1.

Facts
 

(1)

KFI’s tax treatment of the Dividend at Issue

A TRS is an over-the-counter derivative. It is a type of equity swap in which all economic risks and benefits associated with direct holding of the underlying asset are transferred to the risk buyer (i.e., changes in the value of the underlying asset and all related income from the underlying asset such as interest, dividends, etc.) and the risk seller receives certain fees from the risk buyer in return.

Pursuant to the TRS with the FFI, the KFI paid the price differential and dividend received from the underlying Korean listed shares, in return for an interest plus certain spread from the FFI. Meanwhile, in order to hedge its risk under the TRS with the FFI, the KFI at its discretion purchased and held Korean listed shares or entered into a TRS with another financial company.

Since TRS is an internationally common and widely used financial product, especially among financial institutions, the KFI treated the swap payments to the FFI including the Dividend at Issue as business income of the FFI and did not withhold tax pursuant to the business profits article of the applicable tax treaty.
 

(2)

Imposition of withholding tax by the NTS based on the substance-over-form principle (“SOF”)

However, during the tax audit of the KFI, the NTS argued that although the dividend from the Korean listed shares held by the KFI to hedge its TRS position was received by the KFI, since the KFI was required to immediately pay such amount upon receipt to the FFI pursuant to the TRS, the FFI should be deemed the beneficial owner of the dividend with the right to control, manage and dispose of the dividend received by the KFI. Thus, NTS viewed the TRS as having been entered to evade Korean withholding tax on Korean source dividend which would otherwise have been payable by the FFI had the FFI invested directly in the Korean listed shares. In justifying their position, the NTS also cited a US TRS case (which triggered the creation of the US IRC Section 871(m)) and the Swiss Supreme Court ruling where tax was imposed on dividend equivalent payments under TRS.

Based on such arguments, the NTS treated the Dividend at Issue as Korean source dividend income of the FFI, while deeming the KFI as the withholding agent for such dividend income and imposed withholding tax to the KFI.
 

2.

TT Decision

The TT cancelled the withholding tax imposed on the grounds that (i) it is difficult to deem that there is a discrepancy between form and substance in the ownership of Korean listed shares by the KFI, (ii) there is a commercial purpose for the FFI to enter into TRS, and (iii) it is difficult to conclude that the TRS was entered into for a tax avoidance purpose.

Specifically, the TT ruled that it is difficult to deem that the FFI rather than KFI substantially controls and manages the Korean listed shares since: (i) the KFI acquired the Korean listed shares with its own funds at its discretion to hedge its TRS position, exercised all rights (e.g., voting rights) related to the Korean listed shares and was not subject to any restrictions in disposing of the shares, and (ii) the FFI only had the right to receive the agreed amount under the TRS.

The TT recognized that there is a commercial purpose of entering into TRS since it can provide the FFI a greater exposure to listed Korean shares through leverage compared to a cash investment.

The TT also noted that considering the relatively low dividend payout ratio on KOSPI shares (1-2% of the share price), it would seem more reasonable to view that the TRS was entered into for the purposes of deriving capital gain from sale of Korean listed shares (which would be tax exempt for foreign investors if the shareholding is less than 25%) and risk hedging rather than to avoid Korean withholding tax on the dividend.

In addition, the TT held that it is difficult to use foreign tax precedents as grounds for taxation in this case, especially since the US TRS case concerned a “structured” TRS involving transfer of underlying asset between the parties at the commencement and maturity of the TRS.
 

3.

Impact on Future Transactions

Based on the TT’s ruling that the TRS is not a tax avoidance transaction and the KFI holding the Korean listed shares should be considered as the substantive owner of the dividend income from the Korean listed shares, the uncertainty surrounding the Korean tax treatment of TRS seems to have been resolved to some extent. However, the issue of whether a certain transaction can be re-characterized and taxed by applying the SOF is a question of facts and circumstances. Therefore, it would be difficult to say that the TT decision may be applied uniformly to all TRS transactions, and it is therefore necessary to consider the Korean tax implications of TRS based on the particular structure and facts of each transaction.