South Korea’s First Major Investor-State Dispute in the 21st Century: Foreign Investors and Tax

Joon Yoo, Vol. 37 Associate Editor

This past summer, a hearing was held at the International Centre for Settlement of Investment Disputes (ICSID) in Washington, D.C. concerning an international arbitration between the South Korean government (hereinafter “the Government”) and Lone Star Funds (hereinafter “LSF”), a U.S.-based private equity fund that filed this arbitration claim at the ICSID to seek reimbursement of $4.68 billion from the South Korean government.[i] The stakes are enormous, and not only because of the amount of money in controversy. ICSID’s decision cannot be appealed as in ordinary lawsuits and if South Korea loses this dispute many more similar suits by foreign business entities could follow.[ii] The dispute involves two major issues: (1) whether or not the Government unduly delayed the sale of LSF’s controlling interest in Korea Exchange Bank (KEB), especially by refusing to approve the KEB’s sale to HSBC in 2007; and (2) whether or not the Government’s taxation of the profit from KEB’s sale in 2012 was in violation of the bilateral investment treaty between South Korea and Belgium-Luxembourg.[iii] Most importantly, the outcome as to the second issue will turn on how to interpret the bilateral investment treaty that does not expressly mention the tax status of foreign subsidiaries based in Belgium which could have been used as mere paper companies to funnel investment into another country solely for the purpose of taking advantage of favorable tax provisions of the treaty.

The whole story began in 2003, when LSF acquired a controlling interest in KEB, the fifth largest Bank in South Korea at that time, despite controversy as to whether such a transaction violated the Korean law that prohibited the sale of a controlling interest in a Korean bank to a non-bank business entity unless the bank was in financial distress.[iv] Whether KEB in 2003 was distressed enough to require outside capital infusion was a matter of dispute but the country’s financial regulators decided that the bank was sufficiently distressed and thus permitted its acquisition by LSF later that year.[v] LSF used its Belgian subsidiary to purchase the controlling interest in KEB, taking full advantage of the favorable tax provisions in the investment treaty between South Korea and Belgium.[vi]

Not long after LSF acquired KEB, suspicions of illegality arose and the two entities became engulfed in various investigations and trials for several years. Amid legal controversy, LSF attempted to sell its controlling interest in KEB several times, most notably in the final stages of a deal with HSBC. In September 2007, LSF and HSBC reached a preliminary agreement for the sale of KEB, but under Korean law government approval was necessary in transferring a controlling interest in a bank. Due to the ongoing investigations and litigation surrounding LSF and KEB, the Government refused to approve the sale.[vii] A year later in September 2008 when Lehman Brothers famously collapsed HSBC walked away from the deal and as the global financial crisis significantly depressed KEB’s stock price LSF essentially lost an opportunity to maximize its profit in attempting to sell KEB.[viii] When the guilty verdict from the aforementioned stock manipulation case was confirmed, the Government ordered LSF to sell its shares in KEB because under Korean law an entity that has been found criminally liable was prohibited from holding more than 10% of a bank’s shares.[ix] LSF managed to sell its KEB shares to Hana Financial Group for approximately $2.8 billion in February 2012 and the Government levied a tax on that sale.[x] LSF filed a claim against the Government at ICSID later that year.

As U.S. law students, our intellectual curiosity should focus not on the first issue, which exclusively involves Korean law and LSF-KEB’s activities within South Korea, but on the second issue, which concerns bilateral investment treaties between countries and how a foreign investment conducted through a foreign subsidiary should be treated by the government of a country where that investment is made. LSF argues that its sale of KEB should not have been taxed by the Government because first, it was LSF’s Belgian subsidiary that had purchased and held the KEB shares and second, the Korea-Belgium investment treaty allows tax exemption for investment activities between the two countries, i.e. the Belgian LSF’s sale of its KEB shares to Hana Financial Group, a Korean business entity.[xi] The Government argues that the subsidiaries such as LSF Belgium are merely paper companies and thus should not be protected by investment treaties.[xii] In essence, the Government’s argument means that LSF’s Belgian subsidiary is merely a shell and it is the LSF U.S. which has been the real decision-maker and beneficiary behind the sale of KEB, therefore the Korea-Belgium investment treaty does not apply to the taxation of the KEB sale.

Unless countries – such as South Korea and Belgium in this instance – renegotiate their investment treaties to add provisions that expressly deal with taxation of investments made through subsidiaries owned by companies that are not based in countries covered by the respective treaty, the ICSID’s decision on this LSF-South Korea dispute might have an enormous impact on the business practice of using foreign subsidiaries to fund investments in another country for the purpose of minimizing tax expenditures. For example, if the ICSID rules in favor of South Korea then the use of subsidiaries located in foreign countries to invest abroad would lose part of its attractiveness as a tax-minimizing strategy if the substance of an investment (i.e. the chief decision-maker and beneficiary) is not the subsidiary itself.

Also, this issue of taxation involves statutory interpretation of investment treaties such as the one involved in this dispute. The question here is whether to be formalist/textualist or functionalist in interpreting the tax provision. If the ICSID were to follow the formalist/textualist approach, then it would hold in favor of LSF on this issue because (1) the treaty’s text covers companies based in Belgium, (2) LSF Belgium is a company based in Belgium, (3) it was LSF Belgium that purchased and sold the KEB shares at a profit and therefore tax exemption applies. If the ICSID were to take the functionalist approach, the discussion would become more complex than that for the formalist/textualist approach but the result would likely be that tax exemption does not apply because LSF Belgium is merely a shell that has no substance. Interpreting the treaty through the functionalist lens is further complicated by the pragmatic business concern that, because such investment treaties are signed for the purpose of allowing exemption from double-taxation, i.e. being taxed by both countries to the treaty for the same transaction, taking the functionalist approach to hold in favor of South Korea might have the ripple effect of discouraging foreign investment in general until such treaties are renegotiated for further clarity on the tax status of foreign subsidiaries suspected of being paper companies. The high probability of many more similar ISD suits to follow if South Korea loses this dispute[xiii] implies that investing in foreign countries via foreign subsidiaries is hardly a rare phenomenon in modern capitalism.

Given what is at stake beyond merely the dollar amount, this case is worthy of attention not only to those interested in South Korea but to anyone interested in laws governing foreign investment and taxation.


[i] See $4.68B Lone star versus Korea hearing begins in Washington DC, The Korea Times, May 15, 2015, http://www.koreatimesus.com/first-hearing-opens-over-lone-star-asset-sell-offs-in-korea/.

[ii] See Id.

[iii] See S. Nathan Park, What’s At Stake: South Korea vs Lone Star Funds, The Wall Street Journal: Korea Realtime (Jun. 29, 2015), http://blogs.wsj.com/korearealtime/2015/06/29/whats-at-stake-south-korea-vs-lone-star-funds/.

[iv] See Id.

[v] See Id.

[vi] See Id.

[vii] See Id.

[viii] See Id.

[ix] See Id.

[x] See Id.

[xi] See The Korea Times, supra note 1.

[xii] See Id.

[xiii] See Id.