South Korea is a Rising Sun on the Islamic Finance Horizon
By: Camille Paldi
Paldi says that South Korea has taken many steps towards entering the global Islamic finance market including tabling legislation, engaging in training seminars and hosting conferences, as well as joining various Islamic financial regulatory bodies, preparing for sukuk issuance, and tapping into the London Murabahah Exchange. South Korea, which is one of the major exporters to Islamic nations, has explored the Halal market and Islamic finance may be the natural progression to diversify its investments, assets, and markets and stimulate the Korean economy, keeping the nation competitive. Seoul is not only preparing to enter the Islamic financial market, however, strives to become a hub of Islamic finance in East Asia in competition with Japan, Hong Kong, and Singapore.
Several Korean companies including GS Caltex, Korean Air, Hyundai, Samsung and others are reportedly exploring the possibility of raising funds from the sukuk market. South Korean Chaebols including Lucky Goldstar, Samsung, Korea Shipping and several others have in the past accessed Islamic commodity Murabahah facilities structured through London.
South Korea’s Export-Import Bank of Korea already has a bond programme in Malaysia that can issue Islamic bonds, or sukuk, although it has yet to tap the market. One problem for the domestic Korean market is that the amendment to the Special Tax Treatment Control Act (STTCA), which will facilitate sukuk issuance in Korea has not yet been approved. Local supporters of the introduction of Islamic finance products are confident that the delay is a minor setback. The main hurdles are taxation issues relating to double stamp duty, value added tax (VAT), capital gains, and the definition of what constitutes a security. From a conventional point of view, sukuk for instance, may look like asset-backed securities or like investment certificates. There must be a standard guideline that sukuk are considered as securities. Fortunately, these issues have been recognized by the Financial Supervisory Service of Korea and the central bank.
Although Korea is a latecomer to Islamic finance in Asia, Seoul is trying to promote Korea as a future Islamic finance hub similar to Hong Kong, Singapore, and Japan. Kim Jong Chang, Governor of the Financial Supervisory Service of Korea, the financial services regulator, believes that Islamic finance is a good innovation in the global financial market and has stressed that the Korean government is committed to facilitating it in Korea. Korea believes that the global financial crisis has shown that financial services cannot be divorced from the real economy and sees an ideal fit between its vast industrial base and Islamic finance. Local bankers acknowledge that conventional derivatives, which divorce financial services from the real economy, have historically destabilized the global financial system.
The Bank of Korea is the 59th regulatory body to join the IFSB, bringing total membership to 184, joining the likes of the central banks of Luxembourg and Japan and the monetary authorities of Hong Kong and Singapore. This movement is expected to create a link between Korea and Islamic finance hubs in Southeast Asia. South Korea is definitely a rising sun on the Islamic finance horizon.
During 2007 – 2008, many companies established strategic partnerships with Muslim countries i.e. Good Morning Shin-Han Securities Co. Ltd. and Kenanga Investment Bank Bhd in Malaysia, Korea Investment Co. Ltd. and Malaysia Berjaya Land Berhadin, Daewoo Securities Co. Ltd. and CIMB Investment Bank (Malaysia), and Woori Investment Securities Co. and Am Bank Group in Malaysia. Woori Investment Securities Co. has also entered an MOU with Qatar Islamic Bank for business in corporate finance and investment banking. Due to the rejection of the revised tax bill submitted by the Ministry of Strategy and Finance to the Korean parliament in 2009, these companies took a big hit in terms of financial loss from cancelled sukuk issuances.
Under the current legal system, if sukuk is issued, additional costs will be attached (1.5% – 3.3%) as compared with a conventional bond. Therefore, the Korean government tried to change the law in 2009, however, without success. The current Special Tax Treatment Control Act Article No. 21 defines tax exemption of interest income for foreign currency bonds. The Ministry of Strategy and Finance tried to add No. 2 to article 21. The revised bill can be summarized as follows: domestic corporations would issue the sukuk with foreign currency through a foreign corporate body and the income from sukuk would be considered as interest income.
The tax treatment of ijarah sukuk can be summarized as follows: Exemption on withholding tax from consideration of rental interest, corporate tax will be exempt. Exemption on transfer, registration, and acquisition taxes – when the underlying asset is transferred for sale and resale, the transfer, registration, and acquisition taxes will be exempt. Moreover, in case of sale and resale and payment of rental value-added tax also will be exempt.
The tax treatment for murabahah sukuk can be summed up as follows: Exemption on withholding tax- the profit margin paid by domestic corporations to SPV will be considered as interest and corporate tax will be exempt. Exemption on value-added tax- when the domestic corporation and the SPV sell the underlying asset, value-added tax will be exempt.
The tax problem is the largest hurdle in Korea so far. According to National Accounting Law, while the interest from conventional bonds is considered as an expense and could be a tax exemption, dividends from sukuk are subject to tax. Due to non-tax neutrality, in practice there is a low possibility of sukuk being issued in Korea.
Taxation of Ijarah sukuk can be divided into three phases. The first phase is when the originator transfers the underlying asset to the SPV. At this level, according to the Value-Added Tax Act, Article 1 transfers the underlying asset to the SPV. At this level, according to the Value-Added Tax Act, Article 1, when the asset is transferred to the SPV, this supply of goods is taxable. At the same time, ownership will be transferred, so that income directed to the originator is subject to corporate tax according to Corporate Tax, Article 3. Additionally, registration and acquisition tax will result from the asset transfer.
According to Article 55 of the Corporate Tax Act, corporate tax on the income of a domestic corporation for each business year shall be as follows: 10 % for the cases in which the tax base is less than 200 million won; and 22% for the cases in which the tax base is more than that specified amount (20% after 2012). In addition, an SPV acquiring real estate shall pay the following: 2% of the acquisition values as an acquisition tax, according to Art. 11 of the Local Tax Act, and 10% of the supplied value (value of transfer), which includes all o the monetary value except for such items such as land and houses subject to exemption in accordance with article 12 and article 13 of the Value-Added Tax Act.
The second phase of taxation is when the SPV leases back the asset to the originator, and the originator pays rental to SPV. The rental fee is taxable as it conforms to the supply of services, according to the Value-Added Tax Act, article 7 and according to Article 16. In addition, when the SPV receives rental fees from the originator, it is consoidered as an income of lease, which is subject to corporate tax. The profit is moved to the sukuk holder as a periodic distribution; they are also subject to pay the corporate tax of investment income. The last phase is the maturity date. The SPV sells back the underlying asset to the originator. This time, the same tax that was incurred in the first phase will be attached.
In the case of murabahah sukuk, taxation can also be divided into three phases where tax is attached. First, when the SPV sells the underlying asset to originator, the SPV will be subject to corporate tax and value-added tax due to the sale of the asset. Second, when the originator sells the asset to a third party, corporate tax and value-added tax will be attached. Third, when the originator pays the principle and mark-up of the asset, the mark-up will be considered as income from sukuk. In this case, corporate tax will be attached to the SPV and the sukuk-holder.
Korea also does not recognize the separation of ownership in the process of asset transfer. Therefore, both when the asset is transferred to the SPV and when it is moved back to the originator leads to transfer of legal ownership. Movements of the asset are accompanied by taxes: transfer –of-asset tax, value-added tax, and registration and acquisition tax. Originally, Korean trust law saw all economic interest as belonging to the beneficiary, not to the trustee; accordingly, only the beneficiary is the tax payer according to Income Tax Act, Article 2 (Scope of Tax Liability).
Sukuk could be considered as being the same asset securitization in Asset-backed securitization Act, Article 2 (Definitions). However, even though asset-backed securitization in a conventional banking system is most similar to sukuk, there are some significant differences that lead to difficulties related to the application of the current law to sukuk. First, at the maturity date, asset securitization has a buy-back option over asset ownership. The buy-back option could be applied when real estate is sold; if, after some period, there were no profits, the seller must promise to the buyer to buy back the asset. However, with the sukuk the originator can only buy back the asset at maturity and the price of the asset must be the same as it was in the beginning. Second, asset securitization allows the lease and investor to establish an SPV, while with sukuk the issuer has the entire share of the SPV due to the fact that the issuer of sukuk has higher responsibility. Third, asset securitization in conventional banking and sukuk have different scopes for the underlying assets. Asset securitization includes all tangible and intangible assets, including real estate and secured bonds. However, sukuk only allows tangible assets.
With regards to asset securitization, current banking law also is not in favor of sukuk issuance. Domestic banks and financial institutions are not allowed to deal with real assets except for the purpose of business. In the Enforcement Decree of Banking, sale of real assets is not included (Article 18). Moreover, according to the Banking Act, article 28, banks cannot own non-business real estate except in cases for security; business real estate could be owned if it comprises less than 60% of the total capital. Therefore, domestic banks will face difficulty when they issue corporate sukuk due to the difficulty in adequately backing the sukuk with real assets (Tariqullah Khan, Elsiefy Elsayed, and Eun Kyoung Lee).
I believe that if the business, finance, and legal lobbies in Korea draft and submit an amended tax and other relevant laws and utilize the right lobbying and PR firms, we can see the tax revision within the next two years and soon after a debut sukuk from South Korea.