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16 December 2005
After months of conducting tax audits of foreign investment funds, the National Tax Service has published a press release disclosing the interim result of five tax audits (the National Tax Service is currently conducting another tax audit of a foreign investment fund). So far a total of W214.8 billion has been assessed, as illustrated in the table below.
Basis for assessment
Taxes assessed (in W billion)
Use of jurisdictions solely to claim treaty benefits (ie, application of the 'substance over form' doctrine)
|Violation of transfer pricing rules (eg, payment of interest that is not arm's length to foreign related parties)||30.2|
|Other (eg, failure to pay securities transactions tax and unreasonable allocation of costs)||37.3|
The tax audits have been highly publicized and are a subject of public interest as they are viewed as one of the tax authorities' first attempts to curb tax avoidance (or even tax evasion) by foreign investment funds through various means, including relying on treaty benefits. In addition, the Ministry of Finance and Economy recently published a proposal to revise certain tax law provisions. The proposal and press release are strong indications that the tax authorities intend to tackle tax avoidance by foreign investment funds more aggressively.
The press release discussed a number of cases as examples in which the National Tax Service assessed additional taxes. Three of the cases related to foreign investors.
X, an investment fund which was a resident of country A, established a holding company Y in country B. Y acquired 100% ownership in KCo, a Korean entity that owned Building. After the price of Building appreciated, Y transferred 100% of the shares in KCo to Z, realizing a substantial amount of capital gain.
In general, transfer of real estate, such as Building, results in a substantial amount of tax on the gain. However, by transferring the shares in KCo, Y was able to claim the benefit under the tax treaty between Korea and country B, which exempts such gain from Korean taxation. In addition, acquisition tax and registration tax, which are generally imposed on the transfer of real estate, were also avoided.
The National Tax Service concluded that Y was merely a conduit company which was established solely for the purpose of avoiding Korean taxation. This conclusion was supported by the fact that X internally considered a plan to avoid Korean taxation even before the acquisition of KCo and the series of transactions was carefully carried out based on the plan. Furthermore, the National Tax Service found that Y had never played an active role in acquiring, managing and/or transferring KCo, and that Y had no substance (either economical nor legal) which would enable it to claim benefits under the tax treaty between Korea and country B. In this regard, the National Tax Service noted the following: (i) the actual party to the acquisition of KCo was X and the funds necessary to acquire KCo were transmitted to Korea directly from country A, in which X was a resident; and (ii) Y played no role in the transfer of KCo to Z as all the activities were performed by X's legal advisers, business partners and KCo.
The National Tax Service assessed taxes on the transfer of KCo shares based on the tax treaty between Korea and country A instead of between Korea and country B, pursuant to the 'substance over form' doctrine provided under the Korean domestic tax law.
X was an investment fund which was a resident of country A. It had a wholly owned subsidiary, Y, in country B. It also had a wholly owned subsidiary, KCo, in Korea. Y extended a loan to KCo at a high interest rate.
Under the tax treaty between Korea and country B, the interest paid by KCo to Y was exempt from tax in Korea.
The National Tax Service concluded that KCo could have obtained loans from Korean domestic banks. However, in order to repatriate its investment in KCo and to reduce or avoid Korean taxation at the same time, X had Y extend a loan at an interest rate that was not at arm's length under the transfer pricing rules. The National Tax Service denied the deductibility of a certain portion of interest paid to Y using the comparable uncontrolled price method, with interest rates charged by Korean domestic banks as comparables.
On behalf of an investor, X invested in KCo shares. In this regard, X's subsidiary in Korea, KSub, provided X with consulting services that were essential for investing in Korea. As a result of the investment, the investor realized a substantial amount of gains and paid a portion to X. However, none of the portion was paid to KSub.
The National Tax Service found that the share of the profits paid to X should be allocated to KSub as KSub was instrumental in realizing profits for the investor. Accordingly, based on the activities performed by KSub, the National Tax Service assessed taxes on KSub.
For further information on this topic please contact Jay Shim or Sangmoon Chang at Woo Yun Kang Jeong & Han by telephone (+82 2528 5200) or by fax (+82 2528 5228) or by email (firstname.lastname@example.org or email@example.com).
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