Korea may reapply tax to overseas equity funds

Last spring the South Korean government scrapped capital-gains taxes on domestic mutual funds investing in international equities. The measure caused upheaval in the funds industry, tripping up the then-dominant sellers of international funds Fidelity and BlackRock, which had relied on offshore European-listed Sicavs.

It was a factor behind the extraordinary rise of Mirae Asset, which came to dominate the market for offshore equities, particularly in the then-hot markets of China and India.

Now the market may face a new surprise: some parts of the government are agitating to re-impose the tax by the end of this month.

The tax measures were billed as temporary from the start, but with an expiry date of end-2009, and many retail and institutional investors bought emerging-market equity products from the likes of Mirae Asset and Schroders with that horizon in mind.

Now, sources report, the foreign-exchange department at the Bank of Korea is calling for the imposition of the tax to be brought forward immediately. It is negotiating with the Ministry of Finance and Economy, whose tax department must also agree. Industry sources believe MoFEÆs tax people are not keen to make sudden changes, out of fear for the reputation of Korean policymakers for transparency and predictability.

The government originally scrapped the tax in order to manage the wonÆs exchange rate at a time when the currency was depreciating and capital was fleeing to offshore-domiciled funds. Depending on the capital gain, a fund investing primarily in overseas equity would face a tax of 15.4% to 37%. No such tax has ever existed on funds investing in domestic securities, and the temporary cut was therefore granted to onshore funds, to direct investment flows to locally based managers rather than Sicav funds.

Today the economic situation has changed. The government has become alarmed by huge outflows to Bric markets, which are now seen as risky; Mirae AssetÆs Bric-like Insight Fund raised $4 billion at the peak in October and has since lost some 30% of NAV. Moreover, some Korean exporters such as shipbuilders have engaged in hedging policies by using offshore funds, a practice that sends assets out of the country, and short-term foreign debt among private-sector exporters is on the rise.

Some parts of government, notably the foreign-exchange team at BoK, find this alarming and want to re-impose the capital-gains tax right away.

The funds industry isnÆt pleased by the idea. ôThe industry view is that itÆs better to keep the tax break in place,ö says Young Min, head of research at the Asset Management Association of Korea. ôFund managers are worried about investor confidence in the market, knowing that many people subscribed to overseas funds assuming the tax break would remain until the end of 2009.ö

A sudden imposition of this tax could catch some players by surprise, and those without a wide selection of Sicav or other offshore funds at hand, or those too reliant on locally domiciled products, could suffer.

But should the BoK prevail, this could be a case of closing the stable after the horse has bolted: Korean investors have already begun to redeem their offshore investments, with the industry experiencing its first net outflows from such funds last month. The only product currently selling well is domestic equity funds.