"Taxation on Excess Retained Earnings of Personal Similar Corporations Fails to Reflect Industry Characteristics... Construction Should Be Excluded"

New 'Excess Retained Earnings Tax' Introduced to Prevent Tax Evasion by Personal Similar Corporations
Many Construction Companies Inevitably Suffer Due to Lack of Consideration for Construction Industry Characteristics
"Call for Withdrawal of Corporate Retained Earnings Tax System or Exclusion of Construction Industry"

[Asia Economy Reporter Yuri Kim] The government has introduced a new tax on 'excess retained earnings' to prevent tax evasion by individual quasi-corporations, but an analysis suggests that many construction companies will inevitably suffer due to the failure to consider industry-specific characteristics. There are calls for the repeal of the system, exclusion of the construction sector, or the establishment of reasonable improvements reflecting industry characteristics.

The Korea Construction Industry Research Institute stated this in the report titled 'Problems of Excess Retained Earnings Taxation on Individual Quasi-Corporations and Its Impact on the Construction Industry' published on the 11th.

The 2020 tax law amendment announced last July included a new bill under the 'Special Taxation Restriction Act' to tax excess retained earnings of individual quasi-corporations. The Ministry of Economy and Finance explained that the purpose of the new bill is to "prevent income avoidance through retention by individual business owners and similar corporations." It is expected to be applied from the business year starting in 2021.

According to the Ministry of Economy and Finance, an individual quasi-corporation is a corporation where the largest shareholder and related parties hold more than 80% of the corporate shares. Excess retained earnings are calculated by multiplying the appropriate retained earnings by the shareholding ratio, and the Ministry plans to consider this as dividends paid to shareholders and tax it as dividend income. Retained earnings refer to income generated by a corporation through ordinary and non-ordinary activities that remains within the company without being distributed externally. Appropriate retained earnings refer to the larger amount between 50% of the total distributable income after deducting carried-over losses and taxes for each business year, or 10% of the capital stock. Therefore, excess retained earnings refer to the amount of retained earnings exceeding the appropriate retained earnings accumulated within the company, which the Ministry intends to tax. Since the taxable retained earnings pertain to the 2021 fiscal year, actual tax payments are expected to be made in March 2022 when the financial statements are finalized.

The Korea Construction Industry Research Institute anticipates that while the government aims to prevent income tax avoidance through retention by individual quasi-corporations, most of these corporations are small and medium-sized enterprises (SMEs), making their damage inevitable. In Korea, a large portion of SMEs are owned by family owners holding significant shares, so the damage from the deemed dividend income on excess retained earnings is expected to be concentrated. According to the Korea Federation of SMEs, about 9% of all companies are expected to be subject to taxation, and a survey of 300 unlisted SMEs showed that 49.3% had a largest shareholder and related parties holding more than 80% of shares. Senior Research Fellow Youngdeok Kim of the Korea Construction Industry Research Institute said, "The target of retained earnings taxation is likely corporations that have been avoiding taxes by keeping money in the corporation for tax evasion purposes," adding, "However, there are many retained earnings held for normal business or management activities unrelated to tax evasion, so controversy is expected to continue."

The Ministry of Economy and Finance is reportedly considering excluding companies engaged in normal business activities from taxation through detailed enforcement decrees to be announced at the end of the year, taking these points into account. However, there is still no clear standard to distinguish between retained earnings for normal activities and those for tax evasion, and even if such standards are established, confusion is expected to increase due to issues in handling corporate retained earnings.

Among industries, the construction industry is expected to have many companies subject to taxation because they often secure a certain level of retained earnings to conduct public projects and housing businesses. Small and medium-sized construction companies, which mainly participate in projects under 10 billion KRW, often maintain retained earnings to obtain good scores in management status evaluations for public construction projects. The Korea Construction Industry Research Institute stated, "Construction and housing projects involve many unpredictable risks and require significant equity investment, and many construction company representatives hold the position of largest shareholder."

Currently, public construction projects under 10 billion KRW ordered by local governments and national agencies are awarded based on evaluations of construction capability, including construction experience and management status, as well as bid prices, according to detailed standards by the Ministry of the Interior and Safety and the Public Procurement Service. Management status is evaluated based on credit ratings for corporate bonds or commercial paper and financial ratios (debt ratio, current ratio, etc.). Since small and medium-sized construction companies often find it difficult to obtain credit ratings due to their size, they are frequently scored based on financial ratios. As a result, many retain earnings to achieve better management status evaluation scores, and if the retained earnings tax is implemented, most small and medium-sized construction companies are expected to be subject to taxation and face heavy tax burdens, according to the Korea Construction Industry Research Institute's analysis.

Senior Research Fellow Kim said, "There has been controversy over retained earnings taxation in the past," adding, "The reason it has not been taxed until now is mainly due to ongoing debates about the nature of retained earnings." He emphasized the need to recognize that retained earnings are not a means for companies to avoid investment. High retained earnings and retention rates should be seen as indicators of sound corporate management, reflecting high profitability and strong investment capacity.

He added, "Choosing a corporate business entity with corporate growth in mind, the retained earnings tax system may act as a regulation, causing reluctance to convert to corporations," and emphasized, "Introducing deemed dividend taxation on corporate retained earnings distorts tax fairness between individual and corporate businesses and distorts economic actors' behavior, which is undesirable."

The Korea Construction Industry Research Institute considers it desirable to repeal the introduction of deemed dividend income on excess retained earnings. Although the Ministry of Economy and Finance maintains that the tax cannot be repealed after its introduction, including many large, medium, and small companies in the construction industry as taxable entities is inconsistent with the law's intent. Given the construction industry's characteristics, such as business processes and project durations, securing retained earnings is inevitable, so excluding the construction industry from taxation is advisable. The institute stated, "Considering the nature of construction projects as order-based industries with long project durations and unpredictable large-scale investments, retained earnings should be recognized as a means for sustainable operations and business expansion." Therefore, it is suggested that the construction sector be excluded from the excess retained earnings tax, reflecting industry characteristics.

Senior Research Fellow Kim added, "It is necessary to flexibly apply the scope of appropriate retained earnings considering industry characteristics or consider raising the threshold for appropriate retained earnings," suggesting raising the standard for appropriate retained earnings used to calculate excess retained earnings to better reflect reality, and differentiating the scope of appropriate retained earnings by industry, such as construction, rather than applying a uniform standard. He said, "More fundamentally, future tax policies for companies should recognize corporate autonomy and creativity and broaden interpretations of normal business activities."

This content was produced with the assistance of AI translation services.