Substance-over-form principle

Substance-over-form principle (실질주의 원칙/實質主義原則) is found in such cases as evaluation of a legal document, accounting, taxation, and so forth.

Take an example of a letter of guarantee. Even though its title is the letter of comfort, its substance amounts to a letter of guarantee if the author uses the active word like guarantee or ensure.

In accounting, substance over form is an important principle used "to ensure that financial statements give a complete, relevant, and accurate picture of transactions and events". If an entity practices the 'substance over form' concept, then the financial statements will show the overall financial reality of the entity (economic substance), rather than the legal form of transactions (form). In accounting for business transactions and other events, the measurement and reporting is for the economic impact of an event, instead of its legal form. Substance over form is critical for reliable financial reporting. It is particularly relevant in cases of revenue recognition, sale and purchase agreements, etc.

In taxation, the substance over form principle prevails all over the world. The following report of Shin&Kim explains the principle from the Korean perspective.

Key words
subtance-over-form principle, OECE Model Tax Convention, UN Model Tax Convention, SPC, conduit, resident

OECD Model Tax Convention
As taxation has a considerable influence on the rate of return of a cross-border investment, a tax treaty between countries is also important. In general, such a treaty is modeled upon the OECD Model Tax Convention or the UN Model Tax Convention, with revisions made as countires deem necessary.

The OECD Medel Tax Convention provides that the income-source country shall impose taxes on the real-estate income of the "resident" of a contracting state but the resident country shall impose taxes on gains from share transfers.

In contrast, the UN Model Tax Convention provides that the income-source country shall have the taxation right with respect to gain from a share transfer if the share acquisition exceeds a certain threshold and the resident country shall have such taxation right in other cases.

The two tax conventions are similar in that both provide that the income-source country shall impose taxes on the real-estate income of the resident of a contracting state. Because tax treaties differ on the treatment of gains from share trnasfers, there are differences in many cases of actual taxation depending on which tax treaty is applied. The matter of which tax treaty is applicable is crucial to someone investing in shares in a foreign company.

In case of SPC in tax haven
In the event that a foreign corporation establishes a special purpose company (SPC) in a tax haven and makes an investment in Korea, and then earns income from such an investment, such an SPC meets the requirements of a "resident" in the tax haven in most cases, as it is established under license or authorization pursuant to the provisions of local laws. Therefore, generally, an investor who has established an SPC in a contracting state to invest in shares in the other contracting state under tax planning argues that:

(i) such an SPC shall not be subject to taxation by the other contracting state as it constitutes a "resident" of a contracting state

(ii) the status of the "resident" of the SPC recognized by a contracting statte under the tax treaty shall not be denied and the benefits under such tax treaty shall not be deprived under the substance-over-form principle pursuant to the internal law of the other contracting state, and

(iii) even if the substance-over-form principle is applicable, the tax treaty between a contracting state and the other contracting state shall apply to the SPC, as it is a company with legal substance, not a conduit.

Positions of Korean government and courts
Korean taxation authorities treat an SPC of an ivestor as a conduit of the investor and apply the substance-over-form principle to the SPC under domestic tax laws, and accordingly impose corporate income taes on the investor, treating the investor as the owner of the capital gain from the share transfer transcation if the SPC was created as a formality, according to the pre-designaed investment/governance structures only for tax-avoidance purposes through "treaty shopping" regardless of whether the SPC is a resident of a contracting state.

Courts in Korea have accepted the position of Korean taxation authorities. In fact, regarding several recent cases in which an issue was whether the tax treaty is applicable, the court has consistently denied thae application of benefits under a tax treaty between a contracting state and the other contracting country, applying the substance-over-form principle in line with the position of Korean taxation authorities, and ruled that the applicable tax treaty is the one signed by and between a country of which the actual investor is a resident and the other contracting state.

Such judgments are based on the view that the substance-ver-form priciple may be applied as standard of the interpretation of the relevant tax treaty even if such a tax treaty does not contain separate provisions on the substance-over-form principle, as it is based on the Constitution of the Republic of Korea. The position of Korean courts is that the substance-over-form principle is a legal system designed to realize the principle of equlity of tax burden, which has been derived from the principle of equality or that of prohibition of discrinination, as provided in Article 11 (1) of the Constitution.

Conclusion
Then, arguments can be made about to what extent the substance-over-form principle is applicable. It is clarified by existing precedents that

1. the substance-over-form principloe shall apply in determining who is a "party to which the capital gain belongs" at least, and

2. the application of the substance-over-form principle shall neither deny the effect of an agreement under private laws validly constituted between the parties nor create a new agreement.