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On July 30, 2018, the Korean Ministry of Economy and Finance (“MOEF”) announced the proposed tax law changes/amendments for 2019 and beyond (“Proposals”). The Proposals are expected to be reviewed and finalized by the Korean National Assembly in December 2018.
Some key Proposals that should be of great interest to private equity funds and other investors relate to the Korean taxation of a foreign collective investment vehicle, referred to as an Overseas Investment Vehicle (“OIV”) in the Korean tax law. An OIV is broadly defined as an overseas vehicle that raises funds through an investment offering, manages investment assets, derives value from the acquisition and disposition of such assets, and distributes such derived value to its investors. Consequently, partnerships, limited liability companies and other types of collective investment vehicles (e.g., trusts) would likely be included in the definition of OIV.
The key provisions of the Proposals in relation to an OIV that will impact tax planning for foreign funds are summarized below.
1. Background: There has been ongoing confusion regarding the taxation of foreign funds
For foreign investors, nothing in Korean taxation has been more controversial or contentious than the concept of “beneficial ownership” as applied to foreign funds by the Korean tax authority (“NTS”). Under the current rules provided in the tax law, an OIV should basically be looked-through to the ultimate investors for application of tax treaty benefits (“OIV regime”). The tax treaty benefits are claimed by submitting the Report of Overseas Investment Vehicle (“OIV Report”) and other tax forms to the withholding agent, based on the residence and tax treaty eligibility for each investor.
However, in a line of cases dealing with foreign funds, the Supreme Court ruled that a foreign fund established in a non-tax treaty jurisdiction can also be regarded as the beneficial owner (“BO”) of Korean-source income. Subsequently, the NTS started to take the position that the foreign fund itself should be treated as the BO (rather than looking-through to the ultimate investors as per the OIV regime). And since most foreign funds are located in tax haven jurisdictions without any tax treaty protection (such as Cayman Islands, BVI, etc.), this meant full Korean domestic taxation would apply on capital gains, dividends, etc.
2. The Proposals would revise the foreign entity classification rules and strengthen the OIV regime
The MOEF’s Proposals include 3 significant amendments to clarify and enhance the scheme for taxing Korean-source income with respect to OIVs (e.g., foreign funds).
Revision to the entity classification rules
First, under the current foreign entity classification rules, a foreign entity (including an OIV) is considered a company for Korean tax purposes if any 1 of the following 4 criteria are met:
a. The entity has legal personality under the law of the country in which it was incorporated;
b. The entity is only comprised of partners or members with limited liability;
c. The entity has the same or similar characteristics to a company as defined under the Korean Commercial Law; or
d. The entity can hold assets, can be a party to a lawsuit, or has rights and obligations separate from its members/partners.
Under this Proposal, the 4th criteria will be eliminated. According to guidelines published by the MOEF, the reason for the elimination of last criteria was that, in the past, there was confusion since a partnership in many jurisdictions can hold assets and be a party to a lawsuit, etc.
Clarification on taxation of non-corporate OIVs
Second, the rules for taxation of non-corporate entities will be revised to provide clarification regarding how Korean tax will be applied to such entities.
Specifically, this Proposal states that Korean-source income earned by a non-corporate foreign entity is retained and tested at the level of each investor. In addition, if the entity only discloses a portion of its partners/investors, only that portion of the income will be taxed at the investor level (the remainder being taxed at the entity level). And in the case of corporate investors, the Proposal clarifies that corporate income tax (rather than individual income tax) will be applied.
New rules to determine if an OIV can be viewed as the beneficial owner
Third, a new provision will be introduced to prescribe specific rules to determine the beneficial ownership of Korean-source income in case of investment into Korea through an OIV.
Under this Proposal, an OIV (e.g., a foreign fund) shall be viewed as the BO of Korean-source income if any 1 of the following 3 conditions is satisfied.
a. If the OIV is liable to tax in its jurisdiction of residence and the OIV was not established to avoid/reduce tax on Korean-source income ;
b. If the OIV does not disclose its partners/investors, then the OIV shall be regarded as the BO to the extend its investors are not disclosed (but the OIV will be taxed at the Korean domestic corporate income tax rates); or
c. If the OIV is respected as the BO under an applicable tax treaty.
These Proposals are schedule to become effective from January 1, 2020.
3. Significance: Foreign fund investors should have more clarity on the Korean tax implications of their investments
Taken as a whole, these Proposals would confirm that the look-through approach prescribed under the current OIV regime is the correct approach to tax Korean source income in the case of foreign funds and other collective investment vehicles. Accordingly, assume the Proposals are enacted into law as put forth, we believe the NTS may no longer rely on the Supreme Court cases to stop and impose domestic Korean tax on an OIV located in a non-treaty jurisdiction to the extent that the OIV can disclose its investors. Thus, these Proposals can be viewed as a favorable development and should provide more clarity in structuring investments into Korea for foreign private equity funds and other investors.
But please note that these Proposals will be effective from January 1, 2020. It is currently unclear whether the NTS will still accept the OIV regime/look-through approach between now and when these Proposals are enacted into law.
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