BMS Korean Capital Gains Tax Risks – 0421-01

Korean Capital Gains Tax Risks for PE Funds: How Tax Liability Insurance Can Help In Korean M&A transactions involving foreign PE funds, uncertainty often arises regarding the identification of the beneficial owners under the capital gains tax (CGT) rules and which deal parties bear the risk. This is where TLI steps in. A TLI policy offers deal parties a quick and capital-efficient solution to take the risk off the negotiation table by covering a potential financial loss arising from a successful challenge of the agreed CGT position. This way, no party bears the risk and indemnities and holdbacks can be avoided. Korea’s CGT rules in brief

A foreign shareholder deriving a capital gain from transfer of shares in a Korean entity is taxed at the lesser of 11% of the gross sales proceeds or 22% of the gain 1 unless there is a tax treaty in place which restricts levy of such taxation. 2 In an M&A transaction, the buyer must withhold any CGT due from the purchase price. In the case of an underpayment of CGT, Korea’s National Tax Service ( NTS ) can assess the CGT, plus interest and penalties, from either the buyer or the target entity. The applicable statute of limitations has recently been extended to 10 years. When the seller is a foreign non-tax-transparent entity with meaningful economic substance in the jurisdiction where it is a tax resident, the application of said CGT rules is not controversial. Things get (much) more complicated when the seller is a foreign PE fund. Typical fund structures A typical PE fund structure involves a tax-transparent vehicle incorporated in a tax-efficient jurisdiction, such as the Cayman Islands (the Fund ). Investors in the Fund participate as limited partners ( LPs ), while the general partner ( GP ) manages the Fund. Using capital raised from LPs, the Fund then sets up a special purpose vehicle ( SPV ) to acquire shares in a target entity ( Target ). The diagram depicts this structure: 3






1  Absent a permanent establishment in Korea. 2  Most tax treaties concluded by Korea are in line with article 13(5) of the OECD Model Convention on Income and on Capital, and restrict the levy of tax on capital gains derived by a foreign shareholder from the alienation of shares in a Korean entity, unless it concerns alienation of shares in a “land-rich entity” (in short: the shares derive more than 50 percent of their value from immovable property situated in Korea). 3  Simplified for this note. In practice, the Fund shall have multiple SPVs and target entities and may also engage an internal or external fund manager and/or investment advisor.


Practice & risk allocation Despite the new OIV rules, foreign PE funds continue to deal with uncertainties when assessing the CGT position of their ultimate investors, (i.e. the LPs), if only because the ‘beneficial ownership’ concept is inherently subjective and in constant flux. Equally, evidenced by history, the NTS may scrutinize a CGT position taken and aim to assess underpaid CGT, plus interest and penalties from the buyer or the Target. Kim/Everett note the following on the practice in Korea: “The NTS will scrutinize the CGT positions of foreign funds under audit, focusing on whether the OIV rules have been properly applied, whether the requisite filings were made, and whether the filings are supported by tax residency certificates and other documentation supporting beneficial ownership conclusions. Recent Tax Tribunal decisions 5 and tax rulings provide comfort that the OIV rules will be respected, and the OIV will not be deemed as the beneficial owner except in the limited cases described above. While it is possible to seek additional rulings to clarify the treatment in unique situations, there is currently sufficient clarity to look through the OIV based on the OIV rules.” In the case of significant CGT exposure, buyers and sellers may stake out opposing positions during negotiations because of the risk of a future assessment by the NTS. It can become a contentious issue in the negotiations as buyers do not want to risk NTS holding them accountable. As such, buyers typically require a seller indemnity spanning the duration of the statute of limitations with financial security, such as an escrow. 6 How TLI can help M&A transactions involving specific indemnities and holdbacks to deal with CGT risks are not always ideal. For instance, the seller might be looking for a ‘clean exit’ from the Target and may not be willing to stand behind potential tax liabilities arising post-completion. Also, the buyer may not be comfortable with recourse through only an indemnity. A misalignment between deal parties on risk allocation might spiral into a deal-breaker. This is where TLI steps in. A TLI policy offers deal parties a quick and capital-efficient solution to take the risk off the negotiation table by covering a potential financial loss arising from a successful challenge of the agreed CGT position. This way, no party bears the risk and indemnities and holdbacks are avoided.

If the Fund exits a particular investment, the SPV will typically sell the Target shares, resulting in a capital gain (provided the investment has been successful). The question is then whether a CGT exemption under a tax treaty is available. Now this is where it gets complicated, as Kyu Dong Kim and Jeremy Everett, partners at Yulchon, explain: “A determination must first be made as to who is the beneficial owner of the capital gain. 4 Supreme Court decisions look at beneficial ownership in the context of Korea’s ‘substance-over-form’ rules, which allow the NTS to look through legal form if the recipient of the income does not carry on normal business activities or was established solely for tax avoidance purposes. The aggressive application of these rules has resulted in substantial tax assessments, particularly for PE funds, which assessments have largely been appealed over the course of the past 15 years with inconsistent results. To address this uncertainty, new procedural rules became effective in 2012 and 2014 that introduced an Overseas Investment Vehicle ( OIV ) reporting system that provided clarity on the determination of beneficial ownership when funds are involved. Under the OIV rules, a fund cannot be considered the beneficial owner and cannot claim a reduced treaty rate or exemption in its own name. Instead, the fund is responsible for gathering information and filing designated forms on behalf of the ultimate investors that is used to determine and report the beneficial owners, the applicable treaties, and the amount of withholding tax due. These rules are now widely accepted, and recent Tax Tribunal decisions on the determination of beneficial ownership after the introduction of the OIV regime have helped provide comfort and greater certainty that the OIV regime will be respected. The 2019 Tax Reform bill added further clarity and bridged the gap between existing court decisions and the original intent of the OIV rules. These rules, which went into effect on January 1, 2020, allow a limited exception to the general look- through treatment of OIVs in rare cases in which the OIV is liable to tax in its country of residence, is subject to a higher rate of withholding tax than the ultimate investors would have been subject to (lack of tax avoidance motive) and the OIV is considered the beneficial owner under the applicable tax treaty. Further, the OIV may be subject to tax (under domestic tax law without the application of a tax treaty) if the OIV fails to provide the required information on the beneficial ownership and treaty status of its ultimate investors.”

4  In the due diligence process, withholding tax exposure may also be discovered in relation to assumptions regarding the beneficial owner(s) for prior dividend, interest, and royalty payments of the target. 5  Including the Prudential real estate fund case and AEP/KKR case. 6  In some cases, buyers require sellers to keep the SPV ‘alive’ for the duration of the indemnity, which also results in additional costs and administrative burdens.


Insurable CGT risks Insurers generally underwrite CGT risks with a low probability of materializing but high severity. Furthermore, there must be a sound legal basis for the tax position being taken; insurance cannot be obtained for an incorrect CGT position based on detection risk. Before considering underwriting a CGT risk, insurers will require an opinion/memo from a reputable law or advisory firm supporting the CGT position’s technical soundness. Such advice should detail: 1. the tax-technical analysis of the CGT position; 2. financial exposure; and 3. likelihood of NTS’ success in challenging the CGT position before the tax court. 7 There is a good appetite to underwrite Korean tax risks. Steven Harwood, Regional Head of Transactional Liability – Asia Middle East for Berkshire Hathaway Specialty Insurance, notes the following: “At BHSI we make a qualitative assessment of any tax risk for which insurance is being sought. We consider matters such as the nature of the risk; the tax-technical analysis; the quantum of risk exposure and the jurisdiction involved. Particularly with respect to the latter, we think South Korea is an interesting jurisdiction because of the strong rule of law and apparent consistency in the application of tax laws by courts.” Coverage, policy period & timing A TLI policy would insure the taxpayer against ‘losses’ arising from an insured CGT position. These losses include: (i) tax due following NTS’ assessment or determination (ii) interest and non-criminal penalties (if applicable) (iii) defense costs incurred by the insured in defending a challenge from the NTS (iv) tax gross-up for payments made under the policy (if applicable) Policy period is typically aligned with the statute of limitations. A TLI policy can be executed within two weeks. Costs The premium is a percentage of the insured amount and a one-time-only payment. Premiums range between 2%-6% of the limit of liability insured. Pricing primarily depends

on factors such as (i) strength of the CGT position; (ii) jurisdictions involved; (iii) amount of the financial exposure and (iv) dispute history of the insured. Additionally, insurers charge underwriting fees to cover their costs for external advice on the insured CGT position. Claims A TLI policy is only effective when it pays out in the event of a valid claim. Claims handling procedures and track records are critical factors when selecting an insurer and BMS always cautiously considers these factors when advising clients. Insurers are sensitive to their reputation when it comes to claims handling. Most insurers have in-house claims teams to warrant a streamlined claims process. Practice illustrates that claims under TLI policies are being handled with due care. Harwood, outlines that: “We operate our global business on the philosophy that “Claims is our Product”. Tax risks are complex by their very nature so it’s particularly important for customers to be confident that their insurer will engage and deal with a claim, however it may arise. We have a dedicated and experienced claims team located in Asia which, coupled with our long-term commitment to the market and a strong balance sheet and security rating, gives customers the reassurance they need in selecting BHSI as their risk carrier.” Required information To approach insurers and obtain pricing and other terms for a CGT risk arising from a Korean M&A transaction, BMS would need to receive the following information: 8 1. details of the M&A transaction 2. copy of the tax opinion/memo 9 3. calculation of the potential financial exposure and associated costs Conclusion In Korean M&A transactions involving foreign PE funds, uncertainty often arises regarding the identification of the beneficial owners under the CGT rules and which deal parties bear the risk. This is where TLI steps in. A TLI policy offers deal parties a quick and capital-efficient solution to take the risk off the negotiation table by covering a potential financial loss arising from a successful challenge of the agreed CGT position. This way, no party bears the risk and indemnities and holdbacks can be avoided.

7  Insurers usually won’t require a percentage to be attributed to the chance of success if challenged, rather they would wexpect to see a ‘should’ level of opinion. 8  This information would be subject to Non-Disclosure Agreements. 9  A tax opinion or advice would normally be provided to insurers on a “non-reliance basis”.


Contacts We hope you enjoyed the read. For a confidential discussion, please contact our tax insurance experts in Hong Kong, Singapore or London.

Dean Andrews Head of Tax Liability Insurance T: +44 (0)20-7480-0308 M: +44 (0)7876-815-643

Martijn de Lange Managing Director T: +852 3579-5486 M: +852 9772-9951

Jessica Bradley Associate Director

Aris Wong Managing Director T: +65 6230-7987 M: +65 8321-6236

T: +44 (0)20-7374-5109 M: +44 (0)7880-443-186

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