Korean tax turmoil

Private equity investors with exposure to South Korea have been given the jitters by a regulatory clampdown. How much do they really have to worry about? By Andy Thomson.

Limited partners with exposure to foreign funds investing in South Korea must have found recent developments in the country highly disconcerting. Barely a day has gone by without yet more news of actual or planned clampdowns by the authorities against funds and individuals accused of tax evasion.

In perhaps the most high profile case so far, tax officials asked prosecutors to investigate Steven Lee, the former head of Korean operations for Texan private equity fund Lone Star. According to a report in the Korean Herald, the country’s National Tax Service (NTS) is alleging that Lone Star Korea manipulated the earnings of its 14 special purpose companies so as to minimise its Korean tax payments.

Lee, 36, was appointed Lone Star’s Korea head in 1998 and led the acquisition of a 51 percent stake in Korea Exchange Bank, the country’s fifth-largest lender, in October 2003. Lee stepped down from his post on September 28, citing personal reasons.

The day after his resignation, the NTS levied 214.8 billion won ($207 million) in back taxes on five foreign funds operating in the country and accused them of under-reporting cash transfers to their headquarters or inflating costs. The names of the funds involved were not disclosed.

On October 6, the NTS hinted that more executives of foreign private equity funds active in South Korea may face investigations into their tax affairs and also indicated that individuals implicated in these investigations could be barred from leaving the country.

Of concern to foreign private equity funds and their investors is an apparent background of growing hostility towards the profits being reaped by overseas-based investors from their dealings on Korean soil. The $1 billion recouped by Newbridge Capital from its sale of Korea First Bank to Standard Chartered in January 2005 was a particularly sensitive issue – and a reminder of the backlash against foreign funds in neighbouring Japan last year when a Ripplewood Holdings led consortium reaped a fortune from that country’s banking sector through the IPO of Shinsei Bank.

But do investors really have much to worry about, or is this a storm in a teacup? Korean regulators are keen to insist that they are applying the laws equally against both local and foreign investors. If foreign firms, so the argument runs, are prepared to try and exploit loopholes then that’s their fault and no-one else’s.

Even if not a storm in a teacup, is it at least a storm that will blow over? In a recent report on Korea by the Economist Intelligence Unit, a section dealing with Korean policy towards foreign investment predicted that in 2006-07: “A backlash against perceived foreign dominance in the financial sector may lead to non-Korean bidders being disadvantaged in future privatisations in this sector, at least temporarily.”

The word ‘temporarily’ in the above quote is significant. Looking ahead to 2008-10, the report continues: “Foreign capital will increasingly be accepted as a normal part of the scene.”  Hence, the message for investors keen on opportunities in the country is to take a long-term view. The ride may be bumpy at present, but there’s every prospect of a smoother ride in the years ahead.