In light of the remarkable growth of Islamic finance and its increasing relevance in the global finance market, market participants in South Korea are turning to Islamic finance. The Government and various regulatory authorities in Korea are streamlining legal, regulatory, accounting and tax requirements. However, the non-conventional structures and instruments of Islamic finance present unique challenges. This article examines the typical features of Sukuk, the structure of Sukuk, the legal nature of Sukuk in Korea and the tax issues and reform proposals relating to Sukuk.
This article is part of the PLC multi-jurisdictional guide to securitisation. For a full list of contents visit www.practicallaw.com/securitisation-mjg.
In light of the remarkable growth of Islamic finance and its ever increasing relevance in the global finance market, as a conduit between oil-rich countries in the Middle East as well as other Islamic countries in Asia and the rest of the world, market participants in South Korea (Korea) are turning their eyes to Islamic finance. To keep pace with global trends and to take advantage of the huge potential for market growth, by becoming a direct or indirect participant in the Islamic finance market, the Korean Government and various regulatory authorities in Korea are making genuine efforts to support such entry, by streamlining legal, regulatory, accounting and tax requirements. However, the non-conventional structures and instruments of Islamic finance present unique challenges that must be overcome before Korea can finally taste the fruits of Islamic finance. In this sense, the time is ripe to evaluate the feasibility of Islamic finance and, in particular, Sukuk in the context of Korean law.
Against this background, this article examines:
The typical features of Sukuk.
Structure of Sukuk.
The legal nature of Sukuk in Korea.
Tax issues and reform proposals relating to Sukuk.
Sukuk, which is commonly referred to as "Islamic bonds" but is more accurately described as "Islamic Investment Certificates", is an asset-based instrument that represents an undivided pro-rata ownership (legal or beneficial) of the Sukuk holders in the underlying asset. Unlike debt-based conventional bonds that pay interest, Sukuk is Sharia-compliant and accordingly, returns are paid to investors in line with their proportional ownership in the underlying asset.
For a typical Sukuk transaction, a special purpose vehicle (SPV) is established as an issuing entity for the Sukuk. It issues Sukuk certificates to investors (Investors) for the purpose of raising funds for investment in the underlying asset, through a pre-arranged transaction with the original holder of the underlying asset (Originator). In such a transaction, the Investors that hold Sukuk certificates that represent an undivided pro-rata ownership (legal or beneficial) of the underlying asset are entitled to all proceeds arising from the underlying asset.
Sukuk is often compared to conventional financial instruments. For instance, Sukuk is compared to asset-backed securities, due to its asset-backed nature and the transaction structure, which is similar to that of conventional asset-backed securities. Sukuk is also viewed as being very similar to conventional bonds, except that Sukuk has an added layer of an asset-backed transaction that circumvents the conventional bonds' lack of compatibility with Sharia principles, given their interest-bearing nature. Also, unlike conventional bonds, on maturity or the occurrence of an event of default, Investors are entitled to enforce their rights in relation to the underlying asset. Sukuk can be listed on a stock exchange and settled through a clearinghouse and has a maturity of one to 20 years.
Among the many types of Sukuk that are available, the two types of Sukuk that have recently come into the limelight in Korea, due to their potential relevance and application to the Korean markets, are Sukuk-al-Ijara and Sukuk-al-Murabaha.
Sukuk-al-Ijara is typically structured as follows (see box, Typical structure of Sukuk-al-Ijara):
1. SPV is established as the issuing entity for the Sukuk, and issues Sukuk certificates to Investors for the purpose of raising funds to finance the purchase of a certain asset.
2. Originator sells the asset to SPV for a pre-determined purchase price according to an asset sale and purchase agreement.
3. SPV then leases the asset to a third party (often Originator itself or a third party connected to Originator) according to an Ijara (Islamic lease) agreement for a fixed period of time, in exchange for periodic lease payments. The payment obligations of Originator to SPV under the Ijara agreement mirror the payment obligation of SPV to Investors who hold the Sukuk certificates.
4. Simultaneously with entering into the Ijara agreement, Originator will grant a purchase undertaking in favour of SPV, undertaking to purchase the asset from SPV at a pre-determined price (which should be an amount equal to any outstanding amounts still owed under the Sukuk).
5. Sukuk represents an undivided pro-rata ownership of the underlying leased asset and the Sukuk certificate evidences such ownership.
It must be noted that the issuance amount of Sukuk-al-Ijara is restricted to the value of the underlying asset, and the underlying asset, once used for the issuance of Sukuk, cannot be re-used for another purpose until the maturity of the Sukuk that is already issued. While Sukuk-al-Ijara is predicated on the transfer of the underlying asset, there are many instances where "true sale" of such underlying asset does not take place in practice.
Sukuk-al-Murabaha is typically structured as follows (see box, Typical structure of Sukuk-al-Murabaha):
1. SPV enters into a Murabaha Master Agreement with Originator.
2. SPV issues Sukuk certificates to Investors for the purpose of raising funds to finance the purchase of a certain asset, and purchases the asset for a price of X.
3. SPV sells the asset to Originator for a price of X plus a margin of P.
4. Originator pays X plus P to SPV, usually in instalments. Although resale of the asset by Originator is not mandatory under Sukuk-al-Murabaha transactions, the Originator must resell the asset within a certain period of time in order to enjoy the proposed tax exemption (see below, Tax issues relating to Sukuk).
5. SPV pays the proceeds it has received from Originator to Investors.
Although Sukuk-al-Murabaha can be issued, any negotiations of the price of Sukuk-al-Murabaha or trading of them in the market would be contrary to the principles of Sharia and therefore prohibited. This is because any transfer of Sukuk-al-Murabaha would result in the obligations of Originator being transferred to a new investor, with whom Originator has no asset-based transaction. Accordingly, any resulting transaction may give rise to a mere monetary obligation, which may be viewed as an interest-bearing transaction.
Korea has yet to witness its first issuance of Sukuk. There remain many legal, financial, accounting and tax issues that need to be fine-tuned and streamlined before Sukuk can be issued in Korea. Currently, whether a Korean company can resort to Sukuk to raise funds arouses much debate and controversy among legal scholars and practitioners.
The question of whether the issuance of Sukuk is allowed in the context of Korea's current legal regime requires consideration of many legal issues under the Korean Commercial Code (KCC) and the Financial Investment Services and Capital Market Act of Korea (FISCMA).
To justify the issuance of Sukuk under Korean law, the legal nature of Sukuk must be ascertained. However, certainty seems lacking in the current legal environment. There has, so far, been no consensus among legal scholars and practitioners as to whether Sukuk can be classified as one of the types of "investment securities" that a Korean company is permitted to issue under the KCC and the FISCMA.
Further, although Sukuk bears a strong resemblance to conventional corporate bonds under the KCC, the KCC takes an exhaustive approach to defining corporate bonds. Sukuk does not neatly fit into one of the types of corporate bonds defined in the KCC. Whether Sukuk can instead be issued under the KCC is not therefore likely to be answered in the affirmative. In addition, the concept of beneficial ownership (which is commonly used in Sukuk transactions in other jurisdictions) is not recognised under Korean law, which makes structuring more difficult.
Active initiatives for legislative change are currently underway to facilitate Sukuk in Korea. One example relates to defining a new type of investment securities that can be issued by a Korean company. Such investment securities would be defined broadly enough to encompass both Sukuk-al-Ijara and Sukuk-al-Murabaha. If adopted, such legislative change would be a cornerstone for the development and continued evolution of Korea's financial and capital markets, by allowing a listed company in Korea to rely on Sukuk-al-Ijara and Sukuk-al-Murabaha as an alternative funding source. However even before the much awaited legislative change, it would be possible for a Korean company to issue Sukuk through an offshore SPV, as doing so would not be regulated by the requirements of Korean law.
Currently, no corporate income tax is imposed on interest income received by a foreign entity in relation to foreign currency denominated notes or bonds. However, in the case of issuance of Sukuk through an offshore SPV, it is questionable whether any amount received by the offshore SPV exceeding the original investment amount may be viewed as interest income arising from foreign currency-denominated notes or bonds. Apart from corporate income tax issues, it is also questionable whether individual transactions forming a part of the overall Sukuk transaction would be viewed as a "single" transaction for the purpose of other relevant taxes, such as acquisition tax and registration tax.
If and to the extent that the Sukuk transaction is not viewed favourably from a tax perspective, many of the attractive features of Sukuk as an alternative method of raising funds would be outweighed by hefty transaction costs, in the form of various taxes. To overcome this, there has been a continued demand from many players in Korea's financial and capital markets for the grant of tax benefits or exemptions relating to the Sukuk transaction. Given the increasing recognition of Islamic financing in both domestic and international markets, the Korean Government has reacted favourably to such demand and, as a first step, submitted in late September 2009 a draft amendment of the Special Tax Treatment Control Act (STTCA) to the national parliament for deliberation.
The key aspects of the proposed amendment involve considering a series of transactions in the issuance of Sukuk (in particular Sukuk-al-Ijara and Sukuk-al-Murabaha) as a "single" transaction. The practical implications of such an amendment would include:
Granting tax exemptions from corporate income tax for any investment returns in excess of the original investment amount received by the offshore SPV involved in Sukuk transactions meeting requirements of the STTCA, by regarding such income as "interest income" subject to tax exemption.
Granting tax exemptions relating to certain taxes (for example, acquisition tax and registration tax) which arise during multiple transfers of the underlying assets among the parties to the Sukuk-al-Ijara transaction.
In substance, the proposed amendment seeks to remove various taxes that exist at different stages of the overall Sukuk transaction. This would create a level playing field for the Sukuk transactions, by removing the tax barriers that make the Sukuk transactions less appealing and commercially viable compared to other conventional bonds.
The following are the transactions and exemptions envisaged by the proposed tax amendment of the STTCA.
A Korean company (Korean Company), through its offshore special purpose company (Issuing Company), issues foreign-currency designated securities (Securities) to non-residents of Korea or an offshore company, for the purpose of raising funds in a manner that is in compliance with Islamic principles that prohibit interest-bearing transactions.
Transaction one. If and to the extent that:
The Issuing Company purchases the underlying asset (Asset) using the proceeds of issuance of the Securities and, simultaneously, leases the Asset to the Korean Company.
The Issuing Company agrees with the Korean Company to sell the Asset back to the Korean Company on expiration of the lease period, at a price equal to the initial purchase price.
The maturity of the Securities is within the bounds stipulated by Enforcement Decree of the STTCA.
The Korean Company agrees to pay to the Issuing Company the lease payments (before expiration of the lease period) and the sales proceeds of the Asset (on expiration of the lease period).
The following tax exemptions would be available:
Any lease payments made by the Korean Company to the Issuing Company will be deemed to be interest payments.
Such lease payments (deemed to be interest payments) received by the Issuing Company will be exempt from corporate income tax.
The asset leasing services provided by the Issuing Company, the sale of the Asset by the Korean Company and the subsequent re-sale of the Asset by the Issuing Company will not be viewed as transactions that attract value-added tax (VAT).
For the purpose of imposing corporate income tax on the Korean Company and the Issuing Company, the Korean Company will, at all times, be deemed to be the owner of the Asset.
Transfer of the Asset between the Korean Company and the Issuing Company will not be subject to acquisition tax and registration tax.
Transaction two. If and to the extent that:
The Issuing Company purchases the Asset using the proceeds of issuance of the Securities at a certain price (X) and re-sells the Asset to the Korean Company, at a price which is higher than the original purchase price (X+P).
The original purchase price and the subsequent sale price of the Asset by the Issuing Company are pre-agreed among the Korean Company, the Issuing Company and the holders of the Securities, before issuance of the Securities.
The Korean Company sells the Asset within a period designated by the Enforcement Decree of the STTCA.
The Korean Company pays to the Issuing Company the amount corresponding to P (before maturity of the Securities) and the amount corresponding to X (on maturity of the Securities).
The following tax exemptions would be available:
Any payment of P made by the Korean Company to the Issuing Company will be deemed to be interest payments.
Such payments (deemed to be interest payments) received by the Issuing Company will be exempt from Korean corporate income tax.
The sale of the Asset by the Issuing Company and the subsequent sale of the Asset by the Korean Company will not be viewed as transactions that attract VAT.
For the purpose of imposing corporate income tax on the Korean Company, the acquisition price of the Asset will be deemed to be the value corresponding to the purchase price of the Asset (X+P) plus any incidental costs, less the price differential (P).
If these transactions do not take place after application of the relevant tax exemptions:
The corporate income tax imposed on the Issuing Company will be the amount of corporate income tax (after applying the relevant tax exemptions) plus an additional tax.
The VAT imposed on the Issuing Company will be 110% of the VAT which would have been imposed on the Issuing Company, but for the tax exemptions.
The corporate income tax imposed on the Korean Company would include interest on the amount of additional tax that would have been imposed on the Korean Company, but for the tax exemptions.
To enjoy these tax exemptions, the Korean Company or the Issuing Company will need to apply for them under the STTCA.
Given the many uncertainties to be resolved and hurdles to be overcome, it is evident that Korea faces a long, tough road to fully embrace the techniques and applications of Islamic finance (in particular, Sukuk). However, some of the much awaited progress is currently underway in Korea, to relax some of the legal and regulatory restrictions. In particular, an amendment of the FISCMA and STTCA is currently being deliberated before the Korean parliament to provide a legal basis for issuance of Sukuk in Korea. There is no doubt that such an amendment, if adopted, would be a step in the right direction.
Areas of practice/expertise. Mee-Hyon Lee is a partner at Lee & Ko with more than 20 years of practice experience in the area of finance and tax, with qualifications to practise both in Korea and New York. She has been the principal transaction lawyer on many of Korea’s largest and most innovative structured finance transactions. These include representing Korea Asset management Corporation in the first cross-border securitisation in Korea securitising non-performing loans (NPL) it owned, which has become a model in all NPL securitisation by other financial institutions in Korea; representing JP Morgan and other co-arrangers in the loan financed for the acquisition of Haitai Food Products, which was selected by IFLR as the winner of the Asian debt and equity-linked deal of the year in 2001; and representing Korean Air in its cross-border securitisation of ticket sales receivables in 2007. She is also a member of the task force for Islamic finance for the Ministry of Strategy and Finance of Korea.
Areas of practice/expertise. Yong-Jae Chang is a partner at Lee & Ko and has extensive experience in leveraged finance, securitisation and structured finance. He regularly represents many leading Korean and international banks and financial institutions. He has worked on a variety of high profile transactions in Korea, including the leveraged finance for the acquisitions of Haitai Confectionery, Hanaro Telecom, Fila, BuyTheWay, WiniaMando, Hi-mart and Oriental Brewery; and the cross-border securitisation of airline ticket receivables for Korean Air and residential mortgage-backed loans for SC First Bank (some of which received the prestigious IFLR Asian Awards). He has particular interests in cross-border transactions and is currently the Co-chair of the Cross Border Investment Committee of the Inter-Pacific Bar Association (IPBA). He is also a member of the task force for Islamic finance for the Ministry of Strategy and Finance of Korea.