As companies worldwide continue to rein in investment spending in the aftermath of the financial crisis, governments around the world are seeking to reinvigorate their respective economies. In South Korea, the Ministry of Strategy and Finance (MOSF) introduced a $40 billion stimulus package in July to boost domestic demand and keep Asia’s fourth-largest economy on a firm recovery path. Most recently, the focus has shifted towards the retained earnings of Korea’s largest companies. A new set of tax rules, if approved in the parliament, would introduce a 10 percent tax on companies’ retained earnings if affected firms do not boost dividend payouts, spend on their workers and increase investment to acceptable thresholds. Korean companies are notoriously thrifty with dividends, paying out an average of 21 percent of their profits last year, according to the MOSF, compared with the 40 percent global average. According to CEO Score, a Korean research firm that tracks the country’s major conglomerates, cash reserves of Korea’s top 10 conglomerates rose more than eight times between 2001 and the first quarter of this year, to about $464 billion.

Divided opinion

The rules will apply only to large companies with equity capital of more than 50 billion won ($50 million), as well as members of conglomerate groups subject to cross-shareholding restrictions. Starting next year, affected Korean companies will have two choices to avoid facing a 10 percent excess retained earnings tax, says Dong So Kim, a senior tax attorney at Kim & Chang. “Corporations can either utilise 60 to 80 percent of current year income for investment, wage increases and dividends, or utilise 20 to 40 percent of current year income for wage increases and dividends. Once an election is made, it cannot be changed for three years,” he says. Based on last year’s earnings, companies that belong to the Hyundai Group would have had the largest exposure to the law, facing 284.1 billion won ($275 million) in further taxes if the base was set at 60 percent, according to CEO Score. “The other two prongs in the government’s three-pronged stimulus package consist of a new 10 percent tax credit for increasing employee salaries above a defined threshold, and a tax rate reduction for qualifying dividend income received by individuals residing in Korea,” says Jeremy Everett, senior tax counsel at Kim & Chang.

The ultimate goal of the new rules is to spur domestic consumption and revitalise Korea’s economy, rather than generate tax revenue. “Should (the excess corporate cash tax law) be activated as planned, we would like our tax revenue from this to reach zero,” says Moon Chang-yong, head of the MOSF’s tax bureau.

Shareholders, investors and employees of large public Korean companies have welcomed the new initiative, as well as businessmen from small and medium-sized companies whose main focus is on the domestic market, says Kyung Geun Lee, a partner at Yulchon and head of the firm’s international tax practice.

On the other hand, many economists and industry professionals have expressed concern over the negative effects the new legislation could cause, especially in the long term. “Some people are worried that this legislation could reduce the general competitiveness of the Korean economy or Korean multinationals because they will have to reduce the size of their retained earnings which may reduce their funds for new investment in the future,” says Lee. For his part, Kim says that some companies, investors and creditors may be concerned about the effect of the new rules on liquidity and financial soundness of the affected companies, since they will be incentivised to drastically increase expenditures and distribute dividends in a relatively weak economy.

Furthermore, while the new rules offer tax breaks for companies that raise wage levels, companies may be hesitant to do so because slashing wage levels if business contracts is a troublesome task. As a result, some companies may prefer incurring the tax rather than spending their cash on wages and dividends, says Lee. “The tax payment is just a one-time burden, but if they increase wage or salary levels, it creates a perpetual impact in the future,” he says.

A macroeconomic outlook

The new tax rules contain similarities to an old law that took effect in 1991, but was scrapped 10 years later in 2001 for failing to meet its goal of boosting dividends. However, while the concept of encouraging dividend payments by large conglomerates is similar, lawyers note that there are some significant differences between the two laws. “The prior rule applied when corporate assets exceeded 10 billion won, so it had a much lower threshold,” says Everett. “The prior law focused on undisposed earnings that exceeded an ‘appropriate threshold’. The tax could be avoided if the corporation’s earnings were above the threshold by actually paying enough dividends to reduce the undisposed earnings or by setting up a reserve for company development, which could only be offset against net operating losses or be converted to paid-in capital,” says Everett.

Yulchon’s Lee adds that a significant difference is that the new proposed rules say that even if the affected company does not increase dividend payments, they can avoid paying the tax if they invest in wages or certain future projects. “The new rules are also aimed at boosting household income and stimulating the economy, while the old rules did not have this macroeconomic outlook,” he says.

The legislation, which needs parliamentary approval, would apply for three years starting in 2015. The law itself is expected to be finalised by the end of December, with detailed guidelines to follow a month or two later. “Historically, amendments proposed by the government have a relatively high chance of passage at the National Assembly. Because the new excess retained earnings tax is a key part of the government’s three-pronged stimulus package aimed at boosting household income and stimulating the economy, the government will likely exert every effort to ensure passage. However, even if the proposal is successfully confirmed through the parliamentary approval process, there may be some changes to the thresholds and calculation methodology given the opposing views and rigorous debate on the merits of the proposed tax,” says Kim.

Because the thresholds and calculations have not been finalised, Lee advises companies that may be affected by the new rules to wait until the final bill is finalised before deciding on an action plan. If the proposed rules are passed in the National Assembly, it will be several months before the true effects of the new tax on Korea’s conglomerates and its economy will emerge. “Even though the new rules will last for just three years, there may be longer-term consequences if they are not carefully managed in the implementation stage,” says Lee.