In recent years, a decline in the population, shortage of people who are eligible to take over businesses, an excessively burdensome inheritance tax on shares of private companies, and other issues have been hindering the succession of small and medium sized enterprises (including continuation of businesses through the transfer of rights to the next generation) that form the backbone of the Japanese economy. Nevertheless, by taking advantage of the changes made in the 2018 Japanese tax reform bill, which included changes that facilitate the succession of businesses, private companies are now actively engaging in the planning and execution of the succession of their businesses.
If a proprietor of a company suddenly dies or becomes unable to manage the company without making the necessary preparations for succession of his/her business, a so-called "succession race" may arise, or the successor of the company may face an unexpectedly large amount of taxes. In some cases, these situations decrease the value of the company's business or may even force the company to close entirely, without anyone succeeding the business. In order to avoid such outcomes, proprietors of private companies should always be ready to hand over their businesses to a successor in a timely manner.
Business succession in Japan is governed by the Companies Act, Civil Code (specifically, the part governing inheritance) and the Act on Facilitation of Succession of Management of Small and Medium Sized Enterprises, as well as the tax code. Therefore, careful analysis of legal and tax matters is recommended when preparing for business succession. Otherwise, an unexpected dispute may arise wherein it becomes impossible to obtain stakeholders' consent, or the ideal form for succession of the business may not be possible.
2. Methods of Business Succession
Business succession in Japan generally takes the form of one of three methods: (i) succession by a family member ("Family Succession"), (ii) succession by an internal successor (a company officer) ("Succession by Officer"), and (iii) external succession ("Succession through M&A"). These three methods should always be compared against the final method of (iv) closing the business, liquidating the company and receiving distribution of residual property, although such method is not normally thought of as a type of business succession.
(1) Family Succession and related issues
Family Succession is a method of business succession in which a family member, such as a child of the current proprietor of a company, is gifted or inherits the proprietor's share of the business. This method has been widely used by most private companies.
However, in cases where there are multiple children who could serve as a potential family successor, disputes may arise among them regarding matters such as the effectiveness of the business proprietor's will, infringement of their legally reserved portion of the inheritance, and calculation of a fair market price of the shares to be cashed out based on a demand. Moreover, there may be family members hostile to the business successor, or shareholders other than family members may exist. The more players there are, the more likelihood that disputes will become complicated. In order to avoid such disputes, it is necessary to grasp in advance the relevant legal issues, including current shareholdings, share value (not only the value under the Inheritance Tax Act but also the fair market price under the Companies Act), assets other than shares held by the current proprietor, and availability of the special provision concerning legally reserved portions of inheritance under the Act on Facilitation of Succession of Management of Small and Medium Sized Enterprises, to develop a scheme to prevent unnecessary disputes as much possible, and prepare a will and other necessary documents.
(2) Succession by Officer and related issues
Succession by Officer is a method of business succession by a director or employee of a company who is qualified to serve as a successor.
This method, unlike in the case of Family Succession, does not give rise to disputes among inheritors; however, it is usually pointed out that this method also has disadvantages, including difficulties in fund-raising for the share acquisition, and in terminating joint guarantees provided by the current proprietor due to conflicts of opinion with external shareholders, etc., who do not engage in the business of the company, when such guarantees become an obstacle to the future management of the business.
(3) Succession through M&A and related issues
Succession through M&A is a method of business succession by a person external to the company when a proper successor cannot be found from among family members or within the company. The succession takes place through selling the shares or the business of the company to a third party. Both private companies and public companies adopt this method by using methods such as a tender offer when they intend to initiate a business succession.
In case of Succession through M&A, the negotiation of the price of the business with the purchaser is naturally of paramount importance. It is also necessary to select a scheme that is advantageous under tax laws, depending on the characteristics of the subject company, while mitigating the impact on the business after the succession. Though an increasing number of private companies are engaging in M&A, due care is needed when drafting contracts in order to prevent disputes from arising later regarding a violation of representations and warranties, etc.
The method of Succession through M&A is used both by companies in good-standing as well as promising companies that are currently underperforming. In many cases, excessive debt is, depending on the circumstances, written off by using methods such as out-of-court rearrangement and civil rehabilitation simultaneously with the business succession.
Since Succession through M&A is a method of business succession that has been on the rise recently, it can be said that, for a company that is considering purchasing another company, the reasonable opportunity to engage in a merger is also increasing.
(4) Comparison with Closing the Business
In cases where a company is underperforming regarding its profits and losses, despite a large amount of net assets, heirs who are considering whether to close the business or pursue business succession will tend to find it safer to receive distribution of the company's residual property as shareholders after closing the business and liquidating the company, rather than pursue a business succession. This is because such inheritors can hold abundant cash on hand after the inheritance and can be ready to make payment of inheritance tax.
Of course, there may be cases where choosing to close and liquidate a business is also more financially advantageous. Nonetheless, if an inappropriate method is chosen to close and liquidate the business (including dismissal of employees, sale of assets, and settlement of off-balance-sheet debt), the amount of residual property may be less than expected. Also, if closing and liquidating the business is chosen without considering the difference between the tax rate on a deemed dividend paid as distribution of residual assets and the tax rate for capital gains generated by the shares transferred in an M&A transaction, the inheritors may face a tax disadvantage. For these reasons, before selecting this method, it is advisable to carefully consider all relevant factors.
3. Business Succession and Corporate Rehabilitation
If a company owes excessive financial debt, a potential successor may hesitate to take over the company. It is said this is one of the strongest factors preventing business succession.
In such case, business succession may be considered within the framework of corporate rehabilitation.
In particular, one option available for such heavily indebted company is to improve its balance sheet through the reduction or exemption of financial debt after undergoing out-of-court rearrangement proceedings while conducting business succession. If the reduction or exemption of financial debt is permitted, the liability of the previous proprietor as a guarantor is unprotected and such liability needs to be paid from the personal assets of the previous proprietor. However, in some cases, subject to the consent of financial creditors, the exemption from payment of such liability may be allowed under the Guideline for Guarantee by Proprietors of Small and Medium Enterprises while securing certain assets without undergoing bankruptcy.
Such arrangement will result in a better outcome if planning regarding the structure of business succession starts at an early stage.
The above is a short description of the methods of business succession in Japan and their underlying issues. In advising on a business succession, we render legal advice on a case-by-case basis while collecting and considering a broad range of facts, including the business results of such company, trends in the relevant industry, shareholding, shareholders, and qualities of the successor candidates, among other things.
The lawyers of Oh-Ebashi LPC & Partners have expertise in tax law, corporate law, laws of succession, corporate rehabilitation, etc., and can organize a team that includes external professionals, such as qualified accountants, certified public accountants and M&A consulting firms if required, to offer you a one-stop service to ensure your business succession is successful.