The Corporate Tax Planning Law Review: South Korea

Introduction

Korea has codified domestic tax laws and has tax treaties in force with almost all Western and other developed countries. For Korean tax purposes, tax treaties take precedence over Korean domestic tax laws. In the following sections, certain key tax issues that might be relevant to multinational enterprises (MNEs) making investments into, or doing business in, Korea are addressed.

Korea has a worldwide taxation system, under which Korean-source income of a Korean corporation as well as its foreign-source income is subject to taxation in Korea. Foreign tax credits on foreign-source income are available subject to certain limitations. Because the Korean tax system offers no participation exemption regime, Korea is not a favourable jurisdiction for establishing a holding company for overseas investments. There could be double taxation on dividends paid locally because a 100 per cent dividend received deduction is available only in respect of dividends received from a wholly owned subsidiary.

Korea, a member of the OECD, continually introduces tax rules, some of which have already been adopted by many other OECD countries, such as partnership taxation, a collective investment vehicle regime and a consolidated tax return regime, and implements rules and regulations in response to the OECD recommendations to address base erosion and profit shifting (BEPS) issues.

All international transactions are potentially subject to or bound by the arm's-length principle. Recently, the Korean tax authorities have attempted to apply the profit split method, among the transfer pricing methods, especially in transactions involving intangibles. Furthermore, the Korean tax authorities have increasingly challenged the permanent establishment issues in tax audits of MNEs in several of which substantial VAT repercussions were entailed. The issues of beneficial ownership of Korean-source income and income classification (e.g., royalty versus business income) also frequently arise in tax disputes to determine which withholding tax rates are to be applied.

Local developments

i Entity selection and business operations

Korean domestic business entities, regardless of their form, are taxed on their worldwide income. Therefore, their Korean-source income as well as foreign-source income is subject to taxation in Korea. Foreign tax credits are available. In contrast, foreign business entities are taxed only on their Korean-source income.

Under Korean tax law, no business entity is treated as being transparent for tax purposes by default. Only certain types of business entities may choose to be treated as a partnership that is transparent for tax purposes, for example:

  1. johap formed by a contractual arrangement between the johap's members (johap may loosely be translated as an unincorporated association, which is not a legal entity separate from its members);
  2. hapmyung hoesa (general partnership company; it is an incorporated entity, but all members of the hapmyung hoesa have unlimited personal liability for the entity's obligations); and
  3. hapja hoesa (limited partnership company; it is an incorporated entity, but at least one member of the hapja hoesa has unlimited personal liability for the entity's obligations).

All of the above are incorporated entities but may choose to be treated as partnerships for tax purposes. A partnership itself is not subject to income tax, but its partners are (i.e., entity-level taxation is avoided).

Entity forms

Under the Korean Commercial Code (KCC), the following five forms of legal entity are available: (1) joint stock companies; (2) limited companies; (3) limited liability companies; (4) general partnership companies; and (5) limited partnership companies.

These are incorporated entities and, as such, generally have a separate legal status from their shareholders or members (owners). However, all members of general partnership companies have unlimited personal liability for the entity's obligations, and at least one member of a limited partnership company must have unlimited personal liability for the entity's obligations. Although these entities are generally subject to entity-level taxation, general partnership companies and certain limited partnership companies may elect to be treated as partnerships for Korean tax purposes, as discussed above.

Joint stock companies and limited companies are the most commonly used corporate forms. Joint stock companies have the ability to issue corporate bonds, and their shares can be publicly traded if listed on a stock exchange, but they are subject to more stringent corporate formalities. Limited companies are subject to simpler rules so can be managed more efficiently.

In addition to corporate income tax paid by a company (assuming that no partnership election is made), the shareholders or members of the company, whether natural persons or corporate entities, are also subject to income tax in respect of dividends received from the company. Double taxation may be partly relieved through tax credits or deductions.

For US tax purposes, only joint stock companies are per se corporations (i.e., ineligible to make a 'check-the-box' election).

A shareholder or a member of a company may exit from an investment through share transfer, capital redemption or liquidation of the entity. The specific requirements for each exit alternative vary depending on the form of the entity. Generally, joint stock companies offer the most freedom for shareholders in disposing their shares, whereas, for the other forms of entity, consent from the other members is typically required.

Domestic income tax

A Korean company is subject to both corporate income tax (a national tax) and local income tax in respect of its worldwide income (i.e., both Korean domestic-source income and foreign-source income). Corporate income tax rates are progressive. The tax bases and corresponding corporate tax rates are as follows (all inclusive of both corporate income tax and local income tax):

  1. up to the first 200 million won, 11 per cent;
  2. between 200 million and 20 billion won, 22 per cent;
  3. between 20 billion and 300 billion won, 24.2 per cent; and
  4. above 300 billion won, 27.5 per cent.

In addition, corporations with net assets of more than 50 billion won may be subject to additional income tax on 'excessive retained earnings', which are earnings not disbursed in the form of investment in machinery and equipment or increased wages. The Special Tax Treatment Control Law provides various tax incentives to, among other things, investment in machinery and equipment, research and development, employment and restructuring.

Net operating losses cannot be carried back but may be carried forward for 15 years,2 and they are allowed only to offset against up to 60 per cent of taxable income for the concerned fiscal year. As an exception, for a small or medium-sized enterprise (as defined), one year carry-back of net operating losses is allowed without the 60 per cent limitation.

A sole proprietorship's income is subject to both the national income tax and the local income tax at the owner level at their individual income tax rate, which is also progressive (6.6 per cent to 49.5 per cent).

International tax

As mentioned above, Korean companies are subject to Korean corporate income tax in respect of their worldwide income or gain. Thus, foreign-source income as well as Korean-source income is subject to corporate income tax in Korea. To avoid double taxation, Korean companies may claim foreign tax credits on foreign income taxes paid or to be paid on foreign-source income, subject to a number of limitations, including a country-by-country limit, in determining their Korean corporate income tax liability. Excess foreign tax credits can be carried forward for 10 years, and unused credits that are carried forward will be treated as deductible expenses in the 11th year. Conversely, foreign corporations and local branches of foreign corporations are taxed on Korean-source income only. For this purpose, foreign-source income attributable to local branches of foreign corporations is treated as domestic-source income.

There is a controlled foreign corporation (CFC) regime, as explained in Section II.ii, which aims to prevent deferral of taxation on certain types of overseas earnings.

Under Korean tax law, no patent box regime exists. However, Korean tax law allows, subject to certain conditions, a 50 per cent tax reduction in income generated from the transfer of a patent or technology that a small or medium-sized enterprise (as defined) acquired as a result of its own research and development.

Capitalisation requirements

Interest deduction is limited in certain situations. First, under the thin capitalisation rules, interest deductibility of a Korean company whose debt-to-equity ratio exceeds 2:1 (6:1 in the case of regulated financial institutions) is limited in respect of loans either from a foreign controlling shareholder or from a third-party lender that is guaranteed by a foreign controlling shareholder.

In addition, interest deductibility is limited depending on the use of the underlying loans. For instance, interest on loans incurred to acquire or maintain non-business assets, including certain loans to related parties, is not deductible.

Finally, in respect of BEPS Action 4, a limitation on interest deductibility has been effective from 2019. Related-party interest is not deductible to the extent of the greater of (1) the amount of interest disallowed under the thin capitalisation rules and (2) the net interest expense incurred on related-party loans that exceed 30 per cent of earnings before interest, taxes, depreciation and amortisation.

ii Common ownership: group structures and intercompany transactions

Ownership structure of related parties

A Korean domestic parent (but not a foreign parent) may elect to file a consolidated tax return in respect of its 100 per cent-owned domestic subsidiaries with approval of the commissioner of the relevant regional tax office. Once elected, consolidation is mandatory for all 100 per cent-owned subsidiaries, and the election is irrevocable for five fiscal years.

There is no particular loss sharing regime (by statute or contract) for related parties in general except for the consolidated tax return regime; however, for joint business operation or management between corporations, there is a rule that regulates the amount of deductible expenses incurred or paid by the joint operation.

Under the CFC regime, a Korean shareholder that holds 10 per cent or more of a foreign subsidiary directly or indirectly could currently be taxed on its share of the foreign subsidiary's certain type of undistributed earnings. More specifically, the CFC regime applies if the following conditions are met:

  1. the foreign subsidiary is a related party to the Korean shareholder, as defined in the International Tax Coordination Law (ITCL); and
  2. the foreign subsidiary is located in a jurisdiction in which its income is subject to an effective tax rate of 70 per cent or less of the highest Korean corporate tax rate (i.e., 17.5 per cent equals 70 per cent of the highest marginal corporate tax rate 25 per cent).

There are certain exceptions to the current taxation. For example, companies with retained earnings of less than a certain threshold amount, holding companies that meet certain requirements, or companies that are engaged in an active trade or business in the local jurisdiction are not subject to the CFC rules.

In addition, the CFC rules do not apply to a foreign branch of a Korean company; the branch's income in its entirety would be directly included in calculating the current taxable income of the Korean company.

Domestic intercompany transactions

There are local transfer pricing rules according to which the tax authorities may disregard transactions with related parties when they determine that the tax burden of a domestic corporation has been unjustly reduced through such related-party transactions. In such a case, the tax base of the domestic corporation is calculated by applying an arm's-length price to the related-party transaction in question, but no corresponding adjustment is allowed.

There are no deductible or tax-exempt related-party payments that can reduce the overall net income.

There is no participation exemption, but a dividend received deduction (DRD) is available on dividend received locally (i.e., dividend income that a domestic corporation receives from another domestic corporation in which it has made an equity investment). This amount as calculated under the relevant tax law provisions is not included in the gross income for the purpose of calculating the tax base. The DRD ratio differs depending on ownership ratios and public versus non-public (unlisted) corporation status. For example, a 100 per cent DRD is allowed for dividends from a 100 per cent-owned subsidiary, and a 50 per cent DRD is allowed for dividends from an unlisted subsidiary that is owned not less than 50 per cent but less than 100 per cent.

International intercompany transactions

Although the commentaries or various guidelines issued by OECD are not part of tax law in Korea, the Korean government, as a member of OECD, continues its endeavour to incorporate such commentaries or guidelines into its domestic tax law – as such, the Korean tax authorities recognise and the Korean tax laws closely adhere to the arm's-length principle and OECD's Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the OECD Transfer Pricing Guidelines). The Korean government has implemented several BEPS measures.

According to the ITCL, the Korean tax authorities may determine or recalculate the taxable income and corresponding taxes of domestic corporations (including foreign invested corporations) based on the arm's-length price. Transfer pricing issues that are often raised by the tax authorities are for the price of goods imported from foreign related parties for resale to customers in Korea, interest on intercompany loans, management service fees, and royalties on licensing of patents or know-how from overseas affiliates.

As mentioned above, the thin capitalisation rules limit the interest deductibility for domestic corporations in respect of loans from a foreign controlling shareholder. There are also rules that limit deductibility of overall interest expenses based on the use of the underlying loans.

The above-mentioned Korean CFC regime mandates taxation at the Korean shareholder level of its allocable portion of the foreign subsidiary's undistributed income earned in low-tax jurisdictions.

Dividends received by a Korean company from its foreign subsidiaries are subject to corporate income tax in Korea at the Korean company level. Foreign tax credits are available for any foreign income taxes on the dividends paid by the Korean shareholder. In addition, indirect foreign tax credits may be available in respect of foreign income taxes paid by a foreign subsidiary, subject to certain conditions. Tax sparing credit may also be available in limited situations.

iii Third-party transactions

Sales of shares or assets for cash

Capital gains or losses realised or incurred by a Korean company from the sale of shares or assets are generally treated the same as ordinary business profits or losses and thus are subject to corporate income tax at the normal rates. However, capital gains realised from the sale of certain non-business real estate are subject to an additional 10 per cent tax on top of the ordinary corporate income tax.

There is neither participation exemption nor reinvestment relief on capital gains. Losses incurred by sale of shares or assets are recognised and thus reduce the tax base; there is no limitation on the recognition of losses.

Tax-free or tax-deferred transactions

In the case of an 'unqualified merger', the surviving corporation is deemed to have succeeded to the assets from the merged (or target) corporation at the market price, and therefore the capital gains of the merged corporation is taxed at the corporate income tax rate. Conversely, in the case of a 'qualified merger' that meets the below requirements, the merged (or target) corporation is exempt from taxes on the gains from the transfer, and the surviving corporation benefits from the deferral of taxes on the profits from the merger.

A merger is a tax-free qualified merger if the following requirements are met:

  1. the merger is between domestic corporations that have continued to operate their businesses for at least one year;
  2. the value of the stock of the surviving corporation or the parent corporation of the surviving corporation is at least 80 per cent of the total consideration of the merger that the shareholders of the merged (or target) corporation receive;
  3. the surviving corporation continues to operate the acquired business until the last day of the business year in which the merger occurs; and
  4. at least 80 per cent of the merged (target) corporation's employees, as of one month prior to the merger, are transferred to the surviving corporation, and the ratio remains at or above the 80 per cent threshold until the end of the business year in which the merger occurs.

Similar, but not identical, requirements and tax effects are stipulated for tax-free 'qualified' spin-offs and 'qualified' in-kind contributions.

Therefore, in the case of mergers or spin-offs, to minimise taxes payable, the requirements for tax-free treatment should be reviewed carefully and taxpayers should meet these requirements.

International considerations

There are no specific rules that allow or deal with deferral of tax, recapture or participation exemption in respect of cross-border third-party transactions. Generally, the substance-over-form doctrine applies to cross-border transactions as well as to domestic transactions under which the tax authorities may disregard or recharacterise legal forms employed by the taxpayer and may exercise its taxing rights according to the economic substance of the subject transaction. However, the substance-over-form doctrine rarely applies to unrelated third-party transactions.

Withholding tax applies to cross-border transactions involving payments of domestic-source income to foreign corporations and non-resident individuals, such as interest, dividends, royalties and capital gains. In this regard, tax treaties take precedence over Korean domestic tax laws.

iv Indirect taxes

Generally, the supply of goods or services is subject to 10 per cent value added tax (VAT), certain goods or services are subject to zero rate VAT (e.g., exported goods), and certain other goods or services are exempt from VAT (e.g., financial services). VAT generally applies to transactions between domestic companies, but goods or services supplied by foreign companies to Korean companies may also be subject to VAT. For example, importation of goods into Korea is subject to VAT, and certain recipients (e.g., financial institutions) of services from a foreign entity are required to pay VAT by proxy on behalf of the foreign entity.

A supplier of VAT-taxable goods or services is required to issue a VAT invoice to, and collect the VAT from, the purchaser. A supplier is required to remit to the government the difference between the VAT collected from its purchasers less VAT paid to its vendors, and if the difference is negative, the supplier is entitled to a refund. Issuance of false or fictitious VAT invoices is subject to heavy penalties, such as denial of input VAT credit or criminal punishment. For MNEs, one of the crucial questions is whether a certain supply of goods or services is subject to VAT in given circumstances and who should be the issuer or recipient of VAT invoices. The answers to these questions are not always clear.

In 2015, in response to BEPS Action 1 (Tax Challenges Arising from Digitalisation), Korea introduced a new provision in the VAT law that imposes VAT on foreign companies without a permanent establishment supplying certain electronically delivered services, including game, video or audio, to business to consumer (B2C) users.

International developments and local responses

i OECD-G20 BEPS initiative

Generally, the Korean government welcomes the BEPS Actions but appears to take a position that it will implement the OECD recommendations concerning the BEPS Actions gradually after observing the implementation status in other countries.

Having said that, as of the end of 2021, Korea has completed the implementation of many BEPS measures, including the four minimum standards (countering harmful tax practices; countering tax treaty abuse; transfer pricing documentation and country-by-country reporting (CbC); and ensuring timely, effective and efficient resolution of the mutual agreement procedure (MAP)). New tax law provisions were introduced to reflect the revised OECD Transfer Pricing Guidelines on the use of the comparable uncontrolled price method and methods to be used for transactions involving intangible assets; to limit deductibility of interest paid to related parties and deductibility of interest related to hybrid financial instrument transactions; and to increase the transparency of MNEs engaged in international transactions, as a result of which certain MNEs are required to submit CbC reports as well as master files or local files.

In addition, the MAP has been improved for more effective and timely dispute resolution, including the possibility of arbitration, and Korea signed the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS.

Furthermore, the definition of 'permanent establishment' was broadened to counter tax treaty abuse.

In conjunction with the common approach instructed by the OECD and the Inclusive Framework on BEPS regarding the profit allocation to source country (Pillar One) and the global minimum tax (Pillar Two), the Korean government is expected to enact laws in 2022, effective from 2023. Under Pillar One, a pertinent MNE group is subject to income tax in the source country on 25 per cent of the profit over 10 per cent of the profit before tax. Under Pillar Two, the ultimate parent company of a pertinent MNE group pays the top-up tax in cases whereby the pertinent MNE group enjoys an effective tax rate of less than 15 per cent in a low-tax jurisdiction.

ii EU proposals on taxation of the digital economy

As mentioned in Section II.iv, with regard to BEPS Action 1, Korea introduced a new provision in the VAT law that imposes VAT on foreign companies without a permanent establishment supplying certain services, including electronic services, to B2C users. To implement the new provision, a simplified VAT registration requirement for foreign entities providing the services was introduced. Meanwhile, the BEPS recommendations related to goods exempt from customs duties have not yet been implemented, as there might be issues under Korea's free trade agreements.

iii Tax treaties

As of January 2022, Korea has effective bilateral tax treaties with 94 countries (including almost all North American and European countries). Tax treaties take precedence over Korean domestic tax laws. In making investments into Korea, foreign industrial investors have used a variety of jurisdictions (e.g., their parents' home countries or intermediary holding companies in a tax-favourable jurisdiction). Historically, foreign financial investors, including private equity funds, have primarily used the Netherlands, Belgium, Malta and Ireland for equity investment in Korea, which has resulted in many disputes over the availability of the treaty benefits, including beneficial ownership.

Notable typical or model provisions

Korea's tax treaties with other countries generally follow the OECD Model Tax Convention. The majority of the tax treaties provide a 10 per cent to 15 per cent withholding tax on dividends, interest and royalties. The Korean domestic withholding tax rate on these types of income, which is applicable absent a tax treaty, is 22 per cent. Capital gains derived from the sale of shares are either exempt from Korean income tax under an applicable tax treaty or subject to withholding tax at the lesser of 22 per cent of the capital gains and 11 per cent of the sale proceeds. Capital gains derived from the sale of real estate rich company shares are subject to the normal corporate income tax rate.

Recent changes to and outlook for treaty network

In 2019, Korea amended tax treaties with Singapore and the Czech Republic and, in 2020, with four countries, including Switzerland and the United Arab Emirates. A tax treaty with Cambodia was newly entered into in early 2021, and the Korean government intends to further expand Korea's tax treaty network.

Recent cases

i Perceived abuses

The Korean tax authorities increasingly attempt to reconstruct a transaction according to its economic substance, disregarding its legal form, based on the substance-over-form doctrine under Korean basic tax law. Furthermore, there seems to be a trend towards more aggressive taxation on international transactions by the Korean tax authorities by way of aggressive transfer pricing adjustments, denial of beneficial ownership in Korean-source income, and finding permanent establishments in Korea in their efforts to curtail profit shifting or tax treaty shopping.

In light of the above-mentioned trends of the Korean tax authorities' enforcement activities, getting into a bilateral advance pricing agreement, which should be based on a robust transfer pricing analysis, is recommended from a transfer pricing perspective. To reduce the possibility of Korean tax authorities' challenge in respect of beneficial ownership of Korean-source income, an overseas entity with economic substance should be chosen as a transactional counterparty and the entire investment structure should be considered carefully (e.g., where the intermediary entities between the ultimate parent and the entity owning shares in a Korean company would be established and what would be the business purpose of having an intermediary entity).

In a 2018 case, the Korean tax authorities applied the substance-over-form principle to an inbound licensing transaction whereby a Hungarian IP company licensed rights to broadcast movies and films that were created by a Hollywood film and entertainment company. The royalties received by the Hungarian company were free from withholding tax in Korea under the Korea–Hungary tax treaty, but the Korean tax authorities assessed taxes at the rate of 15 per cent under the Korea–Netherlands tax treaty on the basis that the Hungarian company was established to take advantage of the Korea–Hungary tax treaty and should be denied of its tax treaty benefits under the Korean substance-over-form principle, and that its shareholder, which was a Dutch company, should instead be treated as the beneficial owner of the licence fee. The Supreme Court held that the mere fact that there were tax benefits derived from a tax treaty should not serve as a basis for denying the application of the tax treaty when the licensor is genuinely engaged in a bona fide licensing business.3 The standard for determining whether the licensor's tax treaty benefits should be respected is a complex one, especially in the current tax environment whereby the Korean tax authorities often second-guess the business purpose of entities that are located in jurisdictions that have a favourable tax treaty with Korea.

ii Recent successful tax-efficient transactions

In 2018, the Korean Supreme Court held for the taxpayers in two major beneficial ownership cases. These cases differ from other beneficial ownership cases that were rendered in 2014 and 2016 in that the 2018 cases entailed a new group level restructuring, whereas in the 2014 and 2016 cases, the intermediary holding companies at issue had been in existence for over 10 years. In the 2018 cases, some specific, taxpayer-favourable factual elements were well laid out and proved to the court to justify the reorganisations that brought the change of the entity receiving Korean-source dividends from the relevant Korean companies.

In addition, recently, the Korean Supreme Court held that Luxembourg's SICAV and SICAF investment funds are entitled to a reduced withholding tax rate on interest and dividend income under the Korea–Luxembourg tax treaty.4 The holding of the Korean Supreme Court means that Lux SICAV, which is a collective investment vehicle, is not a holding company stipulated under Article 28 of the Korea–Luxembourg tax treaty and is a Luxembourg tax resident and a beneficial owner of Korean-source income, and thus is entitled to a reduced withholding tax rate under the tax treaty. For Korean-source income paid to an overseas investment vehicle, there is an ongoing debate in Korea as to whether the overseas investment vehicle or the investors thereof should be treated as the substantive owner of the income and at which level the applicable tax treaty should be applied. The latest Korean Supreme Court case on Lux SICAV is significant in that it confirmed that the overseas public collective investment vehicle (which is a public fund) can be recognised as a resident under the tax treaty and is a beneficial owner of Korean-source income.

Outlook and conclusions

As discussed in earlier sections, treaty benefits claimed by foreign entities are increasingly challenged by the Korean tax authorities under the arm's-length principle and the substance-over-form doctrine. In particular, the tax authorities appear to scrutinise treaty benefits claimed in respect of capital gains derived from the sale of shares in Korean companies and dividend, interest and royalty paid by Korean companies to its foreign related parties. In this regard, the Supreme Court decision rendered in 2018 provides some meaningful guidance on the beneficial ownership of Korean-source income. The parameters and attributes discussed in those cases should be reviewed carefully in future tax planning.

In line with OECD's BEPS initiative, the Korean government is expected to introduce additional anti-abuse rules and information reporting requirements to counter aggressive tax planning initiatives. The Korean government is also expected to enact new laws in alignment with the common approach of OECD Pillars One and Two. As such, MNEs investing or planning to invest in Korea need to monitor carefully for developments in Korean tax and have their tax planning ideas vetted by Korean tax professionals to determine their viability.

Footnotes

1 Im Jung Choi is a senior tax attorney, Sean Kahng is a senior foreign attorney, and Hae Ma Joong Kim and Jaehong Lee are attorneys at Kim & Chang.

2 Ten years for the net operating losses incurred for taxable years beginning before 1 January 2020.

3 Supreme Court Decision 2017Du33008 rendered on 15 November 2018.

4 Supreme Court Decision 2016Du35854 rendered on 16 January 2020.

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