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Introduction

Clients often ask us whether it is possible to structure a Decentralized Autonomous Organization (DAO) in Japan. Currently, Japan does not have regulations targeting DAOs, unlike Wyoming State or the Marshall Islands. So, we have written this article summarizing what is typically considered when forming a DAO in Japan.

1.DAO

1.1 What is DAO?

A decentralized autonomous organization (DAO) is a new legal structure with no central authority and members committed to acting in the organization’s best interests. DAOs are used to make decisions in a bottoms-up management style and have gained popularity among cryptocurrency enthusiasts and blockchain technology.

1.2 Classification of DAOs

There are several classifications of DAO described below:

1.     Investment DAO
 
Investment DAOs are for-profit DAOs aim at co-investing in a project. They are more likely to attract funds than Grant DAOs because they aim to generate profits mainly through “economic capital.”
Examples: Genesis DAO, The LAO, BitDAO, etc.
 
2.     Grant DAO
 
The community contributes monies to the grant pool and votes on funds allocation and distribution decisions in a Grant DAO. Innovative DeFi projects are funded using these DAOs, showing how decentralized communities are more flexible with funding than traditional organizations.
Examples: MolochDAO, MetaCarteDAO, Aave Protocol, Uniswap Grants, etc.
 
3.     Protocol DAO
 
When tokens serve as a voting metric for implementing any changes in the protocol, such a governance structure represents protocol DAOs. For instance, MakerDAO has revolutionized the DeFi space with its DAI stablecoin.
Examples: Maker, Compound, Uniswap, Aave, Yearn, Sushi, etc.
 
4.     Service DAO
 
A Service DAO is a decentralized working group. They can receive tokens as compensation for their projects.
Examples: RAID GUILD, DXdao, PartyDAO, etc…
 
5.     Social DAO
 
A Social DAO offers digital democracy where opinions are heard, and people can share common interests.
Example: Bored Apes (BAYC)
 
6.     Collector DAO
 
Artists who use nonfungible tokens (NFTs) to create art rely upon collector DAOs to establish ownership of their art.
Example: PleasrDAO
 
7.     Media DAO
 
Media DAOs allow product owners of content (i.e., readers) to contribute directly without involving advertisers for the native token as a reward in return for their contributions.
Example: Fore Front (FF), Bankless DAO, etc…

Source https://cointelegraph.com/daos-for-beginners/types-of-daos

1.3. Example of an Existing Overseas Law

A few places where DAOs are regulated are Wyoming State and the Marshall Islands. Below is a short description of forming a DAO in the Marshall Islands.

The Legal Form of a DAO on the Marshall Islands

Marshall Islands proposes a non-profit corporation (limited liability company) as a legal entity form for DAO, which stands out from the general practice to establish DAO as a foundation. Such a company is established in compliance with the general corporate law of the Marshall Islands with specific features that:
  • No part of the income or profit of the corporation is distributable to its members, directors, or officers; and
  • Members’ ownership of such a company may be defined in such a plain document as the register of members AND in the company’s smart contract.
  • You must clearly state the company’s purpose and connect it to the non-profit activity. The purpose will be furtherly indicated in the Certificate of Incorporation.

How does this work?

Generally speaking, such a company works as a limited liability company managed by its members. It has three essential constitutional documents: Certificate of Incorporation, Operating Agreement, and Charter of the Company.
The Operating Agreement should include the most crucial matters of your DAO management:
  • additional governing bodies;
  • voting and counting of votes of such governing bodies;
  • amendment of a smart contract;
  • creation and management of treasury.

You can amend any of these matters by the members’ decision in compliance with the procedure prescribed in the previous version of the Operating Agreement. 

Registering a Marshall Islands LLC for DAO


Here’s what the process of establishing a legal wrapper for DAO on the Marshall Islands looks like: 
  • You start by clearly defining the name and purpose of your DAO. Once again, the purpose of your DAO should indicate the non-profit element;
  • At least three founding members draft the Operating Agreement (you may amend the Operating Agreement at any time upon establishment of the company; therefore, it is a common practice to use the template at the first stage to speed up the process);
  • The founding members should pass the KYC process with the local regulator. Apart from the founders, anyone who holds 10% or more governance rights over the company must pass the KYC process
  • The founding members sign the drafted Operating Agreement, Certificate of Incorporation, and Foreign Business Investment License form and file these documents with the regulator;
  • If everything is alright with the documents, the regulator sends the Charter of the limited liability company to the founders.

The above is a reference from Taras Zharan Web 3 Virtual Legal Officer.

 https://legalnodes.com/article/marshall-islands-llc-as-a-dao-legal-wrapper

2. Financial Regulations on DAOs

2.1. Points to Consider

When structuring a DAO, one must consider the financial regulations and the legal form characteristics.

Here are several points to keep in mind:

1. Security regulation under the Financial Instrument and Exchange Act (“FIEA”) may apply when tokens have the possibility of dividends or redemption of the principal of more than 100% (dividends and redemption of the principal of more than 100% are from now on collectively referred to as “dividends, etc.”). As a general rule, token sales of such DAO must be conducted by a Type 1 Financial Instrument and Exchange Business Operator (“Type I license”) or by obtaining a Type 2 Financial Instrument Exchange Business Operator license (“Type II license”).

2. When selling Fungible Tokens without dividends, etc., it is necessary to have a Crypto Asset Exchange Operator conduct the sale or to obtain a Crypto Asset Exchange Operator license.

In contrast, these financial regulations generally do not apply when selling NFTs without dividends, etc.

3. You also need to consider the tax benefits. If you want to pursue tax advantages in an Investment DAO with dividends, etc., you can use a partnership or GK-TK scheme. If tax advantages are not particularly important, an association without rights, a general incorporated association, or a limited liability company can be considered a scheme to issue tokens. For the issuance of Fungible tokens or NFTs without dividends, etc., it may be better to have no particular legal structure.

2.2. Reference Table of Conclusions

The table below summarizes the legal scheme and financial regulations that should be considered in establishing a DAO.

The following regulations apply to token sales of Investment DAOs with dividends, etc. (assuming dividends or principal redemption of more than 100%).

Type of Member’s Rights Form under Japanese Law Free distribution of Tokens Token Sale Investment Management
DAO member’s rights as shareholders’ rights in Limited Liability Companies and Joint-stock Companies Tokenization of shareholders’ rights of limited liability companies, etc. Free distribution of the shareholders’ rights is not allowed under corporate law, etc.

Sales by a third party for an issuer need a Type I license. A Type II license is necessary for the self-offering of a limited liability company. No license is required in the case of self-offering of a joint-stock company.

In the case of solicitation of 50 or more people, there needs to be a submission of a registration statement regarding securities, etc.

No regulation
DAO member’s rights (with dividends), not including shareholders’ rights TK investment, partnership investment, tokenization of rights that are difficult to classify into prescribed legal forms, etc. Unregulated

Sales by a third party for an issuer need a Type I license.

Self-offering needs a Type II license.

In the case of solicitation of 50 or more people, there needs to be a submission of a registration statement regarding securities, etc.

No regulation

(Possibility of Investment Management Business license in the case of securities investment)

On the other hand, a DAO without dividends, etc., is also possible. Its regulations are as follows:

Tokens/NFT Free Token Distribution Sale of Tokens Investment Management(Assuming no dividend)
Utility Tokens No regulation Crypto Asset Exchange Business regulation No regulation
NFT No regulation No regulation No regulation

With respect to possible legal forms for DAOs, the following comparisons can be made:

Status Legal Form Limited Liability Is it possible to distribute? Avoid Double Taxation Others, Comprehensive Evaluation
No Legal Entity Status Association without rights +Tokens with unclear rights 〇? ×

△~〇 High degree of freedom. A good scheme if there is no problem with double taxation.

Civil Law Partnership + Partnership Equity Token ×

△~〇 High degree of freedom. A good scheme if there is no problem with limited liability.

Investment Business Limited Liability Partnership + partnership Equity Token

× Although other points are reasonable, there are restrictions on investment destinations and businesses, such as not being able to purchase NFTs. It’s usually hard to use this scheme as DAO.

Limited Liability Partnership + Partnership Equity Token

× There are valid points; however, to use as a DAO is problematic because of the need to register the name of the union member.

DAO has Legal Entity Status

Corporation (*1) + Tokenization of Anonymous Partnership (e.g., TK-GK scheme)

△ It is necessary to operate in accordance with the Companies Act and the General Incorporated Associations Act. It should be noted that TK holders do not have the right to instruction. The good point is that there is no double taxation and limited liability.

Corporation (*1) + Token with unknown rights

〇?  〇 × △ ~ 〇 It is necessary to operate under the Companies Act and the General Incorporated Associations Act. Besides that, it has a high degree of freedom and is a good scheme if you don’t mind the double taxation problem.

Corporations (*1) + Tokenization of shareholders rights (*2)

 〇  〇(× For general incorporated associations) ×

× Is there a low degree of freedom due to the need to operate per the Companies Act and the General Incorporated Associations Act? For example, it is necessary to manage members as shareholders.

*1 Legal entities include limited liability companies, stock companies, and general incorporated associations. LLCs are generally easier to establish and operate than joint-stock companies. If you want to have a more public image, use a general incorporated association.
*2 Membership rights of a limited liability company, stocks of a stock company, membership rights of a general incorporated association.

2.3 Tokenization of Rights

Tokenization of rights of funds or partnership, where there is an investment of funds (including money and crypto assets), investment management, dividends, or redemption of the principal of more than 100%, would be broadly considered a collective investment scheme (fund) under Japanese law. Below is the summary of the Definition of a Collective Investment Scheme.

Summary of Definition of Collective Investment Scheme
Rights that satisfy the following (i) to (iv)
(i) Rights under a partnership agreement as defined in Article 667(1) of the Civil Code, a silent partnership agreement as defined in Article 535 of the Commercial Code, an investment limited partnership agreement as defined in Article 3(1) of the Act on Limited Liability Partnership Agreement for Investment Business, or a limited liability partnership agreement as defined in Article 3(1) of the Act on Limited Liability Partnership Agreement for Investment
(ii) The existence of a business (the “Invested Business”) in which money (including cryptographic assets) contributed or contributed by the person who has such rights (the “Investor”) is allocated to the Invested Business;
(iii) The investors are entitled to receive dividends of profit generated from the invested business or distribution of assets related to the invested business;
(iv) There are no exceptional circumstances, such as all investors being constantly involved in the business.

The revised Financial Instruments and Exchange Act, which came into effect on May 1, 2020, created the legal concept of Electronic Record Transfer Rights. The rights of tokenized collective investment schemes usually fall under the Electronic Record Transfer Rights below.

Outline of Definition of Electronically Recorded Transfer Rights
Rights that satisfy the following (i) to (iii) but exclude (iv) (Article 2, Paragraph 3 of the FIEA):
(i) Rights listed in each item of Article 2, Paragraph 2 of the FIEA (funds, trust beneficiary rights, members’ rights of general partnerships, limited partnerships, limited liability partnerships, etc.);
(ii) When they are expressed in property values that can be transferred through an electronic data processing system;
(iii) When recorded in electronic devices or other objects by electronic means;
(iv) Cases provided in the Cabinet Office Ordinance have considered the nature of distribution and other circumstances.

The sale of this electronic record transfer right requires a Type 1 Financial Business registration. If soliciting more than 50 people, it will be a public offering (Article 2, Paragraph 3 of the Financial Instruments and Exchange Act), and a securities registration statement must be submitted based on Article 5 of the FIEA.

If the sale is limited to qualified institutional investors or wealthy people of 49 or less, and even if there is resale, there are technical restrictions so that other people cannot become DAO token holders.

When the Investment DAO is formed, it can be sold in such a limited form at first, and after it grows, it can be sold to the general public while complying with increased regulations.

2.4 Tokenization of Company Membership Rights and Financial Registration Regulations

Regarding tokenization of company membership rights, a Type I FIBO license is necessary when a third party sells the rights, and Type II is essential in the case of self-solicitation. In the case of tokenization of company membership rights (shareholders rights) of a joint stock company, a Type I license is necessary in the case of solicitation by a third party, and no license is required in the case of self-solicitation.

2.5 Regulations on Public Offerings, etc.

 If any of the following applies, it becomes a public offering. In principle, it is necessary to submit a securities registration statement.

(i) When soliciting the acquisition of securities from 50 or more persons (excluding Qualified Institutional Investors (QII) in the case there are restrictions on resale other than QII);

(ii) When it does not fall under any of the following categories: Private Placement for QII, Private Placement for Professional Investors, and Private Placement for Small Groups.

2.6 Financial Regulations for DAOs without Dividends

If DAOs have no dividends, etc., they are not considered securities, but different financial regulations may apply.

Tokens/NFTs Free token distribution Token Sales Investment Management (Assumption without dividends)
Utility Tokens Unregulated Crypto Asset Exchange Business License Unregulated
NFTs Unregulated Unregulated Unregulated

Disclaimer

The content of this article has not been confirmed by the relevant authorities or organizations mentioned in the article but merely reflects a reasonable interpretation of their statements. The interpretation of the laws and regulations reflects our current understanding and may therefore change in the future. This article does not recommend investment in DAO. This article provides merely a summary for discussion purposes. If you need legal advice on a specific topic, please feel free to contact us.

Ⅰ. Introduction

We posted (1) an article titled “Crypto Fund“( in Japanese) on 1 June, 2018, and (2) an article titled “Funds Regulations in Japan” on 30 June, 2020.

In 2021 and 2022, we received many inquiries regarding setting up crypto funds. Considering (i) the amendments in 2020 to the Payment Services Act(PSA), (ii) the rise of NFT, DeFi, and stablecoins, and (iii) changes to the taxation of crypto assets,  we therefore are updating  (1) the article titled “Crypto Fund.”

In general, the term “crypto fund” can be used in a variety of ways, such as where (i) the fund’s financial source is crypto assets which include Bitcoin and Ether, (ii) the fund’s investment targets are crypto assets or crypto related businesses for instance BTC, ETH, SAFT, ICO tokens, NFT, stablecoins, security tokens, DeFi, and stocks of crypto related companies, and (iii) the investor’s rights are tokenized.

Therefore, the following is an overview of the regulations that apply to each type of structure.

Since this article focuses on crypto funds, other kinds of funds (investment in fiat currency and securities management) are not mention in this article, except in section VIII.1. For regulations on other kinds of funds, please refer to (2) the above article titled “Funds Regulations in Japan. “

Ⅱ. Regulations on Fund Raising

1. Regulations on Fund Raising in Fiat Currency

Under the Financial Instruments and Exchange Act (FIEA), soliciting investments in money (fiat currency), using it to conduct business, and distributing the proceeds from the business falls under a collective investment scheme (Article 2(2)(v) of the FIEA).

Soliciting investments in a collective investment scheme (public offering or private placement, Article 2(8)(vii)(f)) falls under the Type II Financial Instruments Business (Type II FIB) (Article 28(2)(i) of the FIEA) in principle, and public offering or private placement is not allowed without registration as a Type II Financial Instruments Business Operator (FIBO) (Article 29 of the FIEA). This is also the case for crypto funds where the means of fundraising is money, and the investment targets are crypto assets.

There are some exceptions to this fund regulation under the FIEA, such as (i) cases where the fund completely outsources the solicitation to another Type II FIBO and does not solicit any acquisitions on its own, (ii) cases where the fund uses the exemption so called Specially Permitted Businesses for Qualified Institutional Investor (QII) (Article 63 of the FIEA) (Article 63 Exemption or QII etc. Exemption), and (iii) cases where the fund is more than 50% funded by overseas investors and the domestic investors are limited to certain investors such as QII (Overseas Investors Exemption)( Article 63-8 of the FIEA).

Whether or not the issuer does not conduct any solicitation for acquisition is determined by the circumstances in each case. Solicitation for acquisition refers to the solicitation of an application to acquire newly issued securities and similar activities (Article 2, Paragraph 3 of the FIEA). Solicitation is generally understood to be an act that attracts and encourages investors to acquire a particular security, whether in writing, verbally or through advertising.

Specially Permitted Businesses for QII is an exemption that allows a fund manager to engage in fund services by making a simple notification to the Financial Services Agency (FSA) when all investors in the fund are QII or when the investors include one or more QII and 49 or fewer persons who are expected to have certain investment abilities. However, that exemption has been subject to tighter regulations under the 2015 amendment to the FIEA. Before the amendments, the scope of 49 or fewer investors included general individual investors. It should be noted that after the amendment, individual investors whose total amount of investable financial assets (referring to securities, etc., but not including crypto assets) is 100 million yen or more and who have been in a security account for one year would be able to invest.

2. Regulations on Fund Raising in Crypto Assets

Until the amendment of the FIEA in 2020, soliciting investments in funds with crypto assets was not subject to the FIEA regulation. However, due to the amendment, crypto assets are now considered as money equivalent in relation to fundraising (Article 2-2 of the FIEA). Fund raising with crypto assets is now subject to the same regulations as fund raising with money.

(Summary of Regulations on Fund Raising )

  General Registration Requirements Exceptions
When Completely Outsourced to a Third Party

Article 63 Exemption

(QII etc. Exemption)

Overseas Investor’s Exemption
Sales by Issuer Type II FIBO
Registration

N/A
(for the third party, Type II FIBO

registration)

Available Available
Sales by Third Party (on behalf of the issuers) Type II FIBO
Registration

N/A
if sales activities are sub-delegated to a registered third party

(rarely the case)

N/A
Type II FIBO
Registration

N/A
Type II FIBO
Registration

Ⅲ. Regulations on Investment Management of Funds

1. Regulations When Investments are Primarily in Securities or Derivatives

With respect to funds the term investment management business is understood as the management of money or other property invested by a person connected with investments primarily in securities or derivatives which are based on investment decisions requiring the valuation and analysis of such instruments. In this context, “primarily” means that generally more than 50% of the assets under management are invested in securities or derivatives. To conduct an investment management business, a company must register as an Investment Management Business Operator (Article 28(4) of the FIEA). Similar to Type II FIBO, persons engaging in the investment management business must meet certain criteria, including minimum capital requirements and hiring proper personnel (e.g. a compliance officer with eligible knowledge and experience) for operating the business.

The securities include stocks as well as general security tokens. In order to avoid this regulation, it is necessary to set a limit on the investment objectives to the effect that no more than 50% of the investment should be in securities or derivatives. Similar to the above II.1, there are some exemptions. For example, registration as an investment management business is not required if (i) the fund meets requirements such as full outsourcing of management to other investment management companies, (ii) the fund is conducted as Article 63 Exemptions, or (iii) the fund is set up in a foreign country and investment from Japan is limited.

2. Regulations When Investments are Primarily in Crypto Assets

If the investment target is mainly crypto assets, the FIEA does not apply to the management. Since the management of crypto assets is for investment purposes and not for business purposes, the PSA does also not apply. When investing in NFT, SAFT, DeFi, stablecoins, the FIEA and the PSA do not apply to the management, as it does when investing in crypto assets.

(Summary of Regulations on Investment Management)

  General Registration Requirements Exceptions
When Completely Outsourced to a Third Party Article 63 Exemption (QII etc. Exemption) Foreign Funds that Meet Certain Requirements

Management of Funds that Invest +50% in Securities by GP

Registration of GP as Investment Management Business Operator N/A
(For the third party, Investment Management Business Operator Registration)
Available No registration required

Management of Funds that Invest +50% in Securities by Third Party

Third party must register as Investment Management Business Operator N/A
If management activities are sub-delegated to a registered third party
(rarely the case)

N/A

Third party must register as Investment Management Business Operator Registration
N/A
Third party must register as an Investment Management Business Operator registration

Management of Other Funds (incl. crypto assets)

N/A N/A N/A N/A

 

Ⅳ. Regulations on the Content of Investors’ Rights

1. Regulations on the Distribution of Money and Crypto Assets

A fund is generally set up by using a silent partnership agreement, a limited partnership agreement, or an overseas partnership agreement (collectively, partnership agreement), and investors have rights under such partnership agreement. In a crypto fund, it is assumed that there are cases where (1) the fund’s investment is solicited in crypto assets and then dividends or principal redemption in money, (2) the fund’s investment is solicited in money and then dividends or principal redemption in crypto assets, and (3) the fund’s investment is solicited in crypto assets and then dividends or principal redemption in crypto assets.

Since the transfer of the crypto assets is not a sale or exchange thereof, we believe that the PSA does not apply except in cases of legal evasions, such as formally soliciting investment in a fund with money and immediately redeeming the principal with crypto assets.

2. Regulations on the Tokenized Interest

With the 2020 revision of the FIEA the concept of Electronically Recorded Transfer Rights (ERTR)

were introduced. Article 2(3) of the FIEA defines ERTR as follows:

“Electronic Recorded Transfer Right” are rights that fulfill all requirements from (1) to (3)
and do not fall under (4):
(1) Rights listed in Article 2(2) of the FIEA (funds, beneficial interest in a trust, membership rights of general partnership company, etc.)
(2) which are recorded electronically, and
(3) may be transferred by using an electronic data processing system.
(4) Cases specified by Cabinet Office Ordinance taking into account the liquidity constraints and other circumstances.

Some crypto funds may also consider tokenizing their rights. Interests in a fund which are tokenized are generally considered ERTR. Given their (potentially) increased liquidity they are subject to the same regulations as more liquid Type I Securities. Third parties engaging in the sale of tokenized interests must therefore register as Type I FIBO (Article 28 (1) (i), Article 2 (8) (ix) of the FIEA).

The self-solicitation of tokenized interests by a fund is subject to the same registration requirements as the self-solicitation of funds in general. A fund must therefore register as a Type II FIBO and, if ≥50% of the money is invested in securities or derivatives, as an Investment Management Business Operator, unless an exemption applies. The QII exemption 1 and the exemption in case of entrustment of all sales and investment activities to third parties also apply to tokenized funds.

For more detailed information on security token offerings (STOs), please click here.

(Business Regulations and Notifications Requirements under the FIEA for the Sale and Management of Tokenized Funds)

 

General Registration Requirements

Exceptions

When Completely Outsourced to a Third Party

Article 63 Exemption (QII etc. Exemption)

Foreign Funds that Meet Certain Requirements

Sales
Sales by Issuer Type II FIBO
registration

N/A
(for the third party, Type II FIBO

registration)
Available Available
  Type I FIBO
registration

N/A
If sales activities are sub-delegated to a registered third party

(rarely the case)
N/A
Type I FIBO
registration

N/A
Type I FIBO
registration

Investment Management

Management of Funds that Invest +50% in Securities by GP

Registration of GP as Investment Management Business Operator

N/A
(for the third party, Investment Management Business Operator registration

Available

No registration required

Management of Funds that Invest +50% in Securities by Third Party

Third party must Register as Investment Management Business Operator

N/A
If management activities are sub-delegated to a registered third party
(rarely the case)

N/A
Third party must register as Investment Management Business Operator Registration

N/A
Third party must register as Investment Management Business Operator registration

Management of Other Funds (incl. crypto assets) N/A

N/A

N/A N/A

Ⅴ. Disclosure Regulations

Since ERTR are generally subject to the same regulations as Type I Securities, disclosure requirements apply if investors’ rights are tokenized. An issuer of ERTR is therefore obliged to prepare a prospectus (Article 13 (1) of the FIEA) and to register the offering with the FSA (Article 4 (1)). In addition to the initial disclosure, ongoing disclosure requirements apply (Article 24). Something different only applies in the case of private placements. These are placements with QII, professional investors or a small number of investors (≤ 50 investors) only.
If investors’ rights are not tokenized, disclosure requirements apply to public offerings of type II securities, which fall under the category of Rights in Securities Investment Business, etc. (Article 3 (iii) (a)) that mainly invest in securities. In the case of Type II Securities, if the number of holders is less than 500 in response to a solicitation for acquisition, it does not fall under public offerings (Article 2 (3) (iii) and Article 1-7-2 of the FIEA Enforcement Order), and disclosure requirements do not apply.


(Disclosure Regulations)

Type of
Securities
Type of Solicitation Investors Obligation to Disclose
Type I
Securities

Private
placement

Private

placement with

QII only*

QII only Notification of specific matters
(Article 23-13 (4) of the FIEA,
Article 20 (1) of the Cabinet Order on Disclosure of Regulated Securities)

Private

placement to a

small number of

investors*
≤49 investors

Private

placement to

specified

investors*

Specified

investors only
N/A
Public offerings Unlimited
number of
investors

Securities registration statement **

(continuing disclosure of semiannual

reports, extraordinary reports, etc.)

Type II
Securities

Private placement

≤499 investors N/A

Public offerings

Unlimited
number of
investors

Generally not applicable

Rights in Securities Investment
Business, etc. are regulated

* Technical measures must have been taken to restrict resale.
** When the total issue price is less than JPY 100 million the obligation to file a securities registration statement does not apply (Article 4(1)(v) of the FIEA).

Ⅵ. Fund Scheme

1. Fund Scheme if Investing in Crypto Assets

Funds are generally structured using various types of partnership agreements. In Japan, investment Limited Liability Partnership (LLP) agreements are often used to set up PE funds and VC funds, etc. However, LLP is legally only allowed to engage in certain businesses (Article 3 (1) of the Act on LLP), and it does not include the acquisition and holding of crypto assets or stablecoins. Therefore, if the investment target is crypto assets or stablecoins, LLP cannot be used, and silent partnership agreements should be considered2.

2. Fund Scheme if Investors Rights are Tokenized

Suppose a fund tokenizes rights under a partnership-type agreement and transfers the token to investors. In that case, it seems necessary to consider whether simply tokenizing existing rights on the agreement will work properly.
For example, the following issues should be considered:

Ⅶ. Supplement

1. Investment in Crypto-Related or Blockchain-Related Companies

Funds that are financed in cash and invest primarily in shares of crypto-related or blockchain-related companies are sometimes called crypto-related funds.
As a fund that invests primarily in securities, such as this fund is, in principle, required to be registered as a Type II FIBO for its public offering or private placement and as an investment management business operator for its management (refer to II1. and III1.).

2. Management of Own Funds

When a company launches an “in-house fund” to invest its own funds in shares of crypto-related or blockchain-related companies, it may also be called crypto-related funds.
However, this does not fall under “investment of money or other properties invested or contributed from a person who holds the following rights or other rights specified by the Cabinet Order” (Article 2 (8) (xv) of the FIEA), so fund regulations under the FIEA do not apply.

3. Tax Issues of Crypto Funds

We are not experts in tax issues, but we describe here for your reference since tax issues are often a significant issue when setting up a crypto fund.4
If a company owns actively traded crypto assets in Japan, it is taxed at market value at the end of the term (so-called unrealized gains tax).
When a crypto fund is set up with TK-GK scheme, the silent partnership investors are not considered to own the assets, but GK is deemed to own, and therefore, in principle, unrealized gains are taxed in GK. However, if such unrealized gains are distributed to investors based on the silent partnership agreement, GK will not be taxed on that portion (effectively pass-through), while the portion equivalent to such gains will be treated as income of the investors (both individual and corporate investors).

When a crypto fund is set up with an overseas partnership, it is taxed as if investors themselves own assets of the fund (pass-through). Therefore, corporate investors of the overseas partnership are subject to unrealized gains tax.

Unrealized gains tax might be avoided by using a scheme in which a company is set up in a foreign country that does not tax unrealized gains and Japanese investors invest in the company as a silent partnership, and then unrealized gains are not allocated to the investors. However, it is necessary to consider Anti-Tax Haven Rules when using this scheme. If the overseas company’s shareholders are domestic companies or domestic individuals, the overseas company may be deemed to be a paper company or not meet the economic activity standards, and income of the overseas company might be deemed as income of the shareholders.

Therefore, you should consider the following factors and consult with legal and tax professionals to structure a crypto fund.

Scheme Unrealized Gains
Taxation on SPV
Unrealized Gains Taxation
on Corporate LP
Unrealized Gains Taxation
on Individual LP
Taxation on Shareholders of SPV
TK-GK

Taxed on GK
(if unrealized gains are distributed, GK will not be taxed)

Taxed if it is distributed Taxed if it is distributed N/A
(in principle)

Overseas
Partnership

N/A
(depending on country)

Taxed N/A N/A
(depending on country)
TK-Overseas
Company
N/A
(depending on country)
N/A
(in principle)
N/A
(in principle)
Anti-Tax Haven Rules may apply

Disclaimer

The content of this article has not been confirmed by the relevant authorities or organizations mentioned in the article but merely reflects a reasonable interpretation of their statements. The interpretation of the laws and regulations reflects our current understanding and may therefore change in the future. This article does not recommend the investment in crypto funds. This article provides merely a summary for discussion purposes. If you need legal advice on a specific topic, please feel free to contact us.

Non-fungible tokens (NFT) have been a topic in the Japanese crypto industry since early 2018. With the NFT craze in 2021, they have become increasingly popular and seen more mainstream adoption. It does, therefore, not come as a surprise that the Japan Cryptocurrency Business Association (JCBA) and Blockchain Contents Association (BCA), as two of the leading industry associations in Japan, issued NFT guidelines more recently.

In this article, we are taking a closer look at the state of the Japanese NFT market and the legal and regulatory environment for NFTs while considering the JCBA and the BCA guidelines.

JCBA NFT-guidelines (April 2021, written in Japanese)
https://cryptocurrency-association.org/dl/nft_guideline202104.pdf

BCA NFT-guidelines (2nd edition) (December 2020, written in Japanese)
https://eb3d626b-4b51-42f2-b2d4-0f682cc5645e.filesusr.com/ugd/e9a87a_2028e5c7115d4fcd933e9f55e6262762.pdf
We have been advising leading blockchain gaming companies on NFTs and other NFT-related matters since early 2018.
In case you are looking for more information on blockchain games and crypto art, you might find the following two articles interesting.

Blockchain Games and the Japanese Law (November 2018, written in Japanese)
https://innovationlaw.jp/blockchain-games-under-japanese-laws/

Buyer Beware – Digital Art and Non-Fungible Tokens (NFT)
https://innovationlaw.jp/en/buyer-beware-digital-art-and-non-fungible-tokens-nft/

I. The State of the Japanese NFT Market

1. Blockchain Games

Traditionally, items purchased in a game could only be used within the game and not be transferred to other players. This has changed with blockchain games, where game items are represented by NFTs. By allowing players to control the NFTs, they become able to buy, sell, exchange, and lend items represented by NFTs to other players – even outside of the game. According to the JCBA, the use of NFTs further ensures that the game assets do not disappear after the termination of the game. What is most likely meant is that the NFT does not cease to exist. Yet, it may lose its value as the represented asset might not be used anymore due to the termination of the game.
Popular blockchain games on the Japanese market include My Crypto Heroes, Crypto Spells, and Contract Servant.

Traditional online games Blockchain games
  1. In-game items do not exist outside of the game and can generally not be transferred, sold, or lent freely to other players outside the game.
  2. Game assets accumulated over time become unavailable and useless after the game is terminated.
  1. Users may transfer, sell, or lend game assets represented by NFTs to other players of the game (Game Assets).
  2. Third parties can provide services using tokens.
  3. As long as a blockchain exists, NFTs representing digital assets are permanently available.

Source: JCBA Guideline, page 4.

(1) My Crypto Heroes
My Crypto Heroes by double jump.tokyo was released in November 2018. The game is an RPG in which players can gather, build their character, and win items by completing challenges and fighting enemies. Both heroes and items are represented by NFTs and can be freely transferred peer-to-peer or traded on NFT markets.

My Crypto Heroes fast became the world’s number one blockchain game and still has the highest number of (active) users and transactions.

(2) Crypto Spells
Crypto Spells by Crypto Games is a card game in which players use cards represented by NFTs to fight with the computer and other players. There are several ways to acquire new cards, including battles and trading/exchanging them with other players within and outside the game.

(3) Contract Servant
Contract Servant by Axel Mark is a card game in which players have a deck of eight cards (servants). There are two types of servants – common servants and token servants, where the token servant is issued as an NFT. The tokens can then be traded among players through a market function. Players are further able to earn rewards from league battles each week.

(4) Other Notable Games
Other notable blockchain games in Japan are Crypton, Crypton Racing, and Brave Frontier Heroes. Further, double jump.toyko launched MCH+, a blockchain game development program that is based on the knowledge gained from My Crypto Heroes.

2. Crypto Art

In February 2021, Christies sold a Beeple artwork for JPY 7.5 billion. The artwork itself is stored on the InterPlanetary File System (IPFS) and represented by an NFT on the Ethereum blockchain. In Japan, a number of crypto art related services have been launched more recently. The major platforms are nanakusa, NFT Studio, and Token Link.

(1) nanakusa
In March 2021, Smart App released nanakusa – a marketplace for crypto art. nanakusa allows crypto artists to mint NFTs and sell crypto art via the platform. Purchasers of crypto art may further sell artworks – or more precisely, the NFT representing the artwork – via the trading platforms. From the information provided, it seems that royalties are paid to the crypto artists for all secondary sales.

(2) NFT Studio
In March 2021, CryptoGames released NFT studio. The platform allows artists to mint NFTs on Ethereum and Polygon for their crypto art. Similar to nanakusa, NFT studio includes features that allow artists to participate in the price for secondary sales.

(3) TOKEN LINK
In January 2021, Platinum Egg released Token Link, an NFT market for game items. Only a few months later, in April, Platinum Egg implemented an auction mechanism for crypto art.

3. NFT Market

(1) Coincheck NFT Market
In March 2021, Coincheck, the operator of one of the largest crypto exchanges in Japan, launched an NFT market. Currently, the only NFTs listed on the market are from Crypto Spells and The Sandbox. More NFTs will be listed in the future. The company has 2 million active users and hundreds of billions of yen in crypto assets under custody. As such, Coincheck will be an important partner for content providers and a gateway to the Japanese market for foreign projects.

When applying for listing, from our experience, projects must provide Coincheck with information about the blockchain used, the primary sale, IP content, and, where applicable, transaction volumes on other markets. As Coincheck is a member of the JCBA and a head of the NFT committee of the JCBA, it is also valuable to check JCBA guidelines in more detail.

(2) Participation by Major Companies
While Coincheck’s NFT market is the first of its kind in Japan, other major companies, including Mercari[1], LINE[2] and GMO Internet group[3] have announced that they are considering launching their NFT market. The entry of other major players is a clear sign that NFTs are gaining increasing mainstream traction on the Japanese market.

II. NFT Guidelines of Japanese Organizations

Currently, there are no laws and regulations that specifically deal with NFTs. Depending on their design, NFTs may, however, fall under the definition of crypto assets, prepaid payment instruments, or money orders under the Payment Services Act (PSA) or the Banking Act or constitute securities within the meaning of the Financial Instruments and Exchange Act (FIEA). Whether this is the case must be analyzed on a case-by-case basis. The guidelines prepared by the JCBA and the BCA aim to provide some more clarity in this regard.

(1) JCBA guidelines
The JCBA is one of the leading industry associations in Japan. Its members range from crypto-asset exchanges to other crypto asset service providers. The NFT committee of the JCBA issued NFT guidelines on April 26, 2021. The guidelines are meant to provide local and foreign NFT issuers with more clarity when applying for a listing on a Japanese NFT market.

Matters covered by the JCBA guidelines
(1) Use cases of NFTs
(2) Flowchart for determining whether NFTS fall under existing laws and regulations
(3) Profit-sharing arrangements
(4) Settlement
(5) Gambling
(6) Premiums and Representations Act
(7) Anonymity and privacy
(8) Security
(9) User protection
(10) Handling of new NFTs (type of NFT that requires careful handling)

The following chart provides a good overview of the key considerations when determining the legal and regulatory environment for NFTs.

Source: JCBA Guideline page 5.

In the case of blockchain games, it is also necessary to consider gambling laws. According to Japanese criminal law, gambling is a criminal offense. It is defined as a game of chance where players can win monetary prizes, except for small gifts. While the definition is rather blurry, NFT issuers implementing mechanics similar to gatcha should consider gambling regulations carefully.

Blockchain games that include incentives for users, such as the free issuance of NFTs, must further comply with the Premiums and Representations Act. The Premiums and Representations Act regulates the free provision of goods and services by a business which aims to induce potential customers to buy the business’s products or services.

The Premiums and Representations Act stipulates limits for lotteries, competitions, etc. While the total amount differs, the following limits must generally be considered for lotteries and other competitions.

  Description Examples The maximum amount of premiums
Premiums (general) Premiums that are offered to anyone visiting a shop or anyone purchasing goods or services. Gifts to all purchasers, gifts to all visitors, etc. (1) If the transaction price is less than JPY 1,000, the premium must not exceed JPY 200.

(2) If the transaction price is JPY 1,000 or more, the premium must not exceed 2/10 of the total transaction price.
Premiums and prices (game of luck and game of skill) Premiums that are given to users as prices in a game of chance or skill. Lotteries at the store.
Quiz games and other games
(1) If the transaction value is less than JPY 5,000, the maximum amount of the prize must not exceed 20x the transaction value.

(2) If the transaction value is JPY 5,000 or more, the maximum amount of the prize must not exceed JPY 100,000.

※Both are capped at 2% of the total transaction value.

Source: Prepared by our office based on the Consumer Affairs Agency website, etc.

The JCBA guidelines further provide that NFT issuers should implement measures that prevent users from using NFTs for money laundering and terrorist financing; consider security risks for storing NFTs and implement measures to deal with thefts or losses; properly explain to users that there is the risk that the NFT might become worthless if the service is terminated; and consider that NFTs are highly likely to be used for criminal purposes, including money laundering.

(2) BCA guidelines
The BCA was established by SNS and gaming companies and is involved in a number of initiatives aiming at the protection of minors and the elderly when using blockchain applications. On March 24, 2020, the BCA published the BCA guidelines on blockchain content (incl. NFTs) to protect consumers and promote self-regulation. A revised version of the paper was published on December 25, 2020.

Matters covered by the BCA guidelines
(1) Gambling
(2) Premiums and Representations Act
(3) PSA
(4) FIEA
(5) Prevention of scams and other fraudulent practices

The interpretation of the laws and regulations, including the PSA, FIEA, Gambling Laws, and Premiums and Representations Act, is largely in line with the interpretation by the JCBA.

With respect to gambling, the BCA guidelines hold that blockchain games should avoid or at least carefully consider implementing any of the following mechanics: (i) in-game gachas (vending machine type mechanics) that issue NFTs or other in-game items; (ii) collection of fees to participate in rewards.; (iii) randomized creation and burning of NFTs and other in-game items with monetary value; and (iv) collection of fees to participate in competitions where the collected fees are distributed to the participants depending on their ranking.

The BCA guidelines further include self-regulation for member companies that include (i) the prohibition of loss compensation, (ii) the prohibition of insider trading, (iii) the monitoring and prevention of market manipulation, and (iv) the obligation to disclose material information to all users.
In addition, the guidelines hold that the issuance of NFTs may involve scams and other fraudulent practices, such as the termination of services shortly after selling the NFTs. To prevent fraudulent practices, member organizations are advised to (i) provide all material information to their users, (ii) secure the necessary funds and resources to ensure that the content shown to the users is actually delivered, and (iii) conduct test sales of NFTs and extensive beta-testing to enable users to understand the content of the services and NFTs prior to the actual launch.

III. Future Issues

Given the fact that NFTs are a relatively new phenomenon that is still evolving, many issues are yet solved. The following explanations are meant to provide some guidance for matters not included in the BCA and JCBA guidelines but relevant for the industry.

(1) NFTs and External Services
In most cases, the data represented by NFTs is stored off-chain. This raises the question of how consumers can be protected from later changes to the service and what companies can do to avoid claims for damages. In the case of blockchain games, NFTs typically represent assets that are stored on the servers of the blockchain game company. If the company now decides to change its terms of use or to terminate its services, this may ultimately render the NFT worthless and, in some cases, non-functional. To ensure that the game company does not face any claims for damage, this scenario must sufficiently be covered in terms of use. The same applies to crypto art, where the artworks are stored on the servers of a marketplace. If the data is stored and subsequently deleted on the InterPlanetary File System (IPFS), the situation is much more unclear and requires further consideration.

(2) NFTs and IP
For NFTs that are used for crypto art or in blockchain games, it is necessary to consider the relationship between the content provider and the holder of the NFT carefully. Two aspects are of utmost importance. First, the rights that are represented by the NFT should be clearly stipulated in the sales documentation of the initial sale. This also includes the question of how the rights represented by the NFT are transferred. Second, the relationship between the off-chain data and the NFT, as well as the retention of the off-chain data, should be considered carefully to avoid potential actions for damages. In cases where the content provider participates in all further sales, this should be clearly indicated in the contract as well. In the future, it is possible to discuss what rights should be granted as best practices.

(3) Issues concerning the trading of NFTs
If not explicitly provided in the contract, it is unclear under Japanese laws whether the rights represented by an NFT – i.e., the economic substance – are transferred (i) if both parties agree to the transfer and the transfer is recorded on the blockchain or (i) by mere agreement. To increase legal certainty and to ensure that the data recorded on the blockchain accurately reflects reality, the terms of sale should clearly stipulate that transfers only become effective if it is recorded on the blockchain. While there is no legal precedent, we believe that this solution is most practical and reflects the parties’ intentions.

(4) Taxation of NFTs
The taxation of NFTs another issue to be considered. In February 2019, the Japan Cryptocurrency Tax Association (JCTA) found that the taxation of income from the sale of NFTs is “an issue that has not been clarified in tax law.” The document finds, however, that “NFTs have an independent value, and if income is generated from the sale or exchange of NFTs, it will generally be taxed as miscellaneous income.”

(5) Secondary distribution of NFTs and rewards for creators
For many projects, content creators are rewarded when a secondary sale takes place. Examples are the above-mentioned nanakusa and NFT Studio, who both pay royalties to the content creator for secondary sales. In other cases, the content creator might want to transfer all his IPs to achieve higher prices for the initial sale. It is likely that both models will exist side by side in the future, but best practices still have to evolve. Further discussions are necessary in that regard.

Disclaimer
The content of this article has not been confirmed by the relevant authorities or organizations mentioned in the article but merely reflects a reasonable interpretation of their statements. The interpretation of the laws and regulations reflects our current understanding and may therefore change in the future. This article does not recommend the use of or investment in NFTs. This article provides merely a summary for discussion purposes. If you need legal advice on a specific topic, please feel free to contact us.

EOD


[1] On April 2, 2021, Mercari announced that it established a new company to plan and develop blockchain-related services, including NFTs.

[2] LINE tweeted recently that it is building an NFT platform. The tweet states that it intends to build services that make it easy to mint, buy, sell, and exchange NFTs.

[3] GMO announced developing a marketplace that allows users to buy and sell NFTs representing digital art and music from famous artists.