After the Asian financial crisis, the Korean government adopted a domestic capital gains exemption rule, setting a 25% threshold for withholding tax on share sales by foreign investors. Under the rule, if a foreign investor together with its related parties owns less than 25% stake in a locally listed company, capital gains derived from share sales by the foreign investor are exempt from Korean tax. 

Last year, the Korean government seemed ready to depart from this long-standing 25% rule and lower the threshold from 25% to 5%. The Korean government announced 2018 tax law proposals August last year, including a proposal to lower the withholding threshold for foreigners from 25% to 5%. This came as a surprise to Korean securities firms, which have an obligation to withhold tax on capital gains as withholding agents, and prompted complaints and protests in the industry. Still, the Korean government seemed set on lowering the threshold. In January 2018, the Korean Ministry of Strategy and Finance (“MOSF”) issued an official announcement for the amendment of the Presidential Decree of Korean tax laws, including the reduction of exemption threshold to 5% with an effective date of July 1, 2018.

However, the Korean government ultimately decided to suspend its plan for lowering the threshold and maintain the 25% threshold, at least for the time being. On February 6, 2018, the MOSF released a press statement that it will review the proposal again later this year due to the necessity to improve the related “infrastructure” first.

The MOSF’s announcement came after the MOSF sought opinion from industry players on the proposal over a 3-week period following its announcement for the proposed change back in January this year. During this period, the MOSF held discussion sessions where key industry players such as broker-dealers and fund managers as well as tax practitioners voiced their concerns over the proposed change.

These concerns pointed to the practical difficulties of operating the proposed 5% rule. Under the proposed rule, Korean securities firms would be required to withhold tax on capital gains derived from sales by foreign investors with stakes of 5% or more in Korean listed companies. There may be a large number of foreign investors meeting this threshold of 5%, but they typically use several broker-dealers who do not share details of their trades with competitors, making it nearly impossible for Korean securities firms to determine whether their clients hold more than 5% stakes in Korean companies.

For the same reason, the securities firms would find it difficult to determine a foreign client’s cost basis in a stock, and there is virtually no record of historic cost basis of the shares purchased by foreign investors. Capital gains arising from the sale of shares in a Korean company will be subject to withholding tax of the lessor of 11% (including local income surtax) of the sale proceeds or 22% (including local income surtax) of the capital gains unless such capital gains are protected under a Korean tax law or a tax treaty. This means that if a securities firm cannot determine the cost basis and accordingly the capital gains, it would be required to deduct withholding tax on capital gains by applying 11% to the sales proceeds.

The problems associated with implementing the proposed change boil down to the absence of centralized tracking system for the trades of listed shares by non-residents, which the MOSF referred to as the necessary “infrastructure” in its press release. Without a centralized tracking system, securities firms would have to withhold tax on every share sale by foreign investors to avoid any risk of violating the new 5% rule, which would result in unnecessary refund claims filed by foreign investors.

Given that the current administration continues to maintain a policy of increasing tax revenues and enhancing taxation equity between Korean taxpayers and non-residents, if the Korean government has a confidence about the feasibility of setting up such infrastructure in a commercially acceptable manner, it may revisit the reduction of the exemption threshold in the future, as noted by Kyu Dong Kim (Tax Partner of Yulchon’s International Tax Group) in an interview with Tax Notes (the relevant article is attached to this newsletter). If and when it does, the Korean government should seriously consider introducing a reasonable grandfather rule which would protect foreign investors that acquired shares (less than 25%) prior to the adoption of the new 5% rule.