As filed with the Securities and Exchange Commission on July 11, 2006

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 20-F

(Mark One)

o		REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR 12(g) OF THE SECURITIES EXCHANGE ACT OF 1934

OR

þ		ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended March 31, 2006

OR

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from          to         

OR

o		SHELL COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Date of event requiring this shell company report        

Commission file number: 0-30204

Kabushiki Kaisha Internet Initiative

(Exact Name of Registrant as Specified in Its Charter)

Internet Initiative Japan Inc.

(Translation of Registrant’s Name Into English)

Japan
(Jurisdiction of Incorporation or Organization)

Jinbocho Mitsui Bldg.
1-105 Kanda Jinbo-cho
Chiyoda-ku, Tokyo 101-0051, Japan
(Address of Principal Executive Offices)

Securities registered or to be registered pursuant to Section 12(b) of the Act:

Title of Each Class		Name of Each Exchange On Which Registered
None		None

Securities registered or to be registered pursuant to Section 12(g) of the Act:
Common Stock, no par value
(Title of Class)

Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act:
None
(Title of Class)

Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the close of the period covered by the annual report.

As of March 31, 2006, 204,300 shares of common stock were outstanding, including 40,786 shares represented by an aggregate of 16,314,400 American Depositary Shares.

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes þ No o

If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

Yes o No þ

Note—Checking the box above will not relieve any registrant required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 from their obligations under those Sections.

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

      Large Accelerated Filer þ                 Accelerated Filer o                 Non-Accelerated Filer o

Indicate by check mark which financial statement item the registrant has elected to follow:

Item 17 o Item 18 þ

If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No þ

 

 

TABLE OF CONTENTS

PART I			2
Item 1. Identity of Directors, Senior Management and Advisers			2
Item 2. Offer Statistics and Expected Timetable			2
Item 3. Key Information			2
Item 4. Information on the Company			13
Item 4A. Unresolved Staff Comments			40
Item 5. Operating and Financial Review and Prospects			40
Item 6. Directors, Senior Management and Employees			66
Item 7. Major Shareholders and Related Party Transactions			71
Item 8. Financial Information			73
Item 9. The Offer and Listing			74
Item 10. Additional Information			75
Item 11. Quantitative and Qualitative Disclosures about Market Risk			86
Item 12. Description of Securities Other than Equity Securities			88
PART II			88
Item 13. Defaults, Dividend Arrearages and Delinquencies			88
Item 14. Material Modifications to the Rights of Security Holders and Use of Proceeds			88
Item 15. Controls and Procedures			88
Item 16A. Audit Committee Financial Expert			89
Item 16B. Code of Ethics			90
Item 16C. Principal Accountant Fees and Services			90
Item 16D. Exemptions from the Listing Standards for Audit Committees			91
Item 16E. Purchases of Equity Securities by the Issuer and Affiliated Purchasers			92
PART III			92
Item 17. Financial Statements			92
Item 18. Financial Statements			92
Item 19. Exhibits			92
EX-1.1 ARTICLES OF INCORPORATION
EX-1.2 SHARE HANDLING REGULATIONS
EX-4.7 JOINT VENTURE AGREEMENT
EX-4.24 AGREEMENT ON LIMITED LIABILITY
EX-11.1 INTERNET INITIATIVE JAPAN INC., CODE OF CONDUCT
EX-12.1 CERTIFICATIONS
EX-12.2 CERTIFICATIONS
EX-13.1 CERTIFICATIONS
EX-13.2 CERTIFICATIONS

Cautionary Note Regarding Forward-Looking Statements

     This annual report contains forward-looking statements about us and our industry that are based on our current expectations, assumptions, estimates and projections. These forward-looking statements are subject to various risks and uncertainties. These statements discuss future expectations, identify strategies, discuss market trends, contain projections of results of our operations and our financial condition, and state other forward-looking information. Known and unknown risks, uncertainties and other factors could cause our actual results to differ materially from those contained in or suggested by any forward-looking statement. We cannot provide any assurance that our expectations, projections, anticipated estimates or other information expressed in these forward-looking statements will turn out to be correct. We do not undertake any obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

     Important risks and factors that could cause our actual results to differ materially from our forward-looking statements are generally provided in Item 3.D. and elsewhere in this annual report on Form 20-F and include, without limitation:

	•		that we may not be able to achieve or sustain profitability in the near future,
	•		that we may not be able to compete effectively against competitors which have greater financial, marketing and other resources, and
	•		that we may not be able to attract and retain qualified personnel.

PART I

		As of and for the fiscal year ended March 31,
		2002				2003				2004				2005				2006				2006
		(millions of yen, except per share and ADS data)																				(thousands of
																						U.S. dollars,
																						except per
																						share and ADS
																						data (1) )
Statement of Operations Data:
REVENUES:
Connectivity and value-added services revenues:
Dedicated access		¥	14,303			¥	13,815			¥	12,862			¥	11,373			¥	10,625			$	90,443
Dial-up access			3,644				3,155				3,088				2,937				2,674				22,760
Value-added			3,100				3,603				4,296				5,005				6,250				53,200
Other			1,668				1,726				2,118				3,169				3,674				31,272
Total connectivity and value-added services revenues			22,715				22,299				22,364				22,484				23,223				197,675
Systems integration revenues, including related equipment sales			14,356				15,013				11,848				15,854				23,505				200,072
Equipment sales			2,834				6,706				4,567				3,365				3,085				26,262
Total revenues			39,905				44,018				38,779				41,703				49,813				424,009
COST AND EXPENSES:
Cost of connectivity and value-added services revenues			19,800				20,387				20,047				19,484				20,078				170,906
Cost of systems integration revenues, including related equipment sales			12,314				13,090				9,852				12,200				18,120				154,243
Cost of equipment sales			2,540				6,417				4,346				3,111				2,818				23,987
Total cost of revenues			34,654				39,894				34,245				34,795				41,016				349,136
Sales and marketing expenses			3,038				3,176				3,528				2,795				3,080				26,213
General and administrative expenses			1,840				2,205				2,098				2,666				3,147				26,790
Research and development expenses			319				414				358				199				159				1,346
Total cost and expenses			39,851				45,689				40,229				40,455				47,402				403,485
OPERATING INCOME (LOSS)			54				(1,671	)			(1,450	)			1,248				2,411				20,524
OTHER INCOME (EXPENSES):
Interest income			122				67				38				13				13				111
Interest expense			(659	)			(733	)			(702	)			(686	)			(437	)			(3,723	)
Other — net			(406	)			(603	)			1,646				2,573				3,392				28,871
Other income (expenses) — net			(943	)			(1,269	)			982				1,900				2,968				25,259
INCOME (LOSS) FROM OPERATIONS BEFORE INCOME TAX EXPENSE, MINORITY INTERESTS AND EQUITY IN NET LOSS OF EQUITY METHOD INVESTEES			(889	)			(2,940	)			(468	)			3,148				5,379				45,783
INCOME TAX EXPENSE			18				23				33				100				257				2,191
MINORITY INTERESTS IN (EARNINGS) LOSSES OF SUBSIDIARIES			24				153				236				(109	)			(354	)			(3,012	)

		As of and for the fiscal year ended March 31,
		2002				2003				2004				2005				2006				2006
		(millions of yen, except per share and ADS data)																				(thousands of
																						U.S. dollars,
																						except per
																						share and ADS
																						data (1) )
EQUITY IN NET LOSS OF EQUITY METHOD INVESTEES: (2)
Equity method net loss		¥	(5,482	)		¥	(5,625	)		¥	(286	)		¥	(33	)		¥	(14	)		$	(117	)
Impairment loss on investment, advance and deposits for Crosswave			—				(7,153	)			(1,720	)			—				—				—
Total equity in net loss of equity method investees			(5,482	)			(12,778	)			(2,006	)			(33	)			(14	)			(117	)
NET INCOME (LOSS)		¥	(6,365	)		¥	(15,588	)		¥	(2,271	)		¥	2,906			¥	4,754			$	40,463
Per Share and ADS Data (3) :
Basic net income (loss) per share		¥	(56,627	)		¥	(138,689	)		¥	(14,321	)		¥	15,172			¥	24,301			$	207
Diluted net income (loss) per share			(56,627	)			(138,689	)			(14,321	)			15,172				24,258				206
Basic net income (loss) per ADS equivalent			(141.57	)			(346.72	)			(35.80	)			37.93				60.75				0.52
Diluted net income (loss) per ADS equivalent			(141.57	)			(346.72	)			(35.80	)			37.93				60.65				0.52
Basic weighted average number of shares			112,400				112,400				158,554				191,559				195,613
Diluted weighted average number of shares			112,400				112,400				158,554				191,559				195,955
Basic weighted average number of ADS equivalents (thousands)			44,960				44,960				63,422				76,624				78,245
Diluted weighted average number of ADS equivalents (thousands)			44,960				44,960				63,422				76,624				78,382
Balance Sheet Data:
Cash and cash equivalent		¥	11,046			¥	3,588			¥	12,284			¥	5,286			¥	13,727			$	116,846
Total assets			45,263				32,064				42,737				37,116				50,705				431,605
Short-term borrowings			3,820				4,824				6,564				4,725				4,555				38,772
Current portion of long-term borrowings, including capital lease obligations			3,374				4,660				3,936				5,511				4,994				42,508
Long-term borrowings, including capital lease obligations			6,262				7,092				5,188				5,869				5,271				44,865
Convertible notes (4)			15,000				15,000				11,832				—				—				—
Shareholders’ equity (capital deficiency)			7,725				(10,004	)			6,214				11,615				20,222				172,131
Operating Data:
Capital expenditures, including capitalized leases (5)		¥	3,773			¥	4,893			¥	3,523			¥	5,011			¥	4,762			$	40,537
Operating margin (6)			0.1	%			(3.8	)%			(3.7	)%			3.0	%			4.8	%
Net cash provided by (used in):
Operating activities		¥	1,161			¥	1,582			¥	1,923			¥	5,238			¥	6,559			$	55,830
Investing activities			(2,457	)			(7,878	)			(852	)			1,974				1,805				15,363
Financing activities			(1,462	)			(872	)			7,669				(14,213	)			39				331

Reconciliations of the Disclosed Non-GAAP Financial Measures to the Most Directly Comparable GAAP Financial Measures

Capital expenditures

     We define capital expenditures as purchases of property and equipment plus acquisition of assets by entering into capital leases. We have included the information concerning capital expenditures because our management manages these expenditures and believes that it is useful to investors to analyze and compare companies on the basis of such investments. Capital expenditures, as we have defined it, may not be comparable to similarly titled measures used by other companies.

     The following table summarizes the reconciliation of capital expenditures to purchase of property and equipment as reported in our consolidated statements of cash flows prepared and presented in accordance with U.S. GAAP.

Exchange Rates

     Fluctuations in exchange rates between the Japanese yen and the U.S. dollar and other currencies will affect the U.S. dollar and other currency equivalent of the yen price of our shares and the U.S. dollar amounts received on conversion of any cash dividends, which in turn will affect the U.S. dollar price of our ADSs. We have translated some Japanese yen amounts presented in this annual report into U.S. dollars solely for your convenience. Unless otherwise noted, the rate used for the translations was ¥117.48 per U.S. $1.00, which was the noon buying rate in New York City for cable transfers in foreign currencies as certified for customs purposes by the Federal Reserve Bank of New York prevailing as of March 31, 2006, the date of our most recent consolidated balance sheet contained in this annual report. Translations do not imply that the yen amounts actually represent, or have been or could be converted into, equivalent amounts in U.S. dollars.

     The following table presents the noon buying rates for Japanese yen per U.S. $1.00 in New York City for cable transfers in foreign currencies as certified for customs purposes by the Federal Reserve Bank of New York:

     The noon buying rate on July 7, 2006 was ¥113.98 per $1.00.

B. Capitalization and Indebtedness.

     Not required.

C. Reasons for the Offer and Use of Proceeds.

     Not applicable.

D. Risk Factors.

      You should carefully consider the following information, together with the other information contained in this annual report on Form 20-F , including our financial statements and the related notes, before making an investment decision. Any risks described below could result in a material adverse effect on our business, financial condition or results of operations.

We may not maintain our current level of revenues or achieve our expected revenues and profits in the future.

     Although we recorded operating income and net income in the fiscal years ended March 31, 2005 and 2006, we incurred operating losses and net losses in each of the prior six fiscal years, with the exception of positive operating income for the fiscal year ended March 31, 2002, and our accumulated deficit as of March 31, 2006 amounted to ¥29.7 billion.

     As we primarily operate in the Japanese market, if the Japanese economy deteriorates or does not improve, and it results in significantly lower levels of network-related investment or corporate customers respond to conditions by putting a priority on low price rather than quality, it may make it difficult to maintain our current level of revenues or achieve our expected revenues and profits.

     In addition to factors related to general economic conditions in Japan, we may not be able to maintain our current level of revenues and profits or achieve our expected levels of revenues and profits due to several other factors, including, but not limited to:

	•		a continuous decrease in revenues from our Internet connectivity services because of lower unit prices per bandwidth and cancellation of large accounts especially due to severe price competition,
	•		lower revenue growth and lower margins in our growing value-added services and systems integration, if we fail to successfully differentiate our services from those of our competitors, or experience a significant decrease in systems integration revenues from period to period due to the cancellation of one or more large projects or changes in the number of projects resulting from a seasonal fluctuation in the systems integration business in Japan,
	•		an increase in backbone costs due to increased volume of Internet traffic and demand for leasing backbone lines, or a decline in the profitability of connectivity services if we contract for more capacity than we actually utilize to serve our customers,
	•		an increase in expenses for network infrastructure, research and development and other similar investments which we may be forced to make in the future in order to remain competitive, or increased expenses relating to the leasing of additional equipment,
	•		an increase in outsourcing costs, especially in our systems integration, if we fail to manage outsourcing projects effectively or fail to cover outsourcing costs by raising enough revenues from outsourced projects,
	•		an increase in SG&A costs, such as personnel expenses, in conjunction with our expected or planned or continued business expansion, and
	•		a decline in the value and trading volume of our holding of available-for-sale securities from which we expect gains on sale.

     Please see Item 5, “Operating and Financial Review and Prospects, ” for more detailed information concerning our operations and other results.

We may not be able to compete effectively, especially against competitors with greater financial, marketing and other resources.

     The major competitors of our connectivity and value-added services are major telecommunications carriers like NTT Communications Corporation (“NTT Communications”), KDDI Corporation (“KDDI”) and Japan Telecom Co., Ltd. (“Japan Telecom”). Especially for Internet connectivity services, price competition is still severe and may increase. For value-added services, price competition may also increase. This competition may adversely affect our revenues and profitability and may make it difficult for us to retain existing customers or attract new customers. The major competitors of our systems integration business are systems integrators like IBM Japan, NEC Corporation, Fujitsu Limited, NTT Data Corporation and their affiliates. Our major competitors have the financial resources to reduce prices in an effort to gain market share. There is strong competition among systems integrators that may adversely affect our revenues and profitability. Even though Nippon Telegraph and Telephone Corporation (“NTT”) and NTT Communications purchased shares of our company in September 2003, which resulted in the NTT Group becoming our largest shareholder, we plan to continue to operate our company separately and independently from the NTT Group, and will therefore continue to compete with the NTT Group.

     Our competitors have advantages over us, including, but not limited to:

	•		substantially greater financial resources,
	•		more extensive and well-developed marketing and sales networks,
	•		higher brand recognition among consumers,
	•		larger customer bases, and
	•		more diversified operations which allow profits from some operations to support operations with lower profitability, such as the network services, for which we are a competitor.

     With these advantages, our competitors may be better able to:

	•		sustain downward pricing pressure, including pressure on low-price Internet connectivity services offered to corporate customers, which are our target customers,
	•		develop, market and sell their services,
	•		adapt quickly to new and changing technologies,
	•		obtain new customers, and
	•		aggressively pursue mergers and acquisitions to enlarge their customer base and market share.

We depend on our ability to attract and retain qualified personnel.

     Our network, services, products and technologies are complex, and as a result, we depend heavily on the continued service of our engineering, research and development, and other personnel. As our business grows, we need to hire additional engineers, research and development and other personnel. In particular, in order to continue to increase our revenues from value-added services and systems integration, we require more sales and engineering personnel to achieve our expectations. We are not sure that we will be able to keep or attract these human resources and control human resources cost adequately. Competition for

qualified engineers, research and development personnel and employees in the telecommunications service industry in Japan is intense, and there is a limited number of persons with the necessary knowledge and experience. None of our employees are bound by any employment or noncompetition agreement. The realization of any or all of these risks may result in material adverse effects on our business, financial condition and result of operations.

Our business may be adversely affected if our network suffers interruptions, errors or delays.

     Interruptions, errors or delays with respect to our network may be caused by a number of man made or natural factors, many of which are beyond our control, including, but not limited to, damage from fire, earthquakes or other natural disasters, power loss, sabotage, computer hackers, human error, computer viruses and other similar events. Much of our computer and networking equipment and the lines that make up our network backbones are concentrated in a few locations that are in earthquake-prone areas. Any disruption, outages, or delays or other difficulties experienced by any of our technological and information systems and networks could result in a decrease in new or existing accounts, loss or exposure of confidential information, reduction in revenues and profits, costly repairs or upgrades, reputational damage and decreased consumer confidence in our business, any or all of which could have a material adverse effect on our business, financial condition and results of operations.

The confidential customer information that we keep and manage may be leaked.

     We keep and manage confidential information and trade secrets obtained from our customers. We exercise care in protecting the confidentiality of such information and take steps to ensure the security of our network, in accordance with the law protecting personal information that came into effect in April 2005 and the requirements set by the Ministry of Internal Affairs and Communications (“MIC ”), and the Ministry of Economy, Trade and Industry. However, our network, like all Information Technology systems, is vulnerable to external attack from computer viruses, hackers or other such sources. In addition, despite internal controls, misconduct by an employee could result in the improper use or disclosure of confidential information. If any material leak of such information were to occur, we could be subject to lawsuits for damages from our customers, incur expenses associated with repairing or upgrading our security systems and suffer damages to our reputation that could result in a severe decline in new customers as well as an increase in service cancellations. The realization of these or similar risks may have a material adverse effect on our business, financial condition and result of operations.

Business growth and a rapidly changing operating environment may strain our limited resources.

     We have limited operational, administrative and financial resources, which could be inadequate to sustain the growth we want to achieve. As the number of our customers and their Internet usage increases, as traffic patterns change and as the volume of information transferred increases, we will need to increase expenditures for our network and other facilities in order to adapt our services and to maintain and improve the quality of our services. If we are unable to manage our growth and expansion, the quality of our services could deteriorate and our business may suffer.

If we fail to keep up with the rapid technological changes in our industry, our services may become obsolete and we may lose customers.

     Our markets are characterized by:

	•		rapid technological change,
	•		frequent new product and service introductions,

	•		continually changing customer requirements, and
	•		evolving industry standards.

     If we fail to obtain access to new or important technologies or to develop and introduce new services and enhancements that are compatible with changing industry technologies and standards and customer requirements, we may lose customers.

     Our pursuit of necessary technological advances may require substantial time and expense. Many of our competitors have greater financial and other resources than we do and, therefore, may be better able to meet the time and expense demands of achieving technological advances. Additionally, this may allow our competitors to respond more quickly to new and emerging technologies and standards or invest more heavily in upgrading or replacing equipment to take advantage of new technologies and standards.

We depend on our executive officers, and if we lose the service of our executive officers, particularly Mr. Koichi Suzuki, our business and our relationships with the customers, major shareholders of IIJ and other IIJ Group companies and our employees could suffer.

     Our future success depends on the continued service of our executive officers, particularly Mr. Koichi Suzuki, who is our president, chief executive officer and representative director, as well as the president and chief executive officer and representative director of most of other IIJ Group companies. We rely in particular on his expertise in the operation of our businesses and on his relationships with our shareholders, the shareholders of the IIJ Group companies, our business partners and our employees. None of our executive officers, including Mr. Suzuki, is bound by an employment or noncompetition agreement.

Our investments in affiliated companies may not produce the returns we expect and may require additional funding.

     As part of our business strategy and for the purpose of maintaining various strategic business relations, we have, in the past, invested in a number of companies. There can be no assurance that we will be able to maintain or enhance the value or performance of such companies in which we have invested or may invest in the future, or that we will achieve the returns or benefits sought from these investments. Our substantial investment in Crosswave, our former equity method investee, for example, became worthless due to Crosswave’s commencement of corporate reorganization proceedings. In August 2003, Crosswave filed a voluntary petition for the commencement of corporate reorganization proceedings in Japan, and as a result of our equity method net loss and an impairment loss taken in respect of our investment in Crosswave, our net loss for the fiscal year ended March 31, 2003 was ¥15.6 billion, the highest net loss that we have ever experienced. We also wrote off ¥2.1 billion of loans and accounts receivable outstanding from Crosswave for the fiscal year ended March 31, 2004. We also had an impairment loss relating to our investment in Asia Internet Holding for the fiscal year ended March 2004. To the extent that these investments are accounted for by the equity-method and to the extent that the investee companies have net losses, our financial results will be adversely affected to the extent of our pro rata portion of these losses. Furthermore, we may lose all or part of our investment in these companies if their value decreases as a result of their financial performance or if these companies go bankrupt. If our interests differ from those of other investors in entities over which we do not exercise control, we may not be able to enjoy synergies with the investees and it may adversely affect our financial results or financial condition.

     We have invested in affiliated companies, such as IIJ Technology Inc. (“IIJ-Tech”) and Net Care, Inc. (“Net Care”), to expand the service offerings available to our customers. In February 2006, we invested ¥750 million in Internet Revolution Inc. (“i-revo”), a joint venture that we established with Konami Corporation, and i-revo is our equity method investee. In the joint venture agreement, we agreed that we will provide funding up to ¥90 million to i-revo between November 2006 and the end of April 2007 for its capital

investments and working capital. We may provide additional financial support in the form of loans to or additional equity investments in these affiliated companies to enhance or maintain our business synergies with these affiliated companies.

     In October 2005, IIJ Media Communications Inc. (“IIJ-MC”), our former subsidiary, was merged into us after a portion of IIJ-MC’s business was transferred to IIJ-Tech and we have acquired Asia Internet Holding Co., Ltd. (“AIH”), our former equity method investee, after AIH became our wholly owned consolidated subsidiary. We may consider reorganization of other IIJ Group companies in the future which may require additional investments by cash, equity or others.

Fluctuations in the stock prices of companies in which we have invested may significantly influence our financial condition.

     We have invested in non-affiliated companies in order to further our business relationships with these companies. We recorded gross realized gains from the sale of available-for-sale securities of ¥3.2 billion for the fiscal year ended March 31, 2006 and the book value of our remaining available-for-sale securities was ¥6.8 billion at March 31, 2006, which is relatively large in relation to other items on our balance sheet. However, the book value can change significantly due to changes in the financial condition of non-affiliated companies, general economic conditions in Japan or fluctuations in the Japanese stock markets. Fluctuations in the stock prices of companies in which we have invested may have a significant effect on our financial results. As a result, we may not be able to achieve our expected gains on the sale of available-for-sale securities. In addition, should we choose to dispose of all or a portion of these shares, it is not certain that we will be able to do so on favorable terms.

NTT, our largest shareholder, could exercise substantial influence over us in a manner which may not necessarily be in our interest or that of our other shareholders.

     NTT and its affiliates currently own 29.7% of our outstanding shares. In September 2003, we entered into a subscription agreement with NTT in which we granted to NTT pre-emptive rights to subscribe to its pro rata portion of any future issuances of shares by us in order to maintain its shareholding percentage; NTT did not exercise this pre-emptive right when we issued 12,500 additional shares in December 2005. Under this subscription agreement, we have agreed to allow NTT to nominate up to three persons as either directors or statutory auditors, subject to approval by our shareholders at our first general shareholders’ meeting after NTT’s investment. At our general shareholders’ meeting on June 24, 2004, two directors nominated from NTT Group were appointed, one of whom was nominated as an executive vice president. At our general shareholders’ meeting on June 28, 2006, our executive vice president, Mr. Fukuzo Inoue, completed his term and retired, and an other director, Mr. Takashi Hiroi was reapproved to be an outside director. As our largest shareholder, NTT may be able to exercise substantial influence over us. In addition, as part of this subscription agreement, we have agreed to collaborate with NTT in various businesses. While we intend to conduct our day-to-day operations independently of NTT and its group companies and believe that NTT also plans for us to operate independently, NTT may decide to exercise substantial influence over us in a manner which could impair our ability to operate independently. Furthermore, NTT may take actions that are in its best interests, which may not be in our interest or that of other shareholders.

We rely greatly on other telecommunications carriers and other suppliers, and could be affected by disruptions in service or delays in the delivery of their products and services.

     We rely on telecommunications carriers such as NTT Communications, KDDI and Japan Telecom for a significant portion of our network backbone and Nippon Telegraph and Telephone East Corporation and Nippon Telegraph Telephone West Corporation and electric power companies and their affiliates for local access lines for our customers. After the transfer of operating lease agreements from Crosswave, our former equity method investee, following its filing for corporate reorganization, we now procure significant portions

of our network backbone and data center facilities pursuant to operating lease agreements with NTT Communications, our largest provider of network infrastructure. We are subject to potential disruptions in these telecommunications services and, in the event of such disruption, we may have no means of replacing these services, on a timely basis or at all.

     In the Asia-Pacific region, we depend on telecommunications carriers in various countries including less-developed countries whose quality of service may not be stable or who are more susceptible to economic or political instability.

     We also depend on third-party suppliers of hardware components like routers that are used in our network. We acquire certain components from limited sources, typically from Cisco Systems, Inc. A failure by one of our suppliers to deliver quality products on a timely basis, or the inability to develop alternative sources if and as required, may delay our ability to expand the capacity and scope of our network.

     Any problems experienced by our telecommunications carriers and other suppliers could have a material adverse effect on our business, financial condition and results of operations.

There are risks associated with our international business.

     By operating our network internationally, we expose ourselves to the risks of international markets and to other risks that do not exist or are less significant in Japan. One of the components of our strategy is to continue to expand our network reach through our network between the United States and Japan to maintain our network quality. In addition, we have invested in the data center businesses in South Korea. Our international business operations continue to require management attention and financial resources, both of which are in limited supply. We face significant exposure to risks in connection with our international operations, including:

	•		the impact of economic conditions outside Japan,
	•		unexpected changes in or delays resulting from regulatory requirements,
	•		the rate of the development of the Internet industry in countries in Asia,
	•		political and economic instability, and
	•		potential unsatisfactory financial returns from our investments in Asia, including the data center businesses in which we have invested in South Korea.

     These factors could adversely affect our future international expansion and, consequently, our business, financial condition and results of operations.

If we fail to execute our systems integration projects in a timely or satisfactory manner or if we fail to manage customer data in a professional manner, we could be sued and our reputation could suffer.

     A significant portion of our future revenue depends on systems integration projects which we, in cooperation with IIJ-Tech and Net Care, have been contracted to perform. We may not be able to perform our responsibilities under these contracts to the satisfaction of our customers, or at all, if we lack a sufficient number of qualified engineers, lack sufficient task-management capabilities for software-development vendors or fail to manage customer data adequately. If we do not execute these services and projects as contracted or fail to manage customer data in a professional manner, our receipt of revenues may be delayed or lost altogether and we could be sued by our counterparties, which could in turn have an adverse impact on our reputation, results of operation and financial condition.

Regulatory matters and new legislation could impact our ability to conduct our business.

     The licensing, construction and operation of telecommunications systems and services in Japan are subject to regulation and supervision by the MIC. We operate pursuant to licenses and approvals that have been granted by the MIC.

     Our licenses have an unlimited duration, but are subject to revocation by the MIC if we violate any telecommunications laws and regulations in a manner that is deemed to harm the public interest, if we or any of our directors are sentenced to a fine or any more severe penalty under the telecommunications laws, if we employ a director who was previously sentenced to a fine or more severe penalty thereunder or if we have had a license revoked in the past. We believe our licenses and approvals are in good standing and we expect to be able to continue to fulfill the terms of our licenses and approvals to the satisfaction of the MIC. However, there can be no assurance that we will be able to do so.

     Existing and future governmental regulation may substantially affect the way in which we conduct business. These regulations may increase the cost of doing business or may restrict the way in which we offer products and services. As a result of the amendment in April 2004 of the Telecommunication Business Law and deregulation including elimination of the regulatory distinction between carriers providing telecommunications services through networks owned by other telecommunication carriers and carriers which own or have long-term leases for the networks through which they offer telecommunication services, competition may increase. Furthermore, we cannot predict future regulatory changes which may affect our business. Any changes in laws, such as those described above, or regulations or MIC policy affecting our business activities and those of our competitors could adversely affect our financial condition or results of operations. For more information, see Item 4., “Business Overview — Regulation of the Telecommunications Industry in Japan”.

We may be named as defendants in litigation, which could have an adverse impact on our business, financial condition and results of operations.

     We are involved in normal claims and other legal proceedings in the ordinary course of our business. We believe that there are no cases currently pending which would have a significant financial impact on us, but we cannot be certain that we will not be named in a future lawsuit. Any judgment against us in such a lawsuit, or in any future legal proceeding, could have an adverse effect on our business, financial condition and results of operations.

In the event we need to raise capital, we may sell additional shares of our common stock or securities convertible into our common stock, which may cause shareholders to incur substantial dilution.

     We may raise additional funds in the future to raise additional working capital and for other financial needs. We completed private placements in June and September 2003 of an aggregate of 15,880 shares of our common stock to investors in Japan in order to raise funds for working capital and repayment of convertible notes. We issued 12,500 new shares of our common stock along with our listing on the Mothers market of the Tokyo Stock Exchange in December 2005, after conducting a 1 to 5 split of our shares of common stock in October 2005. If we choose to raise such funds from the issuance of equity shares of our common stock or securities convertible into our common stock, existing shareholders may incur substantial dilution.

Item 4. Information on the Company.

A.

History and Development of the Company.

     We are incorporated in Japan as a joint stock corporation under the name Internet Initiative Japan Inc. (“IIJ”). We were incorporated in December 1992 and operate under the laws of Japan. We began operations

in July 1993, making us one of the first commercial providers in Japan to offer Internet connectivity services. In February 1994, we acquired a Type II Telecommunications license, which enables us to operate our own international backbone networks. We became a public company in August 1999 with our initial public offering of American Depositary Shares (“ADSs”) on the Nasdaq National Market.

     On August 20, 2003, Crosswave Communications Inc. (“Crosswave”), our former equity method investee and primary provider of data communication services, and two of its subsidiaries filed voluntary petitions with the Tokyo District Court for the commencement of corporate reorganization proceedings, which are proceedings to rehabilitate an insolvent company similar in some respects to Chapter 11 bankruptcy proceedings in the United States. As a result, we wrote-off our investment in Crosswave and no longer consider Crosswave to be an IIJ Group company. On December 15, 2003, the business operations of Crosswave including its network on which we relied to provide services for our network, were transferred to NTT Communications Corporation (“NTT Communications”). We have contracted with NTT Communications for the continued use of the network services it acquired from Crosswave.

     On June 26 and September 16, 2003, we completed private placements of a total of 15,880 shares of our common stock to investors in Japan for an aggregate amount of ¥13.3 billion for working capital and repayment of our outstanding 1.75% convertible notes due on March 31, 2005. As a result of these transactions, the total number of our issued shares of common stock increased to 38,360 and shareholding of the Nippon Telegraph and Telephone Corporation (“NTT”) Group increased to 31.6%. We have also agreed with NTT that it has the right to nominate three persons to serve as either our directors or statutory auditors, subject to shareholder approval of any nomination at our first general shareholders’ meeting after NTT’s investment. In addition, we and NTT agreed to undertake efforts to jointly engage in the development of broadband and Information Technology and other related business, to expand the business relationship between us and NTT in connection with new business opportunities and to discuss secondment of employees to each other.

     On October 1, 2005, IIJ Media Communications Inc. (“IIJ-MC”), our former consolidated subsidiary, was merged into us after a portion of IIJ-MC’s business was transferred to IIJ Technology Inc., our consolidated subsidiary. Asia Internet Holding Co., Ltd., our former equity method investee, became our wholly owned consolidated subsidiary, and was merged into us on October 1, 2005. In each of the mergers, we became the surviving company.

     On December 2, 2005, we listed on the Mothers market of the Tokyo Stock Exchange. In connection with the listing, we issued 12,500 new shares of common stock for an amount of ¥6.0 billion. As we conducted a 1 to 5 split of our shares of common stock on October 11, 2005, the total number of our issued shares of common stock increased to 204,300.

     On February 1, 2006, we established a joint venture company, Internet Revolution Inc. (“i-revo”) with Konami Corporation, with the purpose of operating comprehensive portals sites. We invested ¥750 million and hold 30.0% of the company. i-revo is our equity method investee.

     Our head office is located at Jinbo-cho Mitsui Bldg., 1-105 Kanda Jinbo-cho, Chiyoda-ku, Tokyo 101-0051, Japan, and our telephone number at that location is (813) 5259-6500. Our agent in the United States is IIJ America Inc., 1211 Avenue of the Americas, Suite 2900, New York, New York 10036 and the telephone number at that location is (212) 440-8080. We have a web site that you may access at http://www.iij.ad.jp/. Information contained on our web site does not constitute part of this annual report on Form 20-F.

     For a discussion of capital expenditures and divestitures currently in progress and those for the past three years, see “Capital Expenditures” in Item 4.B.

B.

Business Overview.

     We offer a comprehensive range of Internet connectivity services and network solutions to our customers in Japan. We offer our services on one of the most advanced and reliable Internet networks available in Japan. Our services are based upon high-quality networking technology tailored to meet the specific needs and demands of our customers.

     We offer, together with other companies or independently, a variety of services to our customers as part of our total network solutions. Our primary services are our Internet connectivity services, value-added services and systems integration. Our Internet connectivity services range from low-cost dial-up access to high-speed access through dedicated lines for individual and corporate customers. Our value-added services include security-related outsourcing services that protect customers’ internal networks from unauthorized access and secure remote connections to internal networks, network-related outsourcing services such as provision, monitoring and maintenance of network equipment and Virtual Private Network (“VPN”), and server-related outsourcing services such as provision of e-mail and web servers and operation and management of e-mail systems, in addition to Internet data center services. Our systems integration are tailored to our customers’ requirements, which include consulting, project planning, systems design, construction of network systems and systems outsourcing. We also sell a significant amount of network-related equipment to our systems integration customers as part of our provision of total network solutions.

     Most of our revenues are generated in Japan and are denominated in Japanese yen. The table below provides a breakdown of the percentage of total revenues among our primary services over the past three fiscal years.

     The variety of Internet connectivity services, value-added services and systems integration we offer enables our customers to purchase all of their Internet-related services and products through a single source. To support our services and for the convenience of our customers, we also offer a variety of hardware, software and other products, such as network equipment, which are sourced mostly from third-party vendors. We aim to be the leading supplier of total network solutions in Japan.

     We have created an Internet network, that extends throughout Japan by leasing lines from telecommunications carriers. Our backbone is one of the highest capacity Internet backbones in Japan. As of July 7, 2006, we operated 13 points of presence (“POPs”) for dedicated access, 17 POPs for dial-up access and 12 Internet data centers. POPs are the main points at which our customers connect to our backbone, throughout Japan. Our policy on the management of our backbone is that we upgrade the bandwidth depending on demand and with maximum cost effectiveness. Our backbone network also extends to the United States, with a total capacity of 7.2 Gbps (3 STM-16 trunk lines), and to China, with a capacity of 600 Mbps (1 STM-4 trunk line) as of July 7, 2006.

Total network solutions

     We are a provider of total network solutions. We provide our customers with tailored, end-to-end Internet and private network solutions. The diversity of services we offer permits each customer to purchase individual services or a bundle of services that we believe provide the most efficient, reliable and cost-effective solution for that customer’s particular needs.

     The primary resources that we use to provide total network solutions to our customers include:

	•		our Internet connectivity services,
	•		our line-up of value-added services, including security, network and server-related outsourcing,
	•		our Internet data center services,
	•		our systems integration, including ongoing consulting, systems design, construction, operation and management, and
	•		other network and application services that our group companies provide.

     Our total network solutions for business users are a primary focus of our business. We consult with businesses and other customers to identify their particular needs. We then draw upon our extensive resources to address those needs.

Internet Connectivity Services

     We offer two categories of Internet connectivity services: dedicated access services and dial-up access services. Dedicated access services are based mainly on dedicated local-line connections provided by carriers between our backbone and customers. Dial-up access services mainly require customers to connect to our POPs through the publicly-switched telephone network. The Internet connectivity part of our total network solutions ranges from low-cost, entry-level dial-up connections from home personal computers to customized wide-area network solutions deploying a range of the dedicated and dial-up services listed below to connect headquarters, data centers, branch offices and mobile personnel. Currently, large telecommunications carriers such as Nippon Telegraph and Telephone East Corporation (“NTT East”) and Nippon Telegraph and Telephone West Corporation (“NTT West”) and other providers are rapidly increasing the variety of last-mile access with ADSL, fiber optic and Ethernet-based lines. Such new lines provide inexpensive high-speed, high-capacity last mile access, and we continue to introduce new variations to our Internet connectivity service to accommodate such developments.

     The following table shows the number of our Internet connectivity service subscribers as of the dates indicated:

     As of July 7, 2006, we mainly offered the following Internet connectivity services.

Dedicated Access Services

     Our lineup of dedicated line access services includes: IP Service, IIJ T1 Standard, IIJ Economy, IIJ Data Center Connectivity Service, IIJ FiberAccess/F, IIJ DSL/F, IIJ DSL/A, IIJ ISDN/F and IIJ Line Management/F. The total bandwidth allocated to our dedicated access services has increased 60.8% to 194.9 Gbps as of March 31, 2006, up from 121.2 Gbps a year earlier.

      IP Service. Our IP Service is a full-scale, high-speed access service that connects a customer’s network to our network and the Internet. The service is used by corporate customers mainly for critical purposes, such as Internet connectivity for corporate headquarters or data centers. As of March 31, 2006, we had 896 contracts for our IP Service compared to 863 for our IP Service as of March 31, 2005. The customer chooses the level of service it needs based upon its bandwidth requirements. As of July 7, 2006, we offered service at speeds ranging from 64 kbps to 10 Gbps.

     Our IP Service revenues, including revenues of IIJ Data Center Connectivity Service, represented 16.6% of our total revenues for the fiscal year ended March 31, 2006 and 21.4% for the fiscal year ended March 31, 2005. We believe that as businesses continue to develop Internet capabilities, this service will continue to be the foundation of our total network solutions offerings.

     Subscribers pay a monthly fee for the leased local access line from the customer’s location to one of our POPs. The amount of this fee varies depending on the carrier used and the distance between the customer’s site and our POPs. Customers subscribing to greater bandwidths use ATM (Asynchronous Transfer Mode) or an Ethernet local access line, which supports over 2 Mbps. We collect the usage fee from the customer and pay this amount to the carrier.

     Although fees are charged on a monthly basis, the minimum contract length is one year. For contracts of at least three years, a 10% per month discount is given.

     We also offer various IPv6-capable Internet connectivity services, namely IPv6 Tunnel, IPv6 Native and IPv6/IPv4 Dual Stack Services. In addition to corporate users, IPv6 Tunnel Service has been available to individual users. IPv6 is the next generation Internet Protocol, which allows IPv6 technology to overcome the problems, such as limited IP address availability, of IPv4, the protocol generally used. IPv6 Tunnel Service is a service to enable customers to use IPv6 technology via IPv4 access network, by encapsulating IPv6 data with IPv4 data. IPv6 Native and IPv6/IPv4 Dual Stack Services are services which provide IPv6 environment to customers without encapsulating it with IPv4 data. IPv6 technology enables customers to connect a vast range of electronic appliances and equipment, including cellular phones, AV equipment, car navigation devices and home electronics. We are the first commercial Internet Service Provider, or ISP in Japan to offer IPv6 service and our management believes that we will reap “first-mover” benefits from our initiative. In an effort to promote the dissemination and use of IPv6, we are not currently charging service fees for IPv6 Tunnel Service.

     For our IP Service, we offer Service Level Agreements to our customers to better define the quality of services our customers receive. We were the first ISP in Japan to introduce this type of agreement.

     We guarantee the performance of the following elements under our Service Level Agreements:

	•		100% availability of our network,
	•		the maximum average latency, or time necessary to transmit a signal, between designated POPs, and
	•		prompt notification of outage or disruption.

     We are able to offer these Service Level Agreements because of the high quality and reliability of our network. Our Service Level Agreements provide customers with credit against the amount invoiced for the services if our service quality fails to meet the prescribed standards.

     Subscribers to our IP Service receive technical support 24 hours a day and seven days a week.

      IIJ T1 Standard. Our IIJ T1 Standard is a connectivity service at 1.5 Mbps that we introduced in October 1999. It is a packaged dedicated line service limited to static routing and allocations of 8 or 16 IP addresses. Last-mile access must be through NTT’s Digital Access 1500 or similar services from other carriers. We support this service by providing guarantees of latency rates under Service Level Agreements. As of March 31, 2006, we had 109 customers for IIJ T1 Standard and IIJ Economy. We are no longer promoting the service since customers demand for a higher speed than the one that the service provides.

      IIJ Economy. IIJ Economy is a packaged Internet connectivity service via a dedicated line at 64 kbps or 128 kbps, targeting small- and medium-sized businesses. We support this service by providing guarantees of latency rates under Service Level Agreements. We are no longer promoting the service since customers demand for a higher speed than the one that the service provides.

      IIJ Data Center Connectivity Service. We also provide connectivity services with respect to our data centers. Our data center connectivity services are an important part of being able to provide high-quality, high-speed, seamless service to our customers. Our connectivity services are asymmetric, meaning that transmission speeds are not the same in both directions— with the downstream transmission being faster to accommodate greater amounts of information being accessed from the Internet versus being sent to the Internet. The fee structure depends on the transmission capacity required for upstream and downstream transmissions. For downstream transmissions, we offer either 10BASE-T connectivity (10 Mbps) or 100BASE-T connectivity (100 Mbps). For upstream transmissions, we offer bandwidths from 1 Mbps to 4 Mbps for 10BASE-T connectivity and 6 Mbps to 48 Mbps for 100BASE-T connectivity. In addition to the above, we offer IPv6-capable data center services, which offer the same services using IPv6. As of March 31, 2006, we had 247 Internet data center connectivity contracts, compared with 231 as of March 31, 2005. Total contracted bandwidth for Internet data center connectivity service was 24.4 Gbps as of March 31, 2006, up from 21.7 Gbps as of March 31, 2005. We support this service by providing the same three guarantee elements, availability, maximum average latency and prompt notification of outage or disruption, as the IP Service above under Service Level Agreements.

      IIJ FiberAccess/F. IIJ FiberAccess/F Service is a dedicated Internet-access service that uses “BFLET’S” fiber optic access lines provided by NTT East and West allowing service at maximum 10 Mbps or 100 Mbps on a best-efforts basis. The service is available in several variations (Business, Basic, Family, Mansion and others), optimizing each customer’s needs in speed and connection interface. Customers can also choose the number of allocated IP addresses from: 1, 4, 8, 16, 32 and 64. We support this service by providing guarantees of latency rates under Service Level Agreements. As of March 31, 2006, we had 13,297 customers for IIJ FiberAccess/F and IIJ DSL/F.

      IIJ DSL/F and IIJ DSL/A. IIJ DSL/F Service provides dedicated line Internet connectivity via ADSL with speeds of up to 47 Mbps. IIJ DSL/F Service is primarily targeted at small- and medium-sized offices and home offices that have access to ADSL lines provided by NTT East and West under the name of “FLET’S ADSL”. We support this service by providing guarantees of latency rates under Service Level Agreements. In May 2006, we began offering IIJ DSL/A, using ADSL lines provided by ACCA Networks.

      IIJ ISDN/F. IIJ ISDN/F Service provides dedicated line Internet-access via ISDN lines with speeds of up to 64 kbps. IIJ ISDN/F Service is primarily targeted at small-and medium-sized offices and home offices where ADSL lines are not available but have access to ISDN lines provided by NTT East and West under the name of “FLET’S ISDN”.

      IIJ Line Management/F. IIJ Line Management/F Service is a service for us to prepare optical fiber or ADSL lines provided by NTT East and West for IIJ FiberAccess/F, IIJ DSL/F and IIJ ISDN/F on behalf of customers. We provide customer support functions for the access lines.

Dial-up Access Services

     We offer a variety of dial-up access services. Our dial-up access services are an important resource in offering total Internet solutions to corporate customers. Our dial-up services allow employees out of the office or frequent travelers to access our network or their own corporate networks through one of our POPs or through our roaming access points. The dial-up services are usually provided with VPN function, that is provided by our value-added services or systems integration to access customers’ own corporate network securely. We also offer dial-up access service for individuals and an OEM service (where we provide services for other companies which sell those services under their own name) for other network operators, such as NTT East and NTT West.

     Our main dial-up access services are our IIJ Dial-up Standard, Enterprise Dial-up IP Service, IIJ Dial-up Advanced, IIJ4U, IIJ mio DSL/DF Service, IIJ mio FiberAccess/DF Service, IIJ mio DSL/SF Service, IIJ mio FiberAccess/DC Service, IIJ mio FiberAccess/SF Service and IIJ mio MobileAccess Service, all as described in the table above. We also provide Terminal-type Dial-up IP Service to customers, but we are no longer promoting this service.

Value-Added Services

     Our customers are increasingly seeking additional network-related services, in addition to Internet connectivity. We provide our customers with a broad range of value-added services and products such as security, network, server-related outsourcing services in addition to Internet data center services. Generally, the service period is for one year and customers are billed monthly. We recognize revenues for these services on a straight-line basis during the service period. Any initial set-up fees received in connection with our value-added services are deferred and recognized over the contract period or estimated average period of estimated to customers.

     We believe that business customers will continue to increase their use of the Internet as a business tool and will increasingly rely on an expanding range of value-added services to enhance productivity, reduce costs and improve service reliability.

     Our value-added services include:

	•		Security-related outsourcing services. As of July 7, 2006, we offered seven main security-related outsourcing services that protect customers’ internal networks from unauthorized access and secure remote connections to internal networks: IIJ DDoS Solution Service, IIJ Security Premium, IIJ Security Standard, IIJ Security Lite, IIJ Security Scan Service, IIJ Network Intrusion Detection Service and IIJ Secure Remote Access. We were the first ISP in Japan to provide firewall services, which we first offered in 1994.
			IIJ DDoS Solution Service. In October 2005, we began offering IIJ DDoS Solution Service to protect customers’ internal networks from distributed denial of service (“DDoS”) attacks, a type of unauthorized access from Internet. The fee depends on the type of service that we provide and the initial fee starts at ¥650,000 and the monthly fee starts at ¥498,000.
			IIJ Security Premium. In July 2000, we began offering IIJ Security Premium, a high value-added firewall operation and management service based on Firewall-1, a product which we license from Check Point Software Technologies Ltd. The service combines and requires contracting for both Firewall Management Service and Firewall Rental Service. For Firewall Management Service, the initial setup fee is ¥200,000 and the monthly fee ranges from ¥150,000, depending on the redundancy of firewall equipment. For Firewall Rental Service, the initial setup fee ranges from ¥200,000 and the monthly fee ranges from ¥67,000

			depending on a number of factors including the number of users and packet filtering performance. The fees for Firewall Rental Service are multiplied by the number of firewall equipment if the customer requires redundancy.
			IIJ Security Standard. In October 1999, we began offering Security Standard Service pursuant to which we install and manage an around-the-clock operation of firewall systems. The initial setup fee ranges from ¥100,000, to ¥300,000, and the monthly fee ranges from ¥50,000,to ¥130,000 depending on a number of factors including the number of users, packet filtering performance and 3DES (VPN) (an encryption technology) performance. Since February 2001, a VPN option is available for this service with an initial cost of ¥20,000 and a monthly fee of ¥10,000 per computer.
			IIJ Security Lite. In December 2002, we began offering IIJ Security Lite, an economical version of a managed firewall service with limited features of operation and maintenance targeting small- and medium-sized enterprises. The initial setup fee ranges from ¥30,000 to ¥50,000, and the monthly fee ranges from ¥25,000 to ¥35,800.
			IIJ Security Scan Service. In March 2002, we began offering IIJ Security Scan Service, a package of services targeting small- and medium-sized enterprises to identify security weaknesses in order to prevent illicit access from external networks and to avert virus infection of in-house servers. It is available in two forms: regular monthly scans and one-time spot checks. The form of service can be selected to meet the specific needs of the customer, such as checks for protocol and network configuration or for vulnerability to specific illegal network intrusion. The service was developed with NRI Secure Technologies Ltd., a Japanese security assessment and auditing solutions provider. For the regular monthly scan service, the initial charge is ¥5,000. The monthly charge for scanning is ¥25,000 for one IP address, and ¥24,000 will be added for every additional IP address. For the spot scan service, the basic charge for scanning one IP address is ¥30,000, and ¥29,000 will be added for every additional IP address.
			IIJ Network Intrusion Detection Service. In April 2001, we began offering IIJ Network Intrusion Detection Service, which offers around-the-clock, non-stop network monitoring and intrusion-detection capabilities, as well as packet information for analyzing detected illicit accesses. The initial cost for the service is ¥300,000, and the monthly fee starts from ¥300,000, depending on the customer’s traffic volume.
			IIJ Secure Remote Access. IIJ Secure Remote Access is a packaged service combining the IIJ Dial-up Advanced with ID Gateway, which controls remote access to in-house servers protected by firewalls. In addition to the 50 dial-up accounts covered by the base rate, the service ensures a secure remote environment by controlling accessible servers and utilization protocols for each dial-up account. In May 2002, IIJ Secure Remote Access was upgraded by adding a remote VPN function. The upgrade enables remote users to transmit and receive data with encryption, offering a secure enterprise network environment with a greater variety of access options, such as connections from overseas via local ISPs. In June 2005, IIJ Secure Remote Access was upgraded by adding an Authentication Service Link Option, which enables customers to use a greater variety of authentication methods.
	•		Network-related outsourcing services. As of July 7, 2006, we offered six main network-related outsourcing services, including provision, monitoring and maintenance of network equipment and VPN to connect customers’ branch and remote offices: IIJ Internet-LAN Service, IIJ SMF-VPN, IIJ Managed VPN Pro Service, IIJ VPN Standard, SEIL Rental Service and IIJ NetLightning.

			IIJ Internet-LAN Service. IIJ Internet-LAN Service is a service which provides connectivity among a company’s branch and remote offices. With this service, customers can use functions provided by Wide-area Ethernet over the Internet.
			IIJ SMF-VPN. IIJ SMF-VPN is a service which uses IIJ SEIL Management Framework (“SMF”) which provides remote configuration and monitoring features of SEIL Series routers at customer remote sites from central management servers at IIJ and the customer’s main office or data center. The technology is patent granted. When a customer at a remote site connects the router to the circuit, the router is automatically configured and connected to the network. System integrators utilizing this technology can reduce configuration and maintenance costs at the remote site.
			IIJ Managed VPN Pro Service. IIJ Managed VPN Pro Service is a service which provides connectivity among a company’s branch and remote offices, utilizing SEIL Series or other routers.
			IIJ VPN Standard. IIJ VPN Standard is a service which provides Internet VPN connectivity among a company’s branch and remote offices based on encryption technology. IIJ rents out encryption equipment at customer sites, configures the equipment for the customer and provides remote monitoring of the encrypted sessions. Initial cost for the service starts from ¥30,000, and monthly fees start from ¥6,900 depending on the equipment features.
			SEIL Rental Service . We rent routers for connection to the Internet and provide configuration, management and monitoring services. We provide SEIL Series or CISCO routers depending on customer requirements.
			IIJ NetLightning. IIJ NetLightning is a service based on Netli, Inc.’s technology that improves web application performance. By utilizing this service, end users can access customer websites faster, without any settings, and customers can thereby reduce the cost of placing mirror sites.
	•		Server-related outsourcing services. As of July 7, 2006, we offered twelve main server-related outsourcing services including provision of e-mail and web services and operation and management of e-mails systems: IIJ Mail Gateway Service, IIJ Post Office Service, IIJ Mail Box Service, e-mail distribution services, IIJ Web Standard, web hosting services, IIJ Download Site Service, IIJ URL Filtering Service, IIJ Document Exchange Service, DNS services, streaming services and IIJ mio Safety Mail Service.
			IIJ Mail Gateway Service. In November 2002, we renovated IIJ Mail Gateway Service to expand the service from large corporate customers to other corporate segments. The service has three options. The first one is virus protection to check the viruses on incoming and outgoing e-mails. The second one is audit to detect the keyword set in advance on the outgoing e-mails. The third one is antispam to check spam for incoming e-mails, which we started to provide in October 2004. Customers can take all or a selection of the options. The initial cost is ¥10,000, and the monthly fee ranges from ¥30,000 to ¥70,000 for the first 50 e-mail accounts and an additional fee per account after the first 50 e-mail accounts ranges from ¥200 to ¥850.
			IIJ Post Office Service. IIJ Post Office Service is an e-mail operation outsourcing service performed by our e-mail server, enabling a customer to allocate and maintain a number of e-mail accounts under its own domain name for its employees, members or other relevant users. The customer can administer e-mail accounts online through our customer support Web interface. In December 2002, we added a virus checking option for incoming and outgoing

			e-mails and an “audit option” to check the content of outgoing e-mails and suspend the ones containing keywords specified in advance. In addition, we added a spam checking option which we started to provide in October 2004 for no additional charge to customers contracting the virus checking option or an “audit option”.
			IIJ Mail Box Service. IIJ Mail Box Service is also an e-mail operation outsourcing service performed by our e-mail server. Unlike IIJ Post Office Service, customers do not have to obtain their own domain names. A customer can administer e-mail accounts online through our customer support Web interface.
			E-mail distribution services. We offer other e-mail outsourcing services, such as services for e-mail distribution to large numbers of e-mail addresses and mailing list functions.
			IIJ Web Standard. The IIJ Web Standard allows customers to use their own domain names while providing them with up to 200 megabytes of web hosting space. By limiting specifications, the pricing of the service is kept to a minimum ¥5,000 per month. Additionally, careful traffic management of the storage space ensures a high-performance web-server environment for users is ensured. This service mainly targets small- and medium-sized enterprises.
			Web hosting services. We offer other web hosting services, such as customized web hosting services and functions to distribute computer files using our ftp servers.
			IIJ Download Site Service. IIJ Download Site Service is a hosting service dedicated to high-volume content downloads from the Internet. The service started on a trial basis in November 2001, and the full-fledged service was launched in February 2002. A dedicated hosting server and dedicated bandwidth are established for each contract to ensure constant stable performance. With disk capacity of 500 megabytes per contract on our hosting servers, access is provided at a maximum transmission bandwidth per contract of up to 80 Mbps. The initial charge for the service is ¥50,000. The monthly charge ranges between ¥60,000 and ¥340,000, depending upon the bandwidth. In April 2003, we added the option of 1 Gbps maximum transmission speed for an additional fee.
			IIJ URL Filtering Service. IIJ URL Filtering Service is a service enabled by the use of IIJ’s proxy server which blocks access to websites deemed inappropriate. The initial cost for the service is ¥30,000, and the monthly fee is ¥40,000 as a basic fee plus an additional fee depending on the number of users in the customer’s internal network.
			IIJ Document Exchange Service. This service is an online storage service with which customers can upload files onto IIJ’s storage server and share them with authorized users. The initial cost is ¥40,000 and the monthly fee is ¥20,000, which includes 1GB of disk space and 50 accounts. The fee for each additional set of 10 accounts is ¥3,000, and each 1GB of additional disk space is ¥10,000 per month.
			DNS services. We offer domain name related services that consist of domain name administration services and domain name server outsourcing services. Domain names such as “.jp”, “.com”, “.net” and “.org” are available.
			Streaming services. We offer Internet streaming services for live broadcasts over the Internet, as well as streaming server hosting services.

			IIJmio Safety Mail Service. IIJ mio Safety Mail Service, launched in December 2001, is a standard e-mail service with an anti-virus function for individual users. The service employs the InterScan VirusWall developed by Trend Micro Incorporated, and features POP/SMTP over SSL which provides secure e-mail transmission by encrypting the e-mail transmission between the users and our mail server, in addition to SMTP authentication, which ensures a higher level of encryption and authorization than what is currently available for general use. In February 2005, we started to provide spam check function without an additional charge. There is no initial charge for IIJ mio Safety Mail Service and the monthly charge is ¥500.
	•		Internet data center services. Our Internet data center services include three primary services which are typically bundled together for our customers: IIJ data center facility services, IIJ data center connectivity services and management and monitoring services. Our Internet data center facility services are co-location services which allow companies to house their servers and routers off-site on our premises. Our Internet data center facilities are leased from third parties such as NTT Communications and are equipped with robust security systems, 24-hours-a-day non-stop power supplies and fire extinguishing systems, and have earthquake-resistant construction and high-speed Internet connectivity with IIJ backbones. We also offer basic monitoring and maintenance services for the equipment. This service enhances reliability because we provide 24-hours-a-day monitoring and have specialized maintenance personnel and facilities. We offer management and monitoring services tailored to our customers’ requirements.
	•		Customer support and help desk solutions. We provide comprehensive customer support and help desk solutions that include network monitoring and trouble-shooting services. Most of our customer support services are provided as an integral part of other services we sell.
	•		IP Phone. We began IP Phone service for individual users of IIJ4U and IIJ mio in May 2003, and for corporate users who are using IIJ’s Internet connectivity services through NTT FLET’S network in December 2003. The telephone service is provided via NTT FLET’S network and customers can make telephone calls with other users connected to NTT FLET’S network or legacy telephones by interconnection with the Publicly Switched Telephone Network, the legacy telephone network.
	•		IIJ EPC Network Service. IIJ EPC Network Service is a service to provide network and server systems for our customers to use Radio Frequency Identification Tag (“RFID”). We offer three types of services. “Premium” is a service to provide customized systems for our customers. “Standard” is a service to provide our systems to provide our systems at our data centers and “Trial” is a service to provide RFID functions to our customers for their trial usage.

Systems Integration

     We offer systems integration tailored to our customers’ requirements, which include consulting, project planning, systems design, construction of network systems and systems and operations outsourcing. Our systems integration mainly focus on Internet business systems and Intranet and Extranet corporate information systems. We have built a strong record in various business fields.

     Examples of systems integration are:

•

connecting over a hundred locations such as gas stations, bank branches and retail shops via Internet-VPN, transmission of data over the Internet with an encryption feature and our proprietary SEIL Series routers and SMF,

	•		voice over IP systems to transmit voice among customer branch offices over Internet,
	•		outsourcing of large scale e-mail servers or systems to detect or delete e-mails with viruses or spam or record all of e-mails incoming to and outgoing from customers,
	•		construction of wireless local area network (“LAN”),
	•		online brokerage systems for securities firms,
	•		outsourcing of websites for online businesses,
	•		re-construction of overall corporate network systems suited to increased traffic data, and
	•		consultation on corporate network security.

     The fee structure of our systems integration is based upon the complexity and scale of the project. We bill our customers for these services on a fixed-fee basis and recognize the revenue when the network systems and equipment are delivered and accepted by the customer. Maintenance, monitoring and operating service revenues are recognized ratably over the separate contract period, which is generally for one year.

     In the planning phase of a systems integration project, we form special project management teams formulated for every new assignment from the customer. We analyze and design the customer’s network and systems with three engineering focuses: reliability, flexibility and extendibility.

     In the network systems construction phase, we procure equipment such as servers and manage application development and software programming tasks which are outsourced to third parties. Network systems construction usually incorporates many of our other connectivity and value-added services.

     In the operation phase, by utilizing data center facilities directly linked to our network, we provide a range of outsourcing services, which take maximum advantage of the Internet system, network operation and management know-how of the IIJ Group companies. Rather than simply looking after the customer’s content, we take care of the customer’s entire computing environment and provide around-the-clock operation and management services, as well as custom-designed monitoring systems. These outsourcing services enable customers to free themselves from the burden of operating the network systems, which demands professional operation and maintenance to ensure prompt and flexible responses to unexpected system problems.

     We also provide our customers with basic, easy-to-order systems integration, which we refer to as IBPS, including provision of network resources such as network equipment, data storage systems, network monitoring and systems operation management, on demand and on a monthly basis, therefore enabling our customers to launch their internal network system securely and cost effectively.

Equipment Sales

     In addition to the Internet connectivity and value-added services and systems integration, we sell our network equipment for connection to the Internet and usage of additional features, which was developed in-house.

      SEIL Series. We started to sell our high-end routers SEIL Series, which was developed in-house, in October 2001 through sales agents. The series includes four types, SEIL/TURBO, SEIL/plus, SEIL/neu 128 and SEIL DOCK 2. SEIL/TURBO has a high throughput and enhanced VPN features and is placed in customer’s main office or data center when a customer connects its branch and remote offices. SEIL/plus is

suitable for broadband connection and is placed mainly in customer’s branch and remote offices. SEIL/neu 128 is suitable for ISDN or 64 k/128 kbps leased line based Internet connection. SEIL DOCK 2 is equipment to provide a back-up feature to customers. By combining SEIL/TURBO and other SEIL Series routers, we are able to provide Internet-VPN solutions connecting corporate branches and remote offices of medium and small enterprises. In addition, we provide rental services for these routers directly to customers.

     We also sell third-party equipment to meet the one-stop needs of our customers.

Network

     Our network is one of our most important assets. We have developed and currently operate a high-capacity network that has been designed to provide reliable, high-speed, high-quality Internet connectivity services.

     We are able to achieve and maintain high speeds through our advanced network architecture, routing technology and load balancing that optimize traffic on our multiple Internet connections.

     The primary components of our network are:

	•		our backbone, which includes leased lines and network equipment, such as advanced Internet routers,
	•		Points of Presence (“POPs”) in major metropolitan areas in Japan,
	•		Internet data centers, and
	•		a network operations center (“NOC”).

Backbone

Leased lines

     Our network is anchored by our extensive Internet backbone in Japan and between Japan and the United States. As of July 7, 2006, we had a total capacity of 7.2 Gbps between Japan and the United States and 600 Mbps between Japan and China. We use our expertise in developing and operating our network to organize and connect these leased lines to form a backbone that has substantial transmission capacity.

     We lease high-capacity, high-speed digital transmission lines in Japan from various carriers. The table below shows our backbone cost.

Backbone Cost

		For the fiscal year ended March 31,
		2002				2003				2004				2005				2006
Backbone cost (thousand yen)		¥	5,656,116			¥	5,235,517			¥	4,719,638			¥	3,550,885			¥	3,516,322

Network upgrades

     As a policy, we put a high priority to maintain the quality of our networks and continuously examine the necessity of upgrades of our networks.

Network equipment

     We use advanced equipment in our network. Our primary routers in our network are Cisco routers. The size of our routers varies depending on the number of customers and volume of traffic served by our POPs. At each POP we connect our dedicated line and dial-up access routers to Cisco backbone routers which then transmit and receive information throughout our network. We primarily lease our network equipment under capital lease arrangements.

      Points of Presence . POPs are the main points at which our customers connect to our backbone. We provide Internet connectivity from our POPs to commercial and residential customers through leased lines and dial-up connections over local exchange facilities. As of July 7, 2006, we had 13 primary POPs which allow for dedicated access and include the main Internet backbone routers that form our network. As of the same date, we also had 17 POPs for dial-up access. The number of POPs for dial-up access include one POP that can be accessed from anywhere in Japan with the minimum local telephone charge.

     Many of our POPs are located in, or in close physical proximity to, “carrier hotels”. Carrier hotels are facilities where we and other major carriers and ISPs have POPs. These are mainly located at facilities of various carriers in Japan like NTT Communications, KDDI Corporation (“KDDI”) and Japan Telecom Co., Ltd. We lease the physical space from these carriers or use such space under other arrangements with terms ranging from one to two years and terminable by either party on three to six months’ notice. We maintain our routers and other networking equipment at these POPs. Our POPs are in, or in close proximity to, the same buildings in which the switches and routers of these carriers and ISPs are located enabling quick and easy interconnection of our equipment with theirs.

      Internet Data Centers. We operate twelve Internet data centers which we use to offer our value-added data center services, three in Tokyo, two in Yokohama, and one each in Osaka, Sapporo, Sendai, Kawaguchi, Nagoya, Kyoto and Fukuoka. These data centers are specifically designed for application hosting, co-location services and high capacity access to our networks. All of these data centers are leased from NTT Communications, CRC Solutions Corp. and KDDI.

     These data centers have 24-hours-a-day, seven-days-a-week operations and security and are equipped with uninterruptible power supplies and backup generators, anti-seismic damage precautions, fire suppression equipment and other features to optimize our ability to offer high-quality services through these data centers.

     In addition, we have invested in data center development outside Japan. We have entered into the “i-Heart” joint venture with Samsung Corp., which operates in Korea with a total investment by us of ¥89 million in May 2000.

      Network operations center and technical and customer support. Our NOC in Tokyo operates 24 hours a day and seven days a week. From our NOC, we monitor the status of our network, the traffic on the network, the network equipment and components and many other aspects of our network including our customers’ dedicated access lines leased from carriers. From our NOC, we monitor our networks to ensure that we meet our commitments under our Service Level Agreements.

Our Group Companies

     We offer our services directly and together with our group companies. Our group companies work closely together in providing total network solutions to our customers. We collaborate on the development of various services and products and market our services and products together as a group. However, our group companies specialize in different aspects of the Internet and networking. Our customers’ main point of

contact is IIJ itself. We then draw upon the resources and special capabilities of the group companies to offer total Internet solutions.

     The table below sets out our group companies, including our subsidiaries and principal equity method investees and our direct and indirect ownership of each of them as of July 7, 2006:

IIJ Technology Inc.

     IIJ Technology Inc. (“IIJ-Tech”) is an important element in our provision of total network solutions to our customers. IIJ-Tech is incorporated under the laws of Japan. IIJ-Tech provides comprehensive network systems integration and consulting services, focusing on design, operation, and consulting for corporate networks (LANs, enterprise networks, Intranets) and their security systems. IIJ-Tech assists customers in creating private IP networks, such as Intranets or virtual private networks, that securely isolate internal network traffic from public Internet traffic and provide each site on the private IP network access to other sites as well as to the Internet. IIJ-Tech can integrate an organization’s multiple sites in different locations in Japan.

     On April 27, 2004, IIJ-Tech completed a private placement of 10,000 shares of common stock to us and other shareholders for an approximate aggregate amount of ¥1,000 million. We accepted most of the placement. Our ownership increased from 64.1% to 69.0% during the fiscal year ended March 31, 2005.

     In October 2005, IIJ-Tech issued 1,235 new shares of common stock to IIJ Media Communications Inc. (“IIJ-MC”) when a portion of IIJ-MC’s business was transferred to IIJ-Tech As IIJ-MC was merged into us, the new shares of IIJ-Tech were succeeded to us and our ownership increased from 69.0% to 72.1%.

     IIJ-Tech had sales of approximately ¥18,441 million for the fiscal year ended March 31, 2006. As of March 31, 2006, IIJ-Tech had 214 full-time employees, and 32 were seconded from us.

IIJ America Inc.

     IIJ America Inc. (“IIJ-A”) is a U.S.-based ISP, catering mostly to U.S.-based operations of Japanese companies. IIJ-A is incorporated under the laws of the state of California.

     IIJ-A had revenues of $9,371 thousand for the fiscal year ended December 31, 2005. As of March 31, 2006, IIJ-A had 22 employees, 4 of whom were seconded from us.

Net Care, Inc.

     Net Care, Inc. (“Net Care”) provides a broad array of support services, from monitoring and troubleshooting to network operations and an end-user help desk.

     On April 27, 2006, our board of directors approved purchase of 450 shares of Net Care from its minority shareholders. We purchased the shares on April 28, 2006. As a result, our ownership increased from 57.0% to 59.3%.

     Net Care had sales of approximately ¥2,367 million for the fiscal year ended March 31, 2006. As of March 31, 2006, Net Care had 165 employees, 12 of whom were seconded from us.

IIJ Financial Systems Inc.

     IIJ Financial Systems Inc. (“IIJ-FS”) is a company wholly owned by IIJ-Tech, whose business was acquired from Yamatane Co., Ltd. in October 2004. IIJ-FS provides integration and operation of security systems.

     IIJ-FS had revenues of ¥2,624 million for the fiscal year ended March 31, 2006. As of March 31, 2006, IIJ-FS had 73 employees.

Internet Multifeed Co.

     Internet Multifeed Co. (“Multifeed”) provides location and facilities for directly connecting high-speed Internet backbones with content servers to make distribution on the Internet more efficient. Multifeed is incorporated under the laws of Japan. Its technology was developed jointly with the NTT Group. Multifeed launched new IX (Internet eXchange — where major ISPs exchange network traffic) services named JPNAP in Tokyo in May 2001 and expanded the service to Osaka in December 2001.

     Multifeed had sales of approximately ¥2,376 million for the fiscal year ended March 31, 2006. As of March 2006, Multifeed had 23 full-time employees, and 4 employees were seconded from us.

atom Co., Ltd.

     atom Co., Ltd. (“atom”), which is incorporated under the laws of Japan, is primarily a web-page design company that aims to define new forms of design work using digital technology in all network-based aspects of design from content production to graphic design.

     atom had sales of approximately ¥797 million for the fiscal year ended March 31, 2006. As of March 31, 2006, atom had 65 employees, 1 of whom was seconded from us.

Internet Revolution Inc.

     On February 1, 2006, we and Konami Corporation established a joint venture company, Internet Revolution Inc. (“i-revo”) to operate comprehensive sites. We invested ¥750,000 thousand in i-revo and owned 30% ownership as March 31, 2006. We account i-revo as an equity method investee in our consolidated financial statements.

     i-revo had sales of approximately ¥3 million for the fiscal year ended March 31, 2006. As of March 31, 2006, i-revo had 34 employees, 10 of whom was seconded from us.

Capital Expenditures

     The table below shows our capital expenditures, which we define as amounts paid for purchases of property and equipment plus acquisition of assets by entering into capital leases, for the last three years.

     Our future capital expenditures are difficult to predict given the rapid changes and uncertainties in our business environment. Most of our capital expenditures relate to the expansion and improvement of our existing network, including the installation of the routers and servers necessary to offer services on our network.

     We have not made any material divestitures in the current or past three fiscal years. We recorded losses on disposal of property and equipment of ¥110 million, ¥144 million and ¥119 million for the fiscal years ended March 31, 2004, 2005 and 2006, respectively. The losses for the fiscal years ended March 31, 2004 and 2005 were mainly due to disposal of back-office systems and telephone rights. The loss for the fiscal year ended March 31, 2006 was mainly due to disposal of software, such as for back-office systems.

Seasonality

     See Item 5.D., “Trend Information — Factors Affecting Our Future Financial Results — Systems integration revenues, including related equipment sales revenues”.

Sales and Marketing

     Our sales headquarters are in Tokyo. We also have branches in Osaka, Nagoya, Sapporo, Sendai, Toyota, Toyama, Hiroshima, Fukuoka and Okinawa in order to cover the major metropolitan areas in which the majority of large Japanese companies operate. As of March 31, 2006, we had approximately 200 people working in sales and marketing.

     We organize our sales personnel into four distinct, separate divisions, Product and Marketing, Operation Management Coordination Division and Strategic Sales. In addition, we have nine branch offices.

     Sales Divisions consists of the following:

	•		Three of Divisions focus on our total network solutions and work with large corporate clients, including telecommunications carriers and ISPs, financial institutions, manufacturers, government institutions, universities and other schools, or focus on the expansion of sales agents for our services and network equipment. In order to provide total network solutions, personnel in our sales divisions work closely with other IIJ Group companies such as IIJ-Tech as well as with other important service providers.
	•		One Division focuses on total network solutions and works with governmental institutions.

     Our Product and Marketing mainly makes and conducts promotion plans on our products and services. Operation Management Coordination Division handles administrative issues. Strategic Sales is responsible for the planning and management on the sales figures, processes and other information.

Customers

     We have approximately 6,500 business and other institutional customers and approximately 630,000 individual subscribers, which includes individuals subscribing to OEM services, as of March 31, 2006. Our main customers continue to be major corporations, including ISPs.

Research and Development

     We have always focused on advancing the use of networking technologies, including the Internet, in Japan. Many of our engineers regularly participate in industry organizations and government-sponsored research projects such as researching new Internet protocol standards, namely Internet Protocol Version 6 (IPv6). These engineers have continued to develop innovative services, applications and products, many of which have set the standard for the Internet industry in Japan. In addition to our efforts to develop innovative services, we have engaged in the research and development of new basic technology since the establishment of IIJ Research Laboratory in 1998.

     Our research and development expenses averaged less than 1.0% of total revenues for the past three consecutive years. For the fiscal years ended March 31, 2006, 2005 and 2004, our research and development expenses were ¥158 million, ¥199 million and ¥358 million, respectively, most of which was personnel expense. The level of research and development expenditures is low in relation to our total costs primarily because we do not engage in extensive research and development of new technologies and products that require large investments. Rather, as noted above and as set forth in more detail below, we are intensively engaged in research and development related to our ongoing business. We focus on monitoring developments in the industry and in developing new and innovative services and applications by using and modifying existing technologies and products.

     As of March 31, 2006, we had approximately 100 people working in our research and development organization, including the staff in IIJ Research Laboratory. Our research and development staff works very closely with our sales and marketing personnel and technical engineers to ensure that our research and development efforts are closely aligned with the demands of our customers.

Research and Development Organization

     We have organized our research and development staff to promptly and effectively address the rapidly changing technological environment of the Internet. Research and development on practical applications of new and developing technologies is the responsibility of the Applied Research and Development Department.

      IIJ Research Laboratory. We established the IIJ Research Laboratory in April 1998 to engage in the research and development of new basic network technologies. Through the IIJ Research Laboratory, we participate in various research and development activities in cooperation with organizations from the private and academic sectors to promote the deployment and implementation of IPv6. The output of the joint undertaking with WIDE project is distributed freely in order to promote the introduction of IPv6 on a worldwide scale. IPv6 is designed to solve problems inherent in the current version of IP, which is IPv4, such as IP address space depletion. In addition, IPv6 is expected to provide new network features such as ubiquitous networking.

      Applied Research and Development Department. Applied Research and Development Department engages in the research and development of technologies to be applied to our services and solutions, collects information on, evaluates on the new technology and conducts business expansion based on the technology IIJ Research Laboratory developed.

Research and Development Strategy

     Our primary research and development objective is to continue to develop innovative services, applications and products that will meet the current and future demands of our customers and that will continue to be at the forefront of the Internet industry in Japan. In furtherance of this objective, our research and development efforts currently are focused on a variety of projects, including:

	•		continued improvement of our SEIL router and SEIL Management Framework, systems which we developed specifically to be integrated into IIJ’s network-related services,
	•		research relating to the methodology of configuration of routers and other servers,
	•		research relating to behavior of Internet routing systems,
	•		software development for management of border gateway protocol, or BGP, which is protocol that allows routers to exchange routing information on the TCP/IP network,
	•		research for Internet traffic monitoring and management,
	•		development of software and evaluation of hardware relating to improving the operations of routers located on our customers’ premises, and
	•		research and development of IPSec, which is a secure version of IP that provides secure communication channels over the Internet.

     A second research and development objective is to continue participating in or otherwise closely monitoring the new products, developments and initiatives of manufacturers and standards-setting and research groups. Through these efforts, we seek to ensure that we have timely and effective access to new technologies and that we implement these technologies effectively. Because the rate of change in technology relevant to our business is so rapid, we believe that the sophistication and experience of our research and development personnel is an important part of our success.

Proprietary Rights

     Although we believe that our success is more dependent upon our technical, marketing and customer service expertise than our proprietary rights, we rely on a combination of trademark and contractual restrictions to establish and protect our technology.

Licenses

     For us to provide certain services to our customers, we have been a licensee under agreements with other suppliers, such as Check Point Software Technologies Ltd., WatchGuard Technologies, Inc., Trend Micro Incorporated, RSA Security Inc., NRI Secure Technologies, Ltd. and MX Logic, Inc.

     We have purchased licenses from the companies in accordance with customer demands for our services.

Trademarks

     We have applied for trademark registrations of our corporate name, “Internet Initiative Japan Inc.” and certain other corporate and product names in Japan, the United States and certain European countries. As of July 7, 2006, 35 registrations have been granted, with 6 pending applications.

Patents

     We have applied for patent registrations in relation to our technology in Japan and the United States. As of July 5, 2006, 4 registrations have been granted, with 6 pending applications. The latest acquired patent is for centralized network management system originally developed by us and is implemented in one of our competitive services, SMF (SEIL Management Framework).

Legal Proceedings

     We are involved in normal claims and other legal proceedings in the ordinary course of business. Except as noted below, we are not involved in any litigation or other legal proceedings that, if determined adversely to us, we believe would individually or in the aggregate have a material adverse effect on us or our operations.

     In December 2001, a class action complaint alleging violations of the federal securities laws was filed against us in the United States District Court for the Southern District of New York, naming as defendants IIJ; Koichi Suzuki, our President, Chief Executive Officer and Representative Director; Yasuhiro Nishi, our former Director, Chief Financial Officer and Chief Accounting Officer; and the Goldman Sachs Group Inc. and Morgan Stanley (formerly, Morgan Stanley Dean Witter, Inc.), both of which served as underwriters of our initial public offering. Similar complaints have been filed against over 300 other issuers that have had initial public offerings since 1998, and all such actions have been included in a single coordinated proceeding in the Southern District of New York. An amended complaint was filed on April 24, 2002. The amended complaint alleges, among other things, that the underwriters of our initial public offering (i) entered into certain alleged compensation arrangements with the underwriters’ clients, such as undisclosed commissions or tie-in agreements to purchase stock in the after-market, and (ii) engaged in manipulative practices to artificially inflate the price of our stock in the after-market subsequent to the initial public offering. The IIJ defendants are named in the amended complaint pursuant to Sections 11 and 15 of the Securities Act of 1933, as amended, and Sections 10(b) and 20(a), and Rule 10b-5 of the Securities Exchange Act of 1934, as amended, on the basis of an alleged failure to disclose the underwriters’ alleged misconduct. The complaint seeks unspecified damages. On July 15, 2002, we joined in an ‘omnibus’ motion to dismiss the amended complaint filed by the issuers and individuals named in the various coordinated cases. In June 2003, we approved a settlement with the plaintiffs in this matter.

     We, along with the settling issuer defendants, filed a motion seeking the court’s preliminary approval of the settlement. The court granted preliminary approval of the settlement on February 15, 2005, subject to certain modifications. On August 31, 2005, the court issued a preliminary order further approving the modifications to the settlement and certifying the settlement classes. The court also appointed the Notice Administrator for the settlement and ordered that notice of the settlement be distributed to all settlement class members beginning on November 15, 2005. A settlement fairness hearing took place on April 24, 2006. If the court determines that the settlement is fair to the class members, the settlement will be approved.

     The settlement releases us and the individual defendants from liability for the conduct alleged in the action. Under the settlement, we agreed to assign away, not assert, or release certain potential claims we may have against our underwriters. As to financial impact on us, the settlement provides that the class members will be guaranteed $1 billion dollars in recoveries by the insurers of the issuers. In addition to IIJ’s portion of the proposed settlement, some of the continuing legal expenses incurred in connection with the partial

settlement would be borne by our insurer based on the settlement agreement and an individual agreement between us and our insurer. Consequently, we believe that there will be no significant financial impact on us as a result of this matter.

Regulation of the Telecommunications Industry in Japan

     The Ministry of Internal Affairs and Communications (“MIC”) regulates the Japanese telecommunications industry. Carriers, including us, are regulated by the MIC primarily under the Telecommunications Business Law.

The Telecommunications Business Law

     The Telecommunications Business Law, which became effective in 1985, was established for the purpose of privatization and deregulation in telecommunications business. After several amendments, the Telecommunications Business Law was considerably amended in July 2003. The amendments to the Telecommunications Business Law, which came into force on April 1, 2004, include, among other things:

	•		the elimination of the classification of Type I Carriers and Type II Carriers;
	•		deregulation of regulations on charges and terms and conditions for providing services by Carriers; and
	•		the introduction of certain terminal-equipment-supplier’s declaration system regarding technical standard conformity.

     The Prior Telecommunications Business Law stipulated that the Carriers shall be classified as either Type I Carrier or Type II Carrier, and imposed regulations in accordance with such classification of Carriers. Prior Type I Carriers, such as NTT East, NTT West, provided telecommunications services by establishing their own telecommunications circuit facilities. Prior Type II Carriers, including us, engaged in the businesses of telecommunications circuit resale and the provision of Internet services by using the telecommunications facilities of Type I Carriers.

     However, from the viewpoint of encouraging telecommunications carriers to carry out diverse business, etc, the Telecommunications Business Law was amended so as to abolish the classification of Type I Carriers and Type II Carriers, and thereupon the rules pertaining to services (i.e., start-up, abolition, charges and tariffs, etc.) were deregulated in principle while establishing rules to protect the users, and the rules pertaining to infrastructure were reviewed as necessary while maintaining the basic framework stipulated under the prior Telecommunications Business Law. For example, (i)the approval system for business entries and withdrawals was replaced by a registration/notification system, (ii)regulations pertaining to service offerings, tariff setting and interconnection between carriers were liberalized, (iii)regulations to protect service users such as announcement of withdrawal, explanation of important matters on services and swift processing of complaints were introduced, and (iv)an authorization system allowing priority usage of public utilities conducive to facilitation of circuit facilities deployment was introduced.

     The following table summarizes changes by the amendment above in some of the major regulatory requirements applicable to telecommunications carriers:

   (Before Amendment)

   (After Amendment)

     Before the amendments to the Telecommunications Business Law, we were classified as a Special Type II Carrier. After the amendments, we are deemed by the effect of Supplementary Provisions to the amended Telecommunications Business Law to have filed the notification to MIC under the amended Telecommunications Business Law. In practice, we filed an actual notification to MIC in April 2004 according to the request of MIC.

Regulations of telecommunications carriers

     The following regulations apply to telecommunications carriers defined in the Telecommunication Business Law.

      Start-up of Services

	•		Carriers with registration
			Registration with the MIC required for telecommunications carriers which exceed criteria established by MIC’s ordinance in relation to the scale of the telecommunications circuit facilities and the scope of areas where such telecommunications circuit facilities are installed.
	•		Other Carriers
			Notification to the MIC required for telecommunications carriers other than the above. We do business under this category.

      Charges and Tariffs

	•		Unregulated, in general. The requirement that standard terms and conditions be applied equally to all users was repealed.
	•		Prior notification to the MIC required for Basic Telecommunications Services (universal services such as basic fee, local call and emergency telecommunication service) and Designated Telecommunications Services (i.e., services which have the controlling power over the market provided by the telecommunications carriers which install what is called the “bottle-neck facilities”). Among the Designated Telecommunications Services, the telecommunications services to be specified by MIC at least once a year will be subject to price cap regulations, under which carriers will be required to obtain approval from the MIC if a proposed change of charge exceeds the price cap. Providing these telecommunications services other than pursuant to the terms and conditions notified to the MIC is prohibited, unless minor exceptions apply.

      Articles of Interconnection Agreements

	•		Unregulated, in general.
	•		Approval from the MIC required for Category I Designated Telecommunications Facilities.
	•		Prior notification to the MIC required for Category II Designated Telecommunications Facilities.

      Telecommunications Facilities of Carriers.

•

A telecommunications carrier that owns telecommunications circuit facilities must maintain its telecommunications facilities (except telecommunications facilities stipulated in MIC’s ordinances as those having a minor influence on the users’ benefit in the cases of damage or failure thereof) in conformity with the technical standards provided in the applicable MIC’s ordinances. Such Carriers shall confirm itself that said telecommunications facilities are in compliance with such technical standards specified in the applicable MIC’s ordinances.

	•		A telecommunications carrier that provides Basic Telecommunications Services must maintain their telecommunications facilities for provision of their Basic Telecommunications Services in conformity with the technical standards provided in the applicable MIC’s ordinances.
	•		Telecommunications Carriers that own telecommunications circuit facilities or provide Basic Telecommunications Services must establish their own administrative rules in accordance with MIC’s ordinances in order to secure the reliable and stable provision of telecommunications services. These administrative rules must regulate the operation and manipulation of telecommunications facilities and the safeguarding, inspecting and testing regarding the construction, maintenance and administration of telecommunications facilities, etc. as provided for by the ministerial ordinance of MIC. Such administrative rules must be submitted to the MIC prior to the commencement of operations, and changes must be submitted to the MIC after they are implemented without delay.

      Order to Improve Business Activities

•

The Minister for MIC may, if it is deemed that business activities of a telecommunications carrier falls under the inappropriate items set forth in the Telecommunications Business Law, insofar as necessary to ensure the users’ benefit or the public interest, order said telecommunications carrier to take actions to improve operations methods or other measures.

      Right of Way Privilege for Authorized Carriers

•

Authorization on the entire or a part of a carrier’s telecommunications business by MIC for the privileged use of land or other public utilities for circuit facilities deployment is required. Right of Way privilege is available to carriers irrespective of registration.

      Merger, Business Transfer or Divestiture of Carriers

•

Post facto notification to MIC without delay is required.

      Business Suspension, Abolition or Dissolution of Carriers

•

Post facto notification to MIC without delay is required. Prior announcement of withdrawals to service users is required in accordance with MIC’s ordinance.

      Foreign Capital Participation

•

Unregulated. Prior notification is required under the Foreign Exchange and Foreign Trade Law for acquisition of shares of telecommunications carriers to which registration for start-up services is applicable. This is not applicable to purchasers of ADSs. The one-third foreign ownership restriction is applicable only to NTT.

C. Organizational Structure.

     The information required by this item is in “ — Our Group Companies” above.

D. Property, Plants and Equipment.

     The information required by this item is in “ — Network” above.

Item 4A. Unresolved Staff Comments

     None.

our 1.75% convertible notes due March 2005 using our cash and cash equivalents as well as available-for-sale securities.

     On December 2, 2005, we listed on the Mothers market of the Tokyo Stock Exchange (“TSE”). In connection with the listing, we issued 12,500 new shares of common stock for an amount of ¥6.0 billion. As we conducted a 1 to 5 stock split on October 11, 2005, the total number of our issued shares of common stock increased to 204,300.

     In order to provide our customers with total network solutions, we provide our services directly or by working together with the subsidiaries and affiliates of IIJ Group. We refer to our subsidiaries and certain affiliates as our group companies, and we have invested heavily in and exercise significant influence over these companies. We consolidate the results of operations of four subsidiaries included among our group companies ¾ IIJ Technology Inc. (“IIJ-Tech”), IIJ America Inc. (“IIJ-A”), Net Care, Inc. (“Net Care”) and IIJ Financial Systems Inc. We account for our investments in the affiliated companies by the equity method.

     There have been significant changes in the scope of our consolidated subsidiaries and equity method affiliates in the last three fiscal years. On August 20, 2003, Crosswave Communications Inc. (“Crosswave”), our former equity method investee, filed a voluntary petition for the commencement of corporate reorganization proceedings in Japan and accordingly, we no longer had the ability to exercise significant influence over the operating and financial policies of Crosswave thereafter. For the fiscal year ended March 31, 2003, we wrote off our equity method investment as well as a ¥5.0 billion security deposit advanced to Crosswave in connection with financing provided by four Japanese commercial banks. In December 2003, Crosswave transferred its business operations to NTT Communications Corporation. We further wrote off ¥1.7 billion of outstanding loans extended to Crosswave and ¥0.4 billion of accounts receivable owned to us by Crosswave in the fiscal year ended March 31, 2004.

     On October 1, 2005, IIJ Media Communications Inc. (“IIJ-MC”), our former consolidated subsidiary, was merged into us after a portion of IIJ-MC’s business was transferred to IIJ-Tech, our consolidated subsidiary. Asia Internet Holding Co., Ltd. (“AIH”), our former equity method investee, became our wholly owned consolidated subsidiary, and was merged into us on October 1, 2005. In each of the mergers, we were the surviving company.

     On February 1, 2006, we established a joint venture company, Internet Revolution Inc. (“i-revo”), with Konami Corporation, with the purpose of operating comprehensive portal sites. We invested ¥750 million and hold 30.0% of the company. i-revo is an equity method investee.

     For a discussion of factors affecting our future financial results, see “Item. 5.D. Trend Information”.

      Results of Operations

     As an aid to understanding our operating results, the following tables show items from our statement of operations for the periods indicated in millions of yen amounts (or thousands of U.S. dollars) and as a percentage of total revenues.

		Fiscal year ended March 31,
		2004								2005								2006
		(millions of yen except for percentage data)																								(thousands of
																										U.S.
																										dollars)
REVENUES:
Connectivity and value-added services revenues:
Dedicated access		¥	12,862				33.2	%		¥	11,373				27.3	%		¥	10,625				21.3	%		$	90,443
Dial-up access			3,088				8.0				2,937				7.0				2,674				5.4				22,760
Value-added			4,296				11.1				5,005				12.0				6,250				12.5				53,200
Other			2,118				5.4				3,169				7.6				3,674				7.4				31,272
Total connectivity and value-added services			22,364				57.7				22,484				53.9				23,223				46.6				197,675
Systems integration, including related equipment sales			11,848				30.5				15,854				38.0				23,505				47.2				200,072
Equipment sales			4,567				11.8				3,365				8.1				3,085				6.2				26,262
Total revenues			38,779				100.0				41,703				100.0				49,813				100.0				424,009
COST AND EXPENSES:
Cost of connectivity and value-added services:
Backbone cost			4,720				12.2				3,551				8.5				3,516				7.0				29,931
Local access line cost			3,500				9.0				4,040				9.7				4,558				9.2				38,801
Other connectivity cost			1,422				3.7				1,361				3.3				815				1.6				6,941
Depreciation and amortization			3,135				8.1				2,938				7.0				2,721				5.5				23,160
Other			7,270				18.7				7,594				18.2				8,468				17.0				72,073
Total cost of connectivity and value-added services			20,047				51.7				19,484				46.7				20,078				40.3				170,906
Cost of systems integration, including related equipment sales:
Cost of equipment sales related to systems integration			1,546				4.0				1,759				4.2				3,591				7.2				30,568
Other			8,306				21.4				10,441				25.0				14,529				29.2				123,675
Total cost of systems integration			9,852				25.4				12,200				29.2				18,120				36.4				154,243
Cost of equipment sales			4,346				11.2				3,111				7.5				2,818				5.7				23,987
Total cost of revenues			34,245				88.3				34,795				83.4				41,016				82.4				349,136
Sales and marketing			3,528				9.1				2,795				6.7				3,080				6.2				26,213
General and administrative			2,098				5.4				2,666				6.4				3,147				6.3				26,790
Research and development			358				0.9				199				0.5				158				0.3				1,346
Total cost and expenses			40,229				103.7				40,455				97.0				47,401				95.2				403,485
OPERATING INCOME (LOSS)			(1,450	)			(3.7	)			1,248				3.0				2,411				4.8				20,524
OTHER INCOME (EXPENSES):
Interest income			38				0.1				13				0.0				13				0.0				111
Interest expense			(702	)			(1.9	)			(686	)			(1.6	)			(437	)			(0.9	)			(3,723	)
Foreign exchange gains (losses)			(7	)			(0.0	)			6				0.0				3				0.0				30
Net gain on other investments			1,413				3.7				2,439				5.9				3,198				6.5				27,219
Other — net			240				0.6				128				0.3				191				0.4				1,622
Other income — net			982				2.5				1,900				4.6				2,967				6.0				25,259
INCOME (LOSS) FROM OPERATIONS BEFORE INCOME TAX EXPENSE, MINORITY INTERESTS AND EQUITY IN NET LOSS OF EQUITY METHOD INVESTEES			(468	)			(1.2	)			3,148				7.6				5,379				10.8				45,783