Globalisation seems like a clichéd term that has been around for some time. However, it is still very much alive because it is a phenomenon that continues to evolve. Whether companies have already made investments or are making new investments abroad, tax laws are constantly changing in response to the evolving practices of globalisation. This article highlights key tax concepts and considerations for South Korean investors making a foray overseas.
With globalisation, international trade and investments are ever-increasing as national borders no longer pose obstacles to global transactions. Directly correlated with the rise of cross-border trade are international tax uncertainties that intertwine taxpayers with sovereign authorities of the investor and investee countries. More often than not, this raises the burden of double taxation, i.e., the same income being taxed twice – even three times.
In order to monitor the several layers of potential taxation, one may look to see the overall effective tax rate of the investment. The simplest way to calculate the effective tax rate would be the total amount of tax paid on worldwide income divided by the income earned on worldwide income, which would allow taxpayers to monitor how much tax is being paid globally. The higher the effective tax rate is, the greater the tax burden will be.
Measures put in place to lower the effective tax rate are two-fold: countries agree to reduce the tax burden through tax treaties, or decide to give relief unilaterally through domestic laws. These two concepts within the realm of double taxation are what every investor should consider in order to minimise taxes and maximise profits from their foreign investments.
South Korea has entered into tax treaties with more than 90 countries. The importance of tax treaties is that they allocate taxing rights for the countries on certain types of income prescribed under the tax treaty. Of course, if there is a lower rate under the domestic tax law of the country in which the dividend is being paid out or interest payments are made, then we do not need to rely on the tax treaty. However, as a rule of thumb, when planning investments abroad, it is important to check first if there is a tax treaty with South Korea in force. This allows for a reduced withholding rate to apply to income types such as dividends, interest and royalties prescribed under the tax treaty.
For example, in the US, without the tax treaty, passive income such as dividends or interest would be subject to a withholding tax rate of 30%. This rate may be reduced to 10% or 15% for dividends and 12% for interest under the tax treaty between South Korea and the US. One point to always be mindful of is that, as in South Korea, there will be tax compliance matters that need to be dealt with. For instance, tax forms need to be submitted in order for the reduced tax treaty rates to apply. Such compliance can be rather time-consuming and tedious. However, it is absolutely necessary that the correct forms are submitted to the withholding agent before the income is paid to benefit from the reduced tax rate. In essence, just because the tax treaty prescribes a lower rate, it does not mean that the lower rate is available automatically. This type of compliance is important and applies to both strategic and financial investors.
A tax treaty does not relieve double taxation completely. It serves to reduce the tax burden by having two countries agreeing to limit the exercise of taxing rights. After paying taxes in the foreign country at a lower rate prescribed under the tax treaty, such taxes paid in the foreign country can be claimed as credits against the tax payable in South Korea.
There are two types of tax credits: The direct foreign tax credit and indirect foreign tax credit. Direct foreign tax credits may be claimed for the taxes that the South Korean entity paid directly, which would be equivalent to withholding taxes, possibly at a reduced rate under the relevant treaty, on income such as dividends and interest. A South Korean entity may claim indirect foreign tax credits on the dividend income received from a subsidiary in regard to the corporate income tax the subsidiary paid, and to the extent that the income that the subsidiary paid the tax on is distributed as dividends to the South Korean parent.
In the past, South Korea’s foreign tax credit laws allowed indirect foreign tax credits for the corporate income tax paid by first-tier and second-tier subsidiaries. Under the current law, however, indirect foreign tax credits are afforded to the tax paid by only the first-tier subsidiary. Further, the amount of foreign tax credit available is the amount of South Korean corporate income tax that would have been due if the income were earned in South Korea. If the foreign tax amount paid exceeds this limit, the excess portion may be carried forward for 10 years.
Some issues to be mindful of are the local regulations regarding permanent establishment, interest expense limitation rules and transfer pricing issues.
With regard to the permanent establishment issue, a South Korean investor should always monitor its activities in the foreign country and be careful not to conduct any business activities, as prescribed under the relevant tax treaty or the foreign country’s domestic tax laws, to give the foreign country’s tax authorities any room to deem the South Korean investor, in lieu of the local subsidiary or local branch, to have a business place in the foreign country. Such a deemed permanent establishment would expose the South Korean investor itself to the foreign country’s tax authorities.
Turning to the interest expense limitation rules, investors planning to utilise a mixture of debt and equity for investment should make sure that the capital structure is within the realm of the interest expense limitation rules, so that such interest expense is not inadvertently denied its deduction and/or the denied interest is re-characterised as dividends for corporate income tax purposes. There are three different ways that the interest expense deduction may be limited:
(1) Many countries impose a debt-to-equity ratio for intercompany loans. South Korean investors should contribute capital in the form of debt and equity within the ratio prescribed by the law in order for the relevant interest expense to be fully deductible. For example, South Korea imposes a 2:1 debt-to-equity ratio;
(2) Denial of interest expense exceeding 20-30% of earnings before interest, taxes, depreciation and amortisation in countries that implemented the base erosion and profit shifting (BEPS) action plan 4, issued by the Organisation for Economic Co-operation and Development (OECD); and
(3) Denial of interest expense on hybrid financial instruments in countries that implemented the BEPS action plan 2, issued by the OECD.
Furthermore, if investors are planning to utilise transactions between related parties, preliminary measures such as a transfer pricing study should be conducted to make sure the interest rates are set at arm’s length.
There will always be legal compliance issues that need to be dealt with first, but when making investments abroad, tax planning should be done simultaneously to make sure that investors are able to maximise the return on their outbound investments. On a final note, the authors would like to provide you with a simple checklist that you should consider when making such outbound investments.
For financial investors, as taxes impact all phases of the investment − acquisition, operation and exit − finding the right investment structure will help minimise the amount of taxes paid at each level of the investment and maximise returns. Depending on the investment strategy and the nature of the expected income from the investment, different structures may be utilised to achieve the highest possible rate of return.
For strategic investors, preliminary tax planning will allow a big-picture perspective to see how a particular investment fits into the investor’s global operation and supply chain. South Korean investors should pay close attention to the effective tax rate when planning to expand their businesses abroad. Some key tax drivers to take note of are:
(1) Holding structure of the investment. Whether the use of a holding company may negatively impact the effective tax rate, or how the use of the holding company would impact the flow of capital and the overall funding structure;
(2) Financing structure. To make sure interest expenses can be utilised to their full capacity, for instance, in an M&A deal, utilising an acquisition debt will allow the company to use interest expense deductions and minimise the corporate income tax exposure;
(3) Global supply chain model. To understand the impact of the investment within the global business operation; and
(4) Tax compliance. To minimise the risk of being subject to unnecessary penalties or fines.
These key tax drivers are ultimately to see how one investment fits in with the current global structure of the investor, and what steps need to be taken so that it becomes fully integrated.
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