During the last few years, the Korean court has considered an increasing number of appeals related to the beneficial ownership issue in the context of treaty claims by foreign enterprises.
Until recently, the Supreme Court did not provide clear criteria for determining the beneficial owner, although it rendered a number of decisions by applying the Korean general anti-avoidance rule (GAAR) – also known in Korea as the substance over form principle – to the specific facts of each case. Generally, the Supreme Court denied beneficial ownership of a holding company investing into Korea from a favorable treaty jurisdiction if the holding company lacked sufficient substance in that jurisdiction such as employees, physical office etc. In particular, special purpose holding companies established by financial investors such as private equity funds in Belgium, Labuan etc., were disregarded while regional holding companies established by multinational enterprises were recognized as beneficial owner in some cases based on the particular facts of the case, as in a 2014 case involving a global retail enterprise and a 2016 case involving a global energy enterprise.
Notwithstanding the exceptions mentioned above, many commentators have raised concern on the potential deterrent effect on foreign investment as a result of the Korean tax authority's broad application of the GAAR with respect to the beneficial ownership issue.
However, in late 2018, two Supreme Court cases have provided clear criteria for determining beneficial owner and clarified its interaction with the GAAR. A summary of these cases and the meaning and implications of these decisions are explained below.
The case at issue involved royalties paid by a Korean entertainment company to an unrelated Hungarian company that licensed rights to broadcast films created by a Hollywood film/entertainment company. The Hungarian company was interposed between the Korean entertainment company and a Dutch company which previously licensed the rights to the Korean entertainment company. Royalties received by the Hungarian company are exempt from withholding tax in Korea under the Korea/Hungary tax treaty, but the Korean tax authorities applied the GAAR to disregard the beneficial ownership of the Hungarian company.
The High Court ruled in favor of the tax authorities and held that the Hungarian company was a mere conduit used for treaty shopping purposes. However, the Supreme Court reversed the High Court's decision on the grounds that beneficial ownership should not be denied by the mere fact that tax benefits were derived from the relevant tax treaty if the foreign entity was otherwise engaged in genuine business activities in line with the entity's business purpose.
More specifically, the Supreme Court adopted a two-step approach under which it first considered whether the income recipient is the beneficial owner based on whether it has beneficiary rights over the royalty income without bearing any legal or contractual obligation to transfer the royalty income to another entity, and then considered whether such beneficial ownership status may be denied under the domestic GAAR. Applying such approach, it decided that the Hungarian entity should be entitled to the treaty benefits because (i) it did not bear any legal or contractual obligation to transfer the royalty income and thus should be regarded as the beneficial owner; and (ii) it had the ability to manage and control the license rights that gave rise to the royalty income, and therefore the GAAR should not apply.
This case is significant in that it is the first Supreme Court case involving the beneficial ownership of royalties paid to a foreign company established in a favorable treaty jurisdiction which was decided in favor of the taxpayer.
Shortly after the foregoing decision, another Supreme Court decision involving withholding tax on dividends paid by a Korean manufacturing company to its Hungarian parent was rendered. The Korean company had originally been held by a US entity but as part of a group corporate restructuring, the shares of the Korean company were transferred to the Hungarian company, which was established to function as a shared service centre and intermediary holding company for the group. The Korean company began paying dividends shortly after the restructuring, and withheld taxes at the reduced rate of 5% under the Korea/Hungary tax treaty.
The Korean tax authorities challenged that the corporate restructuring was merely to avoid paying higher taxes in Korea since the Korean manufacturing company would have withheld tax at 11% on the dividend under the Korea/US tax treaty in the absence of the restructuring. Therefore, they disregarded the Hungarian company and argued that the ultimate US parent was the beneficial owner of the dividends.
Despite the Trial Court and Appellate Court decisions, which held that the Hungarian company was merely a conduit, in reversing the lower courts' decision the Supreme Court applied the same two-step approach as the foregoing 2017Du33008 decision regarding royalty payment and decided that the Hungarian company is the (i) beneficial owner of the dividend income because it did not bear any legal or contractual obligation to transfer the royalty income; and that (ii) the GAAR should not apply since there was a commercial purpose in establishing the Hungarian holding company and it substantially managed and controlled the shares in the Korean company and the dividend income. Further, the Supreme Court reiterated its position in the preceding case that the beneficial ownership status of the income recipient cannot be denied simply because there is a reduction in Korean taxes.
Despite tendency to view corporate restructurings resulting in tax benefits in a negative light, the recent Supreme Court decisions demonstrate that treaty benefits will not be disallowed simply because there is a tax benefit if there are commercial reasons for the restructure and the income recipient is the beneficial owner that substantially manages and controls the asset giving rise to Korean source income.
In rendering the above decision, the Supreme Court also distinguished the concept of "beneficial owner" under the tax treaty and "substantive owner" under Korean GAAR and clarified that a taxpayer must satisfy both criteria in order to be entitled treaty benefits. The criteria for determining beneficial ownership adopted by the Supreme Court, which is in line with OECD principles, indicates that the Korean Supreme Court has taken a step closer to aligning its position with international standards.
In rendering judgment on the two landmark beneficial ownership cases within a two-week interval in favor of the taxpayer, the Supreme Court for the first time set criteria for determining beneficial owner and clarified its interaction with Korean GAAR and noted that the existence of a tax benefit, will not on its own justify the application of GAAR, provided there are commercial reasons and the taxpayer otherwise demonstrates that it substantially manages and controls the asset giving rise to Korean source income.
It is considered that these decisions should provide more clear guidance for foreign enterprises investing into Korea to meet the beneficial ownership requirement under Korean tax law to qualify for treaty benefits, particularly in circumstances involving corporate restructuring resulting in lower Korean taxes.