On December 23, 2022, the South Korean National Assembly passed an amendment (the “Amendment”) to the Special Taxation Act,1 which may have important implications with respect to the application of US withholding rules for certain Korean investors. The Amendment allows eligible Korean investors to treat foreign entities as fiscally transparent under Korean tax law and eases concerns regarding the application of section 894(c) of the Internal Revenue Code (“Section 894(c)”) to certain investments made through commonly used US investment vehicles. As a result, Korean investors may now qualify for treaty benefits that were previously uncertain or unavailable to them. In this Legal Update, we briefly discuss how this Amendment affects US tax withholding decisions and fund structures developed for Korean investors to mitigate the adverse consequences of Section 894(c).
I. Amendment to the Korean Special Taxation Act
Under the Amendment, a Korean taxpayer (including individuals, corporations, and certain trusts) who invests through a foreign entity can apply to the Korean taxing authorities to treat such entity as a transparent entity under Korean tax law for the purpose of attributing income from the entity to the investors. If granted, the foreign entity will be treated as transparent for Korean tax law purposes, and the income from such entity will be treated as if it were received directly by the Korean investor, subject to the regular graduated rates applicable to the Korean investor. The Amendment also states that a presidential decree will prescribe rules for calculating the tax liability for investors who receive income from such entities.
II. Application of Section 894(c) with respect to Korean Investors
Section 894(c) generally denies treaty benefits for certain payments made through an entity that is treated as fiscally transparent for US federal income tax purposes but opaque under the laws of the jurisdiction of the person claiming treaty benefits. Under US income tax regulations, a foreign person may only claim treaty benefits on income earned or received indirectly via a pass-through entity if such pass-through entity is treated as fiscally transparent under the laws of the treaty jurisdiction and the income is “derived by” the taxpayer of the treaty jurisdiction. Historically, it has not been entirely clear or consistent whether certain types of non-Korean entities should be treated as fiscally transparent for Korean tax law purposes, in part due to seemingly inconsistent case law in Korea. Therefore, the anti-hybrid rule under Section 894(c) caused a fair amount of uncertainty and confusion as to whether reduced treaty withholding rates under the United States-Korea Income Tax Treaty would be available with respect to investments by Korean investors in certain non-Korean entities, such as Cayman exempted limited partnerships and Delaware limited partnerships. Furthermore, Section 894(c) has been generally interpreted as denying the benefits of the United States-Korea Income Tax Treaty if a payment is made to a Korean investor through a US limited liability company (an “LLC”) that is treated as a partnership for US federal income tax purposes because, prior to the Amendment, an LLC was treated as a corporation under Korean tax law.
The Amendment would allow Korean investors who invest via a non-Korean entity to mitigate the adverse consequences of Section 894(c) by applying to treat such entity as fiscally transparent for Korean tax purposes.
III. Feeder REIT Structure for Korean Investors
Given the historic uncertainty surrounding the Korean tax treatment of commonly used fund investment vehicles, many Korean investors have opted for more complex structures. For example, a typical structure for US real estate funds involves investors participating in a Delaware limited partnership that holds all of its investments through a US real estate investment trust (a “REIT”). Instead of investing directly into the Delaware limited partnership, many Korean investors have opted to hold their investment through a “feeder REIT” structure to mitigate the effects of Section 894(c). By structuring the investment in a way that allows ordinary REIT dividends to be received directly from the feeder REIT, such Korean investors sought to eliminate any uncertainty as to the tax treatment of intermediary entities under Korean tax law. These feeder REIT structures add complexity, cost and sometimes unintended collateral tax consequences to deal structures. Consequently, US sponsors and Korean investors that have established one or more feeder REITs may want to revisit whether there is a continuing need for the additional structuring and evaluate whether any unnecessary feeder REITs can be liquidated.
IV. Key Takeaways
- Korean investors who invest in foreign pass-through entities can now apply to treat them as fiscally transparent for Korean tax purposes due to the Amendment.
- This change in the law creates more flexibility for Korean investors to make US investments through various types of intermediary entities, without jeopardizing potential benefits of the United States-Korea Income Tax Treaty.
- A US withholding agent, with respect to certain payments made to a Korean investor through non-Korean entities, may request that the Korean investor apply to treat such entities as transparent for Korean tax purposes to eliminate withholding compliance risk.
- A US sponsor that has established a feeder REIT solely to manage withholding compliance risks with respect to Korean investors should consider whether it would make sense to simplify existing structures.