US Citizens/Residents Exercising Stock Options May be Exempt from Korean Income Taxation

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.”

WHY do we use the "lag method" to deduct California Franchise Taxes?

I once got a call (on behalf of another CPA) asking WHY an accrual-basis taxpayer's deduction for California Franchise Taxes ("CFT") must be taken on the "lag method."

In short, the "lag method" involves taking a deduction for the CFT in the year following that in which the taxable income arose from which it was determined (e.g., CFT computed at $100x earned in 20x1, times 8.84% is $8.84x and is deductible in 20x2 for federal income tax purposes).  While this rule has applied for many years, the reason for it doesn't seem to be widely known.

In a nutshell, the CFT deduction is subject to the “lag method” for federal tax purposes due to Internal Revenue Code section 461(d).  But wait, you say...section 461(d) doesn't say anything about CFT!  All it says is the following:

461(d) Limitation on acceleration of accrual of taxes.

      (1) General rule. - In the case of a taxpayer whose taxable income is computed under an accrual method of accounting, to the extent that the time for accruing taxes is earlier than it would be but for any action of any taxing jurisdiction taken after December 31, 1960, then, under regulations prescribed by the Secretary, such taxes shall be treated as accruing at the time they would have accrued but for such action by such taxing jurisdiction.

      (2) Limitation. - Under regulations prescribed by the Secretary, paragraph (1) shall be inapplicable to any item of tax to the extent that its application would (but for this paragraph) prevent all persons (including successors in interest) from ever taking such item into account.

So what does the above text have to do with delaying the deduction for CFT?  Well, it goes back to the general rules for timing (section 461) as well as a bit of history.

At the risk of boring some readers, a bit of background is warranted here.  Any accrual-basis taxpayer wishing to take an expenditure into account (whether deducting or capitalizing it) must first meet the all events test.  Moreover, such item cannot be taken into account until there is economic performance.

Section 461(h)(4) provides that "the all events test is met with respect to any item if all events have occurred which determine the fact of liability and the amount of such liability can be determined with reasonable accuracy." In other words, the liability in question (e.g., for the tax owed to California) must (1) be unconditionally due to the person to whom it's owed, and (2) must be able to be reasonably determined as of the day it's to be taken into account (i.e., generally the last day of the tax year).

Section 461(h)(2) and Treas. Reg. section 1.461-4 provide the rules for determining when economic performance occurs.  In the case of taxes, economic performance occurs when those taxes are paid, in keeping with Treas. Reg. section 1.461-4(g)(6).

Based on the section 461 rules above, wouldn't the CFT be properly accrued as of the last day of the year?  After all, at year-end isn't (1) the tax reasonably ascertainable, (2) the amount unconditionally due, and (3) assuming estimates were paid throughout the year economic performance was met (or the taxpayer had adopted the recurring item exception of section 461(h)(3) and Treas. Reg. section 1.461-5)?

The answer is currently yes, but used to be no. And that's where the history comes in.  

In the early 1970s, California modified its franchise tax regime which imposed a tax on most corporations doing business in the state.  Before this change, a corporation's franchise tax would be measured on the corporation's current-year income, but would apply to the exercise of its corporate franchise (i.e., the right to do business in California) starting with the first day of the corporation's following year.  As a result:

• All events test met (unconditionally due):   No, because the tax was not owed until the company started exercising its corporate franchise on the first day of the next year.
• All events test met (reasonably ascertainable):   Yes, since taxable income and the tax rate were "knowable" at year-end.
• Economic performance met:  Presumably Yes, as noted above.

In doing so, California took action (after 12/31/1960) that effectively accelerated the accrual date of the CFT.  This invoked section 461(d)(1), thereby negating that acceleration for federal income tax purposes.

So there you have it.


Final notes:  

• Too often, taxpayers (and their tax professionals) don't fully understand the rules for claiming deductions in the correct year.  That means write-offs are sometimes being taken too early and sometimes too late.
• The CFT tax deduction is just one example of how the "income tax accounting" rules can be surprisingly complicated and counterintuitive.
• I spent considerable time in KPMG's Washington National Tax practice and have personally seen how timing issues can have a multi-million dollar tax impact on someone's tax bill.  Moreover, timing issues exist in virtually every industry and area of tax, so knowing the rules and how to apply them will (literally) affect most individuals and businesses.  
• Let me know how I can help you (or your advisor) navigate this often-misunderstood area and avoid costly mistakes!

For more discussion of this rule, the following are enlightening.

• Rev. Rul.  2003-90 (http://www.irs.gov/pub/irs-drop/rr-03-90.pdf)
• Wells Fargo & Co. v. U.S., No. 09-CV-2764 (D. Minn. 8/10/12) (http://www.gpo.gov/fdsys/pkg/USCOURTS-mnd-0_09-cv-02764/pdf/USCOURTS-mnd-0_09-cv-02764-5.pdf)