Thin Capitalization Rule in Korea
Overview
The methods by which a foreign invested corporation in Korea can attract funds from foreign shareholders can be divided into equity capital and debt capital. The Law for Coordination of International Tax Affairs (hereinafter referred to as the “LCITA”) has a regulation clause from taxation perspective, which is Thin Capitalization Rule, in cases where capital is raised excessively by borrowing, which applies not only to domestic corporations but also to the domestic permanent establishments of foreign corporations. Set forth below are the details of such regulation.
Main Contents
A. The Concept of Thin Capitalization
If a foreign invested corporation in Korea raises funds by capital or borrowing, the cost of financing will be paid to foreign shareholders in the form of dividends and interest. In this case, the dividend is payable after disposing of the after-tax income in accordance with the Corporate Tax Law, so it is not recognized as a tax deduction but the interest can be recognized as tax deduction. Given these tax differences, the foreign invested corporations in Korea will face economic incentives to raise funds from overseas shareholders in the form of borrowings rather than capital stock.
Therefore, in order to resolve the difference in tax burden due to the funding format and to induce capitalization of investment funds, the thin capitalization rule was institutionalized where interest expense on the excess amount over a certain threshold, which can be calculated by multiplying total borrowing amount by a certain percentage, is not deductible for tax purposes.
B. Calculation of Non-deductible Interest Expense per Thin Capitalization Rule
Pursuant to the thin capitalization provisions under the Law for the Coordination of International Tax Affairs (“LCITA”), where the aggregate amount of borrowings obtained by a domestic corporation (including a domestic permanent establishment of a foreign corporation, hereinafter referred to as the “domestic corporation”) from its foreign controlling shareholder and borrowings obtained from a third party with respect to which a payment guarantee is provided by such foreign controlling shareholder exceeds two times (six times in the case of financial institutions) the amount of capital contributed by the foreign controlling shareholder, the interest paid and discount fees attributable to the excess portion shall not be deductible for corporate tax purposes.
| Disallowed (non-deductible) amount for the corporate tax purpose = A * (B – C) / B A : Total interest expense and discount fee to be paid to the foreign controlling shareholder of the foreign invested corporation in Korea (deductible + non-deductible expense) B : The total amount of borrowed money from the foreign controlling shareholders and/or from the third party with financial guarantee service received by the foreign controlling shareholder times the number of days outstanding during the year C : Two times (six times in case of financial institutions) of the amount of the share capital investment made by the foreign controlling shareholders multiplied by the number of days during the year |
For reference, the details of the provisions of the LCITA related to the calculation of the non-deductible amount are as follows.
| Terminology | Detail |
| The foreign controlling shareholders | A foreign shareholder who directly or indirectly owns 50% or more of the voting shares of a foreign invested corporation in Korea or has de-facto control over the corporation. (*)For reference, in the case of a domestic permanent establishment of a foreign corporation, a foreign controlling shareholder means the head office or branch of such foreign corporation, or a foreign shareholder who directly or indirectly owns 50 percent or more of the voting shares of such foreign corporation and exercises effective control over it. |
| Applicable Borrowings | Interest-bearing liabilities. In other words, excludes liabilities that do not generate interest such as Trade payables and other payables. |
| Interest and discount fee | Includes all items whose substance is equivalent to interest expense such as discounts on issuance of debentures, discounts on bills, and so on. However, it excludes capitalized interest expense on construction project. |
| Calculation of share capital amount injected into a foreign invested corporation in Korea by foreign controlling shareholders | Injected share capital = Shareholders’ equity * shareholding ratio of the foreign controlling shareholders (*) For reference, Shareholders’ equity is the greater of the following amounts. In the case of a domestic permanent establishment of a foreign corporation, the contributed capital amount shall be the amount calculated pursuant to item ①below.) ① Total Asset – Total Liabilities per B/S as of the relevant fiscal year-end ② Contributed share capital as of the end of the relevant fiscal year-end |
C. Secondary Adjustment for Non-deductible Interest Expense
In the case of borrowing from foreign controlling shareholders, the amount of interest that is disallowed for a tax deduction due to the Thin Capitalization Rule is to be disposed of as deemed dividend for the secondary adjustment purpose, and as for the borrowing from a third party, the disallowed amount is to be disposed of as other outside leakage for the secondary adjustment purpose.
In particular, in case the disallowed interest expense is disposed of as deemed dividend for the secondary adjustment purpose, irrespective of whether or not the interest is actually paid out, it is deemed that the corporation paid the dividend on the reporting date of corporate income tax return, which causes the tax (corporate tax or individual income tax) on the dividend payment to be withheld, and after withholding the tax, the corporation must report and pay the withholding tax by the 10th of the following month of the month that date of withholding belongs to. The corporate tax rate and the individual income tax rate applied to the deemed dividend are 22% (including local income tax) and can be subject to the reduced tax rate in accordance with the tax treaty with the country in which the foreign controlling shareholder is located.
For reference, if domestic corporation has already remitted withholding tax on the interest paid to the foreign controlling shareholder to the tax office that has jurisdiction over the tax collection during the course of a year, the amount of tax withheld and paid already can be offset against the withholding tax on the deemed dividend and only net amount can be either remitted or refunded.
Conclusion
Thin Capitalization Rule is a regulation introduced to regulate the reduction of tax revenue due to the artificial adjustment of funding method. Therefore, if a domestic corporation considers raising funds in the form of borrowings, it is necessary to fully examine whether tax disadvantages may arise in accordance with the Thin Capitalization Rule.
English 
Korean