Tax Reform in 2005
Tax reform measures introduced for the 2006 tax year are framed around six goals: improving economic vitality and boosting growth potential; addressing the issues of aging population and widening gap between the rich and the poor; stabilizing real estate market; broadening tax base through the phase-out of non-taxation benefits and tax incentives; promoting balanced development of all areas of the nation; and enhancing convenience for taxpayers.
Highlights of tax changes for the 2006 tax year by goal are as follows;
I. Improving economic vitality and boosting growth potential
a) Tax incentives for corporate reorganization have been reinforced. For example the case of M&A, conditions to be met for deficit carried over to the subsequent financial year which has been taken over by a transferee company to be deductible have been relaxed. In principle, to be eligible for such deduction, the transferee company is required to maintain separate accounts for assets, liabilities, profits and loss from the business it has taken over, and such deficit carried over is deductible to the extent of income generated from the business concerned. In the case of M&A between companies in the same industry or SMEs, however, deficit carried over which has been taken over by the transferee company is now deductible. To the extent of the transferee's portion of the income from the business it has taken over out of total income of the transferee company after the M&A (the proportion is calculated based on the share of assets for the business taken over in whole assets belonging to the transferee company after M&A), even when the condition regarding separate accounting is not met.
Also, under the revised tax law, in case where two unrelated domestic companies swap assets of the same kind in which each of them has used for 2 or more years for their businesses. Any gains from the asset swap is deductible as long as they are used for business purpose until the end of the business year in which the swap takes place. Previously, for such gains to be deductible, the exchanged assets were required to be used for the same purpose before the swap.
b) Business taxation has been refined in a more efficient way;
First of all, for certain businesses such as hotel and massage, advertising costs are now deductible in full amount.
Secondly, there have been efforts made to ensure that Korean tax laws regarding international transactions are in line with international standards. For example, anti-avoidance rules have been toughened. The substance-over form rule is now specified in the Law for the Coordination of International Tax Affairs with a view to making clear that in case where investors unduly claim tax treaty benefits by making investments in Korea through a paper company established in tax haven jurisdictions for tax avoidance purpose, they may be taxed in Korea in accordance with the substance-over-form rule.
Another noticeable change in international taxation is the introduction of the special withholding procedure applicable to foreign companies or funds based in certain areas or countries to be designated by the Minister of the Finance and Economy (effective July 1, 2006). Under the newly introduced procedure, in case where foreign companies or funds in areas or countries designated by the Minister of Finance and Economy derive interest, dividends, royalties or capital gains from the alienation of shares in Korea. They are subject to withholding tax under the domestic tax law. Unless they obtain a prior approval of the Commissioner of the National Tax Service to apply benefits under tax treaties. In case the investor claims within 3 years that he or she is the beneficial owner of the income concerned, being entitled to a reduced tax rate or non-taxation benefit provided under the relevant tax treaty, the tax authorities, will refund an amount equivalent to any overpaid tax including interest accrued within 6 months from the application for the refund.
Moreover, changes were made to make the nation's international taxation system more efficient, for example, when it comes to the rendering of professional services in Korea by nonresidents or foreign companies without permanent establishment (PE) in Korea, expenses such as airfare, accommodations and meal expenses are excluded for withholding purposes under the revised tax law. The definition of a domestic company has expanded to include those having an effective place of management in Korea.
Anti-tax haven rules have been improved as well. Previously, those countries or areas in which an effective tax rate is 15% or less of actually accrued income used to be
judged as tax haven jurisdictions. Now, even when the afore-mentioned criterion is met, those companies with actually accrued annual income of 100 million won or less
are not subject to anti-tax haven rules.
Anti-tax haven rules have been improved as well. Previously, those countries or areas in which an effective tax rate is 15% or less of actually accrued income used to be judged as tax haven jurisdictions. Now, even when the afore-mentioned criterion is met, those companies with actually accrued annual income of 100 million won or less are not subject to anti-tax haven rules.
Thirdly, there have been some changes in deductions for donations. For example, certain donations as defined under the Corporation Tax Law which used to be deductible to the extent of total income in the past are now deductible only to the extent of 50% of total income.
Fourthly, taxation on entertainment expense has been improved. In the past, companies were required to collect documentary evidence for entertainment expenses in excess of 50,000 won so that such expenses can be deductible.
Under the revised tax law, however, in the case of expenses incurred in relation to matters for congratulations or condolences, such obligation is required only for expenses exceeding 100,000 won.
c) Tax changes have been made to help the nation's economy regain vitality. A system under which tax benefits are granted when offspring are granted properties as inheritance prior to their parents' death so that such properties can be used for starting a business has been introduced. Not only that, the expiration date of tax credits granted to investment in energy saving facilities has been extended to the end of 2008. Privately-financed projects for facilities of private universities are now exempted from value-added tax under the revised tax law.
II. Addressing the issues of aging population and widening gap between the rich and the poor:
a) Various measures have been taken with a view to ensure stable life of retired wage earners. For example, under the revised tax law, retirement pension contributions are deductible so that the use of the retirement pension plan can be promoted. Previously, up to 2.4 million won per year of pension savings contributions was deductible. Now, up to 3 million won per year of pension savings contributions and retirement pension contributions combined is deductible. Also, the ceiling on deductions for retirement pension has been raised to 9 million won on from 6 million won, while deductions for lump sum retirement allowance has been lowered to 45% from 50% of the allowance amount so that the switch of the lump sum retirement allowance system to the retirement pension system can be encouraged.
b) There have also been some changes aimed at supporting small and medium size enterprises (SMEs) and the self-employed. VAT rates applicable to the small-sized self-employed have been cut. The rate has been reduced by 5% for the retailing business with the tax being slashed by 10% in the case of restaurant and lodging businesses (The reduced rates will apply on a temporary basis until the end of December 2007).
c) With a view to supporting life of middle and low income families, construction of rental-purpose houses has been promoted through the introduction of new tax incentives. For example, dividends paid by real estate indirect investment vehicles investing in houses built for the long term (10 years or longer) rental are now subject to final withholding tax at 14%.
d) Tax incentives for supporting production activities by farmers and fishermen have been expanded. For example, the expiration date of the period during which equipment for agriculture or fisheries is VAT zero-rated has been pushed back by 3 years to the end of 2008.
III. Stabilizing real estate market:
a) Taxation on capital gains on real estate has been toughened.
1. Capital gains tax
Under the revised tax law, capital gains tax is imposed based on the price at which the transaction of real estate is made instead of government-set price (effective across-the-board from 2007).
2. Taxation on capital gains in relation to transfer of a household (3 or more houses)
In case where a household which owns 3 or more houses including the right to live in new apartment to be built taking the place of old apartment transfers any of them, the capital gains from the transfer is now subject to tax at the rate of 60% and is not eligible for special deduction for long-term holding any more (effective from 2007). Previously, the right to live in the new apartment to be built taking the place of old apartment was not counted in for the purpose of capital gains tax.
3. Taxation on capital gains in relation to transfer of a household (2 houses)
Taxation on capital gains in relation to the transfer of a house by a household owning 2 houses has also been strengthened. Under the revised tax law, capital gains tax rate of 50% applies to capital gains from such transfer and, in this case, special deduction for long-term holding is not applicable (effective from 2007).
4. Taxation on capital gains in relation to transfer of non-business purpose land and farmland
In case where capital gains are derived from the transfer of non-business purpose land and farmland, forest and pasture owned by an absentee landlord, the capital gains tax rate of 60% applies beginning from 2007.
b) Comprehensive real estate holding taxation has also been strengthened. Previously, the comprehensive real estate holding tax was imposed based on the sum of houses or lands owned by a single person. But the imposition of tax is now made with the basis on the sum of houses or lands held by a single household.
Also, the threshold for the imposition of the tax has increased to 600 million won and 300 million won for residential house and land, respectively.
IV. Broadening tax base through the phase-out of non-taxation benefits and tax relief
For the purpose of broadening tax base, non-taxation benefits and tax relief have been scaled back. Deductions for credit card charges have been lowered to 15% from 20%. Also, the scope of eligibility for tax breaks regarding comprehensive savings has been reduced and, as a result, those under 20 are not qualified for such tax breaks any more. Furthermore, capital gains realized by farmers from the transfer of farmland for the purpose of acquiring another parcel of farmland in its place, which were previously nontaxable, are now 100% tax-exempt with the ceiling of 100 million won for 5 years. Not only that, the non-taxable amount allowed for labor income from foreign sources has been cut to the level of 1 million won per month from 1.5 million won per month. Profit making businesses carried on by the government or local authorities are now subject to tax.
V. Promoting balanced development of all areas of the nation
The expiration date for tax deferral granted for companies whose factories or head office have been relocated out of large cities and the Seoul metropolitan area, respectively, to provinces has been pushed back to the end of the year 2008. The eligibility criterion for tax credit for companies' phased relocation to provinces has also been relaxed and the sunset date for such tax credit has been extended to the end of 2008. Moreover, the scope of industries eligible for special tax credit for SMEs which are located in areas other than the Seoul metropolitan area has been expanded to include ship management, construction waste disposal service, advertising and etc., while the expiration date for such special tax credit system has been extended to the end of 2008 as well.
VI. Enhancing convenience for taxpayers
The year-end tax adjustment process has been simplified. Under the new system, all the necessary documents are handled online with no papers being involved and the NTS is also able to rely on the computer system in confirming whether or not the taxpayer concerned has been unduly granted deductions.