PwC alternatives, volume 2 no. 1

International edition

Korea: New withholding tax rule for foreign companies domiciled in tax haven jurisdictions: Labuan designated as a tax haven jurisdiction

In June 2006, the South Korean Ministry of Finance and Economy announced that it has designated the Malaysian island of Labuan as a tax haven jurisdiction. Under a newly introduced rule, withholding taxes will apply to payments made to foreign companies domiciled in Labuan. The current double-tax treaty between Korea and Malaysia will continue to be honored for companies domiciled elsewhere within Malaysia, but not in Labuan.

The new law is the Korean government’s response to foreign companies which generate earnings from Korean transactions but avoid taxes because they are domiciled abroad.

Prior to the Ministry’s designation of Labuan as a tax haven jurisdiction, Korea's National Assembly had approved a new withholding tax regime for foreign companies domiciled in designated offshore jurisdictions. Effective July 1, 2006, income from Korean sources, including dividends, interest, royalties and capital gains of a foreign company located in a designated foreign jurisdiction, will be subject to a domestic withholding tax – generally at a rate of 27.5 percent – regardless of the apparent residence of the foreign entity in a treaty jurisdiction. Labuan is the first jurisdiction to be designated a tax haven under the new law.

A subsequent refund (or pre-approval to apply the treaty benefits up-front) may be obtained from the Korean tax office if the foreign company can demonstrate it should be entitled to receive treaty benefits as the beneficial owner of the Korean source income under the relevant treaty.

The Ministry reserved the right to revise the list of designated foreign tax haven jurisdictions as it deems necessary.

US: Proposed regulations issued relating to application of the portfolio interest rules to obligations held by partnerships and trusts

In June, the U.S. Internal Revenue Service and Department of the Treasury issued proposed regulations concerning the exclusion from gross income of portfolio interest paid to a nonresident alien individual or foreign corporation. The proposed regulations address how the portfolio interest rules apply to interest paid to a partnership (or simple or grantor trust) that has foreign partners (or beneficiaries or owners).

The exemption from gross income for interest on portfolio indebtedness does not apply to interest received by related parties who own, or are treated as owning, a 10 percent or greater equity interest in the U.S. obligor. For purposes of measuring the equity interest in a debtor, options to acquire equity, such as a convertibility feature or warrants, are treated as having been exercised.

In the context of a partnership, the proposed regulations would eliminate an area of uncertainty commonly faced by investment funds that hold both debt and equity, or equity options, in the debtor on a prospective basis. The proposed regulations provide that, when interest is paid to a partnership, the persons who receive the interest for purposes of applying the 10 percent shareholder test are the partners in the partnership. The 10 percent shareholder test then would be applied by determining each partner's ownership interest in the obligor.

Note: The preamble to the proposed regulations cautions that no inference is intended as to whether other limitations set forth in the definition of portfolio interest are to be applied at the partner level, the partnership level or both.

In addition to partnerships, the proposed regulations would provide similar rules for debt obligation held by a simple trust or grantor trust.

The proposed regulations also address the point at which the 10 percent shareholder test is to be applied. This can be at any time during the year. Under the proposed regulations, a determination is to be made at the time the withholding agent, absent any exceptions to withholding, would be required to withhold the tax. This ordinarily is at the time of payment. However, when a domestic partnership or trust is the withholding agent, withholding is required at the earlier of:

• The time when the interest is distributed by the partnership or trust; or,
• The due date for the partnership or trust providing a K-1 to its partners or beneficiaries.

As proposed, the regulations would apply to interest paid on obligations issued on or after the effective date of the regulations. They do not address the question of whether, prior to the effective date, the 10 percent shareholder test is to be applied at the partnership level or the partner level.

In order to determine this, many investment funds have relied on the reasoning in a 1994 Field Service Advice memorandum to support the position that the 10 percent shareholder test should be applied at the partner/beneficiary/owner level rather than at the partnership level. The preamble to the proposed regulations contains a rather extensive explanation of why the government has determined that the proper interpretation of the statute is to apply the test at the partner/beneficiary/owner level. This explanation would provide support for applying the same rule for periods prior to the proposed effective date of the regulations.

Turkey: A step back from the new withholding regime for foreign investors and a rate reduction from 15 percent to 10 percent for resident investors

According to Law 5527 which was published in the official gazette on July 7, 2006, certain elements of the new taxation regime which had taken effect on January 1, 2006 have changed.

The changes came in response to investor concerns that had caused decreases of 20 percent on Turkey’s financial markets and in the value of its currency. With the Law 5527, the Council of Ministers has been authorized to determine the applicable withholding tax rates for each type of investor and source of income. On July 22, 2006, the Council of Ministers determined the withholding tax rates on several sources of income with the decree numbered 2006/10731.

Effective July 7, 2006, the rate of withholding on non-resident investors’ Turkish-sourced income from certain financial instruments will be zero, and there will be no tax filing requirement on capital gains of non-resident investors from the sale of the Eurobonds to Turkish residents.

However, dividends distributed to non-resident corporations which do not have a permanent establishment (fixed place of business or permanent representative) in Turkey and to non-resident individuals will be subject to 15 percent withholding, instead of 10 percent. In this respect, while no withholding shall be applied on dividends generated from stocks held under the non-resident investment fund (NRIF) status (because a permanent establishment should be existing under the NRIF status), 15 percent withholding shall be applied for dividends derived from stocks that are not booked in a Turkish permanent establishment (e.g., stocks purchased after January 1, 2006 and no permanent representation exists). Moreover, where a corporate filing is required for non-resident corporations (e.g., branch profits, or taxable capital gains generated from securities issued/purchased prior to January 1, 2006 and where the NRIF status is not applicable), 10 percent withholding over the profit after corporate tax has been increased to 15 percent.

Effective July 7, 2006, the rate of withholding for resident investors has also been reduced to 10 percent for:

• Income from government bonds and Treasury bills issued after January 1, 2006
• Income from corporate bonds issued after January 1, 2006
• Capital gains from the disposal of stocks purchased after January 1, 2006
• Income from stock lending.

The old system would continue to be applied to government bonds and T-bills that were issued prior to January 1, 2006.

The temporary relief from withholding of income generated from derivatives for the year 2006 has become permanent, except for individual investors.

Oscar Teunissen, Tax partner, +1 (646) 471 3223
David Richardson, Tax managing director, +1 (646) 471 3303
Steve Nauheim, Tax managing director, +1 (202) 414 1524
Puneet Arora, Tax director, +1 (646) 471 1691
Joni Geuther, Tax director, +1 (646) 471 4526
Dmitri Semenov, Tax director, +1 (646) 471 6756

Korea tax services team in the U.S.:

Hae Young Kim, Tax partner, New York, +1 (646) 471 5826
Todd Landau, Tax partner, New York, +1 (646) 471 5312

PwC Turkey team:

Faruk Sabuncu, Tax partner, Istanbul, +(90) 212 3266082