|A. Outline of Thin Capitalization Rule
A multinational enterprise (MNE) may adopt a tax avoidance mechanism under when the contribution of paid-in capital to its subsidiary in Korea is decreased, while increasing its loans to the subsidiary as much as possible. This may result in the minimization of the taxable income of the subsidiary through the increase in interest expense deduction of the subsidiary. Under such an arrangement, non-deductible dividend payments are replaced with deductible interest payments.
To cope with such an arrangement, the LCITA and its enforcement decree contain thin capitalization rules; whereby if a Korean company borrows from its controlling shareholders overseas (CSO), an amount greater than three times its equity (six times in the case of financial institutions) interest payable on the excess portion of the borrowing, computed as shown below, are re-characterized as dividends to which the article on dividends in tax treaty applies. Therefore, treated as non-deductible in computing taxable income.
For purposes of the thin capitalization rules, money borrowed from a CSO includes amounts borrowed from an unrelated third party based upon the CSO's guarantee.
The following is the formula for computing non-deductible interest:
Non-deductible interest = Interest and discount payable to CSO X B/A
A: Debt borrowed from the CSO or guaranteed by the CSO;
B: A - [Paid-in capital contributed by the CSO X 3 (or 6 in the case of a financial institution)].
|B. Debt Under an Arm's Length Situation
Although the ratio of debt owed to a CSO to equity exceeds 3:1, as long as the conditions and the amount of debt owed to a CSO are reasonably compared to the debt from an independent third party, such debt from the CSO will be excluded from the scope of the debt subject to thin capitalization rules. As a result, interest on such debt will be deductible.
Anti-thin capitalization that originated from the arm's length principle is adopted from Article 9(1) of the OECD Model Tax Convention. Thus, if given requirements are satisfied, the debt-equity ratio prevailing in the industry (rather than a 3:1 or 6:1 ratio) will be applied.