, from business conducted through a permanent establishment.

For nonresidents, Income Tax Act Article 164 distinguishes the relevant domestic-source income according to whether they have a permanent establishment. For those with one, it lists income attributable to the permanent establishment together with domestic-source partnership allocations. For foreign corporations, Corporation Tax Act Article 141 distinguishes the tax base between permanent-establishment-attributable income and other domestic-source income.

Income Tax Act Article 212 establishes withholding obligations for payments of domestic-source income to nonresidents and foreign corporations (Payments to Nonresidents and Foreign Corporations and Withholding Tax). For partnership allocations, where a nonresident or foreign corporate partner, including similar prescribed persons, receives money or other assets for domestic-source income arising during the agreement's accounting period or similar period, the allocator is deemed the payer and the Act applies accordingly. The Article also determines how periods exceeding one year are divided and the deemed payment date if no assets are delivered. Article 213 prescribes calculation of the tax withheld.

For nonresident or foreign corporate partners conducting business through a permanent establishment under an investment partnership agreement and meeting listed requirements, Article 41-21 exempts attributable domestic-source income from income tax. Article 67-16 separately exempts qualifying foreign corporations from corporation tax under similar requirements. “Investment partnership agreement” means investment limited partnership agreements under Article 3(1) of the relevant Act and foreign partnership agreements; the latter means foreign agreements similar to those investment limited partnership agreements. Civil Code partnership agreements are not included in this definition, so applicability to their nonresident or foreign corporate partners requires checking the definition. Listed requirements are: being a limited partner; not performing prescribed management acts; having a partnership property interest below 25% calculated under Cabinet Order; and not having a prescribed special relationship with a general partner.

The circulars permit three calculation methods

Circulars specify calculation of partnership profits and losses. Income Tax Basic Circular 36/37 Common-20 provides: “Use method (1) below. However, where method (1) is considered difficult and the person consistently uses method (2) or (3), that calculation shall be accepted.”

Under method (2), “...provisions on allowances, reserves, etc. do not apply.” Under method (3), the allocated amount falls into a single category—real estate, business, timber or miscellaneous income—according to the partnership's principal business.

Corporation Tax Basic Circular 14-1-2 also uses method (1) in principle, accepting consistent use of (2) or (3) “provided there is no adverse tax effect, such as accelerated recognition of substantial depreciation.”

For timing, Income Tax Basic Circular 36/37 Common-19-2 requires individuals to include partnership profits or losses in gross revenue or necessary expenses for the year's relevant income categories. Corporation Tax Basic Circular 14-1-1-2 requires corporations to calculate individual partnership income and expense items corresponding to their business-year periods and include them in gross income or deductions, even without actual distributions or loss payments. On allocation ratios, Income Tax Basic Circular 36/37 Common-19 states that the rule does not apply where the ratio lacks economic rationality in view of contributions, contributions to partnership business and other circumstances.

What amendment history appears in the circulars?

Income Tax Basic Circular 36/37 Common-19 was amended by 2005 Kako 2-39, Kashi 3-11 and Kashin 4-220, which also added 36/37 Common-19-2. Circular 36/37 Common-20 was amended by those notices and by 2012 Kako 2-30 and Kashin 5-25. Corporation Tax Basic Circular 14-1-1 was added by 2005 Kaho 2-14, “XV,” which also amended 14-1-1-2. Circular 14-1-2 was amended by 1980 Chokuho 2-15, “XXXIII”; 1994 Kaho 2-5, “VIII”; and 2005 Kaho 2-14, “XV.”

What happens when investing in a foreign partnership?

The note to Corporation Tax Basic Circular 14-1-1, like Note 1 to Income Tax Basic Circular 36/37 Common-19, defines Civil Code partnerships, etc. as partnerships formed under Civil Code Article 667(1), Investment Limited Partnership Act Article 3(1), or Limited Liability Partnership Act Article 3(1), and similar arrangements overseas.

The Supreme Court judgment of July 17, 2015 (2013 (Gyo-Hi) No. 166) sets a two-stage test for foreign-corporation status under Income Tax Act Article 2(1)(vii) and Corporation Tax Act Article 2(iv): first, determine whether the governing law's wording and legal framework clearly grant or deny status equivalent to a Japanese corporation; if unclear, examine whether the entity can itself be a party to legal acts and bear their legal effects, considering the content and purpose of its governing law. Applying that test, it classified a Delaware Revised Uniform Limited Partnership Act entity as a foreign corporation and held, on the stated facts, that investors could not deduct its rental-business losses from their income.

Points that require care in practice

• The specific scope of “losses prescribed by Cabinet Order” and “amounts calculated under Cabinet Order based on contribution value” requires checking the relevant Order provisions.
• The persons prescribed by Cabinet Order within Article 212's “partners under partnership agreements, including similar persons prescribed by Cabinet Order” must be identified from the relevant Order.
• The “acts prescribed by Cabinet Order as management” in Article 41-21 must be identified from the relevant Order.

Legal basis

• Civil Code, Article 667(1) (Partnership agreements) / Quoted wording: “A partnership agreement takes effect when each party promises to contribute and conduct a joint business.”
• Civil Code, Article 667(2) (Partnership agreements) / Quoted wording: “Contributions may consist of labor.”
• Civil Code, Article 668(1) (Joint ownership of partnership property) / Quoted wording: “Each partner's contribution and other partnership property are jointly owned by all partners.”
• Civil Code, Article 674(1) (Partners' profit and loss allocation ratios) / Quoted wording: “Where the parties have not specified profit and loss allocation ratios, they shall be determined according to each partner's contribution value.”
• Civil Code, Article 674(2) (Partners' profit and loss allocation ratios) / Quoted wording: “Where only a profit or loss allocation ratio is specified, that ratio is presumed to apply to both profits and losses.”
• Civil Code, Article 676(1) (Disposal of partnership interests and division of partnership property) / Quoted wording: “Where a partner disposes of an interest in partnership property, that disposal cannot be asserted against the partnership or third parties dealing with it.”
• Civil Code, Article 676(3) (Disposal of partnership interests and division of partnership property) / Quoted wording: “A partner cannot demand division of partnership property before liquidation.”
• Civil Code, Article 677(1) (Prohibition of enforcement by partners' creditors against partnership property) / Quoted wording: “A partner's creditors cannot enforce their rights against partnership property.”
• Act on Special Measures Concerning Taxation, Article 41-4-2(1) (Special rules on loss offsetting, etc. for real estate income of specified partners, etc.) / Quoted wording: “Specified partner means a partner under a partnership agreement (including similar persons prescribed by Cabinet Order; hereinafter the same in this paragraph) other than a partner who participates in decisions on disposal or acquisition of important property or substantial borrowing for partnership business and personally conducts contract negotiations or other important parts of that business.”
• Act on Special Measures Concerning Taxation, Article 41-4-2(1) (Special rules on loss offsetting, etc. for real estate income of specified partners, etc.) / Quoted wording: “An amount equal to that loss shall be deemed not to have arisen for purposes of Articles 26(2) and 69(1) of the Income Tax Act and other income tax laws and regulations.”
• Act on Special Measures Concerning Taxation, Article 41-4-2(2)(ii) (Special rules on loss offsetting, etc. for real estate income of specified partners, etc.) / Quoted wording: “Partnership business means business conducted under each partnership agreement.”
• Act on Special Measures Concerning Taxation, Article 67-12(1) (Special taxation where partnership business, etc. incurs losses) / Quoted wording: “...Where liability for debts is substantively limited to partnership property value (for silent partnership agreements, etc., property relating to the business) or trust property value, or other prescribed cases apply, the portion of the corporation's partnership or similar loss for that business year (...) exceeding an amount calculated under Cabinet Order based on contribution value or trust property book value (or, in prescribed cases where no substantive loss attributable to the partnership business or trust property is expected, the entire loss) (...) shall not be included in deductible expenses for that year.”
• Act on Special Measures Concerning Taxation, Article 67-12(3)(i) (Special taxation where partnership business, etc. incurs losses) / Quoted wording: “Partnership agreement: partnership agreements prescribed in Civil Code Article 667(1), investment limited partnership agreements prescribed in Article 3(1) of the Investment Limited Partnership Act, similar foreign agreements (including those prescribed by Cabinet Order), and silent partnership agreements, etc.”
• Act on Special Measures Concerning Taxation, Article 67-13(1) (No heading) / Quoted wording: “...Where losses prescribed by Cabinet Order from partnership business (...) for the business year exceed an amount calculated under Cabinet Order based on the corporation's contribution value in that business, the excess (...) shall not be included in deductible expenses for that business year.”
• Act on Special Measures Concerning Taxation, Article 27-2(1) (Special income calculation rules for partners' business income, etc. from LLP business) / Quoted wording: “An individual who is a partner under a limited liability partnership agreement prescribed in Article 3(1) of the Limited Liability Partnership Act (Act No. 40 of 2005) (hereinafter ‘partnership agreement’ in this Article) ...”
• Income Tax Act, Article 2(1)(iii) (Definitions), resident / Quoted wording: “An individual domiciled in Japan or continuously resident there for at least one year to date.”
• Income Tax Act, Article 2(1)(v) (Definitions), nonresident / Quoted wording: “An individual other than a resident.”
• Corporation Tax Act, Article 2(iii) (Definitions), domestic corporation / Quoted wording: “A corporation having its head office or principal office in Japan.”
• Corporation Tax Act, Article 2(iv) (Definitions), foreign corporation / Quoted wording: “A corporation other than a domestic corporation.”
• Income Tax Act, Article 161(1)(iv) (Domestic-source income) / Quoted wording: “Profits arising from business conducted through a permanent establishment under a partnership agreement prescribed in Civil Code Article 667(1) (Partnership agreements) (including similar agreements prescribed by Cabinet Order; hereinafter the same in this item), allocated under that agreement, as prescribed by Cabinet Order.”
• Income Tax Act, Article 161(1)(i) (Domestic-source income) / Quoted wording: “Where a nonresident conducts business through a permanent establishment, income that should be attributable to that establishment if it were an enterprise conducting business independently of the nonresident, considering its functions, assets used, internal dealings with the nonresident's places of business, etc. (...), and other circumstances, including income from transfer of the permanent establishment.”
• Income Tax Act, Article 164(1) (Taxation methods for nonresidents) / Quoted wording: “Income tax imposed on a nonresident shall be calculated by applying Subsection 1 of the following Section (Aggregate taxation of nonresidents' income) to the domestic-source income specified for the category of nonresident listed in each of the following items.”
• Income Tax Act, Article 212(1) (Withholding obligation) / Quoted wording: “A person making payment in Japan to a nonresident of domestic-source income listed in Article 161(1)(iv) through (xvi) (Domestic-source income), excluding income prescribed by Cabinet Order, or to a foreign corporation of domestic-source income listed in items (iv) through (xi) or (xiii) through (xvi), excluding income covered by Article 180(1) (Special taxation of domestic-source income of foreign corporations with permanent establishments), Article 180-2(1) or (2) (Special taxation of interest, etc. relating to trust property), or prescribed by Cabinet Order, must withhold income tax upon payment and remit it to the national government by the tenth day of the month following the month of withholding.”
• Income Tax Act, Article 212(5) (Withholding obligation) / Quoted wording: “For domestic-source income listed in Article 161(1)(iv) allocated as prescribed there, where a nonresident or foreign corporation that is a partner under the partnership agreement in that item (including similar persons prescribed by Cabinet Order) receives money or other assets (hereinafter ‘money, etc.’) for that income arising during an accounting period under the agreement or similar period (if exceeding one year, each one-year period from its start and any final shorter period; hereinafter ‘accounting period’), the allocator is deemed the payer and payment is deemed made on the delivery date (or, if no money, etc. is delivered by the date two months after the day following the accounting period's end, on that date), and this Act applies accordingly.”
• Income Tax Act, Article 213(1) (Tax withheld) / Quoted wording: “Income tax to be withheld under paragraph (1) of the preceding Article shall be the amount specified for each category in the following items.”
• Corporation Tax Act, Article 138(1)(i) (Domestic-source income) / Quoted wording: “Where a foreign corporation conducts business through a permanent establishment, income that should be attributable to that establishment if it were an enterprise conducting business independently of the corporation, considering its functions, assets used, internal dealings with the corporation's head office, etc. (...), and other circumstances, including income from transfer of the permanent establishment.”
• Corporation Tax Act, Article 141, introductory wording (No heading) / Quoted wording: “The tax base for corporation tax on a foreign corporation's income for each business year shall be the income amount relating to domestic-source income specified for the category of foreign corporation listed in each of the following items.”
• Corporation Tax Act, Article 141(i) (No heading) / Quoted wording: “Foreign corporations with a permanent establishment: the following domestic-source income for each business year ...”
• Corporation Tax Act, Article 141(ii) (No heading) / Quoted wording: “Foreign corporations without a permanent establishment: domestic-source income listed in Article 138(1)(ii) through (vi) for each business year.”
• Act on Special Measures Concerning Taxation, Article 41-21(1), introductory wording (Special taxation of foreign partners) / Quoted wording: “Domestic-source income under Income Tax Act Article 161(1) attributable to a permanent establishment of a nonresident or foreign corporation that is a partner under an investment partnership agreement, conducts business through that establishment under the agreement, and meets the following requirements shall be exempt from income tax. For nonresidents, this is limited to income under items (i) and (iv), excluding income under items (ii), (iii), (v) through (xi), and (xiii) through (xvii); for foreign corporations, it is limited to income under item (iv).”
• Act on Special Measures Concerning Taxation, Article 41-21(1)(i) (Special taxation of foreign partners) / Quoted wording: “Being a limited partner of the investment partnership formed under the agreement.”
• Act on Special Measures Concerning Taxation, Article 41-21(1)(ii) (Special taxation of foreign partners) / Quoted wording: “Not performing acts prescribed by Cabinet Order as management of business conducted under the agreement.”
• Act on Special Measures Concerning Taxation, Article 41-21(1)(iii) (Special taxation of foreign partners) / Quoted wording: “The interest in partnership property, calculated under Cabinet Order, is less than 25%.”
• Act on Special Measures Concerning Taxation, Article 41-21(1)(iv) (Special taxation of foreign partners) / Quoted wording: “Not having a special relationship prescribed by Cabinet Order with a general partner of the investment partnership formed under the agreement.”
• Act on Special Measures Concerning Taxation, Article 67-16(1) (Special taxation of foreign partners) / Quoted wording: “Domestic-source income under Article 138(1)(i) of the Corporation Tax Act (excluding income falling within items (ii) through (vi) of that paragraph or Article 161(1)(viii) through (xi) and (xiii) through (xvi) of the Income Tax Act) attributable to the permanent establishment of a foreign corporation that is a partner under an investment partnership agreement (meaning an agreement prescribed in Article 41-21(4)(i); hereinafter the same in this Article), conducts business through that permanent establishment under the agreement, and meets the requirements in the items of Article 41-21(1), shall be exempt from corporation tax (referred to in the following paragraph as ‘covered domestic-source income’).”
• Act on Special Measures Concerning Taxation, Article 41-21(4)(i) (Special taxation of foreign partners) / Quoted wording: “Investment partnership agreement means investment limited partnership agreements prescribed in Article 3(1) of the Investment Limited Partnership Act and foreign partnership agreements.”
• Act on Special Measures Concerning Taxation, Article 41-21(4)(vi) (Special taxation of foreign partners) / Quoted wording: “Foreign partnership agreement means a foreign agreement similar to an investment limited partnership agreement prescribed in Article 3(1) of the Investment Limited Partnership Act.”

Supporting circulars and court decisions

• Income Tax Basic Circular 36/37 Common-20 (Calculation, etc. of partnership business profits, etc.) / Quoted wording: “Use method (1) below. However, where method (1) is considered difficult and the person consistently uses method (2) or (3), that calculation shall be accepted.”
• Income Tax Basic Circular 36/37 Common-20 (Calculation, etc. of partnership business profits, etc.) / Quoted wording: “A method calculating partnership revenue, expenditure, assets, liabilities, etc. as each partner's corresponding amounts according to the allocation ratio.”
• Income Tax Basic Circular 36/37 Common-20 (Calculation, etc. of partnership business profits, etc.) / Quoted wording: “Under this method, provisions on exempt income, dividend credits, withholding tax credits through final returns and similar matters apply to each partner's partnership transactions, but provisions on allowances, reserves, etc. do not.”
• Income Tax Basic Circular 36/37 Common-20 (Calculation, etc. of partnership business profits, etc.) / Quoted wording: “Allocated profits or losses shall constitute revenue or necessary expenses in one category—real estate, business, timber or miscellaneous income—according to the partnership's principal business.”
• Corporation Tax Basic Circular 14-1-2 (Calculation of distributed partnership profits, etc.) / Quoted wording: “Where a corporation consistently calculates amounts included in gross income or deductible expenses for each business year using method (2) or (3), this shall be accepted provided there is no adverse tax effect, such as accelerated recognition of substantial depreciation.”
• Income Tax Basic Circular 36/37 Common-19-2 (Timing of attribution of partnership business profits, etc.) / Quoted wording: “A partner's profit or loss from partnership business shall be included in gross revenue or necessary expenses in calculating each category of income for that year.”
• Corporation Tax Basic Circular 14-1-1-2 (Timing of attribution of partnership profits, etc.) / Quoted wording: “Even without actual profit distributions or loss payments, individual partnership income and expense items corresponding to the corporation's business-year period shall be calculated and included in its gross income or deductible expenses for that year.”
• Income Tax Basic Circular 36/37 Common-19 (Attribution of partnership business profits, etc.) / Quoted wording: “This does not apply where the allocation ratio is considered economically irrational in view of each partner's contribution, contribution to partnership business and other circumstances.”
• Income Tax Basic Circular 36/37 Common-19 (Attribution of partnership business profits, etc.), Note 1 / Quoted wording: “Civil Code partnerships, etc. means partnerships formed under partnership agreements prescribed in Civil Code Article 667(1) (Partnership agreements), investment limited partnership agreements prescribed in Article 3(1) of the Investment Limited Partnership Act, and limited liability partnership agreements prescribed in Article 3(1) of the Limited Liability Partnership Act, and similar arrangements overseas.”
• Corporation Tax Basic Circular 14-1-1 (Attribution of profits, etc. from Civil Code partnership business), Note / Quoted wording: “Civil Code partnerships, etc. means partnerships formed under partnership agreements prescribed in Civil Code Article 667(1), investment limited partnership agreements prescribed in Article 3(1) of the Investment Limited Partnership Act, and limited liability partnership agreements prescribed in Article 3(1) of the Limited Liability Partnership Act, and similar arrangements overseas.”
• Supreme Court, Second Petty Bench, judgment of July 17, 2015 (2013 (Gyo-Hi) No. 166) / Quoted summary: “Whether an entity established under foreign law constitutes a foreign corporation under Income Tax Act Article 2(1)(vii) and Corporation Tax Act Article 2(iv) should first be determined by examining (i) whether the wording of its governing law and the legal system make it clear beyond doubt that foreign law grants, or does not grant, legal status equivalent to a corporation under Japanese law. If that cannot be determined, examine (ii) whether the entity can be recognized as a bearer of rights and obligations by considering, from the content and purpose of its governing law, whether it can itself be a party to legal acts and whether their legal effects are attributable to it.”
• Supreme Court, Second Petty Bench, judgment of July 17, 2015 (2013 (Gyo-Hi) No. 166) / Quoted summary: “Under the circumstances stated in the judgment, where a limited partnership established under the Delaware Revised Uniform Limited Partnership Act constitutes a foreign corporation under Income Tax Act Article 2(1)(vii) and Corporation Tax Act Article 2(iv), and income from its real estate rental business is attributable to that partnership, an investor in the investment business relating to that rental business may not deduct losses arising in calculation of the rental business's income from the investor's own income when calculating total income.”