Jan. 9 (Bloomberg) -- Japan may axe a 40 percent capital gains tax for most foreign investors, a move the government expects could spur Middle Eastern sovereign funds and private equity firms such as Carlyle Group to pump 10 trillion yen ($110 billion) into its sagging markets.

The trade ministry plans talks over the coming months with buyout firms and state funds from Saudi Arabia, the United Arab Emirates, Qatar and Kuwait to outline proposed changes to its tax regime, said a senior ministry official working on the matter, who declined to be named because details haven’t been finalized.

Japan taxes foreign funds more than any other nation in the Organization for Economic Cooperation and Development and has ranked last among member countries as a destination for foreign direct investment for more than a decade. The proposed changes could come as early as April 1 -- subject to parliamentary approval -- and boost investment from foreign funds fivefold over the next few years from 2 trillion yen, the official said.

“This is a significant step,” said Hideki Hashiguchi, chairman of the Japan chapter of the Alternative Investment Management Association. “Japan is at a crossroad in becoming a leader in Asia with its financial industry, and such changes will definitely provide a positive impact for the private equity industry and overseas investors.”

Under the revised law, Japan would become more competitive with the U.S. and Europe by exempting foreign investors from paying capital gains taxes when stakes are held via funds with locally based arms, according to a document outlining the changes that was shown to Bloomberg News.

Carlyle, KKR

Separately, foreign investors who invest in Japan through funds abroad would be exempted from tax if they hold their stakes longer than a year. France and Italy impose a capital gains tax of about 30 percent on such investors, while the U.S. and U.K. do not, according to the trade ministry.

Hedge funds, which often hold stakes for short periods, are not the target of the proposed changes, the official said.

Investors holding more than 25 percent in a Japanese company would remain subject to the current taxes, he said.

The official named Washington-based Carlyle and Kohlberg Kravis Roberts & Co., the New York buyout firm planning to list shares publicly this year, as foreign investors the government is aiming to woo with the new tax regime.

‘Committed’

“This is a good indication that Japan is committed to attracting foreign investment,” KKR’s country head in Tokyo, Shusaku Minoda, said via a spokeswoman.

Carlyle officials declined to comment because the changes remain subject to approval by lawmakers. It last month raised a $13.7 billion fund, the firm’s fifth for U.S. buyouts, amid a worldwide slump in deals. Blackstone Group LP, the biggest private-equity firm, in 2007 raised a $21.7 billion fund, the industry’s largest.

In Japan, Carlyle was involved in only one transaction in 2008, while KKR had none, according to spokespeople for the firms.

The value of investments held by pension funds and endowments has dropped amid the global credit crisis and simultaneous recession in Japan, Europe and the U.S., making competition for foreign investment fiercer than ever. Clients of private-equity funds pledged $82.3 billion to finance their operations in the third quarter of last year, the lowest amount since 2005, according to London-based researcher Preqin Ltd.

Benchmarks Slump

In Japan, some $3.9 billion private equity and buyout deals were announced last year, according to data compiled by Bloomberg. That compares with $90 billion in North America and $73 billion in Europe, according to the data. Tokyo’s benchmark Nikkei 225 Stock Average has slumped 39 percent during the past 12 months, compared with 31 percent for the Dow Jones Industrial Average and 28 percent for London’s FTSE 100 Index.

In an earlier move in June last year to attract more foreign funds, Japan’s Financial Services Agency issued a clarification that exempted managers of offshore investment funds from corporate tax, provided they prove their assets are managed at local discretion.

Also last year, the trade ministry sent a delegation for the first time to meet with state funds in oil-producing nations, including the Saudi Arabian Investment Co.

To contact the reporters on this story: Tomoko Yamazaki in Tokyo at tyamazaki@bloomberg.net; Shigeru Sato in Tokyo at ssato10@bloomberg.net.

Last Updated: January 8, 2009 23:03 EST