Legal issues facing owners and operators of data centers in Japan

Due primarily to its favorable tax treatment, the Tokutei Mokuteki Kaisha, or TMK, is the Japanese entity used by most sophisticated Japanese real estate investors to acquire and hold large real estate assets.  The TMK is a highly regulated entity, and the laws and regulations governing its affairs are rife with traps for the unwary.  For investors in Japanese data centers who use the TMK as their investment vehicle, a couple of these traps arise because of the high value of the TMK’s movable assets (i.e., the data center fit out) in relation to its immovable assets (i.e., the land and buildings and movable assets that are permanently affixed to the land, including the core and shell of the data center).

Under the Japanese Law Regarding Liquidation of Assets (Law No. 105 of 1998, as amended) (the “TMK Law”), a TMK is required to entrust its assets with a Japanese trustee, subject to certain specified exceptions.   One of the exceptions to this entrustment requirement applies to immovable assets (the land and building).   This exception does not extend to the data center fit out unless (1) the fit out is permanently affixed to the immovable assets to the extent the fit out is deemed to constitute a part of the immovable assets (fugo) or (2) the fit out is ancillary assets (jutaru tokutei shisan) to the immovable assets.  If the fit out falls in either of these categories, then the fit out will not be required to be entrusted.  This is important because it can be difficult to find a Japanese trustee that will accept the entrustment of data center fit out that does not fall in either of these categories.

Under the Japanese Civil Code (Law No. 89 of 1896, as amended), a movable asset is considered to be permanently affixed to an immovable asset if removing it would cause damage to the movable asset or the immovable asset or would require special work to remove (i.e., it is not easily removed).   For example, an elevator would considered to be permanently attached, while a refrigerator would not.  As applied to data center fit out, certain items (such as Modular UPS Units, cabling, network switches and routers and portable racks) can typically be removed easily from the land or core and shell without damaging the immovable assets, whereas other items (such as cooling systems and built-in fire suppression systems) cannot be easily removed without causing such damage.  Whether the fit out is permanently affixed to the immovable assets needs to be determined on a case-by-case basis.  However, there is a good possibility that the fit out is determined not to be permanently affixed to the immovable assets.

With respect to the second category – whether the fit out is ancillary to the movable assets – under the TMK Law, a movable asset is ancillary to an immovable asset when it is integrated with the immovable asset and it serves the immovable asset to generate profits.  The analysis looks at whether the use of the movable asset is ancillary to the immovable assets both in its function (the “Function Test”) and in its value (the “Value Test”).  The Function Test would be satisfied if the movable assets would not be acquired, managed or disposed of unless the primary immovable assets were also acquired, managed or disposed of together with the movable assets.  Applying the Function Test is a fact-specific analysis and the results of the test would vary from case to case.  The Value Test probably would not be satisfied if the value of the movable assets exceeds the value of the immovable assets.  Since the value of the fit out can be easily compared to the value of the land and core and shell, this test should be relatively easy to apply.  Since the value of the fit out can be substantial, there is a chance the fit out would not meet the Value Test, resulting in the fit out not being “ancillary” to the immovable assets.

As mentioned above, Japanese trustees are reluctant to accept the entrustment of those fit out items that are required to be entrusted under the above analysis independently, especially if the immovable assets are not entrusted.  In such case, it may be necessary to form another entity to take title to the fit out.  Such other entity would lease the core and shell from the TMK and install and own title to the fit out, and such entity in turn would lease the core and shell and fit out to end tenants and customers.

Another issue that arises if the TMK cannot entrust certain fit out items and owns direct title to the fit out is whether the TMK can take advantage of certain reductions in registration and acquisition taxes imposed on the acquisition of its immovable assets.  The reduction can be substantial and range from 1% to 3% of the acquisition price for the immovable assets.  To qualify for such reduction in taxes under the TMK Law, the value of the TMK’s immovable assets must comprise at least 75% of the TMK’s total assets.  For most real estate assets, this is not an issue, but the high value of the fit out may cause a TMK to fail to meet the 75% valuation threshold.  Since the tax reduction could be substantial, this is another reason why an investor may choose to use another entity to take title to the fit out. 

If the investor uses a separate entity (a “Master Lessee”) to acquire and hold the fit out, the Master Lessee will typically lease the core and shell from the TMK and in turn sublease the core and shell and lease the fit out to end tenants and customers.  If the Master Lessee receives funding through tokumei kumiai investments,  the Real Estate Syndication Law (fudosan tokutei kyodo jigyo ho) (Law No. 77 of 1994, as amended) (the “RESL”) will apply if the profit from the lease of the immovable assets (the core and shell) is distributed to the TK investor.  Under such circumstances, the RESL requires the Master Lessee to obtain a real estate syndication license or retain a manager that holds such license.  Because the cost and expense of obtaining such license can be substantial (including significant capital requirements and employment of necessary personnel), the more attractive alternative is for the Master Lessee to retain a manager that holds such a license. 

While using a Master Lessee to own the fit out is not fatal for a data center investment, it does add costs and complications for the investor.  Most investors would prefer to avoid additional such cost and complexity, but in some cases it cannot be avoided.