An increase in the number of overseas investments by Korean companies is leading to more transactions between Korean companies and their overseas subsidiaries. Korean companies are increasingly looking to minimize the tax burden on their international investments and this article examines the tax issues of two real examples where a Korean company has invested in real estate projects in Vietnam and Cambodia. Specifically, the examples investigate the choice that the parent company has between i) a credit and a deduction for taxes paid overseas, and ii) the decision of a contract for an international project.
Korean tax laws provide for relief against international double taxation through a foreign tax credit or foreign tax deduction on foreign taxes paid by resident taxpayers on foreign sourced income. In accordance with Article 57.1 of the Corporate Tax Act, Article 104.6 of the Restriction of Special Taxation Act and any applicable tax treaty, a Korean company may select the method by which foreign taxes are deducted from its corporate tax amount. It may also select the method by which foreign taxes are included in deductible expenses in calculating its taxable income. (For a company or trust established in accordance with the Indirect Investment Asset Management Act or the Real Estate Investment Company Act, ordinary tax credit shall be calculated according to Article 57.2 of the Corporate Tax Act. However, when indirect tax credit is involved, Article 104.6 of the Restriction Act is still applicable.)
A taxpayer can switch methods each fiscal year. In general, foreign tax credit has more advantages than the deduction method, which indirectly affects the amount of taxation. However, the percentage of foreign sourced income is capped under the tax credit method, which can skew results.
In the example above, Korean Company X has a subsidiary, Company Y in Cambodia and is seeking to minimise its overall tax payments. Cambodia’s corporate tax rate is 20% and the withholding tax rate on dividends is 14%. Company Y will pay the entire available amount for dividends.
It is clear in scenario one that tax deduction method is more advantageous than tax credit. However, in scenario two, where X sustained a loss in fiscal year one, X will carry forward W21.2 million for a future tax credit up to five years under the tax credit method, or it will carry forward the deficit amount of ? 41.2 (?20 – 21.2) up to five years under the tax deduction method.
In year two, X cannot make use of its the W21 million carried forward because there will be a separate tax credit applied in fiscal year two, which exceeds the tax credit limit. However, the deficit carried forward can be fully deducted from the tax base for fiscal year two. Taking the tax deduction route in fiscal year one and the tax credit route in fiscal year two therefore delivers the best results.
The entire tax payment of a parent company and its subsidiaries can also vary depending on which entity is used as a contractor for a foreign business project. Taking the following example, Korean construction firm, Company A, owns a Korean subordinate, Company X, which is a main subcontractor of Company A and which will perform a contract for a construction project in Vietnam. Companies A and X each have a foreign subsidiary in Vietnam, Subsidiaries B and Y, respectively. To perform this project, A can be a contractor with two options: A gives an order to X and X subcontracts the order to Subsidiary Y (Case one), or A gives an order directly to Subsidiary Y (Case two). On the other hand, Subsidiary B can be a contractor with different options: B gives an order to X and X subcontracts the order to Subsidiary Y (Case three), or B gives an order directly to Y (Case four).
Before reviewing the example, it is necessary to examine the tax laws of both countries and the tax treaty between Korea and Vietnam. First, since the tax treaty between Korea and Vietnam does not allow an indirect tax credit, Article 104.6 of the Restriction of Special Taxation Act is applicable. Second, when X pays dividends to A, Article 18.3 of the Corporate Tax Act is applicable. (This provision is to prevent double taxation on dividends between Korean companies. To compare the four cases, A is assumed to own 100 percent of the outstanding stocks of X, which result in the exclusion of dividends from A’s taxable income.) Vietnam’s corporate tax rate is 28% and since 2004 foreign investors have no longer been subject to remittance tax when transferring their profits out of Vietnam. B and Y will pay the entire available amount for dividends.
On a general level, it would be simple to conclude that the more income is generated in Vietnam, the higher the tax liability. Therefore, to minimise the overall tax liability, it is advantageous for a company to be a contractor located in a country with a low effective tax rate.
However, it is important to pay attention to other issues. First, in Vietnam, Foreign Contractor withholding tax can be imposed if applicable (foreign entities will be subject to the Foreign Contractor withholding tax even though they are not physically present in Vietnam). Second, if the duration of a construction project is more than six months, it can be regarded as a permanent establishment and subject to taxation of that country, with a resulting higher tax burden.
In conclusion, although the foreign tax credit route is more advantageous than the tax deduction route, the latter should not be written off.
This article was originally published in Asialaw.