Not long ago, I came across a situation in which a US citizen/resident (“Client”) exercised stock options to acquire stock in a South Korean corporation (“KoreaCo”). KoreaCo granted the options to Client as compensation for services that Client performed in the US during a prior year. Client has never been an employee of KoreaCo and performed no services in Korea.
Around the time of the option exercise, the Korean professionals involved insisted that Client was subject to Korean taxation on the excess of the stock’s fair market value (“FMV”) over the cost of exercising the option. (i.e., treating the “bargain purchase price” as income)
For the sake of discussion, assume that the excess was equal to $1 million, which would have given rise to an approximate Korean tax of $200,000.
Issue:
Is Client liable for the $200,000 of Korean income tax noted above?
Brief answer:
No. The United States – Republic Of Korea Income Tax Convention (the “Treaty”) prohibits Korea from taxing Client on the $1 million.
Discussion:
Tax treaties are bilateral (i.e., applying to both parties) agreements between countries that can override one or both countries’ domestic tax rules to the extent that taxpayers qualify for their benefits. These benefits often allow applicable taxpayers to be subject to lower rates of tax on income associated with one or both countries. This could involve reduced withholding rates on things like dividends paid by a domestic corporation to a non-domestic shareholder (e.g., withholding 10% instead of 30%), or even full exemption or certain types of income.
According to the Korean professionals involved in the matter, Korean tax law states that if an individual in Korea exercises stock options for a payment of 100x when the stock has a FMV of 300x, such transaction gives rise to a taxable “gain” of 200x, and a corresponding tax of 40x (20% rate x 200x).
However, the Treaty overrides this otherwise-applicable Korean tax rule as follows. The text of the Treaty and the Technical Explanation are available at https://www.irs.gov/businesses/international-businesses/korea-tax-treaty-documents.
Treaty Article 1 (Taxes Covered), paragraph (1)(b) provides that the Treaty covers Korean Income Tax. Per the Korean tax professionals, the tax on the “gain” is a tax covered by the Treaty.
Treaty Article 6 (Source of Income), paragraph (6) provides in relevant part that
Income received by an individual for his performance of labor or personal services, whether as an employee or in an independent capacity, or for furnishing the personal services of another person and income received by a corporation for furnishing the personal services of its employees or others, shall be treated as income from sources within one of the Contracting States only to the extent that such services are performed in that Contracting State.
The Treaty’s Technical Explanation, Article 6 (Source of Income), paragraph 1 elaborates that a Contracting State (e.g., Korea) may tax a resident of the other Contracting State (e.g., United States) only on income from sources within the first-mentioned Contracting State (as long as the resident is not a citizen of the first-mentioned Contracting State).
Treaty Article 16 (Capital Gains), paragraph (1) further clarifies that a US resident recognizing gains in Korea that (a) don’t relate to real property and (b) who does not have a Korean Permanent Establishment (i.e., a fixed place of business in Korea, pursuant to Article 9) is exempt from Korean taxation.
Treaty Article 18 (Independent Personal Services) also indicates that Client is exempt from Korean taxation on the “gain” because Client was not in Korea for any amount of time even if Client did perform independent services.
Based on the above, it is clear that the Treaty exempts Client’s “gain” on the option exercise and that the otherwise-applicable corresponding 20% Korean tax does not apply.
Caveat: the above discussion relates solely to Korean income tax imposed on the economic “gain” and not any other taxes (e.g., stamp duties and social insurance contributions). This article is meant solely for general awareness purposes and should not be relied upon as professional advice. Proper treatment of each situation will depend on the specific facts and circumstances and the reader should seek out their own professional advice.
Interesting aside: Would payment of the $200,000 Korean tax would be eligible for a foreign tax credit? Unfortunately, the answer is no because that Korean tax is not truly a tax imposed on Client since the Treaty prohibits Korea from imposing it in this example. To qualify for the foreign tax credit, payment must be compulsory for it to be considered a “tax.”