How to Incorporate in Japan: Part 1

New rules mean new opportunities
by Terrie Lloyd

On May 1st, 2006, one of the biggest revisions in the last 50 years of the Japanese commercial code, the "Sho-ho," was enacted. The new code not only significantly reduces the investment needed to set up a company, but also completely revamps the government's thinking about what companies are for, how they should be used, and whether foreigners should be allowed to get in on the action. Foreign and domestic M&A, low-cost one-yen companies, freely using assets as investment currency, and purpose-made investment vehicles (LLPs) are now all allowed. In a two-part series over the next two issues of J@pan Inc magazine, we will not only endeavor to explain these exciting new changes, but give you practical advice on negotiating your way around the new paper trail.

A Need to Change the System
Japanese tradition has regarded setting up a company as an extremely serious undertaking. Once formed, a company should be run long term - often for generations - and be primarily for the benefit of the employees, society (well, the tax man), and in distant third place, the shareholders. To ensure that this actually happened, the government instituted a number of controls that held back all but the most committed of founders. The most famous of these controls was the high cost of minimum capitalization required. For a Yugen Kaisha (a format often favored by mom-and-pop stores), it was JPY3m, and for a Kabushiki Kaisha (a joint stock company), it was JPY10m - stiff enough sums to keep the riff-raff out!

Other controls included having to appoint three directors and a Statutory Auditor. The Statutory Auditor in particular was a special challenge to foreign firms, since they typically had no family or close friends to ask to help out. Thus, expensive proxies had to be employed. Another significant barrier was the prevention of companies from using their assets, such as unlisted stock, to purchase another company unless they went through a tedious and often unfavorable court valuation process. And if your stock happened to be in a company based in another country, well, just forget about it.

For these reasons, anyone brave enough to found a company was highly regarded and respected. The title "shacho" (president) always denoted commitment to society values, a high level of self-sacrifice, and the likely backing from shareholders with some substance.

But in actual fact, the system was severely abused, especially in the period from the late nineties until this year. The lure of riches coming from listing on the public stock markets created a whole new generation of young would-be entrepreneurs with very little backing. These people soon discovered that you could borrow the capital for a company from friends and family, and after incorporation then take out a director's loan and return the original money. They also found out many other ways to bypass the system, such as dividing assets up into amounts of JPY4,999,999 or less, which they could use as investment capital without having to submit to a court review.

But while the fresh wave of entrepreneurs were learning how to work the system, especially since the dot.com boom of the late 90's, something new was also occurring. The pull of the stock market was also prompting investors to back the brash newcomers, thus creating a tornado of investment and employment that didn't escape the notice of the bureaucrats in Kasumigaseki. Although this new system of doing business was undisciplined, it certainly met the objectives of government: employ more people, replace manufacturing with services, and create a strong base for the nation's future.

Thus it came about that the government would try an experiment. In February 2003 the concept of One-Yen "Kakunin Kaisha" companies was made law. We covered these in previous issues of Japan Inc. (http://www.japaninc.com/print.php? articleID=1123) and pointed out that even though such companies were indeed cheap to establish, they were also temporary, only lasting for five years; limited, in that only newcomers to running a company could make one; and painful to manage, because substantial quarterly government body reporting was required.

Despite these disincentives, surprisingly, the One-Yen "Kakunin Kaisha" proved extremely popular, and the Nikkei reported last year that through to January 2005, over 20,000 were established.

Thus, the introduction of the new legislation indicates that the realities of a changing market have at last been recognized by the government. The rules for setting up and running a company are now substantially loosened and that is good news for those of us wishing to set up a company in Japan.

The Basic New Vehicles
With the new rules, there are now 4 types of domestic entities (not including branch offices, representative offices, and LLPs), and these are the only types of companies that can be freshly formed. They are the: Kabushiki Kaisha (KK), Godo Kaisha (GK), Gomei Kaisha, and Goshi Kaisha. Of these, the KK and the GK are most useful to foreign entrepreneurs and managers setting up in Japan and we will focus on these. If you are looking for a branch or representative office, then you can find more information about both at the JETRO website, http://www.jetro-.go.jp/en/invest/setting_up/section1.

Let's look more closely at the two main formats and how to choose which one and which sub-type to use:

Godo Kaisha
The Godo Kaisha is equivalent to a US-style limited liability company (LLC) and is the most basic form of incorporation. The liability is limited to the amount invested. This company format is probably best suited to people who want to keep their business operation simple and not have to do a lot of reporting or commercial compliance work. Rather than shareholders in the company, there is a class of investors called participants, and any changes, dividends, rights, etc., have to be applied equally across all share-holders. So while a GK is easier to run, in that it doesn't require shareholder meetings or elected directors, it also has the downside that you can't take a GK public and that even a 1% shareholder can dissent to board-instigated changes and derail them.

Kabushiki Kaisha
There are two main types of KK, those considered "closed," meaning that there are restrictions on the transfer of stock, and "open," meaning that there is no restriction on stock transfers. The difference in whether a company is open or closed reflects in the amount of structure required by law to create and run each type. As you might imagine, an open company requires more structure.

Kabushiki Joto Seigen Kaisha (JSKK)
The JSKK is also called a Closed KK and appears to be the most flexible vehicle for smaller start-ups. Just like any other KK, the founders can raise capital from outside investors, offering different classes of shares, yet they can also keep the reporting and compliance work to a minimum. Essentially JSKK's have the option but are not obliged to have more than one investor, or more than one director - and thus a board of directors. Needless to say, if there is no board, then the need for directors meetings and the subsequent reporting is reduced. Further, no statutory auditor is required either, because instead the company can hire an outside "zeirishi" (Certified Tax Accountant) to attest to the reliability of books. You also do not need to have an outside audit firm; again, this is optional.

Kokai Kabushiki Kaisha (KKK)
In some quarters, the KKK is strangely called a "Public" KK in English, even though it is not listed. To alleviate this, it is now more commonly called an "Open" KK. This is the company vehicle that most closely resembles the previous standard Kabushiki Kaisha format, and thus carries the weight of tradition as well as corporate governance. It is designed for a strong level of transparency and responsibility, and requires the existence of a minimum of 3 directors, a statutory auditor, and regular reporting and compliance. As a result, this company vehicle will most likely find favor with entrepreneurs who have investors behind them.

Defining Large and Small
The Japanese commercial code treats large companies (which are always KK's) more strictly than small ones and requires a higher level of governance. At present, a large company is one that has capital of JPY500m or more, or total liabilities of JPY20bn or more. If your new company qualifies as being large, and you have a JSKK, then you will be required to appoint both a statutory auditor and also an outside accounting audit firm.

Upgrading a Yugen Kaisha
For those readers with a Yugen Kaisha, the good news is that your company doesn't disappear and the new designation for such companies will be the "Tokurei Yugen Kaisha" (TYK). However, over time the restrictions on TYK are rumored to increase and you will be encouraged to re-register the company as one of the other formats. This is going to be quite cheap and easy to do - by Japanese standards! We were told that the conversion cost in a Closed KK will be around JPY240,000 for the registration fees and stamp duty, or JPY100,000 to convert it into a Godo Kaisha. Right now, owners of TYK's will be allowed to continue running them as they have.

Really, Which to Choose?
The biggest question that people ask in setting up a company in Japan is what type of company to implement. While we've given you some guidance in the company descriptions above, most experienced hands will tell you that the best company format is one that offers "the least impediment to conducting business with your customers." This means a company that is perceived as being trustworthy, committed, and present in Japan. By this definition, then, the best company to choose, especially since the capitalization requirements have been removed, is a properly constituted and managed Kokai Kabushiki Kaisha (KKK).

The practical aspects of incorpo-rating a KKK are: logistics of foreign ownership, appointing officers (directors and statutory auditor), naming, and capitalization. Let's cover these briefly here.

1. Foreign Ownership Logistics
For a foreign firm to own a Japanese subsidiary, the local representative needs to provide substantial proof, in Japanese, of the foreign firm's existence. This requires a considerable investment in time and money for the head office management in education, paperwork and communications, as well as, of course, translation. This tedious, back-and-forth process is one reason that the average foreign firm has to pay more than JPY3m to establish a subsidiary in Japan.

But there is an easier way. Since you need a local representative director anyway (if you have a JSKK with one director, then that person is automatically regarded as the representative director), you can simply elect to have this person be the "promoter," the establisher of the company, with one single share. The promoter can then invite the overseas parent company to subscribe for, say, another 999 shares. Since the parent is not the original promoter, the establishment is considered domestic and the paperwork is substantially lessened. After the subscriptions are filled, the Board can then approve the transfer of the promoter's single share to the parent company. Note that to be able to do this level of transfer, you need to have permission written into the Articles of Incorporation ("Tokibo Tohon"). Once registered, the transfer of the share will give the parent company 100% ownership.

2. Appointing Officers
Commonly, many foreign companies are not comfortable relinquishing complete control to a local President (more commonly known as a Representative Director in Japan). For a start-up, this is probably rightly so. However, the commercial code requires at least one representative director be a resident in Japan, so as to receive notices, sign contracts, and otherwise effect actions on the behalf of the company. Now, this person does not need to be the President, leaving the possibility that the role could be filled by someone at the parent company. However, probably a better way to implement control is to have two representative directors at the same time, one providing the public face and the other providing back-up and controls. Although either representative director can bind the company legally, you can use employment contracts and financial fire-walling (keeping money in separate accounts and needing different signatories) to provide some measure of comfort. A Japanese CEO-elect will not like this arrangement, but if you need safety, then this arrangement could be put in place for a trial period at least.

A Statutory Auditor, if you have a Large Company JSKK or a KKK, may be an investor or a family member of the President or other directors. However, they may not be someone who is concurrently serving as an officer or employee of the company. Thus you need to find someone relatively neutral but who is still willing to take on some risk. Not always an easy thing to do.

3. Naming
There are no particular requirements for someone establishing a company in terms of what name you use. However, as in most countries, it is a good idea to do a proper name search for other firms using the same name. If they operate within your business space and within your ward or prefecture, they could make a claim against you for using a name too similar to their own. As a preventative measure, a Judicial Scrivener can perform a search for you.

4. Capitalization
With the new commercial code, there is now no "right" amount with which to capitalize your company. But our advice is to let tradition speak for you. For over 20 years, JPY10m has been the minimum amount of capitalization for a Kabushiki Kaisha, and thus we recommend that you consider making this your capital level as well. Note that you can use the company capital to cover all costs incurred in setting up the company, as well as the operations of the business after establishment.

In the next issue of J@pan Inc, we go into more detail on the process of setting up a company and the resources that you will need to achieve this. JI --> Go to Part 2 of this article