Taxation on thin capitalization

Date: July 17, 2020

I. Introduction

There are two ways for a foreign corporation to provide financial support to its branch in Korea. They are making an investment and providing loans. The investment made by a foreign controlling stockholderis not deemed deductible expenses when the domestic branch pays dividends to its headquarters. However, borrowings are deemed interest expenses, allowing the domestic branch to reduce taxes. Accordingly, domestic branches prefer to borrow funds from its foreign controlling stockholders when they need to raisefunds. Taxation on thin capitalization refers to the practice that artificiallyreduce investment and increase borrowing. Therefore, the government introduced a tax system which does not include interests for the loans borrowed from its foreign controlling stockholders in deductible expenses.

II. Tax Requisition

Where a domestic corporation borrows funds from a foreign controlling stockholder (including funds borrowed from a related party of a foreign controlling stockholder prescribed by Presidential Decree,including relatives) or from a third party under a payment guarantee (including security provided to guarantee payments) by a foreign controlling stockholder,and such borrowings exceed twice the amount invested by the foreign controlling stockholder.

III. Disposition of Income

The interest on a loan obtained from a foreign controlling stockholder, which is excluded from deductible expenses, shall be deemed disposed and the interest on a loan obtained from a related party or from a third party under a payment guarantee issued by a foreign controlling stockholder, which is excluded from deductible expenses, shall be deemed disposed of as other outflows from the relevant corporation.

IV. Scope of Foreign Controlling Stockholders

① A foreign stockholder who, directly or indirectly, owns at least 50/100 of voting stocks of a domestic corporation;

② A foreign corporation, at least 50/100 of whose voting stocks are owned, directly or indirectly, by a foreign stockholder described in subparagraph 1;

③ A foreign stockholder having a relationship under Article 2 (1) 4 with a domestic corporation.

V. Non-Deductible expenses for Interest Payment

(1) Scope of borrowing

The scope of borrowings shall be the liabilities which generate the interest and discount fees: Provided, That the fund borrowed in a foreign currency by a domestic branch of a foreign bank under the Banking Act upon request of the Government or the amount deposited by and borrowed from, in foreign currency, the head office or branch office of the relevant foreign bank in order to use it by one of the following methods, shall be excluded:

① Method to deposit or lend in foreign currencyto a nonresident or a foreign exchange bank under the Foreign ExchangeTransactions Act;

②Method to accept or trade the bonds in foreign currency issued by a non residentor a foreign exchange bank under the Foreign Exchange Transactions Act.

(2) Method for calculating non-deductibleexpenses

The amount deemed not included in deductible expenses shall be the amount of interest and discount fees computed by aggregating each total from multiplying respective debts by respective loans by relevant interest rates in order from the highest interest rate (where at least two loans to which the same interest rate applies exist, in order of the latest loan shall apply)among total loans of a domestic corporation from its foreign controlling stockholder, and the limit on such sum shall be the time the accumulated amount of loans from the loan of the highest interest rate reaches the excess accumulated, and the accumulated amount of the last loan when the accumulated amount surpasses the accumulated excess, which exceeds the accumulated excessshall be excluded.

☞ Calculating accumulated excess

Accumulated excess = Accumulated amount oftotal loans of a domestic corporation (including a domestic place of business aforeign corporation; hereinafter the same shall apply in this Chapter) from itsforeign controlling stockholder (including a third party providing loans to thedomestic corporation under guarantee issued by the foreign controllingstockholder) (accumulated amount of equity investment of foreign controllingstockholder in the domestic corporation × standard multiplier.

☞ The equity investment of a domestic corporation

The equity investment of a foreign controlling stockholder in a domestic corporation means an amount computed by multiplying the larger of the amounts provided for in the following subparagraphs, by the ratio of the capital paid by the foreign controlling stockholder to the total amount of paid-in capital of the relevant domestic corporation as at the end ofthe relevant business year.

① An amount computed by deducting the total liabilities (including reserves and excluding the unpaid corporate tax) from the total assets on the statement of financial position as at the end of the relevant business year

② The paid-in capital calculated using the following formula as at the end of the relevant business year:

Amount of capital + (amount in excess of par value of stocks issued and gains from capital reduction) - (discount on capital stock and loss arising from capital reduction)

③ The scope of interest and discount fees to be aggregated shall include every item as all interest income generated from the loans, the economic substance of which corresponds to interest, such as the amortization of bond discounts and discount charges on accommodation bills, which a domestic corporation must pay to its foreign controlling stockholder: Provided, That the interest on construction capital funds shall be excluded from the scope of interest and discount fees.

VI. Loans under Ordinary Terms and Conditions

Where a domestic corporation, whose multiplier of loans exceeds a foreign controlling stockholder's equity investment by as much as two times, it shall submit the following data to the competent tax authority by the deadline for filing a return:

① Data attesting that the relevant loans are not actual capital contribution, based on the interest rate,maturity, payment method, possibility of conversion into capital, priority over other claims, etc.

② Data on the multiplier of loans against the equity capital of a comparable corporation carrying on the same business type as that of the relevant domestic corporation (hereinafterreferred to as "comparable multiplier"). In such cases, the comparable corporation means a corporation having a representative nature based on its multiplier of loans among domestic corporations having a scale of business and managerial conditions, etc. similar to those of the relevant domestic corporation.

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