2026 Japan Tax Reform: Relaxation of the Permanent Establishment Taxation Exemption for Foreign LPs

The bill implementing the “Outline of FY2026 Tax Reform” (approved by the Cabinet on December 26, 2025) was enacted on March 31, 2026, and promulgated on the same date. The reform includes amendments to the PE (Permanent Establishment) Taxation Exemption applicable to funds (hereinafter the “Amendment”).¹ 

This newsletter provides an overview of the Japanese tax regime applicable to foreign partners in partnership-type funds,² followed by a summary of the Amendment and key practical considerations.

(1) Preliminary Question: Does a Foreign Partner in a Japan-Based Fund Have a Permanent Establishment (PE) in Japan?
Where a foreign partner (i.e., a non-resident individual or foreign corporation) is treated as having a PE (Permanent Establishment) in Japan, income tax withholding on profits derived from the fund’s business, as well as filing and payment obligations for income tax or corporate tax, may arise. Accordingly, for foreign partners serving as partners and for fund managers receiving their capital, whether a foreign partner is treated as having a PE in Japan in connection with the fund’s business is a critical issue.

Under an administrative guideline, where the managing partner (GP) in Japan conducts the partnership business through a PE, each partner is assessed as if directly conducting that business (Income Tax Basic Circular 164-4). As a result, foreign partners are treated as having a PE in Japan, triggering the withholding and filing outcomes described below. In the case of funds in Japan, the managing partner is typically a domestic corporation or similar entity,³  and even non-managing partners are treated as having a PE in Japan. As a result, tax filing obligations and withholding requirements arise with respect to Japan-source income as follows.

(2) General Rule: Taxation of Foreign Partners through Funds in Japan
Where a partnership-type investment fund is organized in Japan, the partnership typically generates income through two stages: (i) receipt of dividends from portfolio companies or proceeds from the disposition of shares in those companies by the partnership; and (ii) subsequent distribution of profits by the managing partner to foreign partners via cash payments or similar methods.

From a tax perspective, under Japanese law, a partnership is not a “corporation” but is treated as a pass-through entity (Corporate Tax Basic Circular 14-1-1; Income Tax Basic Circular 36-37-Kyô-19). Therefore, at stage‑(i), profits or losses arising from the business conducted through the partnership (partnership business) are treated as directly attributable to each partner for corporate tax and income tax purposes. Where a foreign partner is treated as having a PE in Japan, corporate tax or income tax is imposed on PE-attributable income, and the foreign partner must file a tax return (Corporate Tax Act (CTA) arts. 138(1)(i), 141(i)(a); Income Tax Act (ITA) arts. 161(1)(i), 164(1)(i)(a)). Furthermore, if a portfolio company pays dividends, the dividends received by the partnership are treated as directly attributable to the foreign partner, and income tax and special reconstruction income tax⁴ are withheld by the portfolio company (ITA arts. 161(1)(ix)(a), 212(1)).⁵

Ordinarily, stage‑(ii) distributions are merely cross‑border remittances and, by themselves, are not treated as the foreign partner’s income. However, profits arising from business conducted through a PE in Japan under a partnership agreement and allocated under such agreement are characterized as “partnership business profits” and are subject to income tax and special reconstruction income tax withholding at a rate of 20.42% by the managing partner (ITA arts. 161(1)(iv), 212(1), (5)). The profit subject to withholding in this context is the income derived from business conducted in Japan under the partnership agreement, less expenses attributable to such income (Enforcement Order of the Income Tax Act (ITA EO) art. 281‑2(2)). Such expenses include income tax previously withheld on Japan-source income (second parenthetical of the same provision). Accordingly, where a foreign partner receives a distribution from a fund in Japan and income tax has already been withheld on dividends at stage‑(i), a further 20.42% withholding on the partnership distribution is imposed at stage‑(ii) on the net distribution after the earlier withholding.⁶

Note that where a foreign partner has a PE in Japan with respect to business other than the partnership business, the tax office can ascertain the foreign partner’s income inclusive of partnership business profits. Therefore, in such cases, the foreign partner may obtain a certificate of exemption from withholding (source exemption certificate) upon demonstrating that certain requirements are met, and by submitting the certificate to the payer, income tax withholding on partnership business profits is exempted (ITA art. 180; ITA EO art. 304).

(3) Exception: PE Taxation Exemption for Foreign Partners
Where a foreign partner is treated as having a PE in Japan, the resulting tax burden described in (2) above may deter foreign investment in funds in Japan and, in turn, create barriers to inbound investment into Japan (particularly given the limitations of foreign tax credits and tax treaty relief in fully eliminating double taxation). To address these concerns, the FY2009 tax reform introduced an exception, primarily with Investment Limited Partnerships (LPS) in mind, under which certain qualifying foreign partners are exempt from income tax and corporate tax on income attributable to a PE deemed to exist by reason of conducting business through such PE under an investment partnership agreement. In other words, income tax withholding on partnership business profits and the foreign partner’s obligation to file income tax or corporate tax returns are waived (Act on Special Measures Concerning Taxation (SMA) arts. 41‑21, 67-16; “PE Taxation Exemption”). The specific requirements for the PE Taxation Exemption are discussed in Section III. below together with the content of the Amendment.

(1) General Rule: Partnership-Level Determination for Taxation of Business Transfer-Type Shares
Where a domestic partnership disposes of shares of a portfolio company in Japan, the partnership is treated as a pass-through entity as noted in Section II. 1.(2) above, and gains or losses from the disposition are attributed directly to the foreign partner.

However, under Japanese law, a foreign partner without a PE in Japan is not necessarily subject to Japanese taxation on capital gains from the disposition of shares of a domestic corporation. Only capital gains that qualify as Japan-source income are subject to Japanese taxation. In this regard, gains from the disposition of “business transfer-type shares” (ITA EO art. 281(1)(iv)(b), (4); Enforcement Order of the Corporate Tax Act (CTA EO) art. 178(1)(iv)(b), (6)) or “shares of real estate-related companies” (ITA EO art. 281(1)(v), (8); CTA EO art. 178(1)(v), (9)) are treated as Japan-source income. Even if a foreign corporation or non-resident without a PE in Japan disposes of shares of a domestic corporation, capital gains on such shares are subject to Japanese taxation and filing obligations.

Note that these capital gains may be reduced or exempted from Japanese taxation under applicable tax treaties, resulting in taxation solely in the investor’s country of residence (or domicile). In some cases, the applicable requirements may also be modified by treaty. The following discussion addresses the position under Japanese domestic law.

In the private equity fund context, the taxation of capital gains on business transfer-type shares is particularly relevant. Such taxation applies where: (i) at any time within the three years preceding the end of the fiscal year in which the shares were disposed of, a “specially related shareholder group” held 25% or more of the total issued shares of a corporation in Japan; and (ii) the “specially related shareholder group” disposed of 5% or more of the shares of such corporation in the fiscal year of the disposition (ITA EO art. 281(6); CTA EO art. 178(6)). A “specially related shareholder group” is defined as a single shareholder of the corporation in Japan together with persons having a family relationship or similar relationship with such shareholder (ITA EO art. 281(4)(i), (ii); CTA EO art. 178(4)(i), (ii)), and includes partners under a partnership agreement to which the shareholder is a party (ITA EO art. 281(4)(iii), (5); CTA EO art. 178(4)(iii), (5)). Accordingly, requirements (i) and (ii) are determined at the partnership level. That is, when a foreign partner disposes of shares in a corporation in Japan through a partnership, all partners—including partners in Japan—constitute the “specially related shareholder group.” If the partnership holds 25% or more of the shares of the domestic corporation, requirement (i) is met. If the partnership disposes of 5% or more of the shares in a given fiscal year, requirement (ii) is also met.

Thus, where the shareholding percentage and number of shares disposed of under requirements (i) and (ii) are met at the partnership level rather than the individual partner level, a foreign partner without a PE in Japan is nonetheless subject to Japanese taxation as a matter of domestic law.

(2) Exception: Partner-Level Determination for Business Transfer-Type Share Taxation
The partnership-level determination for taxation of business transfer-type share dispositions was identified as an obstacle to inbound investment. In response, a special exception was introduced as part of the FY2009 tax reform.

Specifically, excluding dispositions of shares held for less than one year and dispositions of certain failed financial institution shares, where (a) the PE Taxation Exemption requirements described in Section II.1. above (detailed below) are satisfied, or (b) the foreign partner was a limited partner under the investment partnership agreement during the three years prior to and including the year of the share disposition, and did not engage in any business execution, decision-making, or any approval, consent, or similar act relating to the investment partnership business (in either case (a) or (b), it is further required that at no time within the preceding three years did the shareholding percentage of the foreign partner and its specially related persons (excluding other partners who would be excluded under the PE Taxation Exemption) reach or exceed 25%), the shareholding percentage and number of shares disposed of are determined on a per-partner basis (Cabinet Order for Enforcement of the Act on Special Measures Concerning Taxation (SMA CO), art. 26-31, 39-33-2). This means that the percentage thresholds under (1)(i) (25% or more ownership) and (1)(ii) (5% or more disposition) are applied at the individual partner level.

This special exception for the “specially related shareholder group” determination regarding business transfer-type shares applies where a foreign partner without a PE in Japan satisfies the above requirements and submits a prescribed form⁷ by (in the case of a non-resident) March 15 of the year following the year of disposition, or (in the case of a foreign corporation) the filing deadline for the fiscal year that includes the date of disposition.

(1) Background to the Amendment
Prior to the Amendment, the PE Taxation Exemption referred to in Section II.1. above required the foreign partner seeking the exemption to satisfy the following conditions: (i) being a limited partner; (ii) not engaging in any business execution or decision-making, or any approval, consent, or similar act relating thereto, for the partnership business; (iii) holding less than 25% of the partnership assets; (iv) not being a person with a special relationship with the general partner; and (v) not having any other Japan-source income attributable to a PE (SMA arts. 41‑21(1), 67-16).

As a procedural requirement, the foreign partner must submit a Special Exemption Application Form⁸ to the district director of the tax office having jurisdiction over the tax payment location, through the general partner (GP) responsible for handling the allocation of Japan-source income (including that the substantive requirements described above must have been continuously satisfied from the date of execution of the partnership agreement through the date of submission) (SMA arts. 41‑21(5), 67-16).

However, it had been pointed out that the previous requirements were deterring large-scale foreign investment in Japanese funds; specifically, the cap of less than 25% on a foreign partner’s share of partnership assets, and the risk that LP approval of a managing partner’s conflict-of-interest transactions could be treated as “business execution” for tax purposes. Consequently, the Amendment revisits the eligibility requirements for the PE Taxation Exemption.

(2) Details of the Amendment
The eligibility requirements for the PE Taxation Exemption under the previous regime and a summary of the Amendments are set out in the table below.

<Table: Summary of Amendments to PE Taxation Exemption Requirements>

(1) Relaxation of the Business Execution Requirement
(i) Improved LP and Advisory Board Governance over Conflict-of-Interest Transactions under the Amendment
Regarding the business execution requirement (see (b) of the table in Section III.1.(2) above), the statutory text requires only that a foreign partner who is an LP must not engage in business execution, decision-making, or any approval, consent, or similar act for the partnership business (SMA CO art. 26-30(1)(iii)). In practice, however, many funds establish a contractual body known as an “advisory board”⁹ composed of LPs or their nominees, which provides advice on and approves matters relating to the GP’s business execution. Where an advisory board exercises authority over acts that would constitute “business execution” for tax purposes if performed by an LP (i.e., acts that would cause the PE Taxation Exemption to be lost), the LP members of such advisory board, or LPs who nominated members, would also be treated as having engaged in business execution, thereby losing the PE Taxation Exemption (see also the Q&A published by the Ministry of Economy, Trade and Industry (hereinafter the “METI Q&A”¹⁰)).

Advisory boards are often granted authority to approve, consent to, or otherwise act on conflict-of-interest transactions undertaken by the GP (including transactions that do not formally fall within the self-dealing or cross-fund transactions requiring LP approval under the Financial Instruments and Exchange Act). Where a foreign partner invested in a partnership with such an advisory board and nominated members or exercised voting rights through the advisory board, there was a risk that this would constitute “business execution” for tax purposes, resulting in the loss of the PE Taxation Exemption. For international institutional investors that emphasize governance, this made it difficult to invest in funds in Japan.

Under the Amendment, approval of conflict-of-interest transactions (in a broader sense than the existing exclusion for self-dealing and cross-fund transactions under the Financial Instruments and Exchange Act) is no longer treated as “business execution” for tax purposes (SMA CO art. 26‑30(1)(iii)(c)). By enabling the PE Taxation Exemption to be satisfied even where LP majority vote or LP-member advisory boards are empowered to broadly approve conflict-of-interest transactions, this reform reduces constraints on foreign partners’ involvement in governance for the purpose of ensuring the integrity and transparency of their investments.

The conflict-of-interest transactions newly excluded from business execution are defined as “business execution involving transactions where the interests of a person executing such business, or a person with a special relationship with such person, or other interested parties of such person, conflict with the interests of the limited partners of the investment partnership.” Given the breadth of this language, which contains no further limitation, it is expected that most acts typically contemplated as conflict-of-interest transactions under partnership agreements in practice will fall within this exclusion.

(ii) Remaining Issues Post-Amendment: Limits of the Exemption and Advisory Board Governance in Practice
On the other hand, the METI Q&A indicates that approval of investments exceeding certain investment restrictions imposed on the GP under investment guidelines or similar provisions would constitute approval of business execution.¹¹ While we will need to wait for the updated Q&A reflecting the tax reform, the Amendment itself is not likely to affect this point. Provisions that establish certain investment restrictions under guidelines while permitting exceptions with the approval of a specified percentage of LPs or an advisory board are common in funds both in Japan and internationally. It should be noted that where a foreign partner invests in a fund in Japan that has an advisory board (or LP approval) with such authority and exercises that authority, the PE Taxation Exemption would continue to be unavailable. It is hoped that this issue will be addressed through further relaxation of the PE Taxation Exemption requirements, taking into account current market practice.

(2) Relaxation of the Cap on Foreign Partner Interest through Advisory Board Establishment
Under the Amendment, where an advisory board has been established, the cap on a foreign partner’s interest in partnership assets for purposes of the PE Taxation Exemption is raised to less than 50% (SMA art. 41-21(1)(iii); see (c) of the table in Section III.1.(2) above).

The advisory board required to be established in order to raise the cap on foreign partner interest is defined as a deliberative body composed of limited partners or general partners, or persons nominated by such partners (“limited partners, etc.”), through which such limited partners, etc. may provide advice to, express opinions on, or approve (limited to approval by a majority of such limited partners, etc.) a portion of the business execution conducted by the general partner of the investment partnership for the partnership business (SMA CO art. 26‑30(12)). As there are no further restrictions beyond this definition, it appears that funds that have established advisory boards in practice would generally qualify.

As noted in Section III.2.(1)(i) above, LP governance through advisory boards is a global standard. This Amendment is expected to promote greater foreign partner participation. However, as discussed in subsection (1) above, care must be taken that where the scope of the advisory board’s authority exceeds the specified scope under the Cabinet Order for Enforcement of the Act on Special Measures Concerning Taxation, a foreign partner who nominates advisory board members and exercises authority through the board may lose eligibility for the PE Taxation Exemption.

(3) Abolition of the “No Other PE-Attributable Income” Requirement
Under the Amendment, the requirement that the foreign partner must not have any other PE-attributable income has been abolished (see (e) of the table in Section III.1.(2) above). This resolves the situation in which a foreign partner would lose the PE Taxation Exemption merely because it conducted other business activities in Japan or had invested in even one other fund that did not satisfy the PE Taxation Exemption requirements.

(4) Simplification of the Special Exemption Application Form and Its Limitations
The tax reform outline stated that the required contents of the Special Exemption Application Forms would be revised in connection with the above Amendments. However, the changes to the required contents are limited to reflecting the Amendments to the substantive requirements described above (for example, the deletion of disclosures relating to other PEs held by the foreign partner).¹²

Accordingly, practical burdens associated with the filing of Special Exemption Application Forms that are unrelated to the above Amendments remain unrelieved. For example, the obligation to disclose information such as the interest percentage and profit/loss allocation ratio of the applicant and its specially related persons, the need to trace through to the ultimate investor where the direct investor in a fund in Japan is another fund (fund of funds), the requirement to attach supporting documents such as partnership agreements (including partnership agreements of fund-of-funds vehicles), the obligation to file amendment forms each time disclosed information changes, and the obligation to file renewal forms every five years all continue to apply. Further reduction of these practical burdens remains a matter of industry concern.

(5) Special Exception for Business Transfer-Type Share Dispositions
As discussed in Section II.2. above, the special exception for the “specially related shareholder group” determination regarding business transfer-type shares exists as a separate exemption from the PE Taxation Exemption for foreign partners in funds. However, this exception has not been amended under the current reform, except insofar as the scope of business execution has been relaxed through the provision cross-referencing the PE Taxation Exemption.