Taxation of foreign investors in Japan through Japanese Investment Funds and the FY2026 tax reform

Background

Against the backdrop of Japan’s efforts to promote startup investment and advance the “Tokyo as an International Financial Center” initiative, overseas investors are increasingly looking to invest in Japan as limited partners (LPs) in funds managed by Japanese general partners (GPs).

This article outlines the applicable Japanese tax framework and summarizes the key changes introduced under the FY2026 tax reform.

 

General framework

When a non-resident individual or foreign corporation (a foreign LP) invests in Japanese assets through an investment limited partnership (LPS) managed by a Japanese GP, the foreign LP is, as a general rule, deemed to have a permanent establishment (PE) in Japan. As a result, income attributable to that PE – including dividends, interest, real estate income, and capital gains – may be subject to Japanese income tax or corporate tax.

 

PE Exemption

The FY2009 tax reform introduced a special exemption, allowing foreign LPs satisfying certain conditions to avoid the PE taxation in Japan.

 

Current requirements

These requirements have been criticized as overly strict. In particular, requirements (c) and (e) have acted as significant barriers for foreign investors who commonly make co-investments or invest in multiple Japanese funds simultaneously.

 

FY2026 tax reform: Amendment to PE exemption

The FY2026 Tax Reform Outline (released on 26 December 2025) introduces the most significant overhaul of the PE special exemption since its creation in 2009.

• Increased ownership threshold

The most impactful change is the increase of the ownership threshold from the current “less than 25%” to “less than 50%”. However, the benefit of the higher threshold is conditioned upon establishing an advisory committee (Advisory Board) within the partnership, composed of limited partners. This change meaningfully expands the range of investments – including co-investments and concentrated positions – that can benefit from the exemption.

• Clarification and relaxation of the business execution requirement

The scope of LP activities excluded from “business execution” has been broadened. Under the reformed rule, an LP’s approval of conflict-of-interest transactions by the GP will no longer be treated as business execution (the current rule only excludes approvals of the GP’s self-dealing). This removes a significant practical friction, allowing foreign LPs to engage in customary governance activities without triggering PE risk.

• Abolition of the other PE income restriction

The requirement that the LP must not have other PE-attributable income in Japan (ie requirement (e) above) will be abolished. Foreign LPs will no longer be prevented from simultaneously investing in other Japanese funds or maintaining operating branches in Japan while relying on the PE special exemption for a given fund investment.

• Procedural simplifications

Consequential amendments will be made to the form and content of the exemption application and related filings, in line with the substantive reforms above.

 

Capital gains taxation (25%/5% Rule)

Capital gains arising from the disposition of Japanese shares through the fund give rise to a distinct and independent tax analysis, separate from the PE exemption framework described above.

• 25%/5% Rule

Even where the PE special exemption applies, a foreign LP’s Japanese tax exposure isn’t entirely eliminated. The foreign LP remains subject to Japanese tax on its proportionate share (based on its partnership interest) of certain Japanese-source income items generated through the fund – including dividends, interest, real estate gains, and gains on the disposition of Japanese shares where the 25%/5% rule applies.

Whether capital gains on Japanese shares fall within this taxable income is governed by the 25%/5% rule, which is triggered where both of the following conditions are satisfied: (i) at any point during the three-year period preceding the fiscal year of disposition, the foreign LP held 25% or more of the issued shares of the Japanese company; and (ii) during that fiscal year, the foreign LP disposed of 5% or more of those shares. The 25% ownership threshold under condition (i) is assessed not on the foreign LP’s holding alone, but by aggregating the holdings of the LP together with those of “specially related persons” – broadly, parent and subsidiary companies and other entities under common control and other LP investors in the same fund vehicle.

• Special rule for foreign LPs

Where the PE special exemption applies, a further special rule provides that both conditions are assessed on a per-partner basis, not at the fund level, for the purposes of the 25%/5% calculation purposes. This means that even if the fund as a whole holds or has disposed of shares exceeding the respective thresholds, each foreign LP’s position is assessed individually by reference to its proportionate indirect interest through the fund, aggregated only with its own specially related persons’ holdings.

This per-partner assessment doesn’t apply to short-term held shares (generally, shares acquired and disposed of within one year) or to shares of failed financial institutions, for which the assessment reverts to the fund level.

The 25%/5% rule and its related special provisions are outside the scope of the FY2026 tax reform and will continue to apply on an unchanged basis. Therefore, these issues must be analysed independently from the PE exemption as discussed above.

 

Practical implications

The FY2026 reforms represent a landmark development in Japan’s inbound investment tax framework. By raising the ownership threshold, relaxing governance-related PE risks, and removing the restriction on other PE income, Japan is taking a meaningful step toward aligning its fund tax regime with international standards.

That said, the FY2026 reforms address only the rules governing PE status and don’t alter the other tax consequences even if the exemption applies; therefore, the total tax exposure should be carefully examined.