The global expansion of AI startups has become a necessary survival strategy rather than a mere option. However, hastily establishing overseas corporations and making initial capital investments can lead to unexpected legal and tax risks, resulting in significant crises. Here are the key legal and tax considerations that you must understand for successful overseas expansion.
I. Key Points
It is possible for AI startups to directly invest abroad to establish subsidiaries with initial capital as long as they comply with the reporting procedures outlined in the Foreign Exchange Transactions Act (Article 3 of the Foreign Exchange Transactions Act). However, for successful settlement, it is crucial not only to remit the capital but also to comply with local laws and to thoroughly prepare for the complex international tax issues that may arise in the future. In particular, if the 'place of effective management' of the overseas subsidiary is deemed to be in Korea, it may be taxed as a domestic corporation, and transactions between the parent company and subsidiary will undergo strict verification for 'arm's length pricing'.
Furthermore, to benefit from tax treaty advantages during profit distribution, the overseas parent (sub) company must have the substance of a ‘Beneficial Owner’.
II. Relevant Legal Norms
A. Overseas Direct Investment and Foreign Exchange Transactions Act
When a domestic startup establishes a subsidiary or branch overseas, it falls under the category of ‘Overseas Direct Investment’ as defined by Article 3, Paragraph 1, Subparagraph 18 of the Foreign Exchange Transactions Act (Article 3 of the Foreign Exchange Transactions Act). 'Overseas Direct Investment' refers to acts such as acquiring shares or equity to participate in the management of a foreign corporation or providing funds for the establishment and operation of overseas sales offices.
If a domestic corporation intends to make such overseas direct investments, it has the obligation to pre-report to the designated foreign exchange bank president or the governor of the Bank of Korea according to the foreign exchange transaction regulations. If it remits investment funds abroad or engages in capital transactions without reporting, it may be subject to penalties for violating the Foreign Exchange Transactions Act (Seoul Central District Court, November 17, 2016, 2016 Go Hap 367 judgment, etc.).
B. International Tax Coordination Act
Transactions with overseas subsidiaries are subject to the International Tax Coordination Act (hereinafter 'ITCA'). The ITCA is a law aimed at preventing tax avoidance through transactions with related overseas subsidiaries, and contains essential tax regulations that overseas enterprises must be familiar with, such as transfer pricing systems, thin capitalization rules, CFC rules, and obligations to report foreign financial accounts.
III. Main Legal and Tax Considerations
A. Corporate Establishment and Investment Stage
Deciding on the Entry Form and Place of Effective Management Risk When expanding abroad, various forms such as local corporations (subsidiaries), branches, and representative offices can be considered, each with different legal statuses and taxation methods. Generally, the most commonly used method is the establishment of a local corporation. It is crucial to note that even if the corporation is established abroad (e.g., in a tax haven), if it is judged that the 'Place of Effective Management' is in Korea, it will be regarded as a domestic corporation and taxed on its global income. The 'place of effective management' is determined based on the location where important and substantive decisions necessary for business operations, such as board meetings, the place where the CEO performs duties, and the place where accounting records are kept, are made. Therefore, it is very important for the overseas subsidiary to have an independent decision-making structure and substantial personnel and assets.
Foreign Exchange Transaction Reporting and Foreign Financial Account Reporting Obligation Before investing (remitting) initial capital into an overseas subsidiary, the reporting procedures for overseas direct investment under the Foreign Exchange Transactions Act must be completed. Additionally, domestic corporations that effectively control the subsidiary, such as owning 100% of the subsidiary, may also have reporting obligations for foreign financial accounts in the subsidiary's name. The ITCA imposes reporting obligations on the beneficial owners if the foreign financial account holder and the beneficial owner are different. The Supreme Court has regarded a domestic parent company that owns 100% of the shares in the overseas subsidiary as the 'beneficial owner' of the foreign financial account, determining it as the obligated party for reporting (Supreme Court, March 12, 2020, 2019 Do 11381 judgment, etc.).
B. Corporate Operation and Profit Recovery Stage
Transfer Pricing System All transactions (international transactions) between the parent company and subsidiary, such as licenses for intangible assets (IP), management consulting, and loans, which are core assets of the AI startup, must be conducted at 'arm's length' under the ITCA. 'Arm's length' refers to the price expected to be applied between independent enterprises without special relationships. If it is determined that excessive or insufficient amounts have been exchanged, leading to an inappropriate transfer of domestic income to the foreign subsidiary, the tax authorities may regard the difference as the income of the parent company and impose additional corporate tax (Tax Tribunal, September 24, 2018, 2018-혁구0186 ruling). Especially, determining the arm's length price for service transactions such as guarantee payments, technical support, and management consulting fees is very complex, and the help of experts is essential.
Receiving Dividends and Tax Treaties When repatriating profits from the foreign subsidiary as dividends, the taxing rights on dividend income are adjusted according to the tax treaty between the host country and South Korea. Most tax treaties establish lower withholding tax rates than domestic tax law to prevent double taxation (Daejeon High Court, January 29, 2021, 2020 Nu 10782 judgment). However, to benefit from these tax treaty advantages, the overseas subsidiary must not merely exist as a paper company (Conduit Company), but must actually be a ‘Beneficial Owner’ who substantially controls and manages the respective dividend income (Suwon District Court, November 19, 2020, 2019 Gu Hap 69903 judgment). A nominal company that merely serves to pass income directly to the upper parent company without substantial personnel or assets will not be recognized as a beneficial owner, and thus may be deprived of the benefits of the tax treaty, resulting in the application of high rates of corporate tax under domestic laws (Tax Tribunal, July 26, 2018, 2018 Seo 2202).
CFC Taxation If a subsidiary is established in a country with significantly low corporate tax burdens (tax havens), and that subsidiary does not remit income to the domestic company through dividends but retains it locally, the specific foreign corporation (CFC) retained earnings deemed for dividend rules under the ITCA may apply. This is a powerful anti-tax avoidance measure that treats the remaining earnings of the overseas subsidiary as if the domestic parent company received them through dividends, thus subjecting them to immediate taxation domestically (Tax Tribunal, July 1, 2013, 2013 Bu 4653).
4. Practical Checkpoints
To ensure the successful overseas expansion and settlement of AI startups, the following points must be thoroughly checked.
Selecting the Entry Country: Careful selection of a country that aligns with business objectives and has low tax and legal risks is essential. In particular, the tax treaty content between the target country and South Korea should be meticulously reviewed in advance.
Establishing the Substance of the Overseas Subsidiary: You must thoroughly prepare evidence that the subsidiary is engaging in substantial business activities and not merely existing as a nominal company, such as an independent decision-making board, hiring local personnel, and securing office space.
Establishing Pricing Policy for Transactions: A clear pricing policy (transfer pricing policy) for all transactions between the parent and subsidiary must be established, and related contracts and supporting materials should be thoroughly documented.
Collaboration with Experts: To effectively address complex foreign exchange transaction laws and international tax issues, it is crucial to work closely with legal and accounting experts from the planning stage.
Compliance with Local Laws: Strict compliance with the local laws, including company laws, labor laws, intellectual property laws, and data protection laws (e.g., GDPR), of the host country is essential. It is advisable to seek advice from local legal experts for this purpose.
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