Japan rejigs tax rules to draw more foreign funds

By David Dolan

TOKYO, June 27 (Reuters) - Japan has relaxed its tax code so foreign asset managers and hedge funds can avoid dual taxation, as part of Tokyo's push to revive itself as a global finance centre.

In a two-step process that began in April with the revision of a cabinet order and finished on Friday, the government has retooled tax rules so offshore funds can avoid being classified as having a "permanent establishment" in Japan.

Commonly referred to as a "PE" in tax law, the classification would force offshore funds -- which already pay taxes in their home countries -- to pay domestic taxes on any returns made in Japan.

Faced with sluggish growth and a rapidly shrinking population, the world's second-largest economy is desperate for foreign investment and is especially keen to woo hedge funds, which have an estimated worth of $2 trillion globally.

Until now many of the loosely regulated funds have been forced to set up shop as "investment advisory firms" in order to avoid the double tax bill.

"We must admit that Tokyo's presence in international finance has been in decline for some years," an official at the regulatory Financial Services Agency told reporters.

Data from the FSA shows that while the number of investment advisory companies has nearly doubled to more than 800 in the past four years, the number of investment management firms has languished at around 100 for two decades.

The difference is not insignificant, the FSA reckons, as full investment management firms would draw more people and capital into the market.

The legal change allows local entities to avoid being regarded as having a permanent establishment if they are seen as sufficiently independent of the overseas entity.

Critically, the local entity must bear some entrepreneurial risk, such as receiving pay corresponding to returns on the investment.

That means the Tokyo arm of a U.S. hedge would bear entrepreneurial risk if managers were paid based on the performance of their Japan fund.

If the hedge fund met some other criteria it would be deemed an "independent agent" and not subject to dual taxation.

The tax change also underscores Japan's regulatory shift in recent years.

Regulators are increasingly worried that the world's second-largest economy will lag in financial services, losing out to more flexible Asian centres such as Hong Kong and Singapore.

While famous for churning out cutting-edge gadgets, Japan has also become synonymous among foreign investors for hidebound regulation and burdensome taxation.

Restrictions between banks, brokerages and insurance firms were relaxed under a bill passed by Japan's parliament earlier this month, making it easier for companies to market products across divisions. (Editing by Michael Watson)