Capital Gains on Korean Shares: Taxable by Default

For most foreign investors in a Korean company, the return is expected in one place. The capital gain on exit.

Dividends are usually not in the plan. A Korean company at growth stage reinvests its earnings, and where a dividend policy exists it rarely lines up with a fund’s realisation timetable. Interest income does not belong to an equity investment in the first place.

So almost the entire return rides on a single item at exit. And whether Korea taxes that item divides the after-tax return in two. The stake may treble; what actually reaches the investor depends on what leaves the proceeds first.

The difficulty is that this determination is usually made after the exit has started.

The analysis has two stages, in order

First, domestic law. It decides whether Korea has a taxing right.

Then the tax treaty. It decides whether Korea can exercise that right against this particular investor.

The order matters for a simple reason. If the gain sits outside the domestic charge, there is no need to open the treaty. If it sits inside, the treaty is the only line of defence. Knowing there is only one line changes how the review is done.

In practice the order is often reversed. The treaty is skimmed first, an impression of exemption is formed, and the domestic-law step is skipped.

Domestic law – the default is that it is taxed

The answer is short. It is taxed.

Where a foreign corporation transfers shares issued by a Korean company, the resulting gain is Korean-source income from the transfer of securities. Where the seller is an individual rather than a corporation, the conclusion is the same.

It is a broad default. The company does not have to be real-property-rich. The seller does not have to maintain a permanent establishment in Korea. The seller does not have to be a controlling shareholder.

There is an exclusion, though a narrow one. A provision looks at listing status, holding period and shareholding percentage together, and a gain that satisfies all of them falls outside Korean-source income. The conditions are cumulative, so a single one that does not hold defeats the exclusion.

Where the exclusion does not apply, the gain is taxed. And in real transactions it does not often apply. What remains is the treaty.

The treaty is not a safe assumption

The general shape of a capital gains article is residence-state taxation, with exceptions attached. Those exceptions differ from treaty to treaty.

Some set a shareholding threshold. Some measure that threshold on direct holdings only while others reach indirect holdings. Some add a disposal-volume requirement on top of the ownership test, so that both have to be met before Korea can tax. Some set no shareholding threshold at all.

Two investors selling shares in the same company, on the same day, at the same percentage, can reach opposite conclusions for no reason other than where they are resident.

And two things override the answer under any treaty: whether the company is real-property-rich, and whether the gain is attributable to a permanent establishment in Korea. Neither should be assumed.

An investor resident in a jurisdiction with which Korea has no treaty has no provision to invoke. In fund structures, investors in treaty and non-treaty jurisdictions commonly sit side by side, and then one slice of the same gain is exempt while another is fully taxable.

Meeting the treaty conditions is not the same as being entitled to the treaty

Even where the wording appears to be satisfied, something has to be settled before it. Which person the treaty applies to.

Where the investment is made through a fund, whether the beneficial owner of the income is the fund or the investors behind it changes which treaty applies. One treaty – the fund’s – may govern the whole gain, or each investor’s residence treaty may govern its own slice. Korean law looks through to the investors as the rule, and treats the fund as the owner only where an exception applies.

One of those exceptions is that the vehicle cannot substantiate its investors. Where it bites, treaty exemption, non-taxation and reduced rates do not apply at all. The wording of the article is satisfied and the entitlement to invoke it is lost.

We deal with that determination in a separate article.

And then there is the procedure

In Korea, treaty exemption is obtained by filing, not by assertion.

The withholding obligation sits with the buyer who pays the consideration, and the buyer is the party assessed if the determination turns out to be wrong. From the buyer’s side, withholding costs nothing and applying the exemption carries risk. A file that looks thin in any respect produces a withholding.

Among the documents, the one that governs the timetable is the residence certificate issued by each beneficial owner’s residence jurisdiction. It does not arrive in the week it is requested.

Being exempt on the merits and receiving the exemption at closing are two different outcomes. We deal with that in a separate article as well.

Which is why this belongs at the investment stage

To summarise: the return rides on a single item, domestic law taxes it by default, the treaty answer varies by jurisdiction, entitlement to the treaty has to be settled separately, and even a qualifying position can fail on procedure.

All five can be established when the investment is decided. The treaty wording is the same then. The company’s asset composition can be seen then. The fund’s investor base is already fixed then. The only thing that requires the exit to have started is the price.

Nor does deferring reduce the work. It reduces the options. At the investment stage the holding structure can still be adjusted, investor documents can be assembled in advance, and the withholding mechanics can be written into the share purchase agreement. Two weeks before closing, none of that is available.

Worth checking

Does your investment paper carry an after-tax exit figure, or only a pre-tax multiple?

And is that figure supported by a tax review, or by research? The two are not the same. Assembling public material and arriving at “Korea appears not to tax this” is research. Putting the actual facts to an adviser and receiving a conclusion with its reasoning in writing is a review. A buyer will not accept the former, and a tax office still less.

The distinction has a practical edge. Research-stage conclusions tend to lean optimistic, because the general statement begins with “the treaty allocates taxing rights to the residence state” and the exceptions and prior questions only surface once the facts are applied. Return expectations get built on the assumption that no tax arises, and the withholding lands at exit. By then the price is fixed and there is nothing left to reopen.

If you are an LP, there is a question for your GP: whether a tax opinion was obtained on the Korean investment, and if so what assumptions it rests on. Because the beneficial owner analysis can point to the fund or to its investors, the answer is not the GP’s alone.

If you are a GP, you should have that answer before the question arrives.

For a review of your position, please contact Star Tax & Legal at heebong@star-tax.kr.

Topics: Capital Gains · Fund Exit · Tax Treaties · Beneficial Ownership · Withholding Tax · Foreign Investors