New Organizational Form for Human Capital Power - Discussion on Introducing LLC in Japan -

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1 New Organizational Form for Human Capital Power - Discussion on Introducing LLC in Japan Ministry of Economy, Trade and Industry Industrial Organization Division Organizational forms affect enterprises competitiveness by determining the basic conditions for corporate governance and rules of business activities. The government needs to ensure suitable organizational options to maximize the potential of business. This paper explores the government discussion on introducing a new organizational form, the Limited Liability Company, in Japan to enhance entrepreneurial activities and venture business for economic vitality. 1. Background Since the high economic growth period in the 1960s, the driving forces of Japan s economy had been capital-intensive industries such as steel, chemicals and automobiles. The source of competitive advantage in industry is tangible assets which are represented by large manufacturing fields, big factories, and new machines. Entrepreneurs in industry aim to establish a public company, Kabushiki-Kaisha, so that they can accumulate large amounts of capital from many investors to acquire large, new tangible assets. The Kabushiki-Kaisha is a suitable organizational form for capital-intensive industries. Under the Kabushiki-Kaisha s stable governance with life-time employment and main bank system, managers and employees can build up distinguished tailor-made abilities to exploit tangible assets. Japanese companies competitiveness was heavily dependent on capital and the ability to utilize tangible assets. However, since globalization and the emergence of the knowledge-based economy in the 1990s, the source of competitive advantage has been shifting from tangible assets to intangible assets, which are represented by human capital, intellectual property, and brand equity. Competitors in emerging Asian economies can easily acquire brand-new tangible assets and utilize them with low labor costs. Thus intangible assets, especially human capital with creativity and innovation, are the key factor in differentiating companies from these competitors. During the same period, human capital-intensive industries have been emerging. The information and communication industries, such as software development and media contents development; financial services, such as investment banks and private equity funds; and professional services such as law firms, accounting offices, medical services and education, are becoming the new driving forces of the economy. Not requiring large tangible assets, specialists and professionals organize core staff members and conduct business based on their abilities. In such industries, human capital is the only source of competitive advantage. 1

2 These trend-shifts toward intangible assets and human capital in conventional industries and the emergence of human-capital-intensive industries create major challenges for many managers and entrepreneurs. The Kabushiki-Kaisha system is effective in accumulating a large amount of capital with a centralized governance structure and separation of ownership and administration enforced by law. But such a fixed structure sometimes becomes a major obstacle to building up and facilitating human capital, because separation of ownership and administration tend to hinder the voluntary efforts of managers and employees. Decision-making rules and profit allocation rules are restricted by law and sometimes shareholders interests overrule human capital-holders interests. To deal with this challenge, some managers in Kabushiki-Kaisha established effective incentive measures. Using stock options, profit sharing, welfare programs, and training programs, they are trying to recruit and retain creative core human resources to establish competitive advantage. Some managers seek a stakeholder governance model, merging the traditional Japanese governance model with new management trends. Some managers and entrepreneurs are now focusing on alternative organizational forms. The partnership-type organization, namely Kumiai and Gomei/Goshi-Kaisha (Kumiai with status as a legal entity), which feature solidarity of ownership and administration, are one alternative. The partnership-type organization has a flexible management structure and members can freely determine decision-making and profit allocation rules to utilize voluntary efforts of human capital. The characteristics of partnership - ownership, co-administration, profit-sharing - provide professionals and specialists with major incentives to contribute to the organization. Also, as a pass-through entity, a partnership can avoid double taxation (i.e., at entity level and personal level). With this tax treatment, a partnership can be an attractive organizational option for high-earning professionals. However, partnership-type organizations also have limitations. Kumiai and Gomei/Goshi-Kaisha are required to have at least one general partner who is subject to unlimited liability for the entity s debt and obligations. With this risk, creative human resources might hesitate to establish a partnership. Thus, the government is seeking a hybrid entity between a company and a partnership as a new organizational form for human capital power to enhance business activities in the changing economic environment. The Limited Liability Company (LLC) is the most popular hybrid entity in the United States and should be the model for the new Japanese hybrid entity. 2. Characteristics of LLC The LLC provides equity-holders with the same limited liability protection as a traditional corporation, yet the nature of its management structure as well as the financial relationships among its members are flexible (determined almost entirely by agreement among members) in the same 2

3 manner as in a traditional partnership. LLC has status as a legal entity to hold assets, hire employees, enter into contracts, and incur liabilities as a traditional corporation does, yet it can chose to be taxed as a pass-through entity like a traditional partnership. LLC can provide (1) status as a legal entity, (2) limited liability for all members, (3) flexible management structure, and (4) pass-though taxation within one organizational form. In the United States, the first LLC legislation was introduced by the Wyoming State Government in After the Internal Revenue Service made it clear that properly structured LLCs would be classified as partnerships (pass-through entities) in 1988, adoption of LLC legislation was boosted and all states had introduced LLC legislation by the mid-1990s. During the same period, Limited Liability Partnership (LLP) was introduced as a hybrid entity for professional services. The basic characteristics of LLP are the same as LLC, though LLP members remain personally liable for contracts and debts under their professional responsibilities. LLC and LLP have been leading choices for human-capital-intensive industries in the United States since the mid-1990s. In 2000, nearly a million LLCs were registered, making up 12% of companies. Half are in financial services and the others are in various service sectors and industries including communication and manufacturing. Also, joint ventures which conduct R&D and other special businesses selected LLC as their primary choice of organizational form. Hybrid entities have been introduced not only in the United States. In the United Kingdom, Limited Liability Partnership (LLP) was introduced as a hybrid entity in LLP is used in various business sectors, though the Department of Trade and Industry first planned LLP for the professional service sector. In Germany, GmbH&Co.KG is used as a hybrid entity. It eliminates unlimited liability by amalgamating a company (GmbH as an unlimited liability member) with a partnership-type organization (KG). In France, the SAS was introduced to enhance joint ventures in It has limited liability protection and a flexible management structure and, unlike other hybrid entities, it is subject to corporate taxation. 3. Discussion on introducing LLC To introduce an LLC-type hybrid entity in Japan, discussions on two dimensions are required; establishment of the new entity in organizational legislation and establishment of a new pass-through tax program. Concerning organizational legislation, the key issue for the hybrid entity s base structure is achieving both limited liability protection and a flexible management structure. Although the U.S. and European commercial legislation provides the base structures, current Japanese commercial law does not provide suitable conditions. If the entity has limited liability protection, the management structure is not flexible because commercial law requires a rigid governance structure: a board of directors, an auditor, and fixed decision-making rules such as voting and profit allocation rules so 3

4 that it can protect creditors and shareholders interests. If the entity has a flexible management structure, commercial law requires at least one general partner with unlimited liability for the entity s debt. Since 2003, the Ministry of Justice and its commercial law council have been examining drastic amendment of the commercial law to adopt it to current business needs, with a target date of The new hybrid entity s base structure is suggested in this examination and needs to be realized with reasonable provision for various business considerations. Concerning the pass-through tax program, the current Japanese tax system has limited rules compared to the U.S. and Europe, which have a massive volume of rules on partnership taxation based on abundant experience. Because the Japanese corporate tax system is unique, the government has to examine a new tax system considering practical needs and compliance. For example, the exemption of corporate tax rules for a hybrid entity that meets certain conditions should be discussed. 4. Effect on Japan s economy Introducing an LLC-type hybrid entity will enhance human capital intensive industry in Japan. As in the United States and Europe, the LLC-type hybrid entity will be a primary choice for (1) professional services, (2) start-ups based on human capitals, and (3) joint ventures. The LLC s liability protection and flexible management structure will provide competitive human resources with an attractive organizational form and enhance their activities. Professionals such as lawyers, accountants, management consultants and fund managers are sensitive to liability protection and returns on their contributions. Under current legislation, professionals who consider liability protection important choose Kabushiki-Kaisha, sacrificing return on their abilities because of an inflexible management structure. Professionals who consider returns on contributions important chose Kumiai (partnership), sacrificing liability protection. LLC s liability protection and flexible management structure, which allows for profit-sharing based on human contributions, will provide attractive working condition for professionals. (Currently, lawyers can organize a Bengoshi-Hojin, special company form for lawyers, and accountants can organize special companies, though it is considered that in these special companies liability protection and flexibility of management are insufficient.) Entrepreneurs have usually chosen Kabushiki-Kaisha to start up business because it provides liability protection and reputation (most well-known companies are Kabushiki-Kaisha in Japan. Moreover, trade partners and banks prefer Kabushiki-Kaisha to other organizational forms because it has a stable image.) However, Kabushiki-Kaisha s management structure is too heavy for start-ups with small staff numbers and sometimes it increases operational costs and reduces decision-making speed. And with its tax status as a pass-through entity, founders and business angels 4

5 can aggregate the LLC s initial loss to their own profit to optimize their tax deductions, and can maximize their return by avoiding double taxation in the case of the LLC is making a profit. LLC will be an attractive choice for entrepreneurs with its liability protection and flexible management structure, if it can gain a certain reputation or good image in various sectors. Joint ventures combine companies special abilities to pioneer new business areas. Speedy decision-making and effective profit-sharing mechanisms to increase incentives are required for conducting joint ventures. Under current legislation, however, Kabushiki-Kaisha is the sole choice for companies and its management structure sometimes blocks speedy decision-making and flexible profit allocation. In fact, many companies make special contracts among the joint venture stakeholders to agree on special decision-making and profit allocation rules, although the legal status of such contracts is unstable. LLC s flexible structure will assist speedy decision-making and effective profit-sharing in joint ventures. Also, with tax status as a pass-through entity, an LLC s equity holders can aggregate the LLC s initial loss to their own profit to optimize their tax deductions and avoid double taxation in the case of the LLC is making a profit. Thus, introducing LLC in Japan will enhance human-capital-intensive professional services, promote start-up activities and upgrade industrial structure for economic vitality. Early introduction of LLC is necessary for Japan s human capital power and the necessary discussions should be conducted by various parties. Contact Information: Yoshiaki ISHII Section Chief, Industrial Organization Division, Economic and Industrial Policy Bureau, Ministry of Economy, Trade and Industry tel: , fax:

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