Japan is taking the future of the digital economy seriously, but as the head of the Japanese Digital Agency said, their work is just beginning.

Written by: Kilpatrick Townsend, Stockton LLP

Translated by: TaxDAO

Since taking office in 2021, Japanese Prime Minister Fumio Kishida has been seeking to establish "a new form of capitalism" in Japan. At the core of his vision is the development of Japan's "national strategy" for the "digital economy of the Web3.0 era" - the Kishida government sees this as "key" to "realizing a digital society" and the "future of the Japanese economy." In the midst of global "fierce competition," Japan has "begun large-scale investments" to "pioneer the future of Web3," positioning itself as "the most mature market in the world" based on blockchain technology and making Japan the "global center for 'responsible innovation.'"

Now, two years into the project, Japan has implemented comprehensive reforms, from ongoing tax reforms to leading regulation on the international stage. This year, Japan became one of the largest economies to launch a pilot for central bank digital currency (CBDC). The Japanese Digital Agency states that their work is "just beginning," and time will tell whether their efforts have effectively ensured Japan's leadership in the expanding new digital economy.

I. Japanese Digital Assets and the "Crypto Winter"

Japan "once led the world in the cryptocurrency industry." Subsequently, there were frequent large-scale hacking incidents, prompting strong reactions from regulatory authorities. This reputation and regulatory burden, coupled with high taxes and a lack of regulatory transparency, plunged Japan's once world-renowned cryptocurrency industry into a predicament.

In 2014 and 2017, Japan's cryptocurrency industry experienced two serious hacking incidents. The latter hack at Coincheck resulted in a $500 million loss and undermined consumer confidence. In response, the Japanese government enacted regulations to protect consumers and investors.

Now, cryptocurrency exchanges operating in Japan are required to segregate customers' legal tender and cryptocurrency assets from the exchange's own assets, entrust customer assets to a third-party Japanese bank or a trust company managed by a trustee, designate customers as beneficiaries, store at least 95% of customer funds in offline "cold wallets," and support all online currencies with independent cryptocurrency assets held in cold wallets owned by the exchange. In short, cryptocurrency exchange service providers in Japan must work to ensure investment security.

The regulatory framework has proven to be a double-edged sword. The "current regulatory and tax system" has to some extent led to Japan's "Web 3.0 related businesses" being "left behind by other countries in the world." However, it may help it weather the current "crypto winter."

In this so-called "crypto winter," cryptocurrency prices have "fallen," algorithmic stablecoins have "collapsed," and certain "major global cryptocurrency exchanges" like FTX have "crashed." These events have had an "undeniable" impact on the industry, slowing the development of "blockchain-based web3 businesses." However, due to its strict consumer protection regulations, Japan has "limited the impact of recent global cryptocurrency exchange collapses." In fact, the Chief Financial Technology Officer of the Financial Services Agency (FSA) of Japan has stated that despite the bankruptcy of the FTX Japan exchange under "Chapter 11 of the Bankruptcy Act," "Japanese customer assets are likely to be fully returned."

II. Through a New "National Strategy"

Japan "has witnessed the industry's suffering in the past" and survived. It is for this reason that the Kishida government believes that "Japan is capable of playing a unique role in the cryptocurrency industry," and now is the opportunity to implement a "national strategy" to "vigorously promote the development of a web3 business environment with international competitiveness" and "demonstrate leadership in international regulatory discussions." The government emphasizes that Japan "cannot afford to miss this opportunity."

In January 2022, the ruling party, the Liberal Democratic Party of Japan, established the Digital Society Promotion Headquarters, and at the same time, the Japanese government launched the "national strategy." Since then, its Web3 project team has been directly proposing legislative and regulatory reform recommendations to the ruling party. Many of these reforms have been adopted, but others remain pending.

a. Tax Reform

The most basic component of Japan's "national strategy" is to create a "development environment and tax system that is attractive to entrepreneurs and engineers" to "promote investment." These tax reforms mainly focus on year-end corporate taxes and individual taxes.

(1) Year-end corporate taxes

Traditionally, all cryptocurrency assets held by companies have been required to be valued at market value, regardless of whether these assets are traded by the company, and even if they experience a loss in value during the year. Companies holding these assets are still required to pay taxes based on their market value. This tax rate could be as high as 35%. To promote a "token-friendly environment for corporate financing," the Japanese Web3 policy team has proposed two reforms. First, exempting "year-end corporate income tax on tokens continuously held by issuing companies"; second, exempting "tokens issued by other companies and held by third parties for purposes other than short-term trading."

The first reform took effect in June 2023, and the second reform has just been proposed by the FSA to be included in the 2024 legislative agenda and approved by the Ministry of Economy, Trade, and Industry (METI). Implementing these two measures may alleviate the long-term disadvantage of domestic corporate investors in Japan compared to overseas investors who can rely on more favorable tax treatment.

(2) Individual taxes

Currently, income from cryptocurrency asset transactions is taxed as "miscellaneous income," with a "minimum tax rate of 55%" when "income tax and resident tax" are combined. This tax is levied not only when the held cryptocurrency assets are exchanged for legal tender, but also when they are exchanged for other cryptocurrency assets. This tax situation is "more severe" than in most other countries, leading to a "large outflow of taxpayers" and hindering taxpayer compliance. The Web3 policy team has proposed four reforms. First, a unified 20% tax on cryptocurrency asset transactions; second, taxing "gains and losses" only when converted to legal tender, thereby exempting "taxation of cryptocurrency asset exchanges"; third, allowing individuals to carry forward losses for up to three years; fourth, applying the same tax rate to "cryptocurrency derivative transactions."

Although the Digital Society Promotion Headquarters proposed an emergency proposal in November 2022, these reforms have been excluded from the 2023 agenda, and it is currently unclear whether these proposals will be part of the 2024 legislative agenda.

b. Stablecoin Regulatory Framework

Another pillar of Japan's "national strategy" is to promote the issuance and circulation of unlicensed stablecoins. As of this year, the total market value of stablecoins is $129.5 billion. Creating a safe and open environment for the use of stablecoins is necessary to influence and capture part of the market, promote digital asset trading, and other Web3 industries.

In June 2022, Japan became one of the first major economies to provide a regulatory framework for stablecoins. Japan's newly revised "Payment Services Act" defines stablecoins as "electronic payment instruments" and establishes a new regulated category of "electronic payment instrument intermediaries." This amendment took effect on June 1, 2023.

Now, trust companies and fund transfer operators have the right to issue and trade stablecoins based on existing capital maintenance requirements. This allows them to enter the "corporate payment settlement market" worth "¥100 trillion annually." It is no wonder that four major banks and digital lending institutions have planned to issue their own stablecoins, including Mitsubishi UFJ Financial Group (MUFG) preparing to issue Progmat Coin pegged to the yen. In addition, other "traditional" companies that previously "rarely dealt with cryptocurrency assets" are now "making significant investments in the web3 field."

Since December 2022, the FSA has lifted the ban on the listing of foreign-issued stablecoins. One of the impacts of these reforms is that the major financial technology stablecoin intermediary Circle is currently considering "issuing stablecoins in Japan."

c. Non-Fungible Tokens (NFTs)

This is the starting point of Japan's digital asset "national strategy." In April 2022, the Web3 policy team (then known as the NFT Policy Project Team) released the team's first white paper, outlining the "national strategy for developing (Japan's) digital economy in the Web 3.0 era," including NFTs.

Japan sees NFTs as a "catalyst" for the "digital economy of the Web 3.0 era." The "NFT market" has grown from "¥40 billion in 2020" to "over ¥4.7 trillion in 2021." Japan has "rich, high-quality intellectual property" and believes that "animation and games" have "international competitiveness," giving Japan "enormous potential to lead the world in the NFT business and even the Web3 field."

To capitalize on its intellectual property and the growth of the NFT market, Japan has been seeking to promote the active use of NFTs in Japan. One measure it has taken is to relax regulations for some NFTs as cryptocurrency assets. In March 2023, the FSA announced that any NFTs with a "unit price of 1,000 or more or an issuance volume of less than 1 million" do not fall under the category of cryptocurrency assets. This may place these NFTs on a more favorable regulatory and tax basis.

However, NFT companies and content creators still "face significant obstacles." On one hand, the ambiguity of regulations has led companies to be eager to adopt popular NFT models, such as the "NFT random sales model" combined with a "secondary trading market," which is common in the United States and Europe. Companies are concerned that this may violate Japan's anti-gambling laws. These laws also do not clearly specify whether Japanese companies can legally license their intellectual property to overseas NFT companies for business. The inability of Japanese companies to enter the market has raised concerns about other companies "free-riding" on their valuable intellectual property.

In addition to protecting the rights of content holders and safeguarding their data, clarifying and updating these legal barriers is also necessary for the "further development of Japan's content industry in the web3 era."

d. Investment

Another aspect of Japan's "national strategy" is to reform existing corporate forms to promote "public and private funding for blockchain-related businesses." Globally, in 2022, web3 startups "raised $15.1 billion," a 15-fold increase from 2018. Japan believes that with the "establishment of appropriate legal and tax frameworks," it can encourage investors to "gather in Japan."

Part of establishing an appropriate legal framework is opening up new financing channels for partnerships through digital assets and recognizing new company forms based on web3 technology: Decentralized Autonomous Organizations (DAOs).

Currently, Japan restricts investment business limited partnerships from raising funds through traditional means - stocks, options, and security tokens. These partnerships also need to invest more than half of their capital domestically. The Ministry of Economy, Trade, and Industry of Japan is considering lifting these two restrictions in 2024. This would allow startups to raise funds by selling digital assets and provide more investment opportunities to maximize capital growth, allowing for more reinvestment in domestic startups.

Another driver is the recognition of DAOs. DAOs are entities operated by granting governance voting functions to owners through secure tokens, making membership and operations smooth and fast. However, currently, "there is no clear legal framework to ensure that its members have limited liability and provide" a sufficiently flexible company form for its operation. Even the limited liability company model has certain rules, such as requiring the limited liability company to list all members and their personal information in the articles of incorporation, creating an unbearable administrative burden. Although the Web3 policy team often recommends reforms in this area, it is not clear when such reforms will take place. However, the Digital Department has already created its own DAO to promote research.

e. International Leadership

While the "national strategy" focuses on Japan's domestic development, a key component has always been international leadership. Over the past two years, Japan has made significant progress on the international stage as a regional leader and chair of the G7.

Regionally, Japan has begun to emerge as a leader in the digital market. In May 2023, Prime Minister Kishida launched the Digital Innovation Center at the ASEAN+3 Research Institute for East Asia. He also emphasized the regional cross-border payment system (Bakong system) developed by Japanese startups and the National Bank of Cambodia, which connects the entire region's countries using Cambodia's CBDC and stablecoins. By 2022, the system will have over 8.5 million users, processing over $15 billion in payments, and is planned for expansion.

Globally, Japan assumed the presidency of the G7 in 2023. The government seeks to use its presidency to "play an active leadership role, clarify its position as a leader in technology neutrality and responsible innovation, and look to the future of Web3." In particular, Japan is trying to emphasize its strong history of "consumer and investor protection," establish unified private international law on data and digital asset transfers, and promote the adoption of "travel rules" for digital assets to combat money laundering and terrorist financing by requiring cryptocurrency exchanges to provide origin and destination information when transferring assets.

Japan has fully utilized its opportunity as the rotating presidency of the G7, and its members seem to echo the key points of Japan's "national strategy" talks. G7 leaders unanimously agreed that regulation is crucial for addressing the risks of cryptocurrency activities and avoiding regulatory arbitrage, while supporting responsible innovation. Central bank governors of various countries unanimously agreed that a "reliable, stable, and transparent global payment system is a key foundation of their economies," and that Web3 technologies such as CBDCs and stablecoins can "play a significant role." Digital and technology ministers of various countries agreed on Japan's vision for "Society 5.0" and the development of an "innovative and competitive digital ecosystem."

The results of these agreements include updating the G7's "digital market rulebook," agreeing to hold a summit on digital assets and security in the fall of 2023, supporting the adoption of the "travel rules" officially passed by Japan in April 2022, and hosting an event with the World Bank aimed at "accelerating" the transition to "secure and resilient digital infrastructure."

III. Next Steps

As the government proposes new reforms, identifies new areas for improvement, and tracks progress, Japan's "national strategy" will continue to play a role in the coming years. Japan is taking the future of the digital economy seriously, but as the head of the Japanese Digital Agency said, their work is just beginning.

In addition to the pillars of Japan's "national strategy" discussed above, the Web3 policy team has identified dozens of new areas to explore. This includes optimizing Web3 technology through NFTs to revitalize communities, empowering individuals with disabilities or social isolation to find paid employment in the virtual world, and given the increasing complexity and far-reaching impact of these economic and legal reforms, the need to strengthen cooperation with "law firms and other private sector enterprises."

The ruling party of Japan will hold its annual conference in the fall to pass and determine the legislative priorities for the following year. The focus at this year's conference is important to observe as it advances Japan's "national strategy" to ensure its digital future.

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