Samil Commentary. Korean Tax Update. Korea s Tax Expenditure Plan for April 30, 2018

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1 Samil Commentary April 30, 2018 Korea s Tax Expenditure Plan for 2018 Amended NTS Audit Manual on Crossjurisdictional Audit Proposed Amendments to the External Audit Act Rulings Update Korea s Tax Expenditure Plan for 2018 The Ministry of Strategy and Finance (MOSF) notified government ministries of the country s tax expenditure plan for 2018 which was approved in a cabinet meeting on March 26, The government ministries are required to submit to the MOSF their recommendations and comments on the tax expenditure plan for 2018 including their own assessment of sunset clauses and new proposals for tax exemptions by the end of this April. The tax expenditure plan is drafted by the MOSF every year pursuant to the Special Tax Treatment Control Law. The recent tax expenditure trends indicate a steady decline in national tax exemption ratios (measured by the amount of national tax exemptions in proportion to the total of national tax revenue plus the amount of exemptions). The national tax exemption ratio which stood at 14.3% in 2014 continued to decline to 14.1% in 2015, 13.4% in 2016 and 12.7% (projection) in The Ministry expects the exemption ratio to be 12.9% in 2018 as the government continues to streamline the existing tax incentive programs. The basic guidelines of the expenditure plan for 2018 are as follows. A Rigorous Approach to Tax Expenditure The plan calls for a rigorous approach to streamline, create and manage tax expenditure plans with a focus on job creations, which would help enhance the predictability and tax equity. Sunset provisions on tax exemptions will end as scheduled or be redesigned based on the evaluation results of their effects.

2 New tax expenditures are allowed only when the relevant expenditures would promote job creation and/or innovative growth. Proposed plans or recommendations will be subject to an in-depth review by the Tax Policy Review Committee before being finalized for implementation. Reinforced Evaluation of Tax Expenditure Plans A preliminary feasibility test will be undertaken with respect to a tax incentive proposed by the Ministry of Trade, Industry and Energy to provide local income tax exemptions for business start-ups or expansions in local areas. An in-depth review will be performed to evaluate 12 tax incentive programs that are scheduled to end by the end of 2018 and whose relevant annual tax expenditure amounts to KRW30 billion or more, such as tax deductions for credit card spending. Amended NTS Directive Regarding Tax Audit Manual Includes Guidelines on Cross-jurisdictional Audit The National Tax Service (NTS) announced on April 9, 2018 that its audit manual was amended. Major amendments are provided below. Cross-jurisdictional Audit Cross-jurisdictional audits have been performed under the NTS internal policies to root out potential corruptive links between tax officials and local business powers, etc. Such practices have been regarded as inappropriate as they are not governed by proper regulations. To address this issue, the amended NTS audit manual includes new provisions on the management of cross-jurisdictional audit. The term Cross-jurisdictional audit refers to the tax audit performed by another regional tax office which does not have jurisdiction over the relevant taxpayer when the chief of the relevant regional tax office applies for the rearrangement of jurisdiction over tax audit. The chief of the relevant regional tax office may apply for the transfer of jurisdiction to another regional tax office in any of the following cases under Article 63-3 of the Presidential Decree of the Basic National Tax Law: Where the place of effective business management and that of tax payment of a taxpayer do not fall within the same jurisdiction; Where it deems inappropriate for the regional tax office with relevant jurisdiction to conduct a tax audit, e.g. where a fair tax audit is required for a taxpayer whose business activities are performed centering around certain places; Where it deems necessary to change jurisdiction considering workload and tax audit resources, etc. of tax PricewaterhouseCoopers Page 2

3 The chief of a regional tax office must file with the NTS Commissioner a written application for cross-jurisdictional tax audit if it deems necessary. The NTS Commissioner must assign the jurisdiction to another regional tax office in a fair and reasonable manner and notify the applicant office of the decision in writing. Requirements for a Partial Audit In principle, a tax audit should be performed by tax item. However, to ensure taxpayer conveniences and audit efficiency, if any of following conditions is met, a partial audit is permitted: Where it is necessary to confirm details to determine the amount of national tax refund; Where it is necessary to confirm facts and circumstances related to a decision of a reaudit; Where it is necessary to confirm part of a transaction in the process of a tax audit performed on the counterparty to the transaction; or Where there is a tax evasion attempt specifically tipped by a person, and therefore, it is necessary to confirm it. Extended Period for Prior Notice of Tax Audit An official notification of an intended tax audit must be made to a taxpayer 10 days prior to the audit. The prior notification period will be extended to 15 days. Proposed Amendments to the Presidential Decree of the External Audit Law Aim at Accounting Reform in Korea On April 19, 2018, the Financial Services Commission (FSC) announced the proposed revisions to the Presidential Decree of the Act on External Audit for Chusik Hoesa ( External Audit Act ) to invite public comments on the proposed revisions until the end of May The revisions were announced through a series of discussions by the Korea Accounting Reform Task Force following the approval by the National Assembly of the draft bill to revise the External Audit Act on September 28, The FSC will hold continued public hearings on the proposed revisions, which will be subsequently reviewed by the Regulatory Reform Committee and the Ministry of Government Legislation before being finalized. The finalized Presidential Decree is scheduled to become effective immediately after its proclamation on November 1, Provided below is a brief summary of major changes. Amended Scope of Companies subject to Statutory Audit Requirements As a general rule, external audit will be mandatory for all companies. An exception will be given to smaller companies that satisfy three of the four criteria (i.e. less than KRW10 billion in total assets, less than KRW7 billion in liabilities, fewer than 100 employees and less than KRW10 billion in sales). In other words, smaller companies are still required to satisfy one more criterion to be relieved from statutory audit requirement even after PricewaterhouseCoopers Page 3

4 successful attempts to adjust the value of assets and liabilities to fall below the given thresholds. By adding sales as one of the eligibility criteria, the amendment aims at enhancing accounting transparency of companies having a significant influence on consumers and markets, etc., in particular. Further, Yuhan Hoesa will be subject to the same standards as those for Chusik Hoesa with respect to mandatory external audit, and all the results of audit and review by their statutory auditors will be disclosed to the public. Expansion and Improvement of the Auditor Designation Program The six-plus-three year mandatory auditor designation scheme, where a company selects its statutory auditor through a competitive process for the first six years, and the Securities and Futures Commission appoints it for the three subsequent years, will have fewer exceptions and be regulated strictly so that the scheme can serve as the basic framework for appointing statutory auditors for listed companies. An exception will be limited to the cases where a company meeting certain requirements applies for a review by an oversight body, and the review result shows there is not any violation. The requirements include: a company has a proper internal control system in place and the company made a commitment to appoint a new auditor for the three subsequent years following its designation of an external auditor through a competitive process for six years. Creating Environments for Improving the Exercise of Shareholder Rights The following were proposed to enable shareholders to be more proactive in their exercise of rights at the general shareholder meetings. Flexibly manage the deadline for the submission of financial statements to enable the holding of general shareholder meetings in April. Under the current system, general shareholder meetings are concentrated in late March. Allow institutional investors to apply for the selection of statutory auditors of their investee companies, provided that they have faithfully complied with stewardship codes. Require companies exempt from an external audit to be included in the audited consolidated financial statements of their unlisted parent companies, thereby preventing unfair intra-group transactions. Rulings Update Whether tax sparing credit may apply for the dividends from a Chinese subsidiary Under Article 57 of the Corporate Income Tax Law (CITL), where a domestic company having foreign-sourced income was eligible for corporate income tax reduction or exemption concerning such foreign-sourced income in a country which has a tax PricewaterhouseCoopers Page 4

5 with Korea, the reduced or exempted corporate income tax could be claimed as foreign tax credit within the amount as stipulated by the tax treaty ( tax sparing credit ). Meanwhile, under Article 23 of the Korea-China tax treaty as revised according to Article 5 of the 2nd Protocol to the Korea-China tax treaty, the tax payable of a Korean resident in China under Article 23(1)(a) as revised by Article 5 of the 2nd Protocol shall be deemed to include the tax which would have been payable but for the legal provisions concerning tax reduction, exemption or other tax incentives of China for the promotion of economic development and for this purpose, the amount of tax shall be deemed to be 10% of the gross amount of the dividends in case of Article 10(2), which shall be effective for ten years staring from January 1, In the latest court case, as regards the corporate income tax return filing for FY2011, the Korean company having dividends from its wholly-owned subsidiary in China claimed the direct foreign tax credit for the Chinese withholding income tax paid at the rate of 5% under Article 10(2) of the Korea-China tax treaty and later, in January 2015, it filed the FY2011 amended tax return for a tax refund request by claiming the tax sparing credit for the difference between 10% of the gross dividend and 5% Chinese withholding tax. In March 2015, the tax authorities decided to accept the amended tax return and gave the tax refund for the 5% tax rate difference to the Korean company. However, in May 2015, the tax authorities overturned their decision by arguing that the tax sparing credit should not apply in case where the income tax on the dividends was withheld at 5%, given that the China s Enterprise Income Tax Law has not provided tax reduction or exemption lower than the 5% withholding rate on dividends set forth in Article 10(2)(a) of the tax treaty. A controversy in this case focused on whether the tax sparing credit should apply for the difference between the 10% deemed tax rate and the 5% actual withholding tax payment for the dividend distributed out of the Chinese subsidiary s earnings since For the previous case dealing with the same issue, the Supreme Court had resolved the case by discontinuing the proceedings for the appeal filed by the tax authorities arguing that the tax sparing credit should not apply to the case (Daebeop2014du 38019, ). Despite this precedent, the tax authorities and the Tax Tribunal have rejected taxpayers claims for the tax sparing credit on similar cases. With continued controversies over the tax sparing issue, the Supreme Court recently ruled via the main hearing of the matter that the tax sparing credit should apply in the case. (Daebeop2017du 61393, , etc.) The latest Supreme Court decision would likely put an end to the conflict over the availability of the tax sparing credit under the Korea-China tax treaty. For the purpose of applying the court decision into practices, however, it should be noted that the application of the tax sparing credit under the Korea-China tax treaty ended on December 31, PricewaterhouseCoopers Page 5

6 Whether the new shares received by a nominal shareholder in a comprehensive share exchange transaction would be treated as deemed gift The Commercial Code allows a comprehensive share exchange that all of shares in a target company can be transferred by the shareholder(s) of the target company to the acquiring company (making the acquiring company a parent of the target company) in exchange of new or issued shares in the acquiring company. In addition, according to Article 45-2 of the Inheritance and Gift Tax Law ( IGTL ), in case where there is a difference between the person having a legal title to a property ( nominal owner ) and the actual owner of the property, the property shall be deemed to be gifted to the nominal owner as of the date on which the property is registered in the name of the nominal owner and so, the nominal owner shall be subject to gift tax ( the rule for deemed gift treatment on nominal owner ). In the court case, a nominal owner as a shareholder of a target company received new shares in the acquiring company in return for transferring the shares in the target company to the acquiring company for a comprehensive share exchange transaction. A controversy in this case focused on whether the rule for deemed gift treatment should apply for the new shares received by and registered in the name of the nominal owner under the situation that the nominal owner was subject to gift tax under the rule for deemed gift treatment regarding the old shares in the target company transferred to the acquiring company. In the past, the Supreme Court decided that, unless there were special circumstances for the lack of tax avoidance purposes, the rule for deemed gift treatment on a nominal owner should apply for the new shares received by the nominal owner in such similar case since a new nominal trust relationship would be deemed to exist between the nominal owner and the actual owner of the new shares in the comprehensive share exchange transaction, which was different from the previous trust relationship for the old shares (Daebeop2013du5791, etc.). However, in March 2018, the Supreme Court overturned the previous decision, stating that the rule for deemed gift treatment should not apply for the new shares in the concerned case unless there were extraordinary circumstances while admitting that the new nominal trust relationship concerning the new shares received may be created. The grounds for the recent Supreme Court decision include that (i) the purpose of the rule is to prevent nominal trust activities for tax avoidance purposes, and therefore, the rule should be applied only to the extent that it is necessary and appropriate to prevent such tax avoidance activities, (ii) the application of the rule for the new shares in the acquiring company may result in the denial of the previous gift taxation for the old shares in the target company, and (iii) the application of the rule for both the shares in the target company and those in the acquiring company may lead to substantially large amount of gift tax as compared to the case where the shares in the target company were originally gifted). (Daebeop2012 du 27787, ) It is observed that the latest decision was based on the previous Supreme Court decision that the rule for deemed gift treatment should not apply in case where a nominal owner newly acquired shares in its name with using proceeds from the sale of the shares to which the nominal owner had a legal title and the rule for deemed gift treatment was or would be applied. (Daebeop2011du 10232, ). This latest decision may be meaningful PricewaterhouseCoopers Page 6

7 that the rule for deemed gift treatment may not be applied for the new shares received by the nominal owner in the comprehensive share exchange transaction regardless of whether it is proved that there exists no tax avoidance purpose therein. Whether to include interest expenses on general purpose borrowings in acquisition tax base In this case, a Korean company engaged in the construction and engineering business acquired land and buildings ( property in question ) for the years from 2005 to 2010, and it filed and paid acquisition tax on the property in question under the Local Income Tax Law. In a tax audit, the tax authorities challenged that the company should have included borrowing costs (including interest expense amounting to around KRW 14 billion which was expensed for accounting purpose) incurred from 2005 to 2010 in the acquisition tax base and reassessed the acquisition tax including penalties on the company. With respect to interest expenses on the borrowings which were not specifically incurred for the acquisition of the property in question (so-called general purpose borrowings ) and were expensed for accounting purpose, the company and the tax authorities disputed over whether the acquisition tax base should include a portion of the interest expenses on general purpose borrowings attributable to the acquisition of the property in question, as calculated under one of the methods stated in either the CITL or the Korean GAAP. For the dispute case, in March 2018, the Supreme Court ruled that the taxpayer did not capitalize the interest expense on the general-purpose borrowings and include the expense in the acquisition cost of the property in question and also, it was not sufficiently verified via the evidences submitted by the tax authorities that the said borrowings were incurred directly for the purpose of acquiring the property in question or were incurred indirectly for the acquisition of the property in question and substantially invested for the acquisition of the property. As a result, the Court returned this case to the lower court decision by asserting that the interest expense attributable to the acquisition of the property in questions as computed by the tax authorities under the Korean GAAP should not be included in the acquisition tax base. Further, the Court ruled that the tax authorities should bear the burden of proof in proving that the general purpose borrowings were directly or indirectly incurred for the acquisition of the property subject to acquisition tax and in determining the scope of interest expense being included in the acquisition tax base. (Deabeop2014du 46935, ) The decision is significant and meaningful in that the Supreme Court confirmed that in determining whether the general purpose borrowings are incurred for the acquisition of the property subject to acquisition tax and in deciding the scope of the related interest expense being included in the acquisition tax base, the burden of proof is on the tax authorities. Meanwhile, it may be necessary to monitor a decision on the case returned to the lower court for retrial in respect of how the tax authorities would prove that the general purpose borrowings are incurred for the acquisition of the property in PricewaterhouseCoopers Page 7

8 For more information, please contact: International Tax Services Alex Joong-Hyun Lee Sang-Do Lee Sang-Woon Kim Michael Kim Dong-bok Lee Chong-Man Chung Hyun-Chang Shin Chang-ho Jo Il-Kyu Cha Nam-Gyo Oh Young-Ok Kim Robert Browell Domestic Tax Services Jung-Il Joo Yeon-Gwan Oh Young-Sin Lee Chul-Jin Hwang Jin-Ho Kim Min-Soo Jung Chan-Woo Chung Bok-Suk Jung Hyungsuk Nam Dong-Jin Nam Seungdo Na Sung-Wook Cho Sun-Heung Jung Youngsuk Noh Hye-Won Choe Transfer Pricing & International Trade Heui-Tae Lee Henry An Won-Yeob Chon Junghwan Cho Global Mobility Services (GMS) Younsung Chung Corporate Administrative Services (CAS) Jina Park Inheritance & Gift Tax Services Hyun-Jong Lee Financial Tax Services In-Hee Yoon Taejin Park Hoon Jung Nonprofit Corporation Service Center YoungSun Pyun Small and Midsize Enterprise and Startups Service Center Bong-Kyoon Kim Knowledge & Innovation Han-Chul Cho Samil Infomine/ Samil Academy Sang-Keun Song Mirah Kang Samil Tax Corp. Nam-Bok Jo PwC Customs Service Sang-Tae Moon Stay current and connected. Our monthly newsletters and ad hoc alerts keep you updated on Korean tax laws as well as significant business regulatory developments. Please send an if you like to subscribe or want to add someone to the mailing list to: The information contained in this publication is for general guidance on matters of interest only and is not meant to be comprehensive. The application and impact of laws can vary widely based on the particular facts involved. For more information, please contact your usual Samil PwC client service team or professionals listed above. C 2018 Samil PricewaterhouseCoopers. All rights PricewaterhouseCoopers Page 8