The Ministry of Strategy and Finance (“MOSF”) announced its proposed tax law amendments for 2018 (the “2018 Tax Amendments”) on July 30, 2018. According to the MOSF, the purposes of the 2018 Tax Amendments are to promote creation of jobs, improve redistribution of income, and rationalize the tax system. Unless otherwise noted below, upon approval by the National Assembly, the 2018 Tax Amendments will be effective as of January 1, 2019.

We provide below a summary of the key proposed amendments.

1. Expansion of the scopte of permanent establishment of non-resident/foreign corporation

A. Strengthening of the requirement for places where certain activities are conducted that are excluded from the definition of permanent establishment (Article 94(4) and (5) of the Corporate Income Tax Law (the “CITL”), Article 133(3) of the Presidential Decree of the CITL, Article 120(4) and (5) of the Personal Income Tax Law (the “PITL”), and Article 180 of the Presidential Decree of the PITL)

Under the current law, the scope of permanent establishment (“PE”) included in the CITL or PITL does not include any of the following places: i) places used by a foreign corporation only for purchasing assets; ii) places used by a foreign corporation only for storing or keeping assets not for sale; iii) places used by other persons only for processing a foreign corporation’s own assets; and iv) places used by a foreign corporation for advertisement, publicity, gathering and providing information, market research, or for performing other preparatory and auxiliary business activities (hereinafter, the “places where certain activities are conducted”).

According to the 2018 Tax Amendments, even if activities conducted at the “places where certain activities are conducted” are preparatory and auxiliary in nature, such places fall under a PE, if any one of the following conditions is met.

  • If the below conditions are all met:

- A PE of the relevant non-resident/foreign corporation or its related party exists at the same place as the “places where certain activities are conducted” or at another place in Korea.

- Activities conducted at the “places where certain activities are conducted” are complementary to business activities conducted at the PE of the relevant non-resident/foreign corporation or its related party.

  • The overall activity resulting from the combination of the activities carried on by the relevant non-resident/foreign corporation or its related party at the “places where certain activities are conducted” is complementary, and is not of a preparatory and auxiliary character.

With the expansion of the scope of the PE of non-resident/foreign corporation, it is expected that Korean tax authorities will more frequently try to impose tax on non-residents and foreign corporations based on the existence of permanent establishment. Although, in principle, the amended domestic tax law cannot take priority over the existing relevant tax treaty before the corresponding phrases of the relevant tax treaties are amended, the possibility that the tax authority may apply the substance over form principle in determining a PE even under the existing tax treaty cannot be excluded.

B. Expansion of the scope of dependent agent and clarification on types of contracts applicable to determination of dependent agent (Article 94(3) of the CITL and Article 120(3) of the PITL)

Under the current law, any person who has the authority to conclude contracts in Korea on behalf of a non-resident or a foreign corporation and repeatedly exercises such authority is considered a dependent agent and thus falls under a PE of such non-resident or foreign corporation.

As a result of this amendment, even if the agent does not have the authority to conclude contracts, where the agent repeatedly plays the principal role leading to conclusion of contracts that are routinely concluded without material modification by the principal (non-resident/foreign corporation), such agent is considered a dependent agent PE. In addition, the types of contracts that are applicable in determining a dependent agent PE have been clarified as (i) contracts in the name of non-resident/foreign corporation, (ii) contracts relating to the transfer of ownership or the grant of the right to use intangibles held by non-resident/foreign corporation, and (iii) contracts relating to provision of services by non-resident/foreign corporation.

With the expansion of the scope of the PE of non-resident/foreign corporation, it is expected that taxation against non-residents or foreign corporations with respect to the deemed PE will be more easily made and that the tax authority will more frequently try to impose tax on non-residents or foreign corporations with respect to their PEs.

Even before the OECD Model Tax Convention was amended in 2017, the tax authority has interpreted the scope of dependent agent PE broadly and has tried to impose tax for the reason that a similar provision (Paragraph 32.1, Commentary on Article 5 of the 2014 OECD Model Tax Convention) had already been included in the Commentary on the OECD Model Tax Convention relating to PE. Even in the situation where the current tax treaties concluded by Korea are not amended in accordance with the 2017 OECD Model Tax Convention, it is expected that the tax authority will argue that the amended domestic tax law should be applicable.

2. Rationalization of the tax system relating to domestic source income of overseas investment vehicle ("OIV")

A. Rationalization of the criteria for determining a foreign corporation (Article 1 of the Presidential Decree of the CITL)

  • Under the current Presidential Decree of the CITL, a foreign corporation means any of the following entities:
  • An entity endowed with legal personality pursuant to the law of the state in which it was incorporated;
  • A domestic entity whose type of business is the same as, or similar to, the type of business of a foreign entity is a corporation under domestic law; or
  • An entity that owns an asset, becomes a party to a lawsuit, or directly holds a right or owes an obligation, independent of its members.

The proposed 2018 Tax Amendments will delete the above fourth criterion (the subject of rights and obligations).

Although a limited partnership, etc. formed in a foreign country has been classified as a foreign corporation in accordance with the above fourth criterion prior to this amendment, such limited partnership will be classified as “an entity other than a corporation”, the respective members (investors) of which will be taxed based on the substance. Therefore, it is expected that the possibility that a limited partnership formed in a foreign country may be treated as the substantive owner of income will be lower than before.

This rule will be effective for taxable years beginning after January 1, 2020.

B. Clarification on the method of taxing an entity other than a corporation (Article 2 of the PITL and Article 3-2 of the Presidential Decree of the PITL)

According to the current PITL, with respect to an entity other than a corporation, where (i) the method of profit distribution or the distribution ratio among partners of the entity is pre-determined or (ii) such profit is confirmed to be practically distributed, each of the partners will be taxed. Otherwise, the entity will be deemed one individual resident or non-resident and taxed accordingly.

Under the proposed amendment, with respect to (i) above, where only some of partners are identified, the identified partners will be taxed accordingly. Also, where a partner is a corporation, the CITL will apply.

With this amendment, the tax treatment of an investment fund established in a foreign country which is classified as an entity other than a corporation has become clearer.

This rule will be effective for taxable years beginning after January 1, 2020.

C. Special rule treating OIV as substantive owner of domestic source income (Article 121 of the PITL and Article 93-2 of the CITL)

The 2018 Tax Amendments may allow withholding agents to regard an OIV as the substantive owner of domestic source income, if it falls under one of the following cases. With respect to an OIV that is not a corporation, only ② and ③ below are relevant.

  • In case where the following conditions are all met: 
    • The OIV is liable to tax in its residence country.
    • The OIV should not be established for purposes of unduly reducing the amount of personal income tax or corporate income tax with respect to domestic source income. 
  • The OIV fails to prove investors (or in case the OIV does not prove all investors, to the extent of the unproved portion only). However, even if the OIV is deemed as the substantive owner, it will be taxed in accordance with domestic tax law (i.e., the application of benefits under the tax treaty concluded with the residence country of the OIV will be denied).
  • The OIV is considered the substantive owner under the relevant tax treaty

By prescribing reasonable cases where tax treaty benefits can be granted to OIVs under law, this amendment will correct imperfections in the current system.

This rule will be effective for taxable years beginning after January 1, 2020.

D. Special rule relating to the statute of limitations for the imposition of national taxes in accordance with the change of substantive owner (Article 26-2 of the National Tax Basic Act (the “NTBA”))

Under the current NTBA, where a decision or judgment is made final on the objection, request for examination or adjudication, any disposition may be made within one year from the date when the decision or judgment is made final, even if the statute of limitations for the imposition of national taxes has expired.

According to the proposed amendment, even where the substantive owner of relevant domestic source income is confirmed through a decision or judgment made by a proper judicial court, the special rule relating to the statute of limitations for the imposition of national taxes will also apply.

With this amendment, where the substantive owner has been changed through the court decision, the tax authority has obtained a legal basis to impose tax on the changed substantive owner, despite the lapse of the statute of limitations for the imposition of national taxes.

This rule will be effective for court decisions which are made final after January 1, 2019 (in case the statute of limitations for the imposition of national taxes expires before December 31, 2018, the previous rule will apply).

3. Abolishment of corporate income tax/personal income tax reduction and exemption for foreign-invested companies (Articles 121-2 and 121-5 of the Special Tax Treatment Control Act (the “STTCA”))

In accordance with the current STTCA, if certain requirements are met, foreign-invested companies are exclusively eligible for (i) a reduction of, or exemption from, corporate income tax and personal income tax with respect to income occurring from the business subject to tax reduction and exemption, (ii) an exemption from VAT and customs duty with respect to imported capital goods, and (iii) an exemption from acquisition tax and property tax with respect to relevant properties.

As a result of this amendment, these exclusive provisions granting foreign-invested companies a reduction of or exemption from corporate income tax and personal income tax with respect to income occurring from the business subject to tax reduction or exemption will be abolished.

Thus, foreign companies expecting tax reduction or exemption for foreign investments should re-review their after-tax profit margin. However, in the case of foreign investors who have obtained or will have obtained tax reduction or exemption before the end of 2018, it is highly likely that they can enjoy tax reduction/exemption benefits due to the grandfather clause.

4. Heightening of effectiveness of transfer pricing regime (Article 5 of the Law for the Coordination of International Tax Affairs (the “LCITA”))

Under the current LCITA, the arm’s length price for a transaction with a foreign related party is the price that is expected to be applied in an ordinary transaction with a person other than a foreign related party.

The 2018 Tax Amendments will prescribe that the tax authority shall clearly delineate the actual transaction in consideration of the commercial and financial conditions between a resident and its foreign related party, the terms of transaction, etc. and determine whether such international transaction is a reasonable one. Also, the proposed amendment will prescribe that the tax authority shall compare the tested transaction with the one to be made between independent companies under similar circumstances, and in case the relevant transaction considerably lacks commercial reason, it shall deny such transaction or properly re-characterize the transaction and thereafter calculate the arm’s length price.

As a consequence, it is expected that the tax authority will more frequently apply the substance over form principle when conducting a transfer pricing audit in the future.

5. Abolishment of preferential application of tax treaty to income characterization (Article 28 of the LCITA)

Under the current LCITA, the provisions of the tax treaty shall preferentially apply to the characterization of a domestic source income of a nonresident or foreign corporation, notwithstanding the domestic tax law.

The proposed 2018 Tax Amendments will delete the above provision. It seems that the intent of the Korean government is not to preferentially apply domestic tax law over tax treaty with respect to characterization of domestic source income of a non-resident/foreign corporation by deleting the above provision, but to make it clear that income characterization under the domestic tax law is effective regardless of the tax treaty and that income characterization under the tax treaty does not always determine income characterization invariably (please refer to Supreme Court Decision 2015Du2710).

6. Expansion of the scope of partial tax investigation to cover non-resident/foreign corporation’s request for refund (Article 81-11 of the NTBA)

Under the new rule, the scope of “partial tax investigation” is to be expanded to cover on-site confirmation procedures to be conducted by the tax authority in responding to a taxpayer’s refund request applied by non-resident/foreign corporation relying on the benefits of a tax treaty.

Through the above new rule, the tax authority is expected to closely review the relevant cases in the similar manner to tax audit procedures at the stage of the tax authority’s decision toward the refund requests.

7. Reduction in the limit for claiming NOL carryforward by foreign corporations (Article 91 of the CITL)

In order to enhance fairness in taxation between domestic corporations and foreign corporations, the proposed 2018 Tax Amendments will also reduce the limit for claiming NOL carryforwards for foreign corporations from 80% of income for a taxable year to 60% of income for a taxable year.

The 60% limit will apply to the fiscal year beginning on or after January 1, 2019.

8. Expansion of the scope of electronic services provided by a foreign entrepreneur that are subject to VAT (Article 53-2(1) of the VAT Act and Article 96-2(1) of the Presidential Decree of the VAT Act)

Under the current VAT Act, where a foreign entrepreneur supplies any game, audio or video file, software, or other services prescribed by the Presidential Decree of the VAT Act (“electronic services”), VAT will be imposed.

The 2018 Tax Amendments will newly include “cloud computing services” in the scope of electronic services. Accordingly, a foreign entrepreneur supplying cloud computing services will bear the obligation to report and pay VAT.

The new rule will be applicable to services provided on or after July 1, 2019.

9. Adjustment of the criterion for exemption from the obligation to report foreign financial accounts (Article 34 of the LCITA)

Currently, Korean nationals (or ex-nationals) residing abroad and visiting Korea for a period not exceeding 183 days within the two-year period before the end of the relevant year subject to the reporting of foreign financial accounts is exempt from the obligation to report foreign financial accounts.

Under the 2018 Tax Amendments, the requirement period will be changed from “not exceeding 183 days within the two-year period” to “not exceeding 183 days within the one-year period” before the end of the relevant year subject to reporting. As the two-year period has been shortened to the one-year period, the short-term Korean tax resident’s burden of reporting foreign financial accounts has been relaxed.

The new rule will be applicable to reporting of foreign financial accounts held in and after 2019.

10. Strengthening of reporting of foreign financial accounts (Article 34-3 of the LCITA, and Articles 34-2(3) and 50(4) of the Presidential Decree of the LCITA)

Under the current LCITA, with respect to foreign financial accounts held by a foreign corporation located in the country which has not concluded a tax treaty with Korea, where a domestic corporation (the reporting obligator) directly or indirectly holds 100% of the interest in the foreign corporation (the reporting requirement), the domestic corporation is considered the substantive owner of the foreign financial accounts and thus is required to report such foreign financial accounts. In case the obligation to report foreign financial accounts has not been fulfilled, only individual taxpayers are required to explain the source of acquisition funds. In case a criminal punishment (criminal fine not exceeding 20% of the amount unreported or imprisonment for not more than 2 years) is imposed for violation of the obligation to report foreign financial accounts, an administrative fine for non-fulfillment of the obligation to report foreign financial accounts will be cancelled in its entirety.

With the 2018 Tax Amendments, a resident will be included in the reporting obligator with respect to foreign financial accounts held by a foreign corporation located in the country which has not concluded a tax treaty with Korea, and the reporting requirement will be expanded to include cases where the foreign corporation is 100% owned directly or indirectly by the reporting obligator (including the interest held by the related party). Also, the subject that is required to explain the source of acquisition funds if the obligation to report foreign financial accounts has not been fulfilled also includes corporations. In addition, in case a criminal punishment is imposed for violation of the obligation to report foreign financial accounts, where the amount of a criminal fine is less than the amount of an administrative fine, the amount equivalent to the criminal fine, among the amount of the administrative fine, will be cancelled, which means that the remainder of the administrative fine will be still effective.

As the punishment for non-fulfillment of the obligation to report foreign financial accounts has been strengthened, a corporation or an individual that holds foreign financial accounts should closely review whether the obligation to report foreign financial accounts is being fulfilled. With respect to the amount of an administrative fine that exceeds the amount equivalent to a criminal fine, the tax authority will be able to continuously impose the administrative fine despite the criminal fine.

The new rule will be applicable to reporting of foreign financial accounts held in and after 2019.

11. Strengthening of reporting of foreign real property and foreign direct investment (Articles 165-2, 165-3, and 165-4 of the PITL, Table 5 of the Presidential Decree of the PITL, Article 121-2, 121-3, and 121-4  of the CITL, and Table 2 of the Presidential Decree of the CITL)

Under the current law, the subject of reporting with respect to foreign real property and the sanction imposed for non-fulfillment of the reporting obligation are as follows:

  • Subject of reporting: a resident/domestic corporation that acquires and operates (leases) foreign real property for investment purposes (no threshold value)
  • Materials to be submitted: the statement on acquisition of foreign real property, the statement on operation (lease) of foreign real property
  • Sanction: administrative fine (1% of the acquisition value; up to KRW 50 million) will be imposed for non-submission or false submission (non-reporting)

In addition, the sanction that will be imposed for non-fulfillment of the obligation to report foreign direct investment is as follows:

  • In case a resident/domestic corporation that has made a foreign direct investment fails to submit materials to be submitted (i.e., the statement on overseas local companies) or falsely submit such materials, an administrative fine of KRW 3 million per case (for individuals) and of KRW 5 million per case (for corporations) will be imposed (up to KRW 50 million per year). 

According to the 2018 Tax Amendments, the subject of reporting with respect to foreign real property has been adjusted, and the sanction imposed for non-fulfillment of the reporting obligation has been strengthened as follows:

  • Subject of reporting: threshold value per case (at the time of acquisition: acquisition value of more than KRW 200 million; at the time of disposal: disposal value of more than KRW 200 million)
  • Materials to be submitted: the statement on acquisition of foreign real property, the statement on operation (lease) of foreign real property, the statement on disposal of foreign real property
  • Sanction: administrative fine of 10% of the acquisition value for non-reporting at the time of acquisition; administrative fine of 10% of operating (lease) income for non-reporting of operating (lease) income; and administrative fine of 10% of disposal value for non-reporting at the time of disposal (up to KRW 100 million)

Also, the sanction for non-fulfillment of the obligation to report foreign direct investment will be strengthened as follows:

  • Table showing the current status of establishment of overseas business offices will be added in the list of materials to be submitted, and an administrative fine of KRW 5 million per case (for individuals) and of KRW 10 million per case (for corporations) will be imposed (up to KRW 50 million per year).

In addition, the obligation to explain the source of funds will be imposed on the person who has failed to report foreign real property or foreign direct investment.

Since the sanction imposed for non-fulfillment of the reporting obligation has been strengthened, companies investing in foreign real property or making a foreign direct investment should closely review whether they are fulfilling the reporting obligation.

The new rule will be effective at the following time:

  • (Adjustment of the subject of reporting) applicable to submission of the statements on foreign real property investment for taxable years beginning after January 1, 2019
  • (Increase and adjustment of administrative fine imposed for non-reporting of materials to be submitted) applicable to submission of the statements on foreign real property investment for taxable years beginning after January 1, 2020
  • (Administrative fine imposed for non-submission of materials on foreign direct investment) applicable to submission of the statements on foreign direct investment for taxable years beginning after January 1, 2019
  • (Obligation to explain the source of funds) applicable to non-fulfillment of the obligation to submit materials for taxable years beginning after January 1, 2019

12. Extension of the statute of limitations for the imposition of national taxes with respect to offshore tax evasion (Article 262 of the NTBA)

Under the current NTBA, for an international transaction, the statute for limitations for the imposition of national taxes is 15 years (for fraud or other illegal act); 7 years (for non-reporting); and 5 years (for under-reporting).

According to the 2018 Tax Amendments, the concept of offshore transaction has been introduced, and the statute of limitations for the imposition of national taxes has been extended. International transactions and transactions made between residents relating to foreign assets or foreign services will be classified as offshore transactions, and for an offshore transaction, the statute of limitations for the imposition of national taxes will be 15 years (for fraud or other illegal act) and 10 years (for non-reporting and under-reporting), respectively.

In addition, with respect to the exchange of information, special rule allowing the extension of the statute of limitations for the imposition of national taxes has been newly introduced. Where a request for exchange of information is filed to a foreign tax authority within the statute of limitations for the imposition of national taxes, such period will be extended to one year from the date when the information is received (up to 3 years from the date when the request for exchange of information is filed).

As it is expected that taxation relating to offshore tax evasion will be strengthened, a close review on reporting of offshore transactions and appropriateness of transaction prices will be required.

The new rule will be effective at the following time:

  • (Extension of the statute of limitations for the imposition of national taxes with respect to offshore transactions) applicable to establishment of the obligation to pay taxes on or after January 1, 2019
  • (Extension of the statute of limitations for the imposition of national taxes in accordance with the exchange of information) applicable to establishment of the obligation to pay taxes on or after January 1, 2019

13. Strengthening of departure tax (Articles 118-9, 118-11, and 118-15 of the PITL)

Under the current PITL, domestic shares (excluding real property shares) held by a majority shareholder are subject to departure tax, and the applicable departure tax rate is 20%. Also, the person who leaves Korea has the obligation to report the current status of the shares held as at the end of year immediately preceding the year in which the person leaves Korea.

As a result of this amendment, real property shares have been newly added as the taxable object of departure tax, and the applicable departure tax rate has been adjusted as follows: 20% for tax base below KRW 300 million; and 25% for tax base exceeding KRW 300 million. Also, the person who leaves Korea will have the obligation to report the current status of the shares held as of the day immediately preceding the reporting date. In addition, the non-reporting/under-reporting penalty (par value of stock x 2%) will be imposed.

It is expected that the taxable object of departure tax will be continuously expanded after 2019 and that the sanction imposed for non-fulfillment of the reporting obligation will be strengthened every year (please refer to the foreign financial account reporting system).

This new rule will be applicable to departures made on or after January 1, 2019.