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09 September 2005
The Ministry of Finance and Economy has announced plans to revise certain provisions in the tax legislation, including:
This update outlines the main proposed revisions. If the proposals are codified
into the legislation, they should take effect on January 1 2006. Anyone who wishes to submit to the ministry any comments on the proposed revisions may do so by September 14 2005.
Codification of 'Substance over Form' Doctrine
Following high-profile media coverage criticizing certain foreign investment funds earning high profits in Korea but paying little or no tax in the country, the tax authorities have conducted tax audits of those funds. However, they have found it difficult to impose tax on these profits as, in many cases, the legal structures of the funds involve companies located in treaty countries, thus avoiding taxation in Korea by relying on treaty benefits.
Currently there are no specific provisions in the tax legislation to allow the tax authorities to look through companies that have no economic substance but exist merely to claim tax treaty benefits, even though the courts and the tax authorities have ruled that such look-through treatment is justified to prevent abuse of the treaty provisions. The courts and the tax authorities are extending the application of the general domestic anti-abuse law - the 'substance over form' rule, which is found under the Basic National Tax Act and the Corporate Income Tax Act - into the area governed by tax treaties. Therefore, it is not surprising that these court cases and rulings have not clearly articulated the technical authority upon which the application of the look-through rule is legally based. As a result, the concept of look-through, as created by the administration and the judiciary, is limited, and the use of this approach to prevent the abuse of tax treaty provisions is seen by some as technically flawed.
As a result the ministry has proposed the introduction of specific language into the Law for the Coordination of International Tax Affairs in order to allow the tax authorities to disregard, for tax purposes, interposed companies that are designed to claim treaty benefits while having no economic substance. In other words, the language would specifically allow the tax authorities to look through such interposed companies and impose tax instead on the beneficial owners of profits derived from investment in Korea in order to curb treaty shopping by foreign residents. To this end, the ministry plans to issue a list of jurisdictions that are presumed to be used for tax avoidance purposes. If a foreign resident or investor located in one of these listed jurisdictions derives profits from investment in Korea in the form of dividends, interest or capital gains from the alienation of shares, the tax authorities will impose withholding tax based on the domestic withholding rates (ie, 27.5% for dividends, 27.5% for interest and the lesser of 11% of the transfer price or 27.5% of the capital gains from the alienation of shares), notwithstanding reduced rates provided under Korea's tax treaties with such jurisdictions.
However, a foreign resident located in a blacklisted country may apply for confirmation from the Korean National Tax Service that it is eligible for treaty benefits (ie, treaty withholding tax rates) prior to receiving Korean source income. Furthermore, if a foreign resident provides documentary evidence to the Korean tax authorities within three years of earning Korean source income proving that it is indeed the beneficial owner of the profits, thereby rebutting the presumption, the tax authorities will refund the withheld portion of the taxes where applicable.
It is not clear if this revision would be seen to overide Korea's legal obligations under tax treaties. For example, many Korean tax treaties provide that treaty benefits will be granted if the claimant is a resident as defined under the treaty, rather than under the domestic law. In addition, it is not yet established what kind of documentary evidence would be considered sufficient to rebut the presumption of tax avoidance.
Currently, under the Individual Income Tax Act and the Corporate Income Tax Act, Korean source income derived from the provision of professional services (eg, accounting, technical services, management services) by a foreign resident or entity that has no permanent establishment in Korea is subject to withholding tax in Korea at a rate of 22%, unless the relevant tax treaty provides for reductions on the gross amount of payment for such services without allowing deductions for expenses inevitably incurred by the foreign resident or entity.
The ministry has proposed that the Individual Income Tax Act and the Corporate Income Tax Act be revised so that deductions would be allowed for expenses incurred in providing professional services (eg, travel, lodging and food expenses). In other words, withholding tax would be imposed on the net payment after taking into account the relevant expenses incurred.
The tax authorities have expressed concerns regarding the possibility of some well-known Korean companies with substantial foreign shareholdings migrating their corporate bases from Korea to foreign jurisdictions. Currently, under the Corporate Income Tax Act, a 'domestic company' is defined as a company having its head office and/or main place of business in Korea. In addition, by reference to the Korean commercial law, the term 'company' is understood to refer to a company established under the Korean Commercial Law. Accordingly, there is concern that if a large Korean conglomerate were to migrate and reincorporate in a foreign jurisdiction, the Korean tax authorities would effectively lose their jurisdiction over the company.
In light of these concerns, the ministry has proposed the addition of a provision under which a foreign company would be regarded as a Korean domestic company if the effective management of the company is in fact exercised in Korea. Notably, the place of effective management test is one-sided. Under the proposal, a company established in Korea but effectively managed in a foreign country would not be treated as a foreign corporation. Therefore, this proposed provision may be viewed as discriminatory under many tax treaties and bilateral investment treaties. Furthermore, it is not clear how this provision would apply in the context of tax treaties - in line with the Office for Economic Cooperation and Development model tax treaty, most Korean treaties provide for a residency tie-breaker provision, so that if an entity is deemed to be a resident of both contracting states, the treaty provides that the entity be considered a resident of only the contracting state. Finally, it is unclear how the tax authorities would determine whether a foreign company has exercised its effective management within Korea. Since many EU jurisdictions have similar rules dealing with the place of effective management, the tax authorities are likely to adopt guidelines based on the cases, regulations and rulings of EU jurisdictions.
Definition of 'tax haven'
Under the current Law for the Coordination of International Tax Affairs, a Korean resident having a 20% or more ownership interest in an entity located in a tax haven is deemed to have received a daily dividend distribution from the entity, even if there has been no actual dividend distribution. The law provides that a tax haven is a jurisdiction in which either the effective tax rate on taxable income has been 15% or less for the last three years or 50% or more of the income is exempt from tax. Also, the National Tax Service is allowed to designate specific jurisdictions that are considered to be tax havens for Korean tax purposes. However, under the Corporate Income Tax Act, the corporate tax rate on Korean domestic entities for the first W100 million of taxable income is 14.3%. Therefore, it is rather contradictory to label jurisdictions which impose a tax rate of 15% as tax havens while Korea itself imposes a lower rate, at least for the first W100 million of taxable income. Furthermore, the National Tax Service has failed to designate any jurisdictions as tax havens.
As a result, the ministry proposes that the tax haven rule be inapplicable if the taxable income of an entity located in a tax haven is W100 million or less. In addition, in order to provide more certainty for tax administration and compliance, the proposed revisions by the ministry require the National Tax Service to designate specific jurisdictions as tax havens in accordance with the practice of other Organization for Economic Cooperation and Development member countries.
Holding company located in tax haven
Many multinational companies have holding companies in jurisdictions that are considered tax havens. However, maintaining holding companies in such jurisdictions is not necessarily motivated only by tax-saving purposes. Instead, operating holding companies in these jurisdictions often provides the multinational companies with many non-tax related benefits, including streamlined management reporting and corporate transparency. Nevertheless, under the current Law for the Coordination of International Tax Affairs, such holding companies are subject to the Korean tax haven rule.
Therefore, the ministry has proposed that the tax haven rule would not apply to a holding company located in a tax haven if the subsidiaries of the holding company are not located in jurisdictions that are considered to be tax havens. In other words, if the purpose of having a holding company in a tax haven is principally based on business needs, rather than tax-avoidance purposes, the Korean tax authorities would not enforce the tax haven rule on that holding company.
For further information on this topic please contact Jay Shim, Young C Lee, Young Min Ma or Sangmoon Chang at Woo Yun Kang Jeong & Han by telephone (+82 2528 5200) or by fax (+82 2528 5228) or by email (email@example.com or firstname.lastname@example.org or email@example.com firstname.lastname@example.org).
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Young C Lee
Young Min Ma