Korea Fines Carlyle, U.S. Firms for Alleged Tax Evasion

After nearly six months of investigation into the activities of foreign private equity firms in South Korea, the country’s National Tax Service (NTS) has announced that it is fining at least four U.S. firms a combined $207 million for allegedly abusing Korean tax codes, under-reporting cash transfers to overseas headquarters and inflating costs to avoid paying required taxes in Korea.

The firms fined are AIG, The Carlyle Group, Goldman Sachs and Westbrook. Two others, Newbridge Capital and U.K.-based HSBC, remain under investigation.

In its announcement to Korean media that it was fining the private equity firms, the NTS released a statement that said it was “shocked to discover” that foreign private equity firms doing business in Korea used offshore-tax havens to shelter the profits on their investments in failing Korean financial institutions during the Asian financial crisis.

Representatives of the U.S. firms had no comment on the regulatory actions in Korea. Tammy Overby, executive director of the The American Chamber of Commerce in Korea, had previously said he had no qualms about the NTS investigations. But she did not return phone calls seeking comment on the fines.

Observers suggest that the NTS action is another in a series of politically motivated events taking place lately against foreign private equity firms doing business in Korea. Korean policy makers have come under pressure from local groups to control outside investment as foreign PE firms have reaped huge capital gains from short-term investments or by purchasing financial firms that have been rescued with public money.

Earlier this year, for example, the NTS investigated Newbridge after its acquisition and sale of Korea First Bank. Newbridge, which acquired the bank in 1999, sold the bank to U.K.-based Standard Chartered Bank in the fall of 2004. The $3.3 billion sale earned the private equity firm $1.5 billion and Newbridge remains under investigation for that sale.

Also, charges against U.K.-based fund manager Hermes Investment Manager allege that the firm manipulated the stock price of Samsung Corp. for its benefit before selling its entire stake in the company in December 2004. The Supreme Prosecutors Office, the country’s top financial regulator, maintains that Hermes made a financial gain of between $28 million and $37 million through unfair stock trading.

Under Korean law, foreign investors are exempt from capital gains if they are based in tax havens that have signed dual taxation treaty prohibition agreements with Korea.

Thus, most foreign funds in Korea are legally domiciled in Labuan, a small island off of Malaysia’s Borneo coast, which is designated as a financial hub by the Malaysian government. Malaysia’s tax treaty with Korea prohibits dual taxation, and the arrangement allows U.S. firms to avoid paying capital gains taxes in Korea. Malaysia, though, takes a commission from profits earned by the firms. So it is generally believed that the government in Kuala Lumpur has little incentive to side with Korea in its pursuit of the firms.

But Newbridge and HSBC are based in the Cayman Islands. The Cayman Islands – a British colony in the Caribbean northwest of Jamaica and an international banking center- does not have such an agreement with Korea, which leaves Newbridge and HSBC more vulnerable to prosecution.

Meanwhile, the Korean legislature has promulgated legislation that will require foreign firms investing in Korea to pay taxes, regardless of their tax domicile registration. That legislation is not likely to be passed until next year.

In case the investigations and fines were not sufficiently chilling, the NTS is also referring the cases to government officials to determine whether to prosecute officials of the funds who it says have failed to abide by tax regulations. The first prosecution resulting from the referral, announced last week, is that of Steven Lee, who recently resigned as head of Lone Star Funds in Korea.

In the meantime, the U.S. firms fined are losing the battle of public opinion. The Korean media is giving prominent play to experts and academics who are proponents of the theory that the government has the right to do as it wishes in regards to reclaiming money from foreign firm’s profitable deals.