US Partnership Tax ReformAn example of stimulus for innovation(*)

…So? For Japan, what’s the use?

2012 June 8Jun Saito

(a researcher on US partnership taxation)

innovation(*): referring to not incremental innovation but disruptive innovation.

1The opinions hereinafter never represent official positions of my affiliated organizations, but are my personal opinions and thoughts.

Rev.3

Gist

1. US Partnership Taxation as an example of stimulus for innovation. How can we spark innovation, which is unpredictable?

2. So? For Japan, what’s the use?…Japan has just begun to struggle for satisfying “the prerequisites such as Civil Code”.

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1.US Partnership Taxation as an example of stimulus for innovation.

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None of us can predict… What we can do is to spark the creativity and imagination of our people.

Innovation"The first step in winning the future is encouraging American innovation. None of us can predict with certainty what the next big industry will be or where the new jobs will come from. Thirty years ago, we couldn’t know that something called the Internet would lead to an economic revolution. What we can do -- what America does better than anyone else -- is spark the creativity and imagination of our people. "---President Barack Obama, January 25, 2011

Innovation

http://www.whitehouse.gov/issues/economy/innovation

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In other words…Not authorized but glass-root challenges can beget innovation.

Unpredictable, so that…

• Not grants but tax-breaks can be effective to stimulate innovation,because grants are paid to projects which are predicted, by authorities, to be successful.

• Furthermore, not tax-breaks in corporate income tax but tax-breaks in partnership income tax can be effective to stimulate innovation,because in corporate tax accounting, R&D expenses and investment are designated and recognized, by the tax-authority, as taxable loss, while in partnership tax accounting , those are recognized, by the people, as taxable loss. The taxable loss reduces the income tax. So, In partnership accounting, the R&D expenses and investment could be easily compensated for by such tax reduction as scheduled by the people. It is not a corporate but a partnership that can stimulate innovation.

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Innovation

Tax-Book difference @ corporates

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• In corporate accounting business accounting tax accounting,so that for instance “realized but not recognized loss” could happen in the tax accounting. In that case, profits @ book < taxable income. So, the corporate income tax could be unexpectedly high, because the corporate income tax is defined as statute rate × taxable income, not profits @ book.

• In partnership accounting business accounting = tax accounting.R&D investments and expenses could be easily compensated for by such income deductions as scheduled by the people.

In the first, Microsoft, YouTube, Facebook, and etc. had startuped in partnership tax entity.

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PartnershipInvestments could be easily compensated for by tax.

Nonlisted Listed

Corporate

Transition of firm form in object economy

Transition of funder

　　　　　

←0→

Time

Time

Darwin’s Ocean(vulnerable to sudden death)Death Valley

gain

loss

Devil’s River Secular world

1976, partnership 2001, LLC 2005, LLC

Transition of funder in monetary economy

Crowdfunding (for the stimulus example of the latest)

Accredited investors:Those who are recognized, by IRS and SEC, as having “economic substance” when they equity invest in private companies. Accredited investors can legally use “tax shelters” such as aggregating cash-out and cash-in to zero-out (which means “taxable income = zero”). For many years, only accredited investors have been allowed to legally perform equity investing in private companies — and to receive accreditation, individuals must meet certain criteria such as having a net worth in excess of $1 million.

Blockers or Stoppers:A blocker or stopper is an entity inserted in a structure to change the character for tax purpose of the underlying income or assets, or both, to address entity qualification issues, to change the method of tax-return filing, or otherwise to get a result that would not be available without the use of more than one entity.

http://techcrunch.com/2012/04/05/with-jobs-act-becoming-law-crowdfunding-platforms-look-to-create-self-regulatory-body/

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(an example of loosening the criteria of compensation for investments)

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Emerging of Partnership Tax Entity

0%

20%

40%

60%

80%

100%

1980 1985 1990 1995 2000 2005

Pre-T

ax-P

rofit

in U

S Al

l Ind

ustry

partnership tax entity （合夥税主体）

corporate tax entity （法人税主体）

Source ： Internal Revenue Service, Statistics of Income, Integrated Business www.irs.gov/taxstats/bustaxstats/

Total Profit = 0.3 T $2007

Total Profit = 3 T $

Note that “proper profits” are plotted. Inter-company transactions are eliminated, so that double-counted profits are eliminated and brought back to the proper source.

Corporate （法人）

Partnership （合夥）

Taxability Taxable entity Non-taxable entity(The partners are taxable.)

Double taxation? Yes, on corporate income & dividends

No, single pass-through taxationon the partners’ incomes

Company longevity Going concern Limited longevity

Income tax levyfrequency

Annually In principle, once at finaldissolution liquidation

Recognition oftaxable income

Kind of pro forma basis Non-recognition rule(except dissolution liquidation)

Book-tax difference? Yes NoFreedom of accounting No, it must use

accrual accountingYes, free to select its

own accounting method

Tax sheltering available? No Yes

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Two types of Business Income Taxation

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Partnership taxation• Limited longevity, which must accompany liquidation at final

dissolution. As a result, annual tax levy is not necessary. Tax paying at the dissolution distribution is a must.

• Non-recognition rule; IRC 721(contribution), 731(distribution) Gain or loss is not recognized by either a partnership or its partners on a contribution of property to the partnership in exchange for a partnership interest. IRC 721. As a result for instance, service contribution is not recognized as begetting transferential profits at the moment. A partner generally does not recognize gain or loss on the receipt of a cash distribution from a partnership. IRC731(a)

• Freedom of accounting; IRC 703(b) A partnership generally is free to select its own accounting method, which may be different from that of its partners. As a result for instance, full expensing of investment, which is allowing investors to fully deduct the cost of an investment from taxable income, reduces the tax paid on the normal return to capital investment to zero, completely removing taxes from the investment decision. (Economic Report of the President 2007. Chapter3 page77.)

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Breakdown of US Industrial Profit (1980 2007)－

- -

1

2

3

1980 1985 1990 1995 2000 2005

Pre-

Tax-

Profi

t (Un

it; Tr

illion D

ollar）

Partnership Tax Entity Corporate Tax Entity w/ o RIC, REIT （ ） RIC, REIT

０

Source ： Internal Revenue Service, Statistics of Income, Integrated Business Data, www.irs.gov/taxstats/bustaxstats/

Regulated Investment Company Real Estate Investment Trust

ITRevolution

calmed

192018171718Partnership Tax Entity

Tax Burden Rate (%): Taxes paid / Profit

354139302931All Industries

547668403841Corporate Tax Entity

200320022001200019991998

Note that “proper profits” are dealt with. Inter-company transactions are eliminated, so that double-counted profits are eliminated and brought back to the proper source.

13

Profit Margin; About 1:2

0%

2%

4%

6%

8%

10%

12%

14%

1980 1985 1990 1995 2000 2005

Profi

t Marg

in; P

re-T

ax-P

rofit

Rece

ipt／

Corporate tax entity Partnership tax entity

Source ： Internal Revenue Service, Statistics of Income, Integrated Business Data, www.irs.gov/taxstats/bustaxstats/

ITRevolution

calmed

Note that “proper profits” are dealt with. Inter-company transactions are eliminated, so that double-counted profits are eliminated and brought back to the proper source.

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14

Main events in the reform history of US partnership taxation.year event contents1935 Economic

substance doctrine

“Tax sheltering” generally means a conduct to get a big deduction with utilizing partnership taxation. The Supreme Court, Gregory v. Helvering, has made a common law; tax sheltering which has “economic substance” is lawful.

1954 IRC Subchapter K

“Simplicity, Flexibility, and Equity as between the partners” is the principle.

1976 At risk law When accommodation, namely borrowed capital, becomes expense, the tax authority will recognize it as deductible if it is backed bond with recourse asset.

1977 The first LLC Actin US. (Wyoming)

Recourse-asset-backed companies, which obtain a kind of limited liability, can enjoy merits pertained to partnership taxation such as tax sheltering.

1986 Passive Activity Loss rule

In PAL rules, incomes are categorized into three types; portfolio Income, passive activity income, and active activity income. If there is no passive income, then no passive loss can be deducted.

ditto “Economic Justice for all”published

Catholic bishops have recommended careful experimentation with several possibilities that hold considerable hope for increasing partnership and strengthening mutual responsibility for economic justice.

19932001

Clinton administration

Clinton, a partnership pro, has accelerated to arrange the institution. IRS-SOI stats put that the number of LLC increased to 0.8M from zero during his term.

1996 Check the boxrule

For tax purpose, any business entity can be eligible for either partnership tax or corporate tax. Also, a discussion; “what is per se corporation” has started.

2010 Obamaadministrationcodified economic substance doctrine

Economic substance could be satisfied only if: the transaction changes in a meaningful way (apart from federal income tax consequences) the taxpayer’s economic position, and; the taxpayer has a substantial non-federal tax purpose for entering into such transaction. The aim is to facilitate people’s economic activity with using partnership scheme and provide the revenue for the Health Care and Education Affordability Reconciliation Act of 2010.

(History of loosening the criteria of compensation for investments)

|

2So? For Japan, what’s the use?

… Japan has just begun to struggle for satisfying “the prerequisites such as Civil Code”. So, a lot of things to do before Japan can make use of it.

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TOP > Civil Code Reform Civil Code Reform About the Civil Code Reform(Law of Obligations) The J apanese Civil Code was enacted in 1896. While partial amendments on the guarantee system were legislated along with modernization of the language of the Civil Code in 2004, the contents of the law of obligations which are mainly compiled in the Book I I I remain basically intact. However, social economy in J apan has dramatically changed in various aspects according to the globalization of the market as well as developments of information technology and transportation measures. In addition, court practice has formed extensive case laws through interpretation and application of the Civil Code since its enactment. Considering such state of affairs, it is considered that provisions of law of obligations in the Civil Code need to correspond to the changes of social economy. In particular, those provisions governing contract which are deeply relate to people’ s daily life and economic activities need to be promptly reformed from the viewpoint of making them more understandable to the public through clarification based on current case laws. Accordingly, on October 28, 2009, the Minister of J ustice consulted with the Legislative Council of the Ministry of J ustice, which is the council to study and deliberate basic law relating to civil, penal, and other legal business upon a request of the Minister of J ustice, for the revision of the Civil Code (law of obligations) at the 160th meeting (Consultation No.88). In response to this consultation, the general assembly of the Legislative Council decided at the same meeting to establish “ Working Group on the Civil Code (Law of Obligations)” for this mission. Deliberation Status English Translation of current Civil Code [PDF]

Japanese government has just begun

Civil Code Reformhttp://www.moj.go.jp/ENGLISH/ccr/CCR_00001.htmlred parts marked by Jun Saito

current (intact) Civil Code translated into English in 2007

year event contents

1639 |1854

National isolation(era of no civil code)

Sakoku ( 鎖国 , “locked country”) was the foreign relations policy of Japan under which no foreigner could enter nor could any Japanese leave the country on penalty of death. In this era, people settled disputes not by civil code but by the arbitration by Samurai echelon to take 忠孝（ loyalty and filial piety) into account.

1853 US Black Ships visit Japan

Powerful colonialism countries pushed Japan to open the country. Japan could not but open, while Japan should avoid to be a fatal victim of wars of aggression.

1868 Meiji Restoration Japan has opened up herself and started hastily-forming Western-style modern state. The slogan: wealth and military power, encouragement of new industries.

1890 Civil Code, France model.

A guest scholar; Boissonade promulgated French-style civil code, but it was almost abolished by objections like “enact civil code, then perish loyalty and filial piety”.

1892 Postpone the enact to 1896

Large scale amendments were made. On the French style groundwork, however, German style civil code was grafted. So, a mockery of civil code was enacted in 1896.

1896 |

now

Malfunction of civil court to settle disputes

Codes of Civil Code were not sufficient to form actual judgments. Instead of codes, in order to temporally settle actual disputes in Japan, various legal interpretations which had been developed in German (or US after 1945) were imported continuously.

1945|

1952

Defeat in World War II, andOccupied by US

US occupation authority reformed most of Japanese institution such as Constitution, Fundamental Act of Education, Tax Law, Corporate Law, and so on. For instance, Dr. Shoup, a specialist in US taxation, has planted in Japan so-called “the best tax system in the world” at that time. But still, no change on the mockery of the civil code.

19551970

High economic Growth.

Japan has enjoyed two-decimal growth rates in its economy for fifteen years. So, no need to change the mockery of civil code, and no fundamental change on all codes.

1992 |

now

Lost two decades in economy

While US has been enjoying the new economy accompanied with the innovation of partnership taxation, Japan has been suffering from so-called “lost two decades”; lingering economic depression, after the collapse of bubble economy in 1980’s. 17

history of Japanese civil code.

|

Civil Code Reform

It’s just like Reconfirmation of good faith?

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current (intact) Civil Code translated into English in 2007

The origin of 「信義に従い誠実に」 was “bona fide”.But now 「信義に従い誠実に」 means, say, “with loyalty and sincerity”. It seems to me that it has different meaning from “good faith” or “bona fide”.

And, finally start!

Social Principles

Not authorized but glass-root challenges can beget innovation.

…and a quick digression

Any Investments could be compensated for by tax.

In particular,not

love-your-neighbors solidaritybut

love-your-enemies solidarity

The intact-since-1896 Partnership Codes (1/3)

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第十二節 組合 Section 12 Partnerships （組合契約） (Partnership Contracts) 第六百六十七条 組合契約は、各当事者が出資をして共同の事業を営むことを約することによって、その効力を生ずる。 Article 667 (1) A partnership contract shall become effective when each of the parties promises to engage in joint business by making a contribution. ２ 出資は、労務をその目的とすることができる。 (2) The subject of the contribution may be services . （組合財産の共有） (J oint Ownership in Partnership Property) 第六百六十八条 各組合員の出資その他の組合財産は、総組合員の共有に属する。 Article 668 The contributions of the partners and other partnership property shall be jointly owned by all partners. （金銭出資の不履行の責任） (Responsibility for Failure to Provide Monetary Contribution) 第六百六十九条 金銭を出資の目的とした場合において、組合員がその出資をすることを怠ったときは、その利息を支払うほか、損害の賠償をしなければならない。 Article 669 In cases where monies are the subject of the contribution, if any partner fails to contribute his/her share of the contribution, he/she must pay interest on the same and otherwise compensate for damages. （業務の執行の方法） (Method of Business Management) 第六百七十条 組合の業務の執行は、組合員の過半数で決する。 Article 670 (1) The management of partnership business shall be determined by the majority of the partners. ２ 前項の業務の執行は、組合契約でこれを委任した者（次項において「業務執行者」という。）が数人あるときは、その過半数で決する。 (2) I f more than one person is delegated to manage the business referred to in the preceding paragraph under the partnership contract (referred to in the following paragraph as "Operating Officers"), the same shall be determined by majority. ３ 組合の常務は、前二項の規定にかかわらず、各組合員又は各業務執行者が単独で行う

ことができる。ただし、その完了前に他の組合員又は業務執行者が異議を述べたときは、この限りでな

い。 (3) Notwithstanding the provisions of the preceding two paragraphs, the ordinary business of a partnership may be performed by each partner or each Operating Officer individually; provided, however, that this shall not apply if other partners or Operating Officers raise objections prior to the completion of the business. （委任の規定の準用） (Mutatis Mutandis Application of Provisions on Mandates) 第六百七十一条 第六百四十四条から第六百五十条までの規定は、組合の業務を執行する組合員について準用する。 Article 671 The provisions of Article 646 to Article 650 shall apply mutatis mutandis to partners who manage the business of a partnership. （業務執行組合員の辞任及び解任） (Resignations and Dismissals of Operating Partners) 第六百七十二条 組合契約で一人又は数人の組合員に業務の執行を委任したときは、その組合員は、正当な事由がなければ、辞任することができない。 Article 672 (1) I f one or more partners are delegated to manage partnership business under the partnership contract, those partners may not resign without reasonable grounds. ２ 前項の組合員は、正当な事由がある場合に限り、他の組合員の一致によって解任することができる。 (2) The partners referred to in the preceding paragraph may be dismissed by the unanimous agreement of the other partners, limited to cases where there are justifiable grounds. （組合員の組合の業務及び財産状況に関する検査） (Inspections by Partners of Condition of Partnership Business and Property) 第六百七十三条 各組合員は、組合の業務を執行する権利を有しないときであっても、その業務及び組合財産の状況を検査することができる。 Article 673 Each partner may inspect the condition of the business and property of the partnership even if he/she does not have the right to manage the business of the partnership. （組合員の損益分配の割合） (Proportions of Partners' Distributions of Profits and Losses)

労務 doesn’t mean “service” but “labor”. 役務 , e.g., may be appropriate.

In China and Taiwan, “partnership” is translated

into 合伙 and 合夥 . And 組合 seems to have different meaning from “partnership”. So, 合伙 or 合夥 seem to be appropriate.

The intact-since-1896 Partnership Codes (2/3)

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第六百七十四条 当事者が損益分配の割合を定めなかったときは、その割合は、各組合員の出資の価額に応じて定める。 Article 674 (1) I f partners have not specified the proportions of the distributions of the partnership's profits and losses, the proportions shall be determined in proportion to the value of each partner's contribution. ２ 利益又は損失についてのみ分配の割合を定めたときは、その割合は、利益及び損失に共通であるものと推定する。 (2) I f the proportions of the distributions are specified solely with respect to either profits or losses, it shall be presumed that the proportions are common to profits and losses. （組合員に対する組合の債権者の権利の行使） (Exercise of Right of Creditors of the Partnership against Partners) 第六百七十五条 組合の債権者は、その債権の発生の時に組合員の損失分担の割合を知らなかったときは、各組合員に対して等しい割合でその権利を行使することができる。 Article 675 I f a creditor of a partnership did not, when his/her claim arose, the proportions of the partners' shares of losses, the creditor may exercise his/her rights against each partner in equal proportions. （組合員の持分の処分及び組合財産の分割） (Disposal Partners' Shares and Division of Partnership Property) 第六百七十六条 組合員は、組合財産についてその持分を処分したときは、その処分をもって組合及び組合と取引をした第三者に対抗することができない。 Article 676 (1) I f a partner disposes of his/her share with respect to the partnership property, the disposal may not be asserted against the partnership and third parties who had dealings with the partnership. ２ 組合員は、清算前に組合財産の分割を求めることができない。 (2) A partner may not seek the division of the partnership property before the same is liquidated. （組合の債務者による相殺の禁止） (No Set-off by Obligor of Partnership) 第六百七十七条 組合の債務者は、その債務と組合員に対する債権とを相殺することができない。 Article 677 An obligor of a partnership may not set off his/her obligation against his/her claim against the partners.

（組合員の脱退） (Withdrawal of Partners) 第六百七十八条 組合契約で組合の存続期間を定めなかったとき、又はある組合員の終身の間組合が存続すべきことを定めたときは、各組合員は、いつでも脱退することができる。ただし、やむを得ない事

由がある場合を除き、組合に不利な時期に脱退することができない。 Article 678 (1) I f a partnership contract does not specify the duration of the partnership, or specifies that the partnership is to continue for the life of a certain partner, each partner may withdraw at any time; provided, however, that, unless there are unavoidable grounds, a partner may not withdraw at a time that is detrimental to the partnership. ２ 組合の存続期間を定めた場合であっても、各組合員は、やむを得ない事由があるときは、脱退することができる。 (2) Even in cases where the duration of the partnership is specified, each partner may withdraw if there are unavoidable grounds. 第六百七十九条 前条の場合のほか、組合員は、次に掲げる事由によって脱退する。 Article 679 In addition to the cases referred to in the preceding Article, partners shall withdraw on the following grounds: 一 死亡 (i) The partner dies; 二 破産手続開始の決定を受けたこと。 (ii) The partner is subject to a ruling for the commencement of bankruptcy procedures; 三 後見開始の審判を受けたこと。 (iii) The partner is subject to an order for the commencement of guardianship; 四 除名 (iv) The partner has been expelled. （組合員の除名） (Expulsion of Partners) 第六百八十条 組合員の A2, ++ 除名は、正当な事由がある場合に限り、他の組合員の一致によって

することができる。ただし、除名した組合員にその旨を通知しなければ、これをもってその組合員に対

抗することができない。 Article 680 The expulsion of a partner may be effected by the unanimous agreement of the other partners, limited to cases where there are justifiable grounds; provided, however, that the expulsion may not be asserted against a partner who is expelled unless a notice to that effect is given to that partner.

The intact-since-1896 Partnership Codes (3/3)

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（脱退した組合員の持分の払戻し） (Refunds of Shares of Withdrawing Partners) 第六百八十一条 脱退した組合員と他の組合員との間の計算は、脱退の時における組合財産の状況に従ってしなければならない。 Article 681 (1) Accounts as between the withdrawing partner and other partners must be settled according to the condition of the partnership property as at the time of the withdrawal. ２ 脱退した組合員の持分は、その出資の種類を問わず、金銭で払い戻すことができる。 (2) The share of the withdrawing partner may be refunded in money, regardless of the kind of his/her contribution. ３ 脱退の時にまだ完了していない事項については、その完了後に計算をすることができる。 (3) With respect to any matter not yet completed at the time of the withdrawal, accounts may be made up subsequent to the completion of that matter. （組合の解散事由） (Causes of Dissolution of Partnerships) 第六百八十二条 組合は、その目的である事業の成功又はその成功の不能によって解散する。 Article 682 A partnership shall be dissolved on the successful completion of the business that is its object, or by the impossibility of such successful completion. （組合の解散の請求） (Request for Dissolution of Partnerships) 第六百八十三条 やむを得ない事由があるときは、各組合員は、組合の解散を請求することができる。 Article 683 Each partner may request the dissolution of the partnership if there are unavoidable grounds. （組合契約の解除の効力） (Effect of Cancellation of Partnership Contracts) 第六百八十四条 第六百二十条の規定は、組合契約について準用する。 Article 684 The provisions of Article 620 shall apply mutatis mutandis to partnership contracts. （組合の清算及び清算人の選任）

(Liquidation of Partnerships and Appointment of L iquidators) 第六百八十五条 組合が解散したときは、清算は、総組合員が共同して、又はその選任した清算人がこれをする。 Article 685 (1) When a partnership is dissolved, the liquidation shall be administered jointly by all partners or by a liquidator appointed by the same. ２ 清算人の選任は、総組合員の過半数で決する。 (2) A liquidator shall be appointed by a majority of all partners. （清算人の業務の執行の方法） (Method of Management of Liquidators' Business) 第六百八十六条 第六百七十条の規定は、清算人が数人ある場合について準用する。 Article 686 The provisions of Article 670 shall apply mutatis mutandis to cases where there is more than one liquidator. （組合員である清算人の辞任及び解任） (Resignations and Dismissals of Liquidators who are Partners) 第六百八十七条 第六百七十二条の規定は、組合契約で組合員の中から清算人を選任した場合について準用する。 Article 687 The provisions of Article 672 shall apply mutatis mutandis to cases where the liquidator is appointed from among the partners under the partnership contract. （清算人の職務及び権限並びに残余財産の分割方法） (Duties and Authority of L iquidators and Method of Division of Residual Assets) 第六百八十八条 清算人の職務は、次のとおりとする。 Article 688 (1) A liquidator shall have the duties to: 一 現務の結了 (i) conclude the current business 二 債権の取立て及び債務の弁済 (ii) collect debts and perform obligations; and 三 残余財産の引渡し (iii) deliver the residual assets. ２ 清算人は、前項各号に掲げる職務を行うために必要な一切の行為をすることができる。 (2) The liquidator may perform any and all acts in order to perform its duties listed in the respective items of the preceding paragraph. ３ 残余財産は、各組合員の出資の価額に応じて分割する。 (3) Residual assets shall be distributed in proportion to the value of the contributions of each partner.

While Rip Van Winkle slept for a hundred years, a busy worker US…

…a busy worker US has evolved their partnership law into a new stimulus taxation for disruptive innovation.

Now in US, almost any R&D investment could be automatically compensated for by such tax reduction as people schedule.

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or, a rootless wanderer

Answer to “So? What’s the use?”

• If Japan wants to make use of US type stimulus for innovation, then the to-do-list is:

1.Reconfirm 19th century Western Civil Code.2.Understand 20th century evolutions on US

partnership taxation.3.Modify them and apply to Japan.

A long way to go.

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Thesis

Anti-Thesis

Syn-Thesis

Dialektik Über Vernunft und Religion

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a bit like

Aufheben over Reason and Religion