South Korea: Recent ruling clarifies whether foreign limited partnership can be looked through for purposes of treaty application
Sang Jin Park
The South Korean tax authority, along with the Supreme Court, have not always been in agreement on the way certain foreign pass-through entities are treated in foreign jurisdictions.
As entity classifications, such as limited liability companies ("LLCs"), limited partnerships ("LPs"), and other various types of investment vehicles, have been a critical factor for cross-border tax advisers, the Korean courts and the tax authority have taken positions that have created more confusion than clarity. For example, the Supreme Court in the Lone Star case ruled that Cayman LPs will be treated as taxable entities that cannot be looked through for purposes of applying the relevant tax treaty. Meanwhile, other Supreme Court rulings have also been unclear as to whether eligible entities could be looked through to its investors for purposes of applying the relevant tax treaty in the context of inbound transactions where Korean source income is remitted outside of Korea.
Despite the conflicting rulings, foreign LPs can be treated as "corporations" under Korean tax laws and thus foreign investors have often been left in a difficult position to claim that the LPs in non-treaty jurisdictions were not the beneficial or substantive owners.
However, the Ministry of Strategy and Finance has released an administrative ruling (Jaekukjo-56, 2015.11.24) that is more in line with the look-through treatment in other developed countries: a foreign investment vehicle in the form of an LP may be looked through to its investors for purposes of applying the relevant tax treaty.
Details of the administrative ruling
The facts of the case state that:
Private Equity Fund ("PEF") A was funded by institutional investors including pension funds, insurance companies, and banks in the US, Canada, and the Netherlands. It was exempt from taxation under the tax laws of the Cayman Islands.
Meanwhile, a LP located in the Cayman Islands, sold its shares in Company B, a domestic company, to Company C, a Belgian company, and realised a certain amount of capital gain.
The taxpayer then filed its tax return by applying the reduced tax rate/exemption pursuant to the tax treaty entered between Korea and the resident country of the investors of PEF A on the basis that the substantive owners of gains were the investors of PEF A, rather than PEF A itself.
The issue in question was whether the relevant tax treaty between Korea and the resident country of the investors of the foreign PEF can be applied in the case where the fund is regarded as an overseas investment vehicle ("OIV") under the Corporate Income Tax Law ("CITL") of Korea.
The administrative ruling said that even if PEF A, a fund established in a country which does not have an effective tax treaty in place with Korea, is regarded as a "foreign corporation" within the meaning provided under the CITL by virtue of being classified as an OIV, the respective tax treaty entered between Korea and the resident country of the investors of PEF A could nevertheless be applied given that the investors are the substantive owners of the income.
The above ruling deviates from the Supreme Court's treatment of LPs in the Lone Star case, where the court ruled that the Cayman LPs should not be looked through for tax purposes with respect to its gains made in Korea as it should be classified as foreign corporations.
In fact, the Supreme Court's view in the Lone Star case (and in other cases involving the treatment of foreign LPs) caused much confusion, not only for inbound transactions, but also for outbound transactions that involve foreign intermediaries established in the form of LPs and LLCs that are treated as fiscally transparent entities in foreign jurisdictions.
However, the above administrative tax ruling released by the Ministry of Strategy and Finance has clarified that LPs that are considered a "foreign corporation" within the meaning of the CITL could nevertheless be looked through for tax purposes in a multi-layered transaction in order to afford the substantive owners with treaty benefits with respect to their gains made in Korea.
Furthermore, the administrative ruling is notable because it is one of the very few that has utilised the substance-over-form principle for the benefit of the taxpayer. Most administrative rulings, either by the Ministry of Strategy and Finance or the National Tax Service, appear to advocate the use of the domestic substance-over-form principle as a means to reach the substantive owner of income for the benefit of the tax authority, to disallow a tax exemption or reduce tax treatment. However, the instant case appears to support the view that an intermediate LP serving little purpose, other than to pool assets on behalf of its investors, may be looked through for purposes of applying the respective tax treaty for the benefit of the taxpayer.
However, the above ruling limits its discussion within the context of treaty application, and should not be misunderstood to suggest that foreign LPs can be looked through for other purposes. For example, in the context of receiving a foreign tax credit in Korea with respect to taxes paid outside the country, a foreign LP is nevertheless treated as a foreign corporation under Korean tax law and the Korean resident may not be able to receive the same look-through treatment for its foreign intermediate LPs.
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