IFA 2010 ROME CONGRESS. Summary and Conclusions

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2 IFA 2010 ROME CONGRESS SUBJECT 1 - TAX TREATIES AND TAX AVOIDANCE: APPLICATION OF ANTI-AVOIDANCE PROVISIONS Branch Reporter Lee, Kyung Geun Summary and Conclusions Korea has not legislated a typical general anti-avoidance rule in its domestic tax law designed to strike down only tax-avoidance arrangements. Instead, Korean tax laws contain substance-over-form provisions and a number of specific anti-tax avoidance provisions. The substance-over-form principle was codified first in the Basic National Tax Act (BNTA) during 1960s and then gradually incorporated in other tax laws including the Law for Coordination of International Tax Affairs (LCITA). The substance-over-form provision in the LCITA is meaningful in that it specifically provides for the application of this principle even to tax treaty cases. Further, the provision is particularly significant for its introduction of some important doctrines, comprising the main conceptual elements of a general anti-avoidance rule in many foreign countries, such as step transactions, economic substance, and the purpose of unduly claiming benefits. The Korean domestic law contains a number of specific anti-avoidance provisions with an international focus, which impact cross-border transactions. Specifically, with the legislation of the LCITA in 1995, Korea introduced the rules concerning transfer pricing, thin capitalization, controlled foreign corporation (CFC) and special rules on gift tax implications. While these specific anti-avoidance rules were being incorporated in certain domestic tax statutes, issues surrounding potential conflicts with tax treaties were seldom raised, as the Korean Government has designed the relevant domestic provisions, mindful of any possible conflict with tax treaties in advance. Ph.D.(Economics), Senior Tax Attorney, Yulchon (Attorneys at Law), Seoul 1

3 In the event of a conflict between a tax treaty provision and a specific antiavoidance rule under domestic law, it is generally believed that the tax treaty should prevail over the specific domestic tax provision. With regard to the issue of a conflict between a tax treaty provision and the substance-over-form provision in Korean domestic law, majority of tax experts including tax authorities in Korea believed that the such a provision should extend to cover tax treaty cases, since the substance-over-form rule can be considered a governing principle having universal applicability in the interpretation of tax treaties notwithstanding the lack of specific language in the tax treaties. Korea s long-standing treaty policy vis-à-vis tax haven jurisdictions has been to avoid engaging in tax treaty negotiations with such countries from the beginning. However, Korea had not maintained a strong position against possible treaty abuses by taxpayers during its treaty negotiations with its counterparts in the past. The aggressive stance against the treaty abuses were taken by the Korean tax authorities only after some tax disputes involving certain foreign funds, which tried to reduce their tax burdens in respect of significant amounts of capital gains derived in Korea during the first half of 2000s, by exploiting certain Korean tax treaties. That is, since 2005 Korean tax authorities have tried to adopted relevant anti-avoidance provisions in its treaties whether they be new tax treaties or existing treaties undergoing renegotiations. In doing so, Korea frequently adopted sample wordings suggested in the Commentaries on Article 1 of the OECD Model Tax Convention. Within the 74 tax treaties entered into by Korea that are currently in effect (as of April 31, 2009), there are numerous specific anti-avoidance provisions but only a few general anti-avoidance provisions. Parallel to its treatment of the domestic antiavoidance provisions, Korea takes the view that the relationship between general antiavoidance provisions and specific anti-avoidance provisions in tax treaties are not mutually exclusive but complementary in nature. 2

4 Table of Contents Part One: Domestic Anti-Avoidance Provisions with an International Scope 1.1 General Overview 1.2 General Anti-avoidance Provisions with International Focus or Effect 1.3 Specific Anti-avoidance Provisions with International Focus or Effect 1.4 The Relationship between the Domestic Anti-Avoidance Provisions and Tax Treaties 1.5 Abuse of the Tax Treaty Itself: Domestic Law Principles or Interpretation of the Treaty? Part Two: General and Specific Anti-Avoidance Provisions in Tax Treaties 2.1 General Overview 2.2 General Anti-Avoidance Provisions in Tax Treaties 2.3 General anti-avoidance provisions with international focus or effect 2.4 Specific Anti-Avoidance Provisions in Tax Treaties 3

5 Part One: Domestic Anti-Avoidance Provisions with an International Scope 1.1 General Overview Generally, as far as anti-tax avoidance regimes are concerned, Korean tax laws contain substance-over-form provisions and a number of specific anti-tax avoidance provisions. In other words, Korea has not legislated any general anti-avoidance rules other than substance-over-provisions in its domestic tax law particularly designed to combat only tax avoidance cases. In so doing, Korean tax laws have failed to clearly define the concept of tax avoidance and the benchmark criteria generally applicable to deny tax benefits. The substance-over-form principle was codified in the Basic National Tax Act (BNTA) during 1960s. Since then, it has further developed to encompass the concepts of step transactions, economic substance, and the purpose of unduly claiming benefits, which constitute the main conceptual elements of the general anti-avoidance rule in many foreign countries. This development culminated in the parallel adoption of the aforementioned rule in the Law for Coordination of International Tax Affairs (LCITA), which purports to expand the applicable scope of the principle even to cases subject to tax treaty application. The Korean domestic law contains a number of specific anti-avoidance provisions with an international focus, which impact cross-border transactions. Specifically, with the legislation of the LCITA, Korea introduced the rules concerning transfer pricing, thin capitalization, controlled foreign corporation and special rules on gift tax implications. While these specific anti-avoidance rules were being incorporated in some domestic tax statutes, issues surrounding potential conflicts with tax treaties were seldom raised, since the Korean Government has designed the relevant domestic provisions, mindful of any possible conflict with tax treaties in advance.in the event of a conflict between a tax treaty provision and a specific anti-avoidance rule under domestic law, it is generally believed that the tax treaty should prevail over the specific domestic tax provision. Majority of Korean tax experts including most tax authorities in Korea believed that the application of a general anti-avoidance provision established under domestic tax laws or followed by courts should extend to cover tax treaty cases, since such a general anti-avoidance rule can be considered a governing principle having universal 4

6 applicability in the interpretation of tax treaties notwithstanding the lack of specific language in the tax treaties. 1.2 General Anti-avoidance Provisions with International Focus or Effect In 1960s, Korea introduced the substance-over-form principle in the BNTA, which regulates fundamental principles commonly applicable to other specific Korean tax laws such as Income Tax Act, Value Added Tax Act, or Property Tax Act. Since then, the same principle was incorporated into the Corporate Income Tax Act (CITA), which is often the subject of most complicated tax disputes with considerable tax liabilities at stake. As such, the application of the substance-over-form principle has taken on much more significance in the context of the CITA compared to other tax laws. Article 14 of the BNTA consists of three paragraphs. The first paragraph states the taxation principle based upon real ownership not nominal ownership and the second one prescribes a principle that taxation should follow substance regardless of name or form. The third paragraph, newly introduced in December 2007, contains the taxation principle based on the economic substance of the overall transaction by integrating a series of supposedly separate steps in a transaction. The aforesaid principle established in the third paragraph first appeared in the Inheritance and Gift Tax Act (IGTA) in December In other words, the National Assembly adopted this principle in IGTA to expand the scope of the gift tax and, thereby, to cover even transactions not enumerated in the law. Later, the same principle was incorporated in the LCITA as well as the BNTA as a sub-concept of the substanceover-form principle. In June 2006, Korea stipulated the substance-over-form provision applicable to cross-border transactions in the LCITA, which adopted the similar provisions in other tax laws already enacted at that time, such as the BNTA, CITA, and IGTA. The detailed contents of these provisions are as follows: Article 2-2 of the LCITA (Taxation based on the Substance-over-Form Principle applicable to Cross-Border Transactions) 1. In the case of a cross-border transaction, if a person to which any income, revenue, property, activity or transaction that is the subject of taxation is attributable in name is different from a person to which such income, revenue, 5

7 property, activity or transaction is attributable in substance, the latter-mentioned person shall be the taxpayer, and tax treaties shall be applied accordingly. 2. In the case of a cross-border transaction, provisions regarding the calculation of the tax base shall be applied based on the substance of the relevant income, revenue, property, activity or transaction, regardless of any term used to refer to them or forms thereof, and tax treaties shall be applied accordingly. 3. In the case a cross-border transaction is recognized as having been consummated for the purpose of unduly claiming benefits under tax treaties and the LCITA by way of indirect means involving a third party or use of two or more activities or transactions, tax treaties and the LCITA shall be applied by regarding it as being entered into directly or as a single continuous activity or transaction, depending on the economic substance. The excerpt above is meaningful in that a domestic tax statute articulates the principle of applying the substance-over-form principle even to cases involving tax treaties. Further, Paragraph 3 above is particularly significant in a sense that it introduced some important concepts comprising the main conceptual elements of a general anti-avoidance rule in many foreign countries, such as step transactions, economic substance, and the purpose of unduly claiming benefits, into the LCITA. Most tax practitioners and commentators in Korea concede that the substanceover-form provisions in Korean tax laws play an important role in preventing tax avoidance arrangements 1 and, thus, should be utilized where no specific anti-avoidance rule can be applied. On the other hand, others view that, in order to discourage tax avoidance schemes more effectively, Korea needs a well defined general tax-avoidance provision in its domestic tax law, specifically targeting tax avoidance cases as is the case in Germany or Canada. 1.3 Specific Anti-avoidance Provisions with International Focus or Effect In 1995, Korea enacted the LCITA which includes some specific anti-avoidance rules widely accepted by the OECD countries and some procedural rules intended to enhance the cooperation with foreign tax authorities, such as mutual agreement procedures (MAPs), exchange of information, etc. As regards the specific anti- 1 Prof. Kyeong-Bong Ahn, Korean branch reporter of the Cahier Form and Substance in Tax Law in his report classified the substance-over-form provision in the BNTA as a general anti-avoidance rule. 6

8 avoidance measures, the LCITA introduced transfer pricing rules modelled after the 1995 OECD Transfer Pricing Guidelines, thin-capitalization rule, controlled foreign corporation rule and special rules concerning gift tax for purposes of preventing double non-taxation. Transfer Pricing Rule: The LCITA authorizes the tax authorities to adjust the transfer price based on an arm's length price and to determine or recalculate a resident's taxable income when the transfer price of a Korean company and its foreign counterpart is either below or above an arm's length price. Thin Capitalization Rule: If a Korean company (or a Korean branch of a foreign company) borrows from its controlling shareholders overseas and its affiliates (collectively, the CSO ) an amount greater than three times of its paid-in capital (six times in the case of financial institutions), interests payable on the excess portion of the borrowing are re-characterized as dividends subject to the dividends article of the applicable tax treaty and, thus, nondeductible for Korean tax purposes. Even though Korea uses fixed ratios in its thin capitalization rule, these ratios merely represent a safe harbour in a sense that as long as the conditions and the amount of debt owed to a CSO are reasonable compared to the debt from an independent third party, the debtequity ratio prevailing in the same or similar industry as the tested party (rather than a 3:1 or 6:1 ratio) will be applied. As a consequence, it can be said that Korean thin capitalization rule is based on Article 9 of the OECD Model Tax Convention and thereby can avoid the challenge of non-discrimination clause (Article 24) of the Convention. Controlled Foreign Corporation (CFC) Rules: The Korean CFC rules provide that distributable retained earnings derived by a foreign corporation residing in any of the low-tax jurisdictions should be deemed to have been distributed to a Korean resident shareholder (deemed dividend) if the Korean resident shareholder owns a direct or indirect interest of 20% or more in the foreign corporation. Low tax jurisdictions refer to jurisdictions in which the foreign corporation has an effective tax rate of 15% or less as well as the designated tax havens. To date, no challenge has ever been mounted in Korea to address the issue of potential conflicts between this rule and the relevant tax treaty provisions 2. 2 While there are certain tax treaties signed by Korea that purport to specifically circumvent possible conflicts between the tax treaties and the domestic CFC rule (e.g. Korea-Germany tax treaty referenced 7

9 Special Rules concerning the Gift Tax: Under the IGTA, a gift tax is imposed only if i) the donee is domiciled in Korea or ii) the donated property is located within Korea. Accordingly, if a Korean individual donates a property located offshore to a donee domiciled offshore, a Korean gift tax cannot be levied. In this case, if the foreign country in which the donee is domiciled does not impose a gift tax, then double non-taxation will occur. In an attempt to prevent such cases, Korea adopted a rule in LCITA that, if a person domiciled in Korea donates an offshore property to a donee domiciled in a foreign country, in which the donee is not subject to a gift tax, the donor should be subject to the Korean gift tax. The Korean Government recently introduced a number of specific anti-avoidance provisions in the corporate and individual income tax laws, which impact cross-border transactions. Provided below are some of the noteworthy provisions: Resident Status Criteria for Corporations: Prior to the year 2006, only corporations established and registered in Korea were considered Korean residents. Following the tax law amendment enacted in December 2005, a corporation whose effective place of management is located within Korea is treated as a Korean resident. As such, a company set up or registered in a tax haven is still required to file a tax return with the Korean tax authorities if the effective management control thereof takes place in Korea. Special Withholding Tax Procedures applicable to Passive Income paid to Residents of the Certain Low Tax Jurisdictions: Instead of the ordinary withholding tax procedure, 3 income from investment in Korea derived by a nonresident without a permanent establishment (PE) in Korea residing in specific jurisdictions as designated by the Minister of Strategy and Finance (MOSF) 4 must be first withheld by a withholding agency according to tax rates prescribed by domestic tax laws. Thereafter, if the non-resident is able to substantiate to the relevant tax office within 3 years from the withholding its eligibility for treaty below), it is generally understood that such treaty provisions were inserted for the sole purpose of clarification. Korea-Germany Tax Treaty, Article 27 (Application of the Agreement in Special Cases) This Agreement shall not be interpreted to mean that: (c) the Republic of Korea is prevented from levying taxes on amounts which are to be included in the items of income of a resident of the Republic of Korea under the Fourth Part of the Republic of Korea s Law for Coordination of International Tax Affairs. 3 Under the usual procedure of withholding tax, withholding agency is supposed to deduct withholding taxes by applying a relevant tax treaty at the time when income or gains are paid. 4 As of July 2009, only Labuan, Malaysia, has been designated as a tax haven jurisdiction for the purpose of this regime. 8

10 benefits as the beneficial owner of the income concerned, any difference between the amount withheld at the domestic tax rate and the reduced treaty rate applicable would be refunded within 6 months. Special Withholding Tax Provision for Payment made to a Star Company : In December 2007, Korea legislated in its individual income tax law a special withholding tax rule mandating that a withholding tax agent paying remunerations to a non-resident company without a Korean PE (a so-called star company ), in return for services by an entertainer or a sportsman, must withhold income tax as prescribed in the law. Prior to this legislation, it was generally understood in Korea that remunerations paid to star companies could not be withheld in Korea unless an applicable tax treaty specifically granted taxing rights to a source country. Therefore, the new provision may raise an issue of conflict with a tax treaty without a provision analogous to Article 17 (2) of the OECD Model Tax Treaty. 5 Deemed capitalization rule: In February 2009, Korean Government promulgated the so-called deemed capitalization rule in its income tax regulations. Under this rule, if the capital amount in terms of its book value is less than the level of the free capital, borrowings from parent companies up to the point of free capital are regarded as part of the free capital. 6 Then the deductibility of interest expense corresponding to this deemed free capital is denied. This rule is applicable only to loans of a domestic branch of foreign banks borrowed from the headquarters or other foreign branches. If both the deemed-cap rule and thin capitalization rule mentioned above are simultaneously applicable to a case in question, only one of the two rules denying the larger amount of interests would be applied. 1.4 The Relationship between the Domestic Anti-Avoidance Provisions and Tax Treaties In order to discuss this issue effectively, it would be better to divide the domestic anti-avoidance provision into the two groups, i.e., general and specific anti-avoidance provisions, and then to address each type of provisions one by one. As regards the specific anti-avoidance provisions, there is a general consensus among international tax experts that in the event of a conflict between a tax treaty provision and a specific antiavoidance rule under the domestic law, the tax treaty should prevail over the latter. The background of this consensus can be explained in detail as follows. According to paragraph 1 of Article 6 of the Constitution, treaties entered into and promulgated hereunder as well as generally accepted international laws have the 5 e.g. Korea-US Tax Treaty 6 Korea relies on the OECD 2008 report re Attribution of Profits to Permanent Establishment as a theoretical background for this deemed capitalization rule. 9

11 same legal force as domestic laws. Further, it is generally believed that a treaty ratified by the National Assembly should be understood as having the same level of legal force as a special law. Accordingly, any conflict between domestic laws and tax treaties should be resolved applying the principle that the special law takes precedence, just as would be the case in the event of a conflict between domestic statutes. Regarding the second issue, i.e. the application of the general anti-avoidance provision of domestic tax laws to bilateral tax treaties, there are largely two schools of thoughts in the academic circle. One is that a special provision specifically permitting the aforesaid application should be inserted into treaties in advance in order to avoid the conflict between the domestic tax law and treaty provisions, and the application to a tax treaty case cannot be justified without such a treaty provision. The other view supported by the majority, and by Korean tax authorities in particular, is that a general provision established under the domestic tax laws or followed by courts should be extended to tax treaties, since such a general antiavoidance rule can be understood as a governing principle with universal applicability in the context of tax treaty interpretation, notwithstanding the absence of specific stipulation in the tax treaty language. It can be reasonably stated that Korea s codification of the substance-over-form principle in the LCITA was largely influenced by the 2003 revision - especially paragraphs 22 and of the Commentary on Article 1 of the OECD Model Tax Convention, particularly given the specific reference thereto by the Korean Government as a basis justifying the new legislative move at the time of its proclamation to the general public in Though there have been very few court decisions in Korea dealing with crossborder transactions involving tax treaty issues, there is one Supreme Court decision 7 in 1993 often cited for its application of the substance-over-form principle in its decision to deny the treaty benefits under the Korea-Netherlands Tax Treaty. Provided below is a brief summary of this Supreme Court Decision: XXX, a Dutch company, argued that capital gains from the transfer of its shares in a Korean company were not subject to Korean tax under the Korea- Netherlands Tax Treaty (the Treaty ) and refused to pay capital gains tax thereon. The Korean Supreme Court, however, ruled that the gains at issue did not qualify for the exemption from capital gains tax in Korea under the Treaty, 7 Korean Supreme Court Case 93Nu

12 since the head office of the Dutch company, while registered in the Netherlands, was merely a shell company without economic substance and, thus, failed to qualify as a Dutch resident eligible for the treaty benefits concerned Following a similar line of reasoning, Seoul Administrative Court rendered a decision 8 in 2007 holding that, in accordance with the Commentaries on the OECD Model Tax Convention and the substance-over-form principle, corporate income tax on the Korean-source income should be imposed on the beneficial owner of such income applying the relevant tax treaty provisions. Similar reasoning can be found in three high-profile cases recently decided by Seoul Administrative Court, which particularly caught the attention of the Korean business community, due to the size of gains realized by a well-known foreign private equity fund and the hefty capital gains tax at stake. One of the main controversies in these cases is whether or not the substance-over-form principle under the BNTA can be held applicable as a guiding principle in deciding which tax treaty is applicable to the case. The relevant facts of this case can be summarized as follows: In 2004, a Belgian company transferred shares in a Korean real property holding company to a non-resident company and claimed a capital gains tax exemption under the Korea-Belgium tax treaty, which does not contain a provision permitting source-based taxation for capital gains from transfer of shares in a real property holding company. Belgian company is owned by a Luxembourg company, which also in turn is owned by a Bermuda company. Shareholders of this Bermuda company consist of three parties - Bermuda LP (38%), US LP (60%), and a Bermuda company (2%). The National Tax Service (NTS) in Korea denied the treaty benefit, disregarding the Belgian company on the ground of lack of the substance and imposed taxes on Bermuda LP, US LP, and a Bermuda company respectively on the grounds that they never paid taxes in their respective residence countries and no income tax returns were filed in respect of gains from the transfer of shares in the Korean real property holding company as prescribed by the Korean corporate income tax law Guhap

13 Each of the three entities appealed to the Seoul Administration Court (the first trial) in In February 2009, the Seoul Administration Court held that tax assessment against the Bermuda LP and the US LP should be cancelled on the ground that the taxes due were incorrectly assessed by misapplying the individual income tax law contrary to the overwhelming proof that Bermuda LP was more properly characterized as a corporation rather than an individual taxpayer. In this vein, on May 2009, the Seoul Administration Court held that the tax assessment on the Bermuda company by the NTS was justifiable because it was assessed as corporate income tax. In this connection, the important point to note is that the Seoul Administration Court in the above three cases supported the NTS argument that the substance-overform rule in the BNTA should be respected in determining which tax treaty should be applied to the case at issue. These decisions would no doubt have significant impact on 12

14 the Supreme Court s final decision in the future, notwithstanding the Supreme Court s penchant for supporting the concept of legal substance rather than economic substance in the past Abuse of the Tax Treaty Itself: Domestic Law Principles or Interpretation of the Treaty? There is a distinct lack of statutory language in domestic law or court decisions issued to date on the subject of the nature of the tax treaty abuse. This is probably because the issue of tax treaty abuse is relatively new in Korea considering that Korean rules governing cross-border investments began to be promulgated and streamlined to meet the higher international standards only after Korea joined the OECD in Against this backdrop, it is difficult to ascertain whether tax treaty abuse itself should be addressed in Korea under domestic law principles or through treaty interpretation, taking into account its object and purpose. On the other hand, this may be a moot point in the sense that the Korean tax authorities or courts may consider domestic law principles together with the object and purpose of a tax treaty when addressing the tax treaty abuse issue. Nevertheless, if the classification were somehow necessary with regard to the above issue, Korea can be said to have frequently relied on domestic law principles or specific domestic tax provisions to prevent tax treaty abuse cases. The outstanding example is the frequent reliance on the substance-over-form principle as codified in the BNTA and the LCITA. The recent increase in efforts by the Korean tax authorities and the National Assembly to introduce anti-treaty abuse measures in domestic tax laws or regulations as shown in section 1.3, indicates Korea s tendencies to rely on domestic tax law principles, rather than engaging in the analysis of object and purpose of tax treaties, to deal with tax treaty abuse cases. 9 For a further discussion on the concepts of legal substance and economic substance, please refer to page 30, the General Report of the 2002 IFA Cahier Form and substance in tax law written by Frederik Zimmer. 13

15 Part Two: General and Specific Anti-Avoidance Provisions in Tax Treaties 2.1 General Overview Korea s long-standing treaty policy vis-à-vis tax haven jurisdictions has been to avoid engaging in tax treaty negotiations with such countries from the beginning. That said, Korea had not maintained a strong position against possible treaty abuses by taxpayers during its treaty negotiations with its counterparts in the past. The aggressive stance against the treaty abuses were taken by the Korean tax authorities only after the recent tax disputes involving certain foreign funds, which tried to reduce their tax burdens in respect of significant amounts of capital gains derived in Korea during , by exploiting certain Korean tax treaties. In other words, until mid-2000s, Korea s position regarding anti-avoidance provisions in tax treaties was somewhat lax and passive in that Korea merely reacted to treaty partners requests for inclusion of anti-tax avoidance provisions and did not actively initiate the insertion of such provisions in tax treaties. However, since 2005, Korean tax authorities have tried to fill potential loopholes by adopting relevant anti-avoidance provisions in its treaties whether they negotiated with new tax treaties or existing treaties undergoing renegotiations. In doing so, Korea frequently adopted sample wordings suggested in the Commentaries on Article 1 of the OECD Model Tax Convention as discussed in the following sections. Within the 74 tax treaties entered into by Korea that are currently in effect (as of April 31, 2009), there are numerous specific anti-avoidance provisions but only a few general anti-avoidance provisions. Parallel to its treatment of the domestic antiavoidance provisions, Korea takes the view that the relationship between general antiavoidance provisions and specific anti-avoidance provisions in tax treaties are not mutually exclusive but complementary. Due to the lack of serious challenges concerning the effects of anti-avoidance provisions included in Korean tax treaties to date, no meaningful court case can be found on the subject of the implication of anti-avoidance provisions in Korean tax treaties. 2.2 Specific Treaty Provisions allowing Application of Domestic Anti-Avoidance Provisions To date, Korea has only two tax treaties that contain the language explicitly permitting the application of domestic anti-avoidance provisions. First, Article 27 14

16 (Application of the Agreement in Special Cases) of the Korea-Germany tax treaty has the following provision: 1. This Agreement shall not be interpreted to mean that (a) a Contracting State is prevented from applying its domestic legal provisions, on the prevention of tax evasion or tax avoidance as long as those provisions are in accordance with the principles contained in this Agreement,--- A similar provision is found in Article 27 (Miscellaneous Provisions) of the Korea-Saudi Arabia tax treaty as follows: Nothing in this Convention shall affect the application of the domestic provisions of a Contracting State to prevent tax evasion or avoidance, if the main purpose or one of the main purposes of any person concerned with the creation or assignment of the rights in respect of which the income dealt with in the Convention is paid was to take advantage of the Articles of this Convention by means of that creation or assignment. That said, the lack of a provision similar to the foregoing in other tax treaties is generally not construed to warrant a different outcome in relation thereto. In other words, domestic anti-avoidance provisions are held applicable to tax treaty cases in general, so long as the domestic provisions do not conflict with relevant tax treaty provisions. 2.3 General Anti-Avoidance Provisions in Tax Treaties General anti-avoidance provisions are not commonly included in the Korean tax treaties. Currently, there are only two tax treaties (i.e., Korea-Israel and Korea-Japan treaties) containing such provision as referenced below: <Protocol of the Korea-Israel Tax Treaty> 3. A competent authority of a Contracting State may deny the benefits of this Convention to any person, or with respect to any transaction, if in its opinion the granting of those benefits would constitute an abuse of the Convention according to its purpose. Notice of the application of this provision will be given by the competent authorities of the Contracting State concerned to the competent authorities of the other. 15

17 <Protocol of the Korea-Japan Tax Treaty> 3. The benefits of the Convention shall not apply if the competent authorities of the Contracting States agree that the taking advantage of those provisions constitutes an abuse of the provisions of the Convention 2.4 Specific Anti-Avoidance Provisions in Tax Treaties Specific anti-avoidance provisions in tax treaties can be divided into the following three groups: (i) provisions included in the OECD or UN Model Tax Conventions itself; (ii) provisions originating from the Commentaries of the OECD or UN Model Tax Convention regarding optional provisions; and (iii) provisions without any comparables in the Commentaries of the OECD or UN Model Tax Conventions. A. Specific Anti-Avoidance Provisions Included in the Model Tax Conventions The list of specific anti-avoidance rules found in the UN Model Tax Convention itself is well summarized in the paragraph 31of the 2008 Subcommittee s Report of UN Tax Expert Committee on Improper Use of Tax Treaties 10 as referenced below: 31. Some forms of treaty abuses can be addressed through specific treaty provisions. A number of such rules are already included in the UN Model; these include, in particular, the reference to the agent who maintains a stock of goods for delivery purposes (subparagraph 5 b of Article 5), the concept of "beneficial owner" (in Articles 10, 11, and 12), the special relationship rule applicable to interest and royalties (paragraph 6 of Article 11 and paragraph 6 of Article 12), the rule on alienation of shares of immovable property companies (paragraph 4 of Article 13) and the rule on star-companies (paragraph 2 of Article 17). Another example would be the modified version of the limited force-of-attraction rule of paragraph 1 of Article 7 that is found in some tax treaties and that applies only to avoidance cases. The notable difference between the OECD Model Convention and the UN Model convention in terms of anti-avoidance provisions is that the OECD Model Convention does not have provisions concerning the agent maintaining a stock of goods for delivery 10 E/C.18/2008/CRP.2. 16

18 purpose (subparagraph 5 b of Article 5 in UN Model Convention) and the limited forceof-attraction rule (paragraph 1 of Article 7 in UN Model Convention). The Korean tax treaties signed with the OECD countries after Korea s accession to the OECD in 1996 have adopted languages identical or similar to the specific tax avoidance provisions of the OECD Model Tax Convention. However, Korean tax treaties with the non-oecd countries and treaties with the OECD countries signed before Korea s accession to the OECD contain provisions concerning either the agent maintaining a stock of goods for delivery purpose or the limited force of attraction rule found in the UN Model Convention. Specifically, Korea s tax treaties with Singapore, Bangladesh, Kuwait, Ukraine, the UK 11 and the US 12 have the provision addressing the agent maintaining a stock of goods for delivery purpose. Further, Korea s tax treaties with Indonesia and Mexico 13 have the provision prescribing the limited force-of-attraction rule found in the UN Model Convention. B. Specific Anti-avoidance Provisions Originating from the Commentaries of the OECD Model Tax Conventions The Commentaries on Article 1 of the OECD Model Tax Convention proposes, under the subtitle of Improper use of the Convention, a number of sample wordings that can be adopted in the actual tax treaties. Since the OECD s update of the Commentaries in 2003, Korea has introduced in its tax treaties, more frequently than before, specific anti-avoidance provisions whose wording is identical or similar to those included in the Commentaries of the OECD Model Tax Convention (hereinafter the Commentaries ). Specific anti-avoidance provisions introduced in the Commentaries can be divided into several subgroups on the basis of their intended effects or the approaches adopted to bring forth such effects. For instance, the Commentaries categorize these provisions into the following groups: conduit company cases, provisions aimed at entities benefiting from preferential regimes, anti-abuse rules dealing with source taxation of specific types of income, remittance based taxation, etc. Provided below are examples of specific anti-avoidance provisions found in Korean tax treaties in accordance with the foregoing grouping adopted in the Commentaries. 11 It was signed in October It was signed in June It was signed in October

19 a) Conduit company cases As mentioned in the General Overview section of the Part Two, Korea s longstanding treaty policy vis-à-vis countries having tax haven jurisdictions used be avoiding tax treaty negotiations altogether with such countries. A significant exception to this policy was the treaty concluded with the United Arab Emirates (UAE), which was signed in September Korea initiated tax treaty negotiations with the UAE in spite of the preferential tax regimes in effect applicable to Dubai as its territory. While making an exception to its tax treaty negotiation policy, Korea chose to insert a strong safeguard provision against possible treaty abuse attempts in the treaty Limitation-on-Benefits Article referenced below: Article 23 (LIMITATION ON BENEFITS) 1. Notwithstanding the application of the other Articles of the Convention, with respect to taxation in the Republic of Korea only the following residents of the United Arab Emirates shall be entitled to the benefits of Articles 7, 8,10 to 15, 21 and 22: a) the Federal and the local governments of the United Arab Emirates; b) a government institution of the United Arab Emirates as defined in paragraph 2 of Article 4; c) a company provided that such company can prove that at least 75 per cent of its capital is beneficially owned by the United Arab Emirates and/or by a government institution of the United Arab Emirates and give substantial evidence that the remaining capital is beneficially owned by individuals being residents of the United Arab Emirates and that the company is controlled by the aforementioned residents. 2. Notwithstanding the provisions of paragraph 1, also the following residents of the United Arab Emirates shall be entitled to the benefits of Article 8, 10 and 11; a) an individual; b) a company, provided that such company can give substantial evidence that its capital is beneficially owned exclusively by the United Arab Emirates and/or by a government institution of the United Arab Emirates 18

20 or local governments and/or by individuals being residents of the United Arab Emirates and the company is controlled by the aforementioned residents. 3. A further prerequisite for relief form Korean taxes under paragraphs 1 and 2 is that the company resident in the United Arab Emirates proves that it was not a principal purpose of the company or of the conduct of its business or of the acquisition or maintenance by it of the shareholding or other property from which the income in question is derived to obtain any of such benefits to the advantage of a person who is not a resident of the United Arab Emirates. 4. Relief from Korean taxes under paragraphs 1 to 3 is conditional on confirmation by the competent authority of the United Arab Emirates that the prerequisite mentioned in paragraphs 1 and 2 have been fulfilled. If the authorities of the Republic of Korea have evidence which casts doubt on the statements which have been made by the person to whom the income or capital is allocable and which have been confirmed by the competent authority of the United Arab Emirates, the competent authority of the Republic of Korea may present this evidence to the competent authority of the United Arab Emirates, the latter shall, as far as possible, make fresh inquiries and shall inform the competent authority of the Republic of Korea of the results. In case of disagreement between the competent authorities of the two Contracting States, the procedure under Article 26 shall be applied. b) Provisions which are aimed at entities benefiting from preferential regimes Following the conclusion of the tax treaty with Korea in 1983, Malaysia enacted the Labuan Offshore Business Activity Tax Act in 1990, whereby eligible entities are exempt from tax altogether or subject to only a nominal level of tax burden, akin to the tax regimes of typical tax haven jurisdictions. While such preferential tax regime was unilaterally introduced by Malaysia, it was generally believed that the treaty benefits available under the Korea-Malaysia tax treaty should continue to be applicable to Labuan as part of the Malaysian territory, considering the absence of a specific treaty provision prohibiting such application, contrary to Korea s original intention and purpose of concluding the tax treaty with Malaysia. The general consensus among the Korean tax authorities was that such unilateral move by Malaysia caused a serious erosion of the tax base of Korea. As of 2003, 19

21 investment in Korea originating from Malaysia stood at around US $6.7 billion, 13 times the amount of Korean investment in Malaysia of approximately US $500 million, making Malaysia a country holding the fourth largest investment in Korea, following the US, Japan, and the Netherlands. Given the size of economy and economic development level in Malaysia, the large scale of investment into Korea originating from Malaysia was viewed as indicating roundabout investment by residents of third countries and even by Koreans engaging in tax avoidance schemes using the Korea- Malaysia tax treaty. During , Korea undertook efforts to add a specific anti-abuse provision in the Korea-Malaysia tax treaty through a series of negotiations with Malaysia. However, faced with persistent opposition by the Malaysian tax authority, Korea resorted to implementing a domestic measure to curb treaty abuse cases, which was introduced in this report under the heading Special Withholding Tax Procedures applicable to Passive Income paid to Residents of the Certain Low Tax Jurisdictions in section 1.3 above. Concurrently, in order to circumvent the occurrence of the same incident with other countries, Korea began to insist on inclusion of a specific anti-avoidance provision aimed at entities benefiting from preferential regimes during its tax treaty negotiations with other countries. For instance, the Korean tax treaties with Canada and China contain provisions with the following language: 14 The Convention shall not apply to any company, trust or other entity that is a resident of a Contracting State and is beneficially owned or controlled, directly or indirectly, by one or more persons who are not residents of that State, if the amount of the tax imposed on the income or capital of the company, trust or other entity by that State (after taking into account any reduction or offset of the amount of tax in any manner, including a refund, reimbursement, contribution, credit or allowance to the company, trust, or other entity or to any other person) is substantially lower than the amount that would be imposed by that State if all of the shares of the capital stock of the company or all of the interests in the trust or other entity, as the case may be, were beneficially owned by one or more individuals who were residents of that State. However, this paragraph shall not apply if 90 per cent or more of the income on which the lower amount of tax is imposed is derived exclusively from the active conduct of a trade or business carried on by it other 14 Article 1 of the Second Protocol of the Korea-China tax treaty 20

22 than an investment business. c) Anti-abuse rules dealing with source taxation of specific types of income The Korea-Germany tax treaty has a specific provision referenced below that restricts source taxation where transactions have been entered into for the main purpose of obtaining the treaty benefits. Article 27 (Application of the Agreement in Special Cases) 2. Subject to the provisions of paragraph 1, the limitations mentioned in the provisions of paragraph 2 of Article 10, paragraph 2 of Article 11, paragraph 2 of Article 12 and of Article 21 shall not apply if it was the main purpose of any person concerned, in creating or assigning of the shares or other rights in respect of which the dividend is paid, or in creating or assigning the debt-claims in respect of which the interest is paid, or in creating or assigning rights in respect of which the royalties are paid, or in creating or assigning of the rights in respect of which the other income is paid, to take advantage of Articles 10, 11, 12 and 21 by means of that creation or assignment without economic reason appropriate to the business operation concerned. Similar provisions are found in the Korean tax treaties with Azerbaijan, Chile, Mexico, Oman, Papua New Guinea, Ukraine and the UK. d) Remittance based taxation Paragraph 5 of the Protocol of the Korea-Singapore tax treaty has a provision granting treaty benefits only to the extent that the relevant income is remitted to or received in Singapore, as referenced below: (5) Where this Convention provides (with or without other conditions) that income from sources in Korea shall be exempt from tax, or taxed at a reduced rate in Korea and under the laws in force in Singapore the said income is subject to tax by reference to the amount thereof which is remitted to or received in Singapore and not by reference to the full amount thereof, then the exemption or reduction of tax to be allowed under this Convention in Korea shall apply to so much of the income as is remitted to or received in Singapore. 21

23 Similar provisions are found in the Korean tax treaties with Malta, Malaysia, Myanmar and the UK. Overall, it appears that those provisions were included in Korean tax treaties at the request of the treaty counterparties rather than at the insistence of the Korean authority, considering that Korea taxes its residents based on their worldwide income without regard to whether such income is actually remitted to Korea. C. Specific Anti-avoidance Provisions with No Comparables in the Commentaries of the OECD Model Tax Convention There are certain anti-tax provisions adopted in the Korean tax treaties that have no comparable language in the Model Conventions or their Commentaries regarding the anti-avoidance provisions against improper use of tax treaties. One example is Article 6 of the Second Protocol of the Korea-China tax treaty, which restricts the scope of tax sparing credits to valid claims only as provided below: Article 6 Notwithstanding Paragraph 3 of Article 23, a resident of a Contracting State deriving income from the other Contracting State, being income referred to in that paragraph, shall not be deemed to have paid tax in respect of such income where the competent authority of a Contracting State considers, after consultation with the competent authority of the other Contracting State, that it is inappropriate to grant the benefits of Paragraph 3 of Article 23 to the said resident, having regard to: (a) whether any arrangements have been entered into by any person for the purpose of taking advantage of paragraph 3 of Article 23 for the benefit of that person or any other person; or (b) whether any benefit accrues or may accrue to any person who is neither a resident of one Contracting State nor a resident of the other Contracting State; or (c) the prevention of fraud, evasion or avoidance of the taxes to which the Agreement applies. A similar provision is found in Article 1 of the Second Protocol of the Korea- New Zealand tax treaty. 22

24 Another type of specific anti-avoidance provision can be found in Article 11(9) of the Korea-UK tax treaty, which prevents back-to-back arrangements of a tax-exempt entity with some entities subject to income tax in the country of resident of those entities as referenced below: 9. The relief from tax provided for in paragraph 2 of this Article shall not apply, if the beneficial owner of the interest; a) is exempt from tax on that interest in the Contracting State of which he is a resident; and b) sells, or contracts to sell, the debt-claim from which that interest is derived within three months from the date on which he acquired that debt-claim. A third type of specific anti-avoidance provision can be found in Article 17 of the Korea-US tax treaty, aimed at combating certain forms of treaty abuses involving holding companies in Korea or in the US, as referenced below: Article 17 (Investment of Holding Companies) A corporation of one of the Contracting States deriving dividends, interest, royalties, or capital gains from sources within the other Contracting State shall not be entitled to the benefits of Article 12 (Dividends), 13 (Interest), 14 (Royalties), or 16 (Capital Gains) if (a) By reason of special measures the tax imposed on such corporation by the first-mentioned Contracting State with respect to such dividends, interest, royalties, or capital gains is substantially less than the tax generally imposed by such Contracting State on corporate profits, and (b) 25 percent or more of the capital of such corporation is held of record or is otherwise determined, after consultation between the competent authorities of the Contracting States, to the owned directly or indirectly, by one or more persons who are not individual residents of the first-mentioned Contracting State (or in the case of a Korean corporation, who are citizens of the United States). 23