Tax-Exempt Capital Reduction Dividends Used as 'Tax Avoidance Tool for Major Shareholders'... Need for Fairness with Ordinary Dividends [Tax Reform: What Needs to Change]

Editor's NoteThe government announces its annual tax law revision proposal at the end of July and submits it to the National Assembly in September. The final decision on the tax law revision is made after deliberation in the National Assembly. However, in reality, the Assembly usually makes only minor adjustments to the government’s proposal, making the government’s tax law revision plan highly significant. With just two to three weeks left before the government’s announcement, Asia Economy has organized the key issues that should be discussed in this year’s tax law revision.

There is growing criticism that listed companies opting for so-called “capital reduction dividends” (tax-exempt dividends), which allow them to pay dividends without incurring taxes, should also be subject to dividend income tax for the sake of fairness with ordinary dividends. For general shareholders, capital reduction dividends offer the advantage of higher investment returns compared to ordinary dividends. However, there are concerns that, for major shareholders, these dividends could be used as a means to prepare inheritance funds, raising issues of tax avoidance. Additionally, since companies use their capital as the source for these dividends, there are worries that continued capital reduction dividends could threaten financial soundness.

A capital reduction dividend is a method in which a company reduces its “capital surplus reserve” within capital surplus, converts it into retained earnings, and uses this as the source for dividends. This is treated as a “return of capital” in accounting, and is thus tax-exempt, as it is considered a partial return of shareholders’ contributed capital rather than a distribution of company profits. For companies, this allows them to use capital surplus reserves instead of retained earnings to fund dividends, while shareholders can receive dividends tax-free.

This is the key difference from ordinary dividends, which are paid to shareholders from retained earnings after taxes on net income generated from business activities. In the case of ordinary dividends, a dividend income tax of 15.4% (including local taxes) is imposed, and for those subject to comprehensive financial income taxation?where total annual dividend and interest income exceeds 20 million won?the tax rate can reach up to 49.5%. For example, if 1 million won is paid as an ordinary dividend, 154,000 won is withheld as tax, and the shareholder receives 846,000 won. In contrast, with a capital reduction dividend, the shareholder receives the full 1 million won without any dividend income tax.

Due to these advantages, the number of companies adopting capital reduction dividends has been rapidly increasing. After Meritz Financial Group drew attention by implementing a capital reduction dividend in 2023, other companies such as Woori Financial Group, Celltrion, and L&F quickly followed suit. According to a comprehensive survey by Leaders Index, a corporate analysis research institute, the number of KOSPI, KOSDAQ, and KONEX listed companies that resolved at their general shareholders’ meetings to reduce capital surplus reserves and transfer them to retained earnings increased sharply from 31 in 2022, to 38 in 2023, 79 in 2024, and is expected to reach 130 in 2025.

The securities industry generally views capital reduction dividends positively. They are advantageous for boosting short-term shareholder returns and can be strategically used to enhance corporate value (value-up). They also improve capital efficiency and return on equity (ROE), potentially driving up stock prices. In fact, RedcapTour, a car rental and business travel service company, hit the upper price limit after announcing a capital reduction dividend in March, demonstrating its short-term positive impact.

On the other hand, some express concern that capital reduction dividends may deviate from their original purpose and undermine taxpayer predictability and legal stability. The issue of tax fairness is a core argument. While ordinary dividends are taxed, capital reduction dividends are not, leading to concerns that similar dividend actions are being treated inequitably. In particular, major shareholders may use capital reduction dividends as a means to avoid taxes by escaping comprehensive financial income taxation.

Park Sujin and Seo Dongyeon, researchers at the Tax Law Research Center of the Korea Institute of Public Finance, pointed out that under the current system, “Shareholders can enjoy similar economic effects to profit dividends while bearing significantly lower tax burdens,” and added, “Furthermore, cases of tax avoidance (abuse) through capital transactions are not being adequately addressed.”

In the long term, capital reduction dividends may run counter to the value-up initiative for the Korean stock market emphasized by the new administration. The government’s value-up policy is fundamentally aimed at enhancing intrinsic corporate value for long-term growth, whereas capital reduction dividends reduce capital for short-term payouts. Even if using capital for dividends can boost stock prices in the short term, it may violate the principle of capital soundness for companies over the long run. The Ministry of Economy and Finance, in response to the recent surge in capital reduction dividends, is reportedly gathering opinions from relevant agencies such as the National Tax Service, Korea Financial Investment Association, and Tax Tribunal to decide on taxation. However, a ministry official stated, “It has not yet been decided whether the issue of capital reduction dividends will be included in this year’s tax law revision proposal.”