Technical Update from Korea - latest

TP Week correspondent DJ Yeo, of Kim & Chang, explains recent changes to thin capitalisation rules in Korea

The changes to the the thin capitalisation rules were proposed by the Ministry of Finance and Economy and were enacted late last year. The new rules, found in the Presidential Decree to the International Tax Coordination Law, are applicable to taxable years beginning on or after January 1 2008 with no grandfathering provisions.

Korea’s thin capitalisation rules, introduced in 1996 and effective from January 1 1997, are triggered if debt borrowed from a foreign controlling shareholder (FCS), as defined, and/or from a third party under a guarantee extended by a FCS exceeds, generally, 300% of the net FCS equity in the Korean party.

Under the previous law, 600% exceptionally applied to certain financial institutions. In addition, although very rarely used, the law also provides that, if a taxpayer can show that the conditions and amount of borrowing from an FCS are reasonable as compared to borrowing by an independent third party or that the debt to equity ratio prevailing in the relevant industry is higher than 3:1, such ratio could also be acceptable.

If the relevant ratio is exceeded, interest and discount expenses attributable to the debt exceeding the threshold amount will not be deductible. For this purpose, equity was measured at the Korean company’s fiscal year end. There are since 2005 no similar rules and limitations applicable to domestic transactions, that is, borrowings between residents, raising the question whether these rules violate the non-discrimination provisions of many double tax treaties in that the rules effectively regulate a Korean company’s borrowing from foreign shareholders (or under their guarantees) only.

The new rules include two main changes to the previous law. First, the beneficial debt to equity ratio of 6 to 1 applicable to companies engaged in a financial business (banks, ABS SPCs) has been abolished, making such companies subject to the same debt to equity ratio of 3 to 1 as all other taxpayers. Reportedly, one reason for the proposal was the Ministry of Finance and Economy’s concern that financial institutions have taken advantage of the appreciation of the Korean Won by borrowing excessively from foreign affiliates (based on the 6:1 ratio) and investing short-term into government bonds, which has been viewed as accelerating the Korean Won’s further appreciation.

The change is also expected to have significant implications to certain special purpose vehicles created for investments in Korea who typically fully utilise the 6:1 debt to equity ratio.

Second, in computing the debt to equity ratio, equity is under the new rules measured by the accumulated daily balance of net equity. Previously, equity was measured by the year-end balance of the equity, making it possible to avoid thin capitalisation issues by injecting an additional amount of capital before year end.