For a foreign corporation deriving South Korean-source income, eligibility for tax treaty benefits is a decisive matter, as tax treaties provide more favourable taxpayer treatment than South Korean domestic tax law (for example, the South Korea-Ireland and South Korea-Hungary tax treaties provide exemption from source country taxation for interest and royalty income).
In most of the treaties entered into by South Korea, a core question in determining such eligibility is whether the recipient of dividend, interest or royalty income is the beneficial owner of such income.
The Supreme Court’s standard for determining beneficial ownership
The South Korean Supreme Court has traditionally applied the substance-over-form principle to determine beneficial ownership, and where “(i) the nominal owner of the income does not have the authority to control or manage the income, with someone else controlling and managing the income and (ii) where this disparity in nominal and substantial ownership is caused by a tax evasion motive”, the nominal recipient of the income does not constitute the beneficial owner and is thus not eligible for tax treaty benefits.
To date, the majority of cases disputed before the South Korean courts concerned foreign capital investments into South Korea through a holding company within a jurisdiction, which has entered into a tax treaty with South Korea providing a favourable tax treatment. Depending on the nature of the foreign capital, the Supreme Court’s approach to these cases can be distinguished as follows.
First, in cases where foreign ‘investment’ capital establishes a holding company to invest in South Korea, the Supreme Court has consistently taken the position that holding companies established by foreign investment capital with a one-time investment purpose do not constitute the beneficial owners of the relevant income and as such are not eligible for tax treaty benefits.
Second, in cases where ‘industrial’ capital establishes a holding company to operate business in South Korea, the Supreme Court has shown the tendency to acknowledge the holding company as the beneficial owner. That is, an intermediary holding company with certain physical substance managing shares in subsidiaries established in various jurisdictions (including South Korea) and exercising the authority to control and manage the relevant income received, is recognised as the beneficial owner of such income by the Supreme Court.
Changes after the Supreme Court’s case law in 2018
Although the Supreme Court did recognise holding companies established by industrial capital as the beneficial owner of their South Korean-source income, the Supreme Court’s overall stance with regard to acknowledging beneficial ownership used to be rather conservative.
Backed by this conservative attitude of the courts, the South Korean tax authorities (the National Tax Service, ‘NTS’) did not shy away from issuing assessments denying beneficial ownership with almost no exception where an intermediary holding company was used, resulting in a tax benefit. The lower courts in turn tended to take sides with the tax authorities, resulting in taxpayers generally being unsuccessful in their tax litigation challenging such assessments.
However, in November 2018, the Supreme Court rendered a landmark decision in which it clearly specified the legal meaning of beneficial ownership for tax treaty purpose. The 2018 Supreme Court decision involved a US-headquartered multinational enterprise, whose holding company deriving South Korean-source income was established in Hungary, against the background of the South Korea-Hungary tax treaty being more favourable to taxpayers than the South Korea-US tax treaty.
Specifically, the Supreme Court clarified that “beneficial ownership must be determined in accordance with whether the recipient of the income enjoys the right to use and enjoy the income without any legal or contractual obligation to transfer the income to another party”. The Supreme Court thus recognised the Hungarian holding company as the beneficial owner of the South Korean-source income even though the holding company structure resulted in a saving of South Korean taxes.
“Following the 2018 Supreme Court decision, numerous courts have found in favour of taxpayers in beneficial ownership cases”
In its commentary, the Supreme Court expressed its view that “while it is difficult to consider a holding company which is established with a tax evasion motive and for an one-time investment purpose, and which transfers the income in full to its upper-level investors as the beneficial owner of such income, if the holding company conducts proper business activities for an extended period of time, a tax evasion motive cannot simply be assumed by the mere fact that there was a saving of South Korean taxes”.
This explanation raises the alarm against denying beneficial ownership on the sole reason that using a holding company has the effect of reducing the taxpayer’s tax burden. It further signifies that where a multinational enterprise’s holding company has been operating for an extended period of time, this increases the likelihood of such holding company being recognised as the beneficial owner of the income received.
Indeed, following the above 2018 Supreme Court decision, numerous courts have found in favour of taxpayers in beneficial ownership cases. A frequent development was that an appellant court, after the 2018 Supreme Court decision, would reverse the decision of the court of the first instance which had denied beneficial ownership prior to the announcement of the 2018 Supreme Court decision.
The Supreme Court in turn would uphold such decision by the appellant court which found in favour of the taxpayer (South Korean case law considers the question of determining the beneficial owner as a factual question to be reviewed by the fact-finding courts (the courts of the first and second instances). As such, it frequently occurs that the Supreme Court (which is a court of law which does not engage in fact-finding activities) will close a beneficial ownership case with an expedited decision rejecting the tax authorities’ appeal challenging the taxpayer’s victory before the appellant court).
While the 2018 Supreme Court decision did not change or overturn the pre-existing case law in itself, it served as the turning point for the courts’ broader acceptance of beneficial ownership and it is clear that the general trend of the case law has changed.
Recent trends regarding beneficial ownership issues
Despite the shift in the case law, the NTS continues to maintain its conservative position as to whether holding companies are the beneficial owners of the income they receive. The majority of the NTS’s related assessments are being issued on dividend income received by holding companies of multinational enterprises, and in many cases, taxpayers are challenging these assessments before the courts, often with positive outcomes.
Many fact patterns involve a multinational enterprise which, as part of improving its governance structure over the Asia-Pacific region, establishes a holding company which in turn acquires shares in a South Korean subsidiary. The courts review whether there was a legitimate business purpose at the time of its establishment, how long the holding company has been in existence, whether it exercised its rights as a shareholder, and what the details of receipt and use of the dividends are.
A collective review of these questions is intended to determine “whether the holding company had any legal or contractual obligation to transfer the dividend income to another party”. The number of cases where the courts find that holding companies constitute the beneficial owners of the dividend income and those where beneficial ownership is recognised even for holding companies with no personal or physical facilities is steadily increasing.
Considering this trend, there is a possibility that the NTS’s strict approach to questions of beneficial ownership may change in the future. For example, in the past, it was almost impossible to expect the NTS to accept arguments of beneficial ownership raised by a taxpayer during a tax audit. This resulted in taxpayers being less motivated to defend their positions rigorously over the audit, and instead opting to facilitate tax appeal processes. However, going forward, it will be possible to consider situations where a taxpayer can defend its position and avoid an assessment in the first place by establishing how its holding company meets all the requirements for beneficial owner set out by the court precedents over the course of an audit.
It is also likely that the NTS’s firm stance has deterred multinational enterprises from their restructuring efforts. This may no longer need to be the case, as going forward, a close review of the requirements for beneficial owner, combined with thorough record-keeping of supporting evidence, will be helpful in reducing risks relating to the beneficial ownership issues of cross border transactions. It will further be possible to pursue restructuring projects which result in a reduction of tax burden if such restructuring is backed by sufficient justification with business rationale.
Remaining issues: Determining beneficial ownership of royalty income derived by global ICT businesses
So far, many of the recent beneficial ownership precedents finding in favour of taxpayers concerned dividend income. As far as royalty income is concerned, the NTS is advocating that an even stricter approach must be applied.
More specifically, the NTS is putting forward arguments that in order to qualify as the beneficial owner of royalties, the recipient must hold personnel necessary for the creation, improvement, management etc. of the intellectual property (IP), must engage in research and development activities and must further contribute to use of the IP by the South Korean payer of the royalties.
There have indeed been recent cases where taxpayers were unsuccessful in their appeals challenging tax assessments that were issued against royalty income derived by Irish holding companies (as seen above, the South Korea–Ireland and South Korea–Hungary tax treaty exempt royalty income from taxation in the source country. As such, if a multinational enterprise owning certain IP sells the rights to such IP to an Irish/Hungarian holding company, or alternatively grants a sublicense to the same, then this would result in an exemption from South Korean withholding tax where the Irish/Hungarian holding company enter into agreements with and receives royalties from South Korean corporation. It appears that the NTS is wary of situations where a transfer of IP is used merely to facilitate a tax evasion).
However, in 2021, the South Korean Supreme Court rendered a decision which held in favour of the taxpayer by recognising the Hungarian entity (to which the US-headquartered ICT enterprise had transferred its IP) as the beneficial owner over the royalty income received.
This decision marked the first beneficial ownership case decided by the Supreme Court regarding the royalty income of a multinational ICT business. In finding that the Hungarian entity was the beneficial owner of the royalties, the Supreme Court collectively considered the circumstances leading to the establishment of the Hungarian entity, its personal and physical facilities, the scope of its capital, the details of its ownership of the IP, as well as the details of its use of the royalty income received (such as research and development, purchase of intangibles, acquisition of other businesses, repayment of debt etc.).
With South Korean enterprises paying exorbitant amounts of royalties to global ICT companies, the relevant withholding tax revenue is also inevitably on the increase every year. It is as such in part understandable why the NTS would take a conservative stance in recognising beneficial ownership in a case where such recognition might result in an exemption from South Korean withholding tax on the ICT business’s royalty income.
It is possible that determination of the beneficial owner may differ in the context of royalty income as opposed to dividend income. However, this does not mean that beneficial ownership can only be recognised if the recipient of the royalties has the capacity to develop the relevant IP or the personal or physical facilities to maintain or improve it. Instead, the core question of beneficial ownership, whether it is royalty income or dividend income, remains whether there exists the authority to control and manage the income.
Accordingly, it is expected that even in scenarios including the transfer or sublicense of IP, provided that such transfer or sublicense occurs with a proper business purpose for the multinational ICT business, related tax risks will be sufficiently manageable by reviewing the requirements for the beneficial owner set out by the case law and by conducting any restructuring efforts in line with such requirements.
|Kyu Dong Kim|
Kyu Dong Kim is a partner primarily focusing on international tax matters and currently co-leading Yulchon’s international tax team.
Kyu Dong has more than 23 years of tax experience and extensive knowledge of all cross-border tax matters, with a particular focus on ICT clients and structuring overseas fund investments into South Korea and overseas investments of South Korean companies.
Before joining Yulchon, Kyu Dong worked with PwC in London and Seoul. He is an active member of the South Korean branch of the International Fiscal Association and a member of two investment committees of the National Pension Fund.
|Yong Whan Choi|
Yong Whan Choi is a partner primarily focusing on international tax matters and currently co-leading Yulchon’s international tax team.
Yong Whan has more than 14 years of tax experience, focusing particularly on TP, permanent establishment, beneficial ownership and royalty issues involving ICT, global semiconductor and automotive clients.
Before joining Yulchon, Yong Whan served for three years as a government attorney representing the South Korea National Tax Service in tax litigation.
|Min Young Sung|
Min Young Sung is a partner in Yulchon’s tax group. He practices primarily on tax disputes and tax advice and strategy focused on international taxation issues.
Min Young has represented various South South Korean conglomerates, multinational companies, and private equity funds in tax audit defenses, tax tribunal appeals as well as tax litigation regarding tax treaty benefits, and PE issues, and has further advised on tax consequences of cross border M&A transactions.
Ja-Young Lee is a senior associate in Yulchon’s international tax team. She has both represented clients in cross-border tax controversy matters before the Tax Tribunal and the South Korean courts, as well as provided tax advice and tax planning strategies to individual clients, with a particular focus on residency issues and cross-border estate planning.
Ja-Young holds obtained a JD degree from Seoul National University Law School.
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