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Application of "Denial Theory of Juristic Personality" in Taxing Capital Gains from Share Transfer Earned by Foreign Investment Companies

In connection with the capital gains from the transfer of shares in SC First Bank by a company established in Labuan of Malaysia, the Seoul Administrative Court (the “Court”) recently held that the Korean tax authority had acted legitimately in imposing the corporate income tax of KRW 43 billion on the purchaser of such shares (the withholding obligor) by deeming the investors of such Labuan company as the actual owner of such gains.

The Court has rendered its decisions supporting the Korean tax authority for taxation over the capital gains from share transfer earned by an investment company established in a foreign country where such capital gains are exempted from tax under the tax treaty with Korea. However, in determining the meaning of “alienator” under the tax treaty, the previous court decisions have applied the Substance over Form Principle under Korean tax law, which is similar to the concept of the beneficial owner under the tax treaty, and have primarily relied on the reasoning that such investment company cannot be viewed as the actual owner of the relevant capital gains.

However, in the above cited case, the Court took a different position from such previous decisions by holding that since the Korea-Malaysia Tax Treaty, without mentioning the beneficial owner, admits the taxation right over the capital gains from transfer of securities only to the country where the alienator is a resident, the alienator cannot be determined based on the beneficial owner, unlike the interest income or dividend income that has provisions regarding the beneficial owner.

In other words, based on the Denial Theory of Juristic Personality, the Court determined that: (a) the investment company in this cited case is a conduit company, which is merely a paper company, established in Labuan to avoid the Korean taxation over the capital gains arising from share transfer; (b) this case falls into the category of where a company was improperly used to avoid the legal application to the investors thereof; and thus (c) the juristic personality of such conduit company can be denied and the investors thereof should be charged for the legal responsibility of such capital gains.

The Denial Theory of Juristic Personality is generally used to protect the creditors of small-sized closed companies or subsidiaries that lack independence. The above cited court decision is the first case that applies the Denial Theory of Juristic Personality to determine the properness of the taxation on the investors of a foreign investment company with respect to the capital gains arising from share transfer earned by such investment company. Therefore, it is worthwhile to further monitor whether such court decision will also be supported by the Supreme Court.

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