South Korea—Trends in Permanent Establishment

Permanent establishment (PE) is a well-established taxation issue that frequently arises when a foreign company has a business presence or undertakes business activities in South Korea. Whether or not a foreign company has a PE in South Korea will have significant tax implications since it will determine how South Korea taxes the foreign company on the income arising in South Korea.

This article summarizes the South Korean PE rules and provides an update on some notable case law, as well as explaining developments in relation to the introduction of the Organization for Economic Co-operation and Development (OECD) Base Erosion and Profit Shifting Action Plans (BEPS Action Plan(s)) into the South Korean domestic tax laws.

Please note that there are two sets of PE provisions under the South Korean tax law: one under the Corporate Income Tax Law (CITL) that applies to corporate taxpayers; and the other under the Individual Income Tax Law that applies to individual taxpayers. These PE rules are generally analogous, but this article refers specifically to the CITL PE tax provisions.

Overview of Domestic PE Rules

The South Korean domestic PE rules in the CITL should generally be familiar to companies that engage in international and cross-border business as they are modeled after the OECD Model Tax Convention as well as (to a lesser extent) the United Nations (UN) Model Double Taxation Convention, although there are some unique wrinkles and exceptions.

The CITL and related regulations provide examples of physical places and activities that could constitute a PE for a foreign company in South Korea. (See CITL Art. 94(2) and (3)). The most commonly encountered types of PE (not an exhaustive list) include:

• physical office or other fixed place of business (fixed place PE);
• place where services are rendered (service PE);
• construction site PE; and
• sales and marketing activities through an agent (agency PE).

Generally, if a foreign company were to have a PE in South Korea, it would be subject to corporate income tax on all South Korean-source income attributable to the PE. The net income after deducting applicable and attributable costs/expenses can be regarded as the appropriate tax base for the PE’s income tax purposes. The South Korean domestic law follows the functionally separate entity approach as per the OECD Model Tax Convention. Under this approach, the PE would be deemed to be a separate and distinct entity from the foreign company for tax purposes, with transactions between the PE and foreign company considered to be at arm’s length.

South Korea has signed over 90 double tax treaties with other jurisdictions around the world. The PE-related articles in nearly all the South Korean tax treaties are derived from and are comparable to either the OECD Model Tax Convention or the UN Model Double Taxation Convention approach. In principle, if there is an applicable tax treaty, it should take precedence over the domestic South Korean tax law provisions regarding PE. However, this principle is not always followed by the National Tax Service (NTS). The NTS also regards the OECD (as well as the UN to a lesser extent) Commentaries as interpretative guidelines, but it will refer to the domestic tax law, regulations and cases if the applicable tax treaty provisions are unclear or ambiguous.

Until the late 1990s, South Korea’s approach and interpretation of both the domestic PE rules as well as the applicable tax treaty provisions were regarded as overly broad and aggressive. In part due to widespread criticism by taxpayers and counterparties in other jurisdictions (particularly from developed countries), the NTS changed their primary approach in assessing foreign companies doing business in South Korea from the perspective of PE to TP, after South Korea joined the OECD in late 1996.

However, in recent tax audits in the post-BEPS environment, there has been more aggressive scrutiny of PE issues and challenges against foreign companies by the NTS. It is expected that this trend will continue in the near future.

Recent Cases Regarding PE

As noted above, the aggressive position and broad interpretation of PE by the South Korean government (i.e., the NTS) when foreign companies conduct business activities in South Korea is well known in the international tax community. However, it is important to note that the Korean courts do not necessarily view PE issues in the same manner as the NTS. In fact, the Supreme Court of South Korea (the Court) has ruled against the NTS in a number of notable court appeals involving PE tax assessment cases.

A seminal and landmark decision in this regard was rendered in 2011. (See 2009 Du19229 (April 28, 2011) (Bloomberg Case)). This case involved Bloomberg LP, a U.S. financial services provider (Bloomberg). Bloomberg leased machines and equipment (Bloomberg Terminals) to South Korean customers, which were used to access financial data by the customers. Bloomberg also sent its employees to Korea periodically to meet customers for marketing and training purposes.

The Court held that the existence of a PE should be determined according to a facts-and-circumstances test; and based on the factors taken as a whole, neither the Bloomberg Terminals nor the marketing/training activities of its employees in Korea could be viewed as essential and important parts of Bloomberg’s business (which was the collection, processing and analysis of financial data).

The Bloomberg Case is important in that the Court indicated that a foreign company’s business activities in Korea need to be sufficiently important and exceed a certain threshold of activity in order to create a PE in Korea. The following are a couple of recent notable cases of the Court involving PE that follow up on the Bloomberg Case.

Holiday Case

In July 2016, the Court rendered a decision on whether the activities of a foreign junket operator (Junket), which received commissions from a Korean casino (the Casino), based on the amount of revenue generated by gamers at the Casino, could create a PE in Korea. (See 2015Du51415 (July 14, 2016)).

In this case, the foreign Junket brought gamers to the Casino. The Junket had an office inside the Casino, and its employees performed various services for the gamers, including providing gaming chips, making reservations and other such services. The Court affirmed the legal principles of the Bloomberg case, but it found that the employees’ activities in this case were indeed important and necessary for the foreign Junket’s business in Korea, and therefore the Junket had a PE in South Korea.

Lone Star Case

In October 2017, the Court issued another notable decision on whether the business activities of a local advisory company (South Korean Adviser) for a foreign private equity fund (PEF) could create a PE in Korea for the foreign PEF. (See 2014Du3044 (October 12, 2017)). This issue could be important for foreign PEFs since the tax exposure would be significantly increased if the activities of a local management or advisory company could expose a foreign fund itself to full PE taxation in Korea.

In this case, applying the test from the Bloomberg Case, the Court held that activities of key executives of the Korean Adviser (who were also key members or directors of the General Partner (GP) of the PEF) did not create a fixed place PE of the foreign PEF in Korea since, inter alia, they acted in the capacity of employees of the Korean Adviser, rather than as directors of the offshore GP. Likewise, the key executives also did not create an agency PE for the foreign PEF either, since they did not habitually exercise the authority to conclude contracts in the name of the foreign PEF.

The Holiday Case and Lone Star Case discussed above re-affirm the Court’s position on PE issues outlined in the Bloomberg case. Specifically, whether a foreign company’s business activities in Korea rise to the level of creating a PE is a factual determination based on the overall facts and circumstances. The foreign company’s activities in Korea must be essential and important to the foreign company’s business as a whole to give rise to a PE.

Impact of BEPS Action Plans on PE Issues in South Korea

The South Korean government has also been steadily introducing and incorporating the recommendations of the BEPS Action Plans into the domestic tax law since 2015. This is also true of the domestic PE rules.

As part of the 2019 tax law amendments, changes to the South Korean PE rules were enacted in line with BEPS Action Plan 7 (Preventing the Artificial Avoidance of Permanent Establishment Status). BEPS Action Plan 7 focuses on updating and clarifying the definition and scope of PE. The revised domestic PE rules, which became effective January 1, 2019, include the following three key provisions:

• clarification of preparatory or auxiliary exception: a foreign company will need to meet more stringent requirements to qualify for the preparatory or auxiliary exception to PE;
• introduction of anti-fragmentation rule: the overall activities of the foreign company and its related parties in South Korea should be combined so as to determine whether such activities overall rise to the level of creating a PE; and
• expanded scope of agency PE: clarified rule that even if an agent does not conclude contracts in South Korea, it may create a PE for a foreign company if the agent plays a principal role in the negotiations.

These new provisions are not expected to drastically change the application of PE assessments in South Korea. Historically, the NTS has already been applying many of these concepts in tax audits. For example, the NTS has taken the position that an agency PE can arise if the dependent agent performs important business functions in South Korea, even if the agent does not actually conclude or execute contracts in South Korea. Therefore, the NTS is likely to view these new provisions as validation of its historic aggressive approach to determining PE status.

With regard to the Court’s position (which has historically been less aggressive than that of the NTS), it is too early to assess the impact. However, these new provisions are not expected to have a significant impact on the Court’s position on PE issues.

Finally, South Korea deposited to the OECD its instrument for ratification of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI) on May 13, 2020. However, in regards to the PE provisions in the MLI, South Korea has reserved the right for the entirety of these provisions not to apply to its tax treaties. Accordingly, a significant change to the NTS’ position on PE provisions in the existing South Korean tax treaties is not expected in the near future.

Planning Points

As discussed earlier, the NTS’ interpretation of what constitutes a PE was historically regarded as overly aggressive and too broad by many taxpayers as well as tax authorities in other jurisdictions. Historically, the NTS would often raise PE assessments, but would often settle such assessments as TP adjustments due to strong push back from taxpayers as well as difficulties in supporting the PE assessment. This was also one of the reason the NTS shifted from focusing on PE assessments to TP challenges in tax audits after South Korea joined the OECD in 1996.

However, with the introduction of the BEPS Action Plans into the domestic tax law and tax treaties, it appears the NTS has become increasingly assured that its historic (i.e., pre-1996), aggressive approach was justified and correct. Accordingly, with the introduction of changes to the PE rules in accordance with BEPS Action Plan 7 in 2019, it is expected that there will be an increase in PE challenges, and greater scrutiny of foreign companies that have business activities in South Korea.

With regards to South Korea’s reservation of the PE provisions in the MLI, this does not necessarily signal a major change in the South Korean position. In fact, one can argue that the NTS’ interpretation of PEs even under the current tax treaties is broader and more aggressive than even the provisions prescribed in the MLI.

Therefore, foreign companies doing business in South Korea are advised to revisit and review the scope of their activities in light of the changes to the domestic PE rules, which seem to signal more PE scrutiny and challenges ahead from the NTS in future tax audits. Accordingly, the PE risk analysis, along with TP review, will become more important than ever before for foreign companies doing business in South Korea.

Tom Kwon is a Senior Foreign Attorney and Partner; and Steve Minhoo Kim is a U.S. CPA and transfer pricing specialist at Lee & Ko, South Korea.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.