Recent Development of Tax Related Legislation and Judicial Decisions in Korea (2015)

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1 IBA National Report Recent Development of Tax Related Legislation and Judicial Decisions in Korea (2015) Sunyoung Kim, Tax Partner Justin Sinchul Kang, Attorney (New York) Deloitte Anjin LLC Seoul, Korea I. SELECTED TAX LAW CHANGES FOR 2015 On December 3, 2014, the National Assembly approved, with some revisions, the tax reform proposals for 2015 submitted by the Ministry of Strategy and Finance. Below highlights a few selected tax law changes that may be applicable to foreign companies doing business in Korea and foreign-invested Korean companies. Unless otherwise noted, all changes are generally effective for the tax year beginning on or after January 1, A. Corporate Income Tax Law ( CITL ) Taxation on undistributed income A resident company, which is a member of a corporate group restricted from crossshareholdings of another affiliate or with net equity exceeding KRW 50 billion, would be subject to an additional tax on undistributed income. Such taxation can be avoided or mitigated if the resident company distributes a certain portion of its income for re-investment, payroll increase, and/or dividends, etc. The purpose of this new tax regime is to facilitate corporate spending to boost the economy and stimulate household spending. Note that this additional tax does not apply to entities classified as a Small and Medium-sized Enterprise ( SME ) 1. According to the revised CITL, a company subject to this tax regime can select one of the 1 The revised Enforcement Decree of the TILL simplified the criteria for a company to qualify as a SME based on sales revenue and total assets. Under the revisions, to qualify as a SME, a company should generally meet the following conditions: (i) the main business should be a qualifying business listed under the TILL; and (ii) sales revenue should be less than certain thresholds which vary depending on the type of business and total assets should be less than KRW 500 billion. A company will also need to satisfy additional new independence requirements (i.e., an entity with total assets of KRW 5 trillion or more should not directly or indirectly own 30% or more of the voting shares of the company) in order to qualify as a SME.

2 two calculation methods provided under the law to determine its tax liability. 2 Once a calculation method is selected, such method cannot be changed for three years. The tax regime would be applicable to fiscal years beginning on or after January 1, 2015 and remain in effect temporarily until December 31, Increase in basic tax deduction limit of entertainment expenses for SMEs The basic deduction limit of entertainment expenses for SMEs was previously set at KRW 18 million. The revised CITL increases a SME s basic deduction limit to KRW 24 million, while the basic deduction limit for non-smes remains unchanged at KRW 12 million. B. Tax Incentive Limitation Law ( TILL ) Extension of Individual Income Tax ( IIT ) incentive for foreign employees The previous TILL provided for a special tax regime for inbound expatriates. Therefore, qualifying foreign employees working in Korea were eligible for an 18.7% flat tax rate (including local income tax) on their income for a five-year period beginning from the foreign employee s Korean employment start date ( Flat Tax Scheme ). The Flat Tax Scheme was scheduled to expire on December 31, However, under the revised TILL, the sunset period for the Flat Tax Scheme has been extended by two years until December 31, Also, for foreign employees working for qualified regional headquarters, 3 there would be no expiration date for the application of the Flat Tax Scheme. In addition to the Flat Tax Scheme, under the previous TILL, foreign technicians and engineers working in Korea were eligible to receive a 50% tax exemption from IIT for 2 years. Based on the amended TILL, the sunset period for such IIT exemption is extended to December 31, However, beginning on or after January 1, 2015, the tax exemption regime is only applicable to foreign technicians and engineers working at the R&D center of foreign invested companies or working under an engineering and technology adoption agreement. Notwithstanding the foregoing, foreign technicians and engineers who have been receiving tax exemptions under the previous TILL will continue to be subject to the previous regulations. 2 The two calculation methods are as follows: (i) [Current year income (*1) x standard rate α (e.g., 60~80%) - (utilization on investment (*2), increase in payroll (*3), dividends)] x tax rate(10%), or (ii) [Current year income x standard rate β (e.g., 20~40%) - (increase in payroll, dividends)] x tax rate (10%). (*1) Current income means total income earned during the taxable year (or net taxable income) less loss carry forward, corporate tax amount, etc. (*2) Investment means acquisition cost of the assets (tangible and / or intangible assets). (*3) Increase in payroll means increase in wages and employees salary (excluding executives and other highlypaid employees). 3 To be a qualified regional headquarter, the Korean entity should perform essential functions such as corporate strategy, human resources, and R&D type services for multinational groups.

3 C. Individual Income Tax Law ( IITL ) Determination of tax residency Under the previous residency rules under the IITL, an individual was treated as a Korean tax resident if he/she satisfied one of the following requirements: (i) the individual has a domicile (i.e., permanent address) in Korea, or (ii) the individual has a place of residence in Korea for one year or more. Also, if an individual resides in Korea for one year or more during two calendar years, such person was viewed as having a Korean residence for one year or more. Under the IITL revisions, the standard of determining residency has been changed from one year to 183 days to prevent tax avoidance by claiming foreign residence. The 183 days standard has been adopted to follow the standard used by most OECD countries. As the new rules are applicable to income earned on or after January 1, 2015, frequent travelers to Korea could be inadvertently treated as a Korean tax resident and become subject to worldwide taxation in Korea. D. International Tax Coordination Law ( ITCL ) Integration of advance pricing agreement process between national tax and customs The revised ITCL introduced a streamlined process for taxpayers to apply for both an advance pricing agreement and advance customs valuation arrangement simultaneously if the pricing methods for national tax and customs are similar. Under the simultaneous application, the Korea Customs Service and the National Tax Service ( NTS ) mutually discuss and agree on the pricing method and appropriate range of the arm s length price and notify the Ministry of Strategy and Finance. This new process is available for applications made on or after January 1, Strengthened thin capitalization restrictions Before the ITCL revision, if a foreign invested company borrowed from a foreign controlling shareholder ( FCS ) or from a third party under a FCS s guarantee, and the amount borrowed exceeds 3 times (or 6 times for a financial company) of its equity (or paid-in capital if greater than equity), any interest expense corresponding to the excess loan amount would not be deductible and be reclassified as dividends for Korean tax purposes. Under the revised ITCL, the debt-to-equity threshold for a non-financial domestic borrower will be lowered from 3:1 to 2:1 (the 6:1 threshold for a financial company will remain unchanged). The ITCL amendment is effective as from January 1, 2015 and does not include a grace period for previous investments with a debt-to equity ratio between 2:1 and 3:1. Therefore, it is possible that a portion of the interest expenses arising from existing loan arrangements, which have satisfied the previous threshold of the 3:1 debt-to-equity ratio, would no longer be deductible immediately starting from this year due to the decrease in the threshold ratio.

4 E. Value Added Tax Law ( VATL ) Reduction in scope of VAT-exempt financial services Under the previous provisions of the VATL, most financial services including banking services, financial investment services, insurance services, and specialized credit financial services were all exempt from VAT. However, based on the revisions to the VATL, the scope of VAT-exempt services in the financial services sector has been reduced. As a result, fees or commissions received for the rendering of non-essential financial services 4 will be subject to VAT. Further, the scope of asset management services which were eligible for VAT-exemption has been reduced depending on the type of assets managed. F. National Tax Basic Law ( NTBL ) Extension of due date for filing amended returns and statute of limitations ( SOL ) on crossborder tax evasion Under the previous NTBL, the due date for filing amended returns to reduce the tax base and/or claim a tax refund by a taxpayer was three years from the original tax filing due date. The revised NTBL extends the allowed time limit for filing an amended return to five years to further protect and improve taxpayers rights. On the other side of the spectrum, the SOL for tax assessment is generally five years (ten years in case of fraud or other unjust acts) for national taxes other than gift and inheritance tax. Based on the revised NTBL, the SOL on tax evasion arising from unjust acts involving international transactions has been extended from ten years to fifteen years, taking into consideration the difficulty in obtaining necessary information to monitor such transactions. In addition, the penalty for underreporting of taxable income through offshore tax evasion has been increased from 40% to 60%. II. Update on Tax Treaty Network As of the end of 2014, Korea has 84 full tax treaties in force. There are several tax treaties that have been signed but not yet in force, which include the treaties signed with Sudan, Nigeria, Gabon, Hong Kong, Kenya, and Tajikistan. The following introduces the main features of the Korea-Hong Kong tax treaty. Under domestic tax laws, Korean sourced dividends, interest and royalties paid to a nonresident is subject to withholding tax ( WHT ) at a rate of 22%. The Korea-Hong Kong tax treaty reduces the WHT rate as follows, provided that the Korean sourced income is derived by a Hong Kong resident. 4 For example, administrative or custodial services rendered by a financial services company will fall under non-essential financial services.

5 Reduced WHT rate on dividends: 10% when a beneficial owner directly holds 25% or more of voting shares of the Korean company, or 15% in all other cases Reduced WHT rate on interest and royalties: 10% In addition, Korean sourced capital gains arising to a Hong Kong resident from the disposal of shares of a Korean company will remain taxable in Korea. The Korea-Hong tax treaty also contains provisions on exchange of information, which would allow competent authorities of the two countries to exchange financial information for the purpose of preventing tax evasion. III. JUDICIAL DECISIONS Recognition of intermediate holding company as beneficial owner Recent Supreme Court cases in 2012 and 2013 have firmly established the application of the substance-over-form principle (domestic general anti-avoidance rule) in determining the beneficial owner for tax treaty eligibility. 5 The case below provides an unusual example where the court has respected an intermediate holding company to be the beneficial owner for purposes of applying tax treaty benefits. In July 2014, the Supreme Court upheld the lower court s decisions that recognized an intermediate holding company to be the beneficial owner. 6 Under the Korea-Netherlands tax treaty, capital gains arising from the disposal of Korean company shares held by a Dutch resident are not taxable in Korea. The case in question involved the transfer of Korean company shares held by a Dutch intermediate holding company ( Dutch Hold Co ) to a Korean resident. The NTS disregarded the Dutch Hold Co as the beneficial owner of the capital gains viewing that the intermediate holding company was only established as a conduit for tax avoidance purposes. Instead, the NTS argued that the shareholder of the Dutch Hold Co, a French company, was the beneficial owner of the capital gains and imposed tax on such basis. The Administrative Court ruled that the Dutch Hold Co was in fact the beneficial owner of the capital gains on the following basis: (i) the Dutch Hold Co had been established for a significant period of time (about 30 years) and holds shares in approximately 50 other subsidiaries; (ii) the Dutch Hold Co engaged in business in Korea by establishing a Korean subsidiary for a significant period of time (approximately 12 years); and (iii) the Dutch Hold Co directly received the consideration for the share transfer and reinvested the proceeds into its other business without distributing it to the French company. The judgment of the Administrative Court was upheld at the High Court and then later was affirmed by the Supreme Court. This is quite an exceptional case given the recent trend of the Supreme Court denying the 5 Two notable cases include those involving LaSalle and WiniaMando where the Supreme Court confirmed that the substance-over-form principle could be applied to determine beneficial owner for tax treaty application purposes. 6 Korea Co v. Head of Seodeajeon Tax Office, 2012Du16466 (Supreme Court of Korea, July 10, 2014).

6 substance of offshore holding companies located in tax preferential jurisdictions for treaty application purposes in Korea. However, it should be noted that the holding of the Supreme Court in this case does not necessarily undermine the applicability of the substance-over-form principle for tax treaty purposes but rather clarifies the criteria for determining beneficial ownership for tax treaty eligibility under such principle. Source of royalty income under the Korea-U.S. tax treaty Under Korean law, treaties duly concluded and promulgated shall have the same effect as the domestic laws of Korea. Therefore, in Korea, tax treaties ratified through approval of the National Assembly have the same validity as domestic tax laws. Furthermore, as tax treaties occupy status as a special law for Korean tax purposes, if a conflict arises between a tax treaty and domestic tax laws, provisions of the relevant tax treaty take precedence over domestic tax laws. The case below further confirms the well established principle of tax treaty provisions taking precedence over domestic tax laws. In October 2014, the Supreme Court held that the payment provided to a U.S. resident as consideration for the use of a patent, which was not registered in Korea, should not be taxable in Korea under the Korea-U.S. tax treaty, regardless of whether the patent was used for manufacturing or sales in Korea. 7 The Supreme Court s decision was made on the following basis: (i) the Supreme Court interpreted the royalty provision of the Korea-U.S. tax treaty to hold that consideration for the use of a patent shall be regarded as Korean sourced income only is such patent is registered and used in Korea, 8 (ii) while the CITL specifies that royalties arising from a patent that is used in Korea shall be regarded as Korean sourced income regardless of whether the patent is registered in Korea, the provisions of the Korea- U.S. tax treaty shall have preference, and (iii) whether the patent is used for manufacturing or sales in Korea is not necessarily relevant in determining the source of income arising from the patent as the consideration provided for the use of the patent shall not be regarded Korean sourced income if such patent is only registered in the U.S. As stated above, the case above confirms that the provisions of the Korea-U.S. tax treaty take precedence over domestic tax laws in Korea. 7 Korea Co v. Head of Dongsuwon Tax Office, 2014Du9554 (Supreme Court of Korea, October 30, 2014). 8 Since Article 6(3) of the Korea-U.S. tax treaty does not specifically state that a patent needs to be registered and used in Korea for income arising from the use of such patent to be regarded as Korean sourced, there are differing views on the matter. Nevertheless, this case represents the current interpretation of the royalty provision of the Korea-U.S. tax treaty by the Supreme Court.