By Anthony Diosdi
The major purpose of an income tax treaty is to mitigate international double taxation through tax reduction or exemptions on certain types of income derived by residents of one treaty country from sources within the other treaty country. Because tax treaties often substantially modify U.S. and foreign tax consequences, the relevant treaty must be considered in order to fully analyze the income tax consequences of any outbound or inbound transaction. The U.S. currently has income tax treaties with approximately 58 countries. This article discusses the implications of the United States.-Republic of Korea Income Tax Treaty.
There are several basic treaty provisions, such as permanent establishment provisions and reduced withholding tax rates, that are common to most of the income tax treaties to which the U.S. is a party. In many cases, these provisions are patterned after or similar to the United States Model Income Tax Convention, which reflects the traditional baseline negotiating position. However, each tax treaty is separately negotiated and therefore unique. As a consequence, to determine the impact of treaty provisions in any specific situation, the applicable treaty at issue must be analyzed. The United States- Republic of Korea Income Tax Treaty is no different. The treaty has its own unique definitions. We will now review the key provisions of the United States-Republic of Korea Income Tax Treaty and the implications to individuals attempting to make use of the treaty.
Definition of Resident
The tax exemptions and reductions that treaties provide are available only to a resident of one of the treaty countries. Income derived by a partnership or other pass-through entity is treated as derived by a resident of a treaty country to the extent that, under the domestic laws of that country, the income is treated as taxable to a person that qualifies as a resident of that treaty country. Under the U.S. Model Treaty, a resident is any person who, under a country’s internal laws, is subject to taxation by reason of domicile, residence, citizenship, place of management, place of incorporation, or other criterion of a similar nature. Because each country has its own unique definition of residency, a person may qualify as a resident in more than one country.
For example, Paragraph 1, Article 3 of the US.- Korea Tax Treaty provides that “resident,” when in the U.S., refers to the U.S. legal definition of the term, and when in Korea, vice-versa. However, the situation is complicated because Korea income tax law applies a different definition that is not mutually exclusive to U.S. tax law in determining individual residency. The Korean standard as found in Paragraph 1, Article 1 of the Korean Income Tax Law provides that a resident is “[a] person who holds his domicile in Korea or has held his temporary domicile in Korea for one year or more.” In addition, in Article 2 of the Presidential Decree, the Korean Income Tax Law provides that “the domicile shall be determined based on the objective facts such as a family living together and property situated in Korea, and the abode shall be the place where an individual stays for a substantial period but does not lead a normal life unlike a domicile.” See (Act No. 9672/2009) (Kor.). The Presidential Decree also provides that “where an individual who resides in Korea has 1) an occupation which requires more than one year of continuous stay in Korea or 2) has a family living together and is judged to reside for more than one year in light of his occupation and property, he shall be treated as having a domicile in Korea.”
Section 7701(b) of the Internal Revenue Code treats an alien individual as a U.S. resident where such an individual is 1) lawfully admitted for permanent residence, (26 C.F.R. Section 301.7701(b)-1(b)(1)) “Green card test:” An alien is a resident alien with respect to a calendar year if the individual is a lawful permanent resident at any time during the calendar year. A lawful permanent resident is an individual who has been lawfully granted the privilege of residing permanently in the United States as an immigrant in accordance with the immigration laws. Resident status is deemed to continue unless it is rescinded or administratively or judicially determined to have been abandoned.”) (2) meets the substantial presence test, (An individual meets the substantial presence test with respect to any calendar year if i) such individual was present in the United States at least thirty-one days during the calendar year, and ii) the sum of the number of days on which such individual was present in the United States during the current year and the two preceding calendar year (when multiplied by the applicable multiplier: current year – 1, first preceding year – ⅓, second preceding year – ⅙) equals or exceeds 183 days) or iii) makes a first year election.
It is entirely possible that a Korean may be a “resident” of both the United States and Korea simultaneously. A tie-breaker provided for in paragraph 2, Article 3 of the U.S.-Korea Tax Treaty can be applied, which looks at factors such as permanent residence, vital interests and citizenship, but again, the end result can be “equal,” and in this case the treaty provides that the question is settled by “mutual agreement.” See U.S.-S. Kor., art 3, para. 2(e).
Business Profits and Permanent Establishment
A central issue for any company exporting its goods or services is whether it is subject to taxation by the importing country. Most countries assert jurisdiction over all the income from sources within their borders, regardless of the citizenship or residence of the person receiving that income. Under a permanent establishment provision, the business profits of a resident of one treaty country are exempt from taxation by the other treaty country unless those profits are attributable to a permanent establishment located within the host country. A permanent establishment includes a fixed place of business, such as a place of management, a branch, an office, a factory or workshop. A permanent establishment also exists if employees or other dependent agents habitually exercise in the host country an authority to conclude sales contracts in the taxpayer’s name.
The United States-Korea Tax Treaty defines a permanent establishment as a fixed place of business through which a resident of one of the Contracting States engages in industrial or commercial activity. This includes the following: 1) a banh; 2) an office; 3) a factory; 4) a workshop; 5) a warehouse; 6) a store or other sales outlet; 7) a mine, quarry, or other place of extraction of natural resources; and 8) a building or construction or installment project which exists for more than 6 months. See note 2, at art 9. The treaty specifically excludes certain activities from the definition of permanent establishment. Some of these activities are: 1) the use of facilities for the purpose of storage, display, or delivery of goods or merchandise belonging to the resident; 2) the maintenance of a stock of goods or merchandise belonging to the resident for the purpose of storage, display, or delivery; 3) the maintenance of a stock of goods or merchandise belonging to the resident for the purpose of processing by another person; 4) the maintenance of a fixed place of business for the purpose of purchasing goods or merchandise, or for collecting information, for the resident; 5) the maintenance of a fixed place of business for the purpose of advertising, for the supply of information, for scientific research, or similar activities which have a preparatory or auxiliary character, for the resident; or 6) the maintenance of a busining site or construction or installation project which does not exist for more than 6 months.
Personal Services Income
Treaty provisions covering personal services compensation are similar to the permanent establishment clauses covering business profits in that they create a higher threshold of activity for host country taxation. Generally, when an employee who is a resident of one treaty country derives income from services performed in the other treaty country, that income is usually taxable by the host country. However, the employee’s income is exempted from taxation by the host country if the following requirements are satisfied: 1) the employee is present in the host country for 183 days or less; 2) the employee’s compensation is paid by, or on behalf of, an employer which is not a resident of the host country; and 3) the compensation is not borne by a permanent establishment or a fixed base which the employer has in the host country.
Article 18 of the United States-Korea Income Tax Treaty permits income derived by an individual who is a resident of one Contracting States from the performance of personal services in an individual capacity, may be taxed by that Contracting State.Income derived by an individual who is a resident of one of the Contracting States from the performance of personal services in an independent capacity in the other Contracting State may be taxed by that other Contracting State, if: a) The individual is present in the Contracting State for a period or periods aggregating 183 days or more in the taxable year; b) Such income exceeds 3,000 United States dollars or its equivalent in Korea won in a taxable year; or c) The individual maintains a fixed base in that other Contracting State for a period or periods aggregating 183 days or more in the taxable year, but only so much of his income as is attributable to such fixed base.
Dividends, Interest, and Royalties
Like the United States, most foreign countries impose flat rate withholding taxes on dividends, interest, and royalty income derived by offshore investors from sources within the country’s borders. Tax treaties usually reduce these withholding taxes. Tax treaties usually reduce the withholding tax rate on dividends to 15 percent or less. The United States-Korea Income Tax Treaty provides that tax on dividends shall not exceed 15 percent on the gross amount of dividend for individuals and 10 percent of the gross amount of the dividend when the recipient is a corporation. However, dividends may be taxed by each country.
Tax treaties also usually reduce the withholding tax rate on interest to 15 percent or less. Under the United States-Korea Income Tax Treaty, interest arising in a contracting state and paid to a resident of the other contracting state may be taxed in that other contracting state. However, the tax so charged shall not exceed 12 percent of the gross amount of the interest.
Most tax treaties provide for lower withholding tax rates on royalties. Typically, the rate is 10%. The U.S.-Korea Tax Treaty withholding rate is also 10 percent. The term “royalty” or “royalties” as used in the United States-Korea Income Tax Treaty means-
1) Payment of any kind made as consideration for the use of, or the right to use, copyrights of literary, artistic, or scientific works, copyrights of motion pictures films or films or tapes used for radio or television broadcasting, parents, designs, models, plans, secret processes or formulae, trademarks, or other like property or rights, or knowledge, experience, or skill (know-how), or ships (but only if the lesser is a person not engaged in the operation in international traffic of ships or aircraft), and
2) Gains derived from the sale, exchange, or other disposition of any such property or rights (other than ships or aircraft) to the extent that the amounts realized on such sale, exchange, or other disposition for consideration are contingingent on the productivity, use, or disposition of such property or rights.
Private Pensions and Annuities
Under the United States-Korea Income Tax Treaty, pensions and other similar remuneration paid to an individual who is a resident of one of the Contracting States in consideration of past employment shall be taxable only in the Contracting State. The term “pension and other similar remuneration,” as used in the treaty, means periodic payments. This provision of the treaty provides an excellent opportunity for a non-resident of the United States to utilize the U.S.-Korea Income Tax Treaty to reduce or eliminate the U.S. tax consequences associated with an Individual Retirement Account (“IRA”) or 401(k) plan distribution. For example, let’s assume that Tom is a Korean national that came to the U.S. on an E-3 Visa for a short-term assignment. While working in the U.S., Tom contributed money to an IRA. Tom has returned to Korea and would like to withdraw money from his U.S. based IRA. However, Tom is concerned about the U.S. 20% withholding tax and the 10% early withdrawal penalty.
Since Tom is a citizen of Korea, a country that the U.S. has a bilateral income tax treaty, Tom may utilize the U.S.-Korea Income Tax Treaty to avoid the 20% withholding tax and the early withdrawal penalty. This is because under Article 23, Paragraph 3, of the U.S-Korea Income Tax Treaty, “pensions and other similar remuneration paid to an individual who is a resident of one of the Contracting States in consideration of past employment shall be taxable only in that State.” The Technical Explanations to the treaty further explain that “paragraph 3 provides that pensions derived and beneficially owned by a resident of one of the Contracting States in consideration of past employment..shall be taxable only in the State [of residency].” This means that under the applicable provisions of the U.S.-Korea Income Tax Treaty, the country of residence has the sole taxing rights over pension distributions.
The terms “pensions and other remuneration” is not defined in the U.S.-Korea Income Tax treaty. However, the OECD defines the word “pension” under the ordinary meaning of the word which covers periodic and non-periodic payments. The OECD also provides that a lump-sum payment in lieu of periodic pension payments that is made on or after cessation of employment may fall within the definition of Article 23. See OECD 2014 Commentary, Art 18. Thus, although Article 23 of the U.S.-Korea Income Tax Treaty makes a reference to “periodic payments,” the word “periodic” does not preclude Tom from excluding a lump sum IRA distribution from U.S. federal income tax. Even though the OECD or Article 18 of the U.S.-Korea Income Tax Treaty does not mention the term IRA, the IRS has clarified that IRAs can be defined as pensions for articles in U.S. income tax treaties. See PLR 200209026. Since Tom is a resident of Korea, he can utilize the U.S.-Korea Income Tax Treaty to avoid U.S. federal tax on the distribution from his IRA.
The United States- Korea Income Tax Treaty also provides that alimony and annuities shall only be taxable in the Contracting State in which the payments are received.
Social Security Payments
According to the United States- Korea Income Tax Treaty, Social Security payments and other public pensions public pensions paid by one Contracting State to an individual who is a resident of the other Contracting State (or in the case of such payments by Korea, to an individual who is a citizen of the United States) shall be taxable only in the first-mentioned Contracting State.
Gains from the Disposition of Property
Under the U.S. Model Treaty, gains from the disposition of property, such as capital gains on the sale of stocks and securities, generally are taxable only by the country in which the seller resides. United States-Korea Income Tax Treaty, provides that a resident of one of the Contracting States shall be exempt from tax by the other Contracting State on gains from the sale, exchange, or other disposition of capital assets unless:
1) The gain is derived by a resident of one of the Contracting States from the sale, exchange, or income from real property;
2) The recipient of the gain, being a resident of one of the Contracting States, has a permanent establishment in the other Contracting State and the property giving rise to the gain is effectively connected with such permanent establishment, or
3) The recipient of the gain, being an individual who is a resident of one of the Contracting States- a) maintains a fixed base in the other Contracting State for a period or periods aggregating 183 days or more during the taxable year and the property giving rise to such gains is effectively connected with such fixed base, or b) is present in the other Contracting State for a period or periods aggregating 183 or more during the taxable year.
Income from Real Property
Tax treaties typically do not provide tax exemptions or reductions for income from real property. Therefore, both the home and the host country maintain the right to tax real property income. This rule applies to rental income, as well as gains from the sale of real property. The United States-Korea Income Tax Treaty is no different.
Disclosure of Treaty-Based Return Positions
Any taxpayer that claims the benefits of a treaty by taking a tax return position that is in conflict with the Internal Revenue Code must disclose the position. See IRC Section 6114. A tax return position is considered to be in conflict with the Internal Revenue Code, and therefore treaty-based, if the U.S. tax liability under the treaty is different from the tax liability that would have to be reported in the absence of a treaty. A taxpayer reports treaty-based positions either by attaching a statement to its return or by using Form 8833. If a taxpayer fails to report a treaty-based return position, each such failure is subject to a penalty of $1,000, or a penalty of $10,000 in the case of a corporation. See IRC Section 6712.
The Income Tax Regulations describe the items to be disclosed on a Form 8833. The disclosure statement typically requires six items:
1. The name and employer identification number of both the recipient and payor of the income at issue;
2. The type of treaty benefited item and its amount;
3. The facts and an explanation supporting the return position taken;
4. The specific treaty provisions on which the taxpayer bases its claims;
5. The Internal Revenue Code provision exempted or reduced; and
6. An explanation of any applicable limitations on benefits provisions.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic tax attorney and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.