Ernst & Young: Korea Supreme Court releases decision on substantive owner

This E&Y Alert examines a Korea Supreme Court (Supreme Court) decision1 issued in relation to the taxation of a Cayman limited partnership as a foreign corporation and the substantive owner of the Korean-source income.

Case overview

On 25 October 2012, the Supreme Court released its decision on the case where a Cayman Limited Partnership (Cayman LP) invested in a Korean company through a series of holding companies including Belgium Holdings N.V. (Belgium N.V.) and generated dividends and capital gains income in Korea. Belgium N.V., the immediate holding company and the owner of the Korean-source income in form, claimed a reduced withholding tax rate on the dividends income and a capital gains tax exemption under the tax treaty between Korea and Belgium. However, the Korean tax authorities denied the application of the tax treaty and assessed capital gains tax and additional withholding tax on the dividends income arguing that the holding companies should be disregarded and Cayman LP should be taxed as the substantive owner of the income based on the following:

• Cayman LP formed a series of holding companies including Belgium N.V. mainly for availing itself of treaty benefits;
• Cayman LP acted as a principal with rights to conclude contracts and decide the investment details through its investment advisors;
• Belgium N.V. was established after the decision of the investment details but just before the conclusion of the relevant investment contract;
• Belgium N.V. was funded by Cayman LP for the investment;
• Legal advice to remit the dividends income through Belgium N.V.’s account was provided so as not to make Belgium N.V. be disregarded; and
• Belgium N.V., of which its assets are mostly composed of shares of a Korean company, did not have any physical substance such as an office and phone number nor did it spend any expense for its own business operation.

In this regard, the Supreme Court ruled that:

• Cayman LP should be taxed as a foreign corporation for Korean tax purposes since it has an independent existence enabling it to act as a principal with rights and obligations separate from its partners; and
• The substantive owner of the income is Cayman LP based on the principle of substance over form doctrine under Korean tax law.

Also, the Supreme Court rejected the taxpayer’s argument that the ultimate investors in Cayman LP, rather than Cayman LP itself, should be taxed as the substantive owners, because the taxpayer failed to substantiate the beneficial ownership of the ultimate investors with supporting documents.

Offshore investment vehicle under new withholding regime

On 1 July 2012, the Korean Corporate Income Tax Law (CITL) introduced a new withholding regime that requires a foreign company, which is the beneficial owner of Korean-source income and wishes to claim a reduced tax rate under a relevant tax treaty, to submit an application form to the relevant withholding agent before the income is paid. If the Korean-source income is paid to beneficial owners through an offshore investment vehicle (OIV), the OIV must receive the application form from the beneficial owners and submit an OIV report including a detailed schedule of the beneficial owners. If this is the case, the treaties between Korea and the resident countries of the beneficial owners of the income shall be applied.

According to the Presidential Decree of the CITL, an OIV is defined as an organization that is established outside of Korea where it solicits money from investors and manages the fund by investing in valuable assets including but not limited to purchases and sales of such assets and the distribution of its profits to the investors.

In other words, an OIV is an organization carrying out investment activities on behalf of its underlying investors, and purchases and sales of investment assets are the critical part of its activities.

A limited partnership might generally satisfy the definition of an OIV under the new withholding regime and Cayman Islands has been commonly used as a jurisdiction for setting up an OIV for investments in Korea.

Considerations

The Supreme Court ruled that Cayman LP is the substantive owner of the Korean source income because it acted as a principal with rights and obligations, and substantially controlled the investment assets. Also, it rejected the argument that the ultimate investors have the beneficial ownership of the Korean source income as the taxpayer failed to substantiate the beneficial ownership status.

The Supreme Court decision creates a significant impact and uncertainties regarding taxation of an OIV and its withholding procedure. In the absence of criteria for determining the substantive owner, it is unclear how to treat an OIV under the new withholding regime, effective from 1 July 2012 in Korea.

Also, the question remains as to whether ultimate investors can be afforded treaty benefits under the tax treaties between Korea and their residence jurisdictions in cases where they invest in Korea through OIVs.