Items Issues Recommendations 1. Eligibility of tax exemption for foreign investment through a domestic holding company According to §121-2 of Special Tax Treatment Control Law (STTCL), tax exemption is provided to qualified foreign invested companies as defined under the Foreign Investment Promotion Law (FIPL). Generally, a foreign investor under FIPL is defined as a foreign corporation or a foreign individual who directly holds 10% or more shares in a domestic company. Accordingly, a foreign investor who indirectly invests in a Korean operating company through a 100% owned domestic holding company would not qualify as a foreign investor eligible for this tax exemption. The establishment of holding companies may promote transparency in corporate governance and facilitate restructuring to increase overall competitiveness. However, the exclusion of indirect foreign investment through a domestic holding company from the tax exemption benefit under STTCL may impede potential foreign investment into Korea. In addition, even when consolidated tax filing is made available, some foreign investors having multiple subsidiaries (which are granted tax exemption under STTCL) may not be able to elect this option by implementing a holding company structure because this will lead to nullification of the exemption eligibility In essence, the economic substance of direct foreign investment in a domestic company and indirect investment through a domestic holding company are the same and therefore indirect investment through a holding company should be also eligible for the same tax benefits. Hence, it is recommended that the corporate tax exemption under STTCL also be made available to indirect foreign investment through a domestic holding company. 2. Scope of entertainment expenses (or business promotion expenses) According to §25 of CITL, "entertainment expenses" refer to those expenses incurred for entertainment purposes or networking, money given as a token of appreciation and other similar expenses incurred by a corporation in relation to its business activities. However, because still the definition of entertainment expenses is not very clear, there are numerous disputes going on between the Korean tax authorities and taxpayers with regard to the scope of entertainment expenses. Recently the tax authorities have amended the relevant tax laws to exclude some promotional gifts from the scope of entertainment expenses as long as the total aggregate amount per recipient is KRW30,000 or less per year. Gifts of KRW5000 or less in value are not even counted. Though the tax authorities may see that it is an expansion of the tax deductible entertainment expense, on the flip side of this new legislation, it may be interpreted as strengthening the ground for assessing taxes on such expenses if they exceed the threshold amount. It may be worthwhile to note that in many other countries, only expenses incurred purely for recreational purposes or entertainment activities are treated as entertainment expenses. It is recommended that a clear definition of the scope of entertainment expenses be provided in relevant laws on the principle of taxation by law. Considering the practices in other developed countries, it is recommended that the scope of entertainment expenses be limited to those expenses incurred for customers purely for recreational purposes (i.e., provision of meals, drinks or other similar entertainment activities for customers). 3. Streamlining of some prior reporting requirements under Foreign Exchange Transaction Regulations Over the years, it has been noted that domestic corporations and Korean branches of foreign corporations have increased their transactions with foreign corporation. As international transactions become more frequent, payables and receivables with non-resident counterparts have also increased. Under the existing Foreign Exchange Transaction Regulation (FETR), a resident company can offset payables against receivables with a same foreign party only after it files a report with the designated foreign exchange bank (if the transaction does not meet the criteria under FETR, it is required to file a report with the Bank of Korea, (BOK)). If the parties wish to utilize periodic offsetting scheme due to frequent transactions, a report must be filed with a designated foreign exchange bank in advance to make settlements. For multi-party nettings, a prior report must be filed with BOK. A payment to a third party other than the transaction counterpart is also subject to prior reporting requirement to BOK. In the event an entity fails to properly report in advance where the relevant non-reported amount is over KRW500M in total, that entity and the person responsible for the reporting can be fined up to KRW 100 million or sentenced to 1 year of imprisonment even if the failure to report was due to lack of knowledge of such requirement or by unintentional mistake. For the failure of advance reporting where the total amount is KRW500M or lower, the entity can be fined for up to KRW50M. It is recommended that the advance-reporting requirements for off-setting of accounts and third-party payments be deregulated. These reporting procedures incur unnecessary administrative fees, discourage transactions with foreign corporations, and produce un-intentional offenders. If certain regulatory measures have to be in place, the authorities may think about a system where they can sort out illegal foreign currency transfers or frauds through a post transaction audit. If such advance-reporting requirements must be maintained, the penalty for violation of the requirements should be reduced to an administrative fine. 4. Withholding tax issues on Korean Source Income Earned by Foreign Investors Over the past 15 years, many foreign investors have employed certain investment structures to make investments into Korea (including stocks/bonds, direct foreign Investments, offshore bank loans, etc.) from offshore jurisdictions that have favorable double tax treaties with Korea. These investment structures have been set up, based upon the consideration of the international tax principles (e.g., the OECD Guidelines) to obtain the tax benefits available under the relevant double tax treaty. The tax benefits include reducing the incidence of Korean taxation on Korean sourced income earned by the foreign investors as well as mitigating the possibility of double taxation on such income. In the past, the Korean tax authorities did not challenge such foreign investment structures. However, on May 24, 2006, new legislation in Law for Coordination of International Tax Affairs (LCITA) governing international transactions was revised to include the codification of the “substance over form” principle and beneficial ownership requirement. Ministry of Finance and Economy(MOFE, currently Ministry of Strategy and Finance) also started re-negotiating existing tax treaties with several countries including Ireland, Netherlands, Belgium aimed at specifically including the limitation on treaty benefits article in such tax treaties. MOFE also introduced a “Special Withholding Procedures” effective July 1, 2006 applicable to certain “designated jurisdictions” considered to be tax haven countries/regions whereby the treaty benefits will only be available to the offshore investor who can prove beneficial ownership of the relevant income. For the moment, only Labuan (a region within Malaysia) has been designated as a region to which this procedure is applicable. In light of these recent developments, the Korean tax authorities are aggressively reviewing past foreign investments into Korea made from EU countries that have favorable tax treaties with Korea with a view of challenging the foreign investor’s beneficial ownership of the Korean sourced income and denying the treaty benefits. To the extent that foreign investors used their subsidiaries in third countries such as Ireland, Belgium, Netherlands (all of which provide certain tax treaty benefits under their respective treaties with Korea) to make investments in Korea, the Korean tax authorities are now seeking to retroactively deny such treaty benefits. Such imposition of back taxes is very disturbing to foreign investors, who made their investment decisions in the past relying on legal guidance and tax opinions as well as widely-accepted market practices. The retroactive denial of treaty benefits on past transactions, prior to introduction of the new 2006 tax legislation, may be deemed to be treaty override by the treaty partners and this could cause diplomatic tension with the treaty partner countries. In the absence of prior guidance, it is recommended that the Korean tax authorities respect the legal substance of past investment structures. Retroactive enforcement of a new law may seriously undermine the foreign investment climate in Korea and run counter to the government’s financial hub initiatives, which are aimed at inducing more foreign investment by creating investment friendly environment in Korea. Although the Korean tax authorities recently implemented an advance ruling system, NTS has expressed that the determination of beneficial ownership is not a subject they would provide any answer though the new ruling scheme. It is recommended that the Korean tax authorities work towards providing a workable guideline on the concept of beneficial ownership and some mechanical tests that can be applied to the concept of the “substance over form” principle to facilitate the determination of whether or not a foreign investor will be considered as a beneficial owner of income and thus can take advantage of treaty benefits. 5. Definition of “use” in determining royalty income from Korean sources According to §93 of CITL, royalties are deemed as Korean sourced if they are the consideration for the use of, or the right to use of property or information within Korea or if they paid from Korea. But there is some tax treaty (e.g. US) under which royalty income can be taxed in the sourcing country only if the relevant intellectual property is used in Korea regardless of who the payer is. Under the Korean tax law, however, there is no clear guideline or definition over the “use” of IPs, i.e. whether it means manufacturing of the relevant products, sales of the final goods, etc The lack of clear guideline often results in tax withholding on the total royalty payments from Korea regardless of where the relevant IPs are used even when it is subject to the tax treaty, which stipulates the place of use criteria in determining the taxing rights of the sourcing country. For example, if the licensor is a resident of the US where the place of final sales is regarded as the place where the relevant IPs were used in computing the foreign tax credit available, it can cause double taxation issue for the licensor as it may not be able to receive foreign tax credit on the portion related to the sales within the US. When determining the place of use under Corporate Tax Law and current tax treaties, the meaning of ‘use’ is not concrete. It is not clear whether the place of use means the place of production or place of consumption. Therefore we recommend that clear definition of “use within Korea” regarding the royalty income be established to enable the practical application of the treaty benefit. 6. Taxation of class B income earned by a non-resident individual? Under §121 of Individual Income Tax Law (IITL), incomes earned by a non-resident individual may be taxed either through a global income tax filing by the individual or simple tax withholding by the payer. The law says that Korean sourced earned income paid to a non-resident individual shall be taxed through withholding. The law, however, does not provide any guidance over the tax rate applicable or withholding methodology when such salary income is paid by the foreign employer (without charging back to a Korean entity or a PE which can be a withholding agent). The tax provision that prescribes the withholding tax rates on each type of Korean sourced incomes of a non-resident individual, i.e. §156-1 of IITL, does not include any rate on such class B earned income. As there is no guideline either on who should report and pay the income tax on such income if the payer is a non-resident without a permanent establishment in Korea, this causes some confusion for non-resident individuals over whether they are actually subject to pay tax in Korea and, if so, how they can meet the obligation. There should be a clear guideline on how to tax the class B income earned by non-resident individuals, if they are actually subject to pay tax in Korea under IITL and any applicable tax treaty. If implementation of a clear guideline is not feasible, the tax law may exclude it from the scope of income subject to pay tax in Korea to eliminate confusion. 7. Securities Transaction Tax on Restructuring Although it is not stated clearly in Securities Transaction Tax Law (STTL), it is interpreted from the relevant rulings that the following cases are generally not subject to STT: - when shares are transferred in the wake of some qualified reorganization under Commercial Act; - when the shares of a disappearing company is transferred in the course of a qualified merger; - when there is a qualified spin-off of a business However, it is unclear whether the similar internal restructurings between two non-resident related party companies are also eligible for this STT exemption. A recent ruling says that STT is applicable when the shares of a Korean subsidiary owned by the disappearing company are transferred to the surviving company in the course of a merger between two non-resident related parties. In order to promote internal restructuring for enhancing the efficiency in business practices, certain form of share transfers that occur from some internal restructuring may be exempt from STT regardless of whether it happens in Korea or overseas. For the purpose of encouraging corporate restructuring, some exceptions (though limited) may have to be allowed to exempt STT. Currently under the relevant tax rulings, it is interpreted that the exemption of STT is available to some reorganizations between domestic companies. But it is not clear whether the answer would be the same for internal restructuring among non-resident related parties. So it is recommended that the tax authorities provide a clear guideline on this matter in a way that does not discriminate foreign companies against Korean domestic companies. 8. Double taxation of dividends received by a Korean parent from a Korean shareholder Korean domestic tax law taxes dividends received by a Korean parent from a Korean subsidiary at regular corporate income tax rates (currently 24.2% including resident surtax) but allows a limited dividend received deduction (DRD) to reduce the level of double taxation at the parent company level. The amount of the DRD depends on whether the parent is a registered holding company and the shareholder ownership percentage in its subsidiary. While it is possible to obtain an 80% or 100% DRD if the parent qualifies as a registered holding company and owns 40% or more of an unlisted subsidiary, it is difficult to qualify in practice. For instance, when European multinationals form joint ventures with Korean companies, they will usually be unable to qualify to form a registered holding company to hold their interest in the JV, since they won’t meet the control requirements under the Financial Holding Company Act and Monopoly Regulation and Fair Trade Law. As a result European multinationals not qualifying as registered holding companies would have to use a regular Korean company to hold its ownership in Korean JVs, resulting in a substantially lower DRD (only 30% DRD if 50% or less of JV is owned). This essentially results in the double taxation of 70% of the JV earnings distributed to the Korean parent established by the European Multinational, which is one of the main reasons European multinationals would not establish a Korean holding company. Other countries provide generous DRD, dividend exemptions, dividend imputation credits, or participation exemptions to ensure that dividends are not taxed twice. The following countries provide good examples. We have assumed, for this purpose, that the parent is located in the same country as the subsidiary, and the parent owns only 25% of the subsidiary: Germany: 95% DRD France: 95% DRD Netherlands: 100% participation exemption Hungary: 100% participation exemption Switzerland: 100% exemption Japan: 100% DRD US: 80% DRD Canada: 100% DRD Mexico: 100% exemption Singapore: 100% exemption India: 100% exemption Australia: 100% dividend franking (imputation) credit (no double taxation) New Zealand: 100% dividend franking (imputation) credit (no double taxation) Increase the DRD for registered holding companies from 80% to 95% provided 40% or more of the shares of the underlying subsidiaries are owned (and leave it at 100% when 100% is owned). Increase the DRD for regular Korean companies not qualifying as registered holding companies from 30% to 80% provided 40% or more of the shares of the underlying subsidiaries are owned (and leave it at 100% when 100% is owned). If it is difficult to implement this at first for all Korean parent companies, then add it first as a tax exemption provision under the Tax Incentive Limitation Law for foreign invested companies to encourage foreign companies to establish Korean holding companies and to permanently reinvest profits in Korea. This will decrease the remittance of dividends abroad (helping to encourage long-term investment and decreasing foreign exchange volatility). This will also help to streamline Korea’s taxation of dividends to be more closely aligned with other OECD countries and major trade partners, making Korea more competitive. This will help to encourage the use of Korea as a regional hub or holding company location.