International investors who've put money into South Korea in recent years could be forgiven for feeling pretty smug. After all, as of December 29 the MSCI Korea Index had delivered an impressive 12.53% annualised return since December 29, 2000.
Not even scandals at some of its biggest companies and a succession of grim geopolitical developments involving nuclear-armed North Korea have wiped the smile off investors' faces.
But a new tax regime which is set to see foreign investors pocket just 89% of the proceeds when they sell Korean stocks – regardless of profit or loss – might just change the mood.
And that isn't the end of the harm: according to the Asia Securities Industry and Financial Markets Association (Asifma), it will also create huge logistical challenges in the country's securities industry and leave investors frustrated.
“The problem is that there’s a lack of understanding of how investments are made – they [the government] keep thinking the impact is small – but in fact it’s huge,” Patrick Pang, head of fixed income and compliance at Asifma, told FinanceAsia.
At issue is a draft regulation issued by the Ministry of Strategy and Finance (Mosf) on Monday. In a revision to its tax policies, Korea's new left-leaning government said it would lower the shareholding ownership threshold above which foreign investors’ capital gains will be taxed.
At present, foreign investors and related parties that collectively hold 25% or more of a listed Korean company are subject to capital gains tax in the country. But based on the new tax code due to go into force this summer, collective shareholding of 5% or more in a company – at the time of the sale or at any point in the previous five years – will lead to a tax liability.
The tax runs to 22% of the capital gains or 11% of total receipts from the sale, whichever is lower. And, crucially, it falls to securities companies’ obligation to withhold any tax payable. Given limited market infrastructure, such companies will struggle to accurately calculate a foreign investor's shareholding in a particular company over time, nor how much money they made – especially given investors may use more than one company when buying or selling.
Unlike, say, Hong Kong, which has built a central securities depository and central clearing and settlement system, Korea has no mechanism now for securities companies to obtain real-time information such as ownership percentages or weighted average acquisition costs.
That makes it highly probably companies will simply withhold 11% every time a foreign investor sells shares in order to comply with their obligation, according to Asifma – which cited comments from its members, including buy-side investors and sell-side agents.
“The sales transaction may or may not generate a profit for an investor, the securities firm will have to protect itself legally by applying 11% of the sales proceeds, withhold it and pay to the Korean government…and the client then will have to go to the Korean government and apply for a refund if it owns less than 5% of the company," Pang said.
"If 11% of sales proceeds by most foreign investors are being withheld pending a refund for an uncertain period of time, it will be unacceptable to most funds and it’s a disaster for the market," he added.
Treaty talk
To be sure, the Korean government has consistently played down the likely impact of the changes. Ministry officials, including head of the tax and custom office Choi Young-rok, argue the new tax code’s impact would be limited, as it applies only to investors from countries with which Korea has not yet signed a tax treaty.
Only 12 countries and territories are affected, according to the ministry – but they include the likes of Singapore and Hong Kong, home to many international investors.
What's more, significant amounts of Korean equity investment by foreigners come via funds – which are typically domiciled in tax-friendly jurisdictions like the Cayman Islands or the British Virgin Islands, and therefore also fall within the scope of the new regulations.
“So it doesn’t matter how many tax treaties they have…a fact of matter is that a lot of the investors we are concerned about come from places which don’t have the tax treaties,” said Pang.
The clock is ticking
For international institutional investors, the rules simply won't work. When a fund's investors make a withdrawal, the fund will sell stocks in Korea but, under the new rules, is likely to find itself simply unable to give the investor back 100% of the proceeds.
What's more, even if the fund was eventually able to wrestle back the 11% tax from the government, it would face foreign exchange risk in the meantime.
Building better market infrastructure would help, but would also take time – Asifma sees no chance of it happening by July, when the new rules are due to kick in.
In 2017, the MSCI Korea Index generated a 30.56% return, comparing to MSCI Emerging Markets Index of 21.68%. It's not a market investors want to miss out on. The proposed changes are open for public consultation until January 29. Investors may well want to have their say.
