Contributed By Bae, Kim & Lee LLC
Alternative investments are attracting a significant pool of local wealth, including sovereign wealth and pensions, and investment by high net worth individuals and family offices.
The growth of Korean investors’ overseas allocations is outpacing that of their domestic allocations, driven by limited opportunities in their own jurisdiction and a thirst for higher returns. Fund managers are extending into new locations, with Korea being an attractive destination for finding new investors.
Under the Financial Investment Services and Capital Markets Act of Korea (FSCMA), collective investment schemes or funds are classified into public funds and private funds, depending on whether the fund is offered to investors by way of public offering (ie, investment solicitations vis-à-vis more than 49 prospective investors) or it is offered to certain eligible investors by way of private placement. There is no separate classification for funds investing in alternative assets. However, since most of the funds investing in alternative assets are established as private funds, the terms “alternative investment funds (AIFs)” and “private funds” will be used interchangeably in this chapter.
Under the FSCMA, private funds are further classified into two types: privately offered collective investment schemes for specialised investment (SIPF) and privately offered collective investment schemes for management participation (“private equity fund” or PEF).
SIPFs can be established using various types of legal structures. In practice, the most common form of SIPF is an investment trust, which has the following features:
SIPFs may also be established in various corporate forms, usually as an investment company or an investment limited liability company, the major features of which are detailed below.
Investment Limited Liability Company
PEFs must take the form of a limited partnership company. Members of a limited partnership company consist of at least one general partner with unlimited liability and at least one limited partner with limited liability to third-party creditors of the limited partnership company. Investors participate in the company as limited partners. The manager must be the general partner of the limited partnership company.
The primary body of law regulating the investment funds industry in Korea is the FSCMA.
The main regulator is the Financial Services Commission (FSC). Many of the supervisory responsibilities of the FSC are delegated to the Financial Supervisory Service (FSS), the enforcement arm of the FSC, which is responsible for day-to-day supervision and regulation of the financial industry, including fund registration and reporting of fund establishment, regular and ad hoc regulatory reporting, securities registration statement filings, processing of fund manager licence applications and so on.
Investment Restrictions – SIPFs
In terms of target investment assets, an SIPF is not subject to any regulatory restrictions other than that it cannot make investments in securities issued by an operating portfolio company with the aim of participating in its management, which is strictly reserved for PEFs.
In addition, SIPFs making investments in real estate assets must not:
Investment Restrictions – PEFs
A PEF is limited to making investments in companies with the aim of participating in their management. Specifically, a PEF can make investments in the following:
A PEF must ensure that 50% or more of the aggregate capital contribution of its partners to the fund are invested in assets described in the first, second, fifth and sixth items above within two years from the time of their respective capital contributions. Furthermore, a PEF must not dispose of any asset described in the first, second, third or sixth items above within six months of its acquisition, except for when the portfolio company is affected by an exceptional event.
Restrictions on Leverage – SIPFs
An SIPF is subject to certain limits on its borrowing, guaranteeing and investment in financial derivatives. Specifically, the ratio of the sum of the following amounts over the SIPF's net assets (leverage ratio) must be lower than 400%:
Restrictions on Leverage – PEFs
A PEF is permitted to borrow money or guarantee for a third party up to 10% of its net assets and only for certain limited purposes, such as temporary shortage of capital for operating costs or investments in portfolio companies. However, a PEF-SPC is permitted to leverage its investments by borrowing money or guaranteeing a third party related to the portfolio company up to 300% of its shareholders' equity.
SIPFs can make investments by way of originating loans. An SIPF which originates loans must comply with an administrative guideline issued by the FSC (Loan Originating SIPF Guideline). The Loan Originating SIPF Guideline provides various restrictions and requirements applicable to loan-originating SIPFs, including the following:
Firstly, loan-originating SIPFs must not make loans to individuals.
Secondly, the investors in a loan-originating SIPF must be limited to institutional investors and financial institutions listed in Article 4(1) of the Loan Originating SIPF Guideline. However, if the loan-originating SIPF extends loans to borrowers which are established for the purposes of acquiring, developing, managing, or improving real estate or special assets (meaning assets other than securities and real estate assets), the foregoing limitation on the investors will not apply to such loan-originating SIPF.
Thirdly, the constituent documents of the loan-origination SIPF must specify:
Korean law does not expressly prohibit private funds from investing in cryptocurrencies. However, it appears that there has not been any Korean fund established for the purposes of investing in cryptocurrencies since the regulators informally took the position that investment managers in Korea should not invest fund assets in cryptocurrencies until the pending legislation creating the regulatory framework on the cryptocurrency market is finalised.
Establishment of a private fund does not require prior authorisation or registration from the regulators. However, an ex-post report must be filed with the FSS within two weeks of a private fund’s establishment.
Local funds must have Korean investment managers as their managers. Specifically, an SIPF must have an SIPF manager as its investment manager and a PEF must have a licensed PEF manager as its general partner. An SIPF manager may outsource its investment management function to offshore investment managers with respect to investments in assets in other jurisdictions, subject to certain reporting requirements and restrictions (see 3.6 Outsourcing of Investment Functions/Business Operations).
An investment trust is a contractual form of fund, so it is not a legal entity. Other SIPFs, established in corporate form, and PEFs are legal entities, but they are restricted from having their own standing officers or employees other than their corporate directors or general partners, who must also be their SIPF managers or PEF managers, as applicable. In addition, corporate SIPFs and PEFs must maintain a main business office, but are required not to have any other business offices.
An SIPF is required to engage a trustee for custody of the fund's assets. In addition, an SIPF in the form of an investment company is required to engage a local administrator and SIPFs established in other legal structures usually engage local administrators.
A PEF is required to engage a trustee for custody of its assets.
Non-local service providers are prohibited from being engaged by local funds.
Taxation of AIFs varies depending upon the type of AIF. In addition, treatment under the relevant tax law may vary depending on whether the AIF meets the following requirements to be classified as a “qualifying fund”:
Taxation of a Trust
There is no taxation at the trust level and taxable income is only recognised once the income is distributed to the investors. Any income distributed by qualifying funds to individual investors is taxed as dividends, whereas income distribution by funds that do not meet the requirements of a qualifying fund is taxed according to the nature of that income (ie, interest, dividends, capital gains, and business profits). When the income is distributed to corporate investors, the distribution constitutes taxable income for a given taxable year and subject to corporate income tax at the corporate investor level. As such, the tax treatment of the distribution does not differ based on whether or not the fund is a qualifying fund.
Taxation of Company-Type Funds
At the fund level, company-type funds such as investment companies and investment limited liability companies under the FSCMA are, in principle, subject to corporate income tax on investment profits from investment operations. However, if 90% or more of the distributable income is paid out as dividends, this amount is deducted from the taxable income, which enables the fund to avoid double taxation at the fund level. After taxes are paid at the corporate level, net profits are distributed to each investor in the form of dividend income and taxed again at the investor level.
Taxation of Private Equity Funds
Domestic PEFs may elect to be treated as pass-through entities for tax purposes so that income tax is not incurred at the PEF level and each partner’s income from the PEF will be subject to corporate income tax or individual income tax. If the PEF does not make such an election, the fund itself, as opposed to the investors, is liable for taxes at applicable corporate income tax rates.
At the investor level, income arising from the PEF is regarded as dividends, except for in the case of the following foreign investors resident in a country that has a tax treaty with Korea:
For those investors that qualify for such exception, their income from the PEF will be classified based on the underlying income recognised by the PEF. Accordingly, if the PEF received capital gains, then distribution of such capital gains to the qualifying foreign investors will be treated as capital gains for the foreign investors and not as dividend income.
Trusts established in Korea generally do not qualify for benefits under the double-tax treaties Korea has entered into with other jurisdictions. However, the Korea-US double-tax treaty allows for treatment of income received by a partnership or trust to be determined by the residence and taxation of the partner or the person subject to taxation on such income. Company-type funds established in Korea would generally be considered Korean-resident corporations and would therefore be eligible for benefits under double-tax treaties.
It is common for PEFs to establish PEF-SPCs as their subsidiaries. Since PEFs are prohibited from using leverage at the fund level, PEF-SPCs are used to leverage investments. In the case of SIPFs, special purpose vehicles (SPVs) are usually used for tax-structuring purposes, especially in relation to outbound investments.
Promoters/sponsors of local AIFs are mostly local companies.
Most of the investors in local AIFs consist of local investors. Therefore, generally Korean investors such as banks, asset managers, corporate investors, insurance companies, government agencies, public pension funds, and family offices invest in AIFs established in Korea.
AIFs established in Korea traditionally preferred to invest locally. However, as domestic investment opportunities have become relatively scarce due to the slowing economy, there has been a noticeable uptick of AIFs actively seeking investment opportunities in other jurisdictions, especially in developed countries such as the USA and European countries.
Due to the slow economic growth and stagnant capital markets, the traditional public funds market (open to all investors including both retail and institutional investors) has been in the doldrums, with total assets under management (AUM) slightly increasing from KRW210.3 trillion (approximately USD174 billion) in 2009 to KRW240.9 trillion (approximately USD197 billion) in March 2020.
In contrast, the private funds market (catering mainly to institutional investors, corporations and high net worth individuals) has seen a huge growth in demand. The AUM of private funds (excluding PEFs) has more than tripled from KRW108.2 trillion (approximately USD90 billion) in 2009 to KRW418.1 trillion (approximately USD342 billion) in March 2020.
In terms of investment strategies, the growth of AIFs focusing on real estate, infrastructure and private credits has been outstanding over the past several years.
There has, however, recently been a series of scandals where private funds managers were reportedly involved in various irregularities, such as mis-selling, embezzlement of fund assets, and managing funds in violation of the constituent documents of the funds, resulting in huge losses to the investors in private funds, especially non-professional individual investors.
An SIPF manager is not subject to any mandatory reporting or disclosure requirement to the investors. In comparison, a PEF manager is required to provide LPs of the PEF it manages with the fund's financial statements, together with a description of the operation and investments of the PEF, at least on a semi-annual basis.
Regulatory Reporting Requirements – SIPFs
SIPF managers must report the following information, regarding each SIPF it manages, to the FSS:
In addition, if any of the following events occurs in relation to an SIPF, its manager must report such event to the FSS within two weeks:
Finally, an SIPF manager must file an amendment report within two weeks when there is a change in any item reported in the fund establishment report of an SIPF it manages.
Regulatory Reporting Requirements – PEFs
A PEF manager must report the following information regarding each PEF it manages to the FSS:
In addition, if a PEF participates in the management of a portfolio company, it must report that management participation to the FSS within two weeks. Finally, a PEF manager must file an amendment report within two weeks when there is a change in the items reported in the fund establishment report of a PEF it manages.
In response to the recent financial scandals in the private funds market mentioned in 2.17 Key Trends, the FSC in April 2020 announced plans to amend the FSCMA and its subordinate decrees and regulations. The amendments will aim to strengthen risk management based on market disciplines, improve investor protection (including additional obligations on the fund sellers), and strengthen supervision and inspection on private funds and related market participants.
SIPF managers are typically established as joint stock companies. PEF managers are established mostly as either joint stock companies or limited liability companies.
Both SIPF managers and PEF managers are subject to the registration regime. The information below sets out the requirements for registration as an SIPF manager and a PEF manager.
SIPF Manager Registration
Local presence – the applicant must be:
Minimum shareholders' equity: KRW1 billion (approximately USD8.3 million).
Personnel: at least three full-time investment professionals.
Facilities: the applicant must have office space and physical facilities, including security equipment and computer equipment sufficient for conducting a hedge fund management business.
Officers: officers of the applicant (including directors and the statutory auditor) must meet the requirements under Article 5 of the Financial Companies Corporate Governance Act – essentially, they should not have been subject to any criminal or other sanctions in the past five years.
Major shareholders: major shareholders, including the largest shareholder and significant shareholders with a 10% or more shareholding in the applicant, must meet certain standards of financial soundness and social credibility.
Financial stability and social reputation: must be financially sound and socially reputable.
Prevention of conflicts of interest: the applicant must have a system in place to prevent conflicts of interest.
PEF Manager Registration
Local presence: no specific requirements. However, the regulator, as a matter of policy, requires the PEF manager to be a local corporate entity in Korea. Most commonly, local PEF managers are established as a joint stock company or a limited liability company.
Minimum shareholders' equity: KRW100 million (approximately USD83,000).
Personnel: at least two full-time investment professionals.
Facilities: not required.
Officers: same as for an SIPF manager.
Major shareholders: not required.
Financial stability and social reputation: same as for an SIPF manager.
Prevention of conflicts of interest: same as for an SIPF manager.
The applicant prepares the application and supporting documents and will normally need to have a pre-filing consultation with the FSS reviewing officer. With respect to the time required for an SIPF manager registration, the FSC must process the application and complete the registration within two months from the time the applicant filed a full application package, excluding time taken by the applicant to supplement the application when required by the regulator. In the case of a PEF manager registration, the FSC must process the application and complete the registration within one month after accepting the completed application package, excluding time taken by the applicant to supplement the application when required by the regulator.
Fund managers are generally established as corporations in Korea. Management/advisory vehicles that are established or tax-resident in Korea are subject to corporate income tax on any form of profit-related returns, including carried interest and management fees.
The corporate income tax rate is 10% on the first KRW200 million of taxable income, 20% on taxable income over KRW200 million up to KRW20 billion, 22% on taxable income over KRW20 billion up to KRW300 billion, and 25% on taxable income over KRW300 billion. In addition, the local surtax is taxed in addition to corporate income tax at progressive tax rates ranging from 0.1% to 2.5% on the taxable income.
There are no exemptions or rules available in Korea to ensure that alternative funds with a manager in Korea do not have a taxable presence in the jurisdiction.
As discussed in 3.3 Tax Regime, there is no special tax treatment on carried interest. It is subject to corporate income tax at the regular tax rates applicable to Korean corporations.
SIPF managers are allowed to outsource their investment function or business operations in relation to the management of SIPFs subject to certain restrictions and a prior reporting obligation to the FSS. Specifically, an SIPF manager may outsource investment function in relation to an SIPF investing in assets located in other jurisdictions to an offshore investment manager, if such offshore investment manager is licensed in its home jurisdiction to engage in collective investment management businesses.
By contrast, PEF managers are not allowed to outsource their management functions to third parties.
See 3.2 Regulatory Regime.
Non-local managers are not allowed to establish local AIFs under Korean law. However, non-local managers may access Korean investors by way of offering AIFs established in other jurisdictions (offshore funds) to Korean investors as long as such offshore funds are registered in advance with the FSS.
Eligible investors for an SIPF are:
Eligible investors for a PEF are:
Since 1 January 2015, establishing a single investor fund has been prohibited in Korea except for when the single investor falls under certain types of prescribed investors, including public funds established pursuant to laws (eg, the National Pension Fund), Korea Post, and mutual aid associations and mutual aid co-operatives (eg, the Korea Teachers Credit Union and the Military Mutual Aid Association).
Traditionally, most of the investors in AIFs consisted of large institutional investors and financial institutions. Recently, however, an increasing number of high net worth individuals has started to invest in AIFs.
Please see 4.1 Types of Investor in Alternative Funds.
Marketing of AIFs must be conducted by way of private placement to the eligible investors listed in 4.1 Types of Investor in Alternative Funds and must not be offered by way of public offering. In addition, the FSCMA provides a few more specific regulations on the marketing of SIPFs, including the applicability of the suitability and appropriateness test, depending on the types of investors and requirements for investment advertisements.
Finally, establishing a single investor AIF is prohibited except for when the single investor falls under certain types of prescribed investors, including public funds established pursuant to specific laws (eg, the National Pension Fund), Korea Post and mutual aid associations and mutual aid co-operatives (eg, the Korea Teachers Credit Union and the Military Mutual Aid Association).
Local investors can invest in AIFs as long as they are eligible investors as listed in 4.1 Types of Investor in Alternative Funds.
SIPF managers and PEF managers can market their own funds without obtaining an additional licence. However, an SIPF manager must employ a certified investment solicitation expert or engage an outside investment solicitation individual registered with the FSC, in order to market hedge funds it manages without engaging an outside fund distributor.
SIPF managers or PEF managers can opt to engage locally licensed investment brokers or investment dealers as distributors of their funds (generally, banks, securities companies and insurance companies). In practice, most SIPF managers engage outside fund distributors, while the marketing of PEFs is usually conducted by their own managers.
Marketing of AIFs is not subject to any mandatory pre-investment disclosure requirement. Customarily, however, managers of AIFs prepare and provide an investment proposal document for the prospective investors which normally includes information on the investment structure, strategies and risks, plus track records of the manager.
With respect to resident investors, the income from the qualifying fund is generally subject to withholding tax at a rate of 15.4% (including local surtax), subject to certain exceptions available for sovereign investors or financial institutions (such as banks and insurance companies). Any taxes withheld by the funds are creditable when the corporate income tax or individual income tax is calculated.
For a resident corporation, any income from the fund is subject to corporate income tax at progressive tax rates. The corporate income tax rate is 10% on the first KRW200 million of taxable income; 20% on taxable income over KRW200 million up to KRW20 billion; 22% on taxable income over KRW20 billion up to KRW300 billion; and 25% on taxable income over KRW300 billion. Local surtax is charged in addition to corporate income tax at progressive tax rates ranging from 0.1% to 2.5% on the taxable income.
Pension funds, as not-for-profit corporations, are also subject to tax. However, the effective tax rates for such pension funds are generally significantly lower because of special reserves that they can set aside and deduct from taxable income. Furthermore, pension funds such as the National Pension Fund or Korea Post are part of the Korean government body and thus, are not subject to corporate income tax.
For a resident individual, any income from the qualifying fund is classified as dividends and subject to individual income tax at progressive tax rates ranging from 14% to 42%. In addition, local surtax is charged in addition to individual income tax at progressive tax rates ranging from 1.4% to 4.2% on the taxable income.
For a non-resident investor, the income from the qualifying fund is generally subject to withholding tax at a rate of 22% (including local surtax) or the applicable withholding rate under the relevant tax treaty, subject to certain favourable exceptions available for foreign sovereign funds which invest through domestic PEFs, as discussed in 2.11 Tax Regime.
Korea signed the Model 1 Intergovernmental Agreement (IGA) with the USA on 10 June 2015. Korea had been treated as if it had an IGA in effect since 30 June 2014, following the issuance of implementation regulations by Korea’s FSC on 18 June 2014.
As of 29 October 2014, the Korean government also entered into the Multilateral Competent Authority Agreement (MCAA) to exchange information with the jurisdictions committed to the Common Reporting Standard (CRS). On 16 February 2017, Korea amended its regulations to implement the automatic exchange of financial information with foreign countries under the CRS and FATCA.