Practice & risk allocation Despite the new OIV rules, foreign PE funds continue to deal with uncertainties when assessing the CGT position of their ultimate investors, (i.e. the LPs), if only because the ‘beneficial ownership’ concept is inherently subjective and in constant flux. Equally, evidenced by history, the NTS may scrutinize a CGT position taken and aim to assess underpaid CGT, plus interest and penalties from the buyer or the Target. Kim/Everett note the following on the practice in Korea: “The NTS will scrutinize the CGT positions of foreign funds under audit, focusing on whether the OIV rules have been properly applied, whether the requisite filings were made, and whether the filings are supported by tax residency certificates and other documentation supporting beneficial ownership conclusions. Recent Tax Tribunal decisions 5 and tax rulings provide comfort that the OIV rules will be respected, and the OIV will not be deemed as the beneficial owner except in the limited cases described above. While it is possible to seek additional rulings to clarify the treatment in unique situations, there is currently sufficient clarity to look through the OIV based on the OIV rules.” In the case of significant CGT exposure, buyers and sellers may stake out opposing positions during negotiations because of the risk of a future assessment by the NTS. It can become a contentious issue in the negotiations as buyers do not want to risk NTS holding them accountable. As such, buyers typically require a seller indemnity spanning the duration of the statute of limitations with financial security, such as an escrow. 6 How TLI can help M&A transactions involving specific indemnities and holdbacks to deal with CGT risks are not always ideal. For instance, the seller might be looking for a ‘clean exit’ from the Target and may not be willing to stand behind potential tax liabilities arising post-completion. Also, the buyer may not be comfortable with recourse through only an indemnity. A misalignment between deal parties on risk allocation might spiral into a deal-breaker. This is where TLI steps in. A TLI policy offers deal parties a quick and capital-efficient solution to take the risk off the negotiation table by covering a potential financial loss arising from a successful challenge of the agreed CGT position. This way, no party bears the risk and indemnities and holdbacks are avoided.
If the Fund exits a particular investment, the SPV will typically sell the Target shares, resulting in a capital gain (provided the investment has been successful). The question is then whether a CGT exemption under a tax treaty is available. Now this is where it gets complicated, as Kyu Dong Kim and Jeremy Everett, partners at Yulchon, explain: “A determination must first be made as to who is the beneficial owner of the capital gain. 4 Supreme Court decisions look at beneficial ownership in the context of Korea’s ‘substance-over-form’ rules, which allow the NTS to look through legal form if the recipient of the income does not carry on normal business activities or was established solely for tax avoidance purposes. The aggressive application of these rules has resulted in substantial tax assessments, particularly for PE funds, which assessments have largely been appealed over the course of the past 15 years with inconsistent results. To address this uncertainty, new procedural rules became effective in 2012 and 2014 that introduced an Overseas Investment Vehicle ( OIV ) reporting system that provided clarity on the determination of beneficial ownership when funds are involved. Under the OIV rules, a fund cannot be considered the beneficial owner and cannot claim a reduced treaty rate or exemption in its own name. Instead, the fund is responsible for gathering information and filing designated forms on behalf of the ultimate investors that is used to determine and report the beneficial owners, the applicable treaties, and the amount of withholding tax due. These rules are now widely accepted, and recent Tax Tribunal decisions on the determination of beneficial ownership after the introduction of the OIV regime have helped provide comfort and greater certainty that the OIV regime will be respected. The 2019 Tax Reform bill added further clarity and bridged the gap between existing court decisions and the original intent of the OIV rules. These rules, which went into effect on January 1, 2020, allow a limited exception to the general look- through treatment of OIVs in rare cases in which the OIV is liable to tax in its country of residence, is subject to a higher rate of withholding tax than the ultimate investors would have been subject to (lack of tax avoidance motive) and the OIV is considered the beneficial owner under the applicable tax treaty. Further, the OIV may be subject to tax (under domestic tax law without the application of a tax treaty) if the OIV fails to provide the required information on the beneficial ownership and treaty status of its ultimate investors.”
4 In the due diligence process, withholding tax exposure may also be discovered in relation to assumptions regarding the beneficial owner(s) for prior dividend, interest, and royalty payments of the target. 5 Including the Prudential real estate fund case and AEP/KKR case. 6 In some cases, buyers require sellers to keep the SPV ‘alive’ for the duration of the indemnity, which also results in additional costs and administrative burdens.
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