|Sang Jin |
As arguably one of the most aggressive tax assessment attempts recently made by the Korean tax authority, the Tax Tribunal held that tax assessed on the grounds that the domestic holding companies established in Korea cannot be disregarded under the Korean substance-over-form principle as long as the company served a non-tax purpose in the overall transaction.
This update examines the Tax Tribunal decision that addressed the issue of whether certain dividend payments made to domestic holding companies established to facilitate a leveraged buy-out (LBO) structure should be disregarded for tax purposes and treated, in substance, as if the payments were made to foreign investors who were the shareholders of the domestic holding companies.
On December 28 2015, the Tax Tribunal reversed the decision reached in favour of the National Tax Service (the Tax Authority) on October 11 2013 at the Administrative Tax Review level. In particular, the Tax Tribunal determined that it was improper for the Tax Authority to assess withholding taxes on dividends paid by a domestic subsidiary to its domestic holding companies on the basis that the holding companies were merely conduits established for the purpose of avoiding taxes. In reaching such conclusion, the Tax Tribunal reasoned that there was insufficient evidence to deny the substance of the domestic holding companies considering the fact that there was a valid business purpose underlying the establishment of the holding companies, which was to raise funding for the LBO, and that the foreign investors did not have control over the dividends received by the holding companies.
The specific facts pertaining to the Tax Tribunal ruling are as follows:
Private equity funds established in the Cayman Islands (the 'Cayman Funds'), established two Dutch holding companies, and subsequently established two Korean stock companies that were qualified as holding companies under the antitrust laws of Korea (the 'Domestic Holdcos'). The Domestic Holdcos acquired 100% share ownership in a Korean target company by financing the necessary funds which primarily consisted of loans from financial institutions, including Korean banks. The loans were secured by the target company's assets and shares.
After acquiring the shares in the target company, the Domestic Holdcos used dividends received from the target company to repay the principal and interest on the loans. With regards to the dividend payments, the target company did not withhold taxes on its payments to the Domestic Holdcos in accordance with the Corporate Income Tax Law (CITL) which provided that no withholding tax shall be imposed on domestic dividend payments made to another domestic company. The Domestic Holdcos also deducted interest paid on the loans.
The Tax Authority conducted a comprehensive tax audit against the Korean target company and imposed taxes on the basis that the target company should have withheld taxes on its dividends paid to the Domestic Holdcos since the payments were in substance made to the Cayman Funds (that is, Cayman Funds were the substantive owners of the dividend income). The Tax Authority also asserted that the Domestic Holdcos should be denied of its expense deductions regarding its interest paid on the loans under an anti-abuse rule referred as the "denial of unfair transaction rule" since the funds borrowed by the Domestic Holdcos should in substance be viewed as funds borrowed by the Korean target company instead.
In response to the above tax assessments, the target company requested an Administrative Tax Review to the head office of the Tax Authority, seeking a redetermination of taxes for such assessments. At the conclusion of the Administrative Tax Review, the Tax Authority canceled the assessment regarding the denial of interest deduction but maintained its assessment regarding the withholding tax assessment on the basis that the Cayman Funds should in substance be viewed as the substantive owner of dividends paid by the target company.
Issue 1: Whether the Domestic Holdcos should be viewed as conduits established for the purpose of tax avoidance.
The Supreme Court has established in various cases that a legal entity lawfully established under the Korean laws cannot be disregarded for lack of substance even if it has no physical presence, and that the issue to be considered should be whether there were independent economic activities or valid business purposes other than to avoid taxes.
In the instant case, there was a valid commercial reason for establishing the Domestic Holdcos, which was to borrow the necessary funds from the relevant financial institutions. From the lenders' perspective, establishing the legal entities in the same country where the target company was located was desirable for purposes of managing and controlling the loans and, considering such factors, establishing the Domestic Holdcos were not unreasonable nor was using such entities in the described investment structure a deviation from other commonly-used LBO investment structures.
Therefore, despite the Tax Authority's allegation that establishing the Domestic Holdcos was a result of a prior tax planning for purposes of avoiding taxes, the Tax Tribunal held the Tax Authority's allegation as unwarranted given that it failed to set forth any evidence for its allegation that the Domestic Holdcos were established for the purpose of avoiding taxes when it was the creditor (that is, the Korean banks) rather than the borrower that requested the Domestic Holdcos to be established during the funding process.
Issue 2: Whether the dividends should in substance be attributed to the Cayman Funds and, if so, whether loans for which the Domestic Holdcos received from the Korean banks should in substance be viewed as loans received by the Cayman Funds.
Neither were there any economic benefits for the Cayman Funds resulting from the dividends paid by the target company to the Domestic Holdcos nor was there any impact on the share value of the target company. Not only was there no provision under the CITL that imposed taxes on unrealised income of the shareholders, but a deemed dividend taxation against an investment structure which contemplated on gaining solely from the sale of shares (that is, capital gains) and paying taxes on such capital gain in the future could also potentially give rise to an issue of double taxation for the foreign investors. Considering the above factors, the Tax Tribunal held that the Cayman Funds should not be viewed as the substantive owner of the dividend income.
Further, the Domestic Holdcos should in fact be viewed as the recipient of the loans in substance considering that: (1) it is common practice for investment funds to utilize indirect loans in obtaining the remaining amount necessary for its contemplated acquisition, and (2) there was no impact on the Korean shares held by the Cayman Funds (i.e., there was no economic benefit) resulting from the dividends which was received by the Domestic Holdcos from its subsidiary.
Treating the Domestic Holdcos as conduits and treating the Cayman Funds as the substantive owner of the dividend income under the substance over form principle is unreasonable given that the Domestic Holdcos were lawfully established for a valid business purpose and that Cayman Funds neither controlled nor managed the dividends received by the Domestic Holdcos. Therefore, the above tax assessment against the Korean target company which was made on the basis that the Domestic Holdcos were conduit companies was ruled unlawful.
Supreme Court ruling reaffirmed
The above ruling adheres to the principle provided under Article 98 of the CITL: withholding tax should be imposed on dividend payments made to a corporate entity only when such payment is Korean-source income paid to a non-resident.
The Tax Tribunal denied the arbitrary restructuring of the transaction carried out by the Tax Authority in its attempt to assess taxes under the substance over form principle.
This ruling is particularly meaningful as it reaffirms the Supreme Court's holding in 2008 Du 8499 Decision (December 19 2012) that a domestic special purpose company regulated under the relevant Korean laws should not be regarded as a conduit for tax purposes as long as it is operated for its specific investment purpose even if the company lacked physical substance and human resource. Had the Tax Tribunal denied the substance of Domestic Holdcos based on the physical substance and human resource of a holding company, it would not only have been a violation of Korean tax law but also against the national policy promoting the establishment of holding companies which could in effect result in a chilling effect for potential investors in Korea. However, thanks to the Tax Tribunal ruling, the tax risk for similar transactions appears to be low and provides taxpayers facing similar tax assessments with some level of comfort in appealing or litigating their cases.
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