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Korea: Regulatory Hurdles to Islamic Finance

November 2010 - Finance. Legal Developments by Lee & Ko .

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Over the last couple of years, market participants in Korea have been following developments in the Islamic finance market with keen interest. They realise that becoming a direct or indirect participant in the Islamic finance market, with its huge potential for market growth, will provide them with advantages.

In this article, we set out the effort the Korean Government (including the various regulatory authorities in Korea) has been making in order to allow certain types of Islamic finance transactions (in particular through the issuance of Sukuk) and also facilitate the entry of Korean market participants into the Islamic finance market. We also set out what we expect would result from such efforts and also highlight the limits of such efforts.

Recent reform efforts

In late September 2009, the Korean Government (in particular, the Ministry of Strategy and Finance) has prepared a draft amendment of the Special Tax Treatment Control Act (STTCA) and tried to submit it to the National Assembly for approval. Although such effort was not successful, the proposed amendment aims to recognise Sukuk transactions as an alternative method of raising funds and neutralise the existing unfavourable tax treatment on such transactions. The main impediment for Korean entities tapping into the Sukuk market has been the various taxes which arise from a typical Sukuk structure under the current Korean tax laws. A typical Sukuk-al-Ijara and Sukuk-al-Murabaha structure will involve the transfer or lease of an underlying asset. Currently, such a transfer or lease of an underlying asset will attract double stamp duty, VAT, capital gains, acquisition and/or registration taxes. Such adverse tax consequences make Sukuk an unfeasible form of financing in Korea. Thus, it was critical to waive such unfavourable tax treatment of Sukuk transactions in order to level the playing field between Sukuk and other conventional foreign currency denominated notes or bonds issued by Korean entities (as the latter is given preferential withholding tax exemption on interest payments). If the amendment is passed by the National Assembly in the future, this will pave the way for Korean entities to issue Sukuk through offshore special purpose vehicles (or SPVs).

However, legislative changes for facilitating the issuance of Sukuk under Korean law are, in comparison, lagging behind. Although the Sukuk bears a strong resemblance to conventional bonds under the Korean Commercial Code (KCC), the Sukuk does not fit into one of the types of corporate bonds which are exhaustively defined in the KCC. Thus, a Sukuk is not an instrument which can be issued under the KCC. Active initiatives for legislative change to facilitate the issuance of Sukuk under Korean law have been seen in Korea in recent years. Such initiatives include adding a definition of a new type of investment securities that can be issued by a Korean company and such investment securities would be defined broadly enough to encompass both the Sukuk-al-Ijara and Sukuk-al-Murabaha. However, no actual steps have been taken by the Korean Government to introduce such amendment legislation to date.

The Korean market participants have also been following the changes to the Japanese banking regulations in December 2008 which now allows the subsidiaries of Japanese banks to engage in Islamic finance transactions. Current Korean banking laws do not permit Korean banks to engage in Islamic finance transactions and we are not aware of any discussions of legislative change to facilitate Korean banks (including their subsidiaries) engaging in Islamic finance transactions.

Anticipated effects in the market

It is currently unclear when the draft amendment of the STTCA will be passed by the National Assembly due to a backlog of draft legislations which are pending in the National Assembly as well as other unforeseen political events (including the recent incident of sinking of a Korean warship). There are reports that the draft amendment of the STTCA will be submitted to and reviewed by the National Assembly in September 2010.

When the draft amendment of the STTCA is passed, we anticipate that various Korean entities which were interested in, yet previously discouraged by the prohibitive tax implications of, Sukuk will renew their interest and seek entry into the Islamic finance market. Their entry into the market will most likely be in the form of their issuance of Sukuk-al-Ijara or Sukuk-al-Murabaha through an offshore SPV.

Given that current Korean laws do not recognise Sukuk as an instrument which a Korean company can issue under Korean law and no legislative changes are anticipated or planned in the near future in this regard, it will be some time before a Sukuk may be issued under Korean law. However, such lack of legislative change should not be reflected as a lack of enthusiasm to develop a domestic Islamic finance market. Korean market participants (including regulators) remain keen to develop a domestic Islamic finance market but the Korean Government and the legislature is struggling to catch up with the market's enthusiasm.

Conclusion

No new significant developments in relation to Islamic finance have occurred in the Korean market in recent years despite the preparation of the draft amendment of the STTCA. Once the amendment of the STTCA is passed and becomes effective, a major impediment to Korean entities tapping into the Islamic finance market (mainly by the issuance of Sukuk) will be removed. Given the market participants' continued interest and enthusiasm in Islamic finance products, we expect many Korean entities will positively consider issuing Sukuk thorough an offshore SPV. The amendment of the STTCA will be a very important first step in the right direction and it will facilitate a framework for issuing Sukuk offshore and also later provide a momentum for allowing Islamic finance products to be issued under Korean law.

 

By Yong-Jae Chang and Bong Sang Cho (Lee & Ko)


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