South Korea: Foreign Investors Face New National Tax Rules

On December 30 2006 the National Assembly approved a package of tax law amendments for 2007. The majority of the amendments came into force on January 1 2007. In addition, on January 17 2007 the Ministry of Finance and Economy proposed additional amendments that may affect foreign investors investing in Korea.

Tax Deferral of Capital Gains

The amendment provides that if a foreign investment company established in order to develop an area within the free economic zones contributes appreciated land to a qualified domestic company in return for new shares of the domestic company, the capital gains arising from this contribution will be set at that time, but deferred until the foreign company disposes of the new shares. The free economic zones are designed to attract international business and are equipped with the necessary infrastructure for business activities. At present, there are three free economic zones in Korea: Incheon, Busan/Jinhae and the Gwangyang Bay area. This amendment is designed to promote foreign investment within the free economic zones.

The new provision applies to in-kind contributions made on or after January 1 2007; the provision is scheduled to expire at the end of 2009.

Reduction of Withholding Tax Rate

As part of efforts to attract foreign investors into the domestic bond market, the withholding tax rate applicable to interest paid to foreign investors (both individuals and companies) has been reduced from 27.5% to 15.4%, to the extent that such interest is accrued on bonds issued by the national government, a local government or a Korean company. The reduction applies only to interest on bonds; for loans and other debt instruments the withholding tax rate remains at 27.5%, unless reduced by an applicable tax treaty. This rate reduction will particularly benefit foreign investors located in jurisdictions with which Korea has no tax treaty. The provision does not affect tax-exemption benefits offered to foreign recipients of interest accrued on foreign currency denominated bonds. It applies to interest accrued on or after January 1 2007.

In 2006, overseas natural resource development companies were introduced to attract market capital into the overseas development of natural resources. Overseas natural resource development companies, which are investment companies under the Overseas Natural Resources Development Business Act, may enjoy the benefits of the dividend declared deduction (DDD) rule. Under the DDD rule, an overseas natural resource development company may deduct from its taxable income 100% of the dividends declared, thus effectively paying no corporate income tax in the event that the company distributes all its distributable profits as dividends. The minimum requirement to qualify for the DDD is the distribution of at least 90% of the distributable profits as dividends. Thus, income derived by an overseas natural resource development company is effectively flowed through to its investors and taxed as dividends in the hands of such investors. Dividends paid to foreign investors will be withheld at 27.5% or a treaty-reduced rate if there is an applicable tax treaty. This new provision applies to dividends paid on or after January 1 2007.

Narrowing of Securities Transaction Tax Exemption

Since the introduction of indirect investment vehicles under the Indirect Investment Asset Management Business Act, such vehicles have been enjoying a securities transaction tax exemption when they transfer listed securities through the stock market, irrespective of whether such vehicles are private or public. The amendment abolished this exemption with respect to private indirect investment vehicles; however, for public indirect investment vehicles the existing exemption has been extended for two more years. Thus, private indirect investment vehicles will be subject to securities transaction tax on a transfer of securities on or after January 1 2007.

In general, the character of the income from a trust is determined according to the character of the underlying asset (ie, interest generating or dividend generating). However, if a trust was established under the Indirect Investment Asset Management Business Act, income from the trust is taxed as (i) interest if 50% or more of its underlying assets are composed of interest-generating assets (eg, bonds), or (ii) dividends if 50% or more of its underlying assets are composed of dividend-generating assets and other investment assets (eg, real estate). Moreover, if a trust was established in a foreign jurisdiction under its relevant laws, the income from the foreign trust is taxed as interest, irrespective of the composition of underlying assets.

The amendment has abolished this multi-faceted approach for Indirect Investment Asset Management Business Act trusts and foreign trusts, unifying the taxation of income from such trusts as dividends, regardless of whether a trust is a domestic or foreign trust and regardless of the composition of its underlying assets. The new provision applies to trusts formed on or after January 1 2007.

A 'johap' is a non-corporate entity that has been used to conduct joint business by two or more members, where the gains or losses from the joint business flow through to the members of the johap. For Korean tax purposes, any income from a johap is taxed once it has passed to the members. There has, however, been uncertainty as to how the profits and losses of a johap should be allocated to members for tax purposes. The amended rule has clarified this issue by providing that profits and losses should be allocated in accordance with the profit distribution ratio agreed by members under the johap agreement; if there is no agreed profit distribution ratio, profits and losses will be allocated in accordance with members' ownership interests in the johap.

Further, the amendment changed the character of income distributed to a johap member who only contributes capital and is not involved in the management of the joint business of the johap (a non-managing member). Under the former rules, johap income distributed to a non-managing member was treated as interest. However, under the amended rules such income is taxed as dividends. The amended provision took effect on January 1 2007.

Under the former rules foreign companies could not appeal to the Korean tax authorities regarding any excess withheld taxes. However, under the revised National Tax Basic Act, if a withholding of tax is made on payment of certain types of Korean-source income and a payment report has been timely filed with the Korean tax authorities, a foreign recipient whose Korean source income has been over-withheld may appeal the decision within three years of the date due for remitting the withholding tax to the tax authorities. This rule applies to the following types of income:

• income from renting ships, aircraft or other industrial equipment;

• business profit;
• personal service income;
• royalties; and
• capital gains from the transfer of securities.

The transitory rule provides that the amendment is applicable starting from the taxable year to which January 1 2007 belongs. Due to the uncertainties surrounding the definition of 'taxable year', however, it is unclear whether the amended rule will apply to payments made in 2006. Further clarification is needed from the tax authorities.

According to the proposed amendment to the Enforcement Decree under the Value Added Tax (VAT) Act announced by the ministry on January 17 2007, investment consulting business will be exempt from VAT. 'Investment consulting business' is the business of providing advice orally, in writing or by other means regarding the investment value of securities, real property or other assets, or regarding judgements on investment in such assets. 'Judgements on investment' means judgements on the type, quantity and price of assets in which investment is to be made and on the method and timing of the purchase or sale. The qualifying investment consulting firm must be a joint stock company under the Commercial Code with minimum paid-in capital of W500 million. In addition, the qualifying firm must be an investment consulting firm under the Indirect Investment Asset Management Business Act which has two or more fund managers and is registered with the Financial Supervisory Committee.

For listed stock sold through the stock exchange, tax treaty protection is not required and capital gains tax is not imposed if a foreign seller (without a permanent establishment in Korea) and its related party owned less than 25% of the shares in or the capital of the Korean company during the year of the sale and the five preceding years. According to the proposed amendment to the Enforcement Decree under the Corporate Income Tax Act announced by the ministry on January 17 2007, when a foreign partnership owns listed Korean company shares and transfers such shares, the determination of the ownership ratio under the 25% exception would be made at partnership level. Thus, even if an investor in the partnership indirectly owned less than 25%, the investor would not be allowed to claim that the 25% exception is applicable on the grounds that the foreign partnership was a pass-through entity and the ownership ratio should be tested at the level of the investor in the partnership.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.