Samsung’s 2015 merger of Samsung C & T and Cheil Industries allowed Samsung heir apparent Jay Y. Lee (pictured above during his trial for bribery) to reconstitute his hold on the conglomerate and avoid a hefty inheritance tax bill, prosecutors say. Image Credit: Bloomberg

What to do if you’re a 95-year-old billionaire and you live in a country with inheritance taxes as high as 65 per cent?

That’s the challenge facing the family of coffee baron Kim Jae-myeong, honorary chairman of Dongsuh group, who built a fortune valued at $2 billion (Dh7.34 billion) by the Bloomberg Billionaires Index. Kim, who’s never appeared on an international wealth ranking, stepped down from management more than two decades ago, but the group remains firmly in family control, with each generation having to find a way to pass down the wealth without running afoul of the taxman.

It’s a common story in South Korea, which rose to become a global industrial powerhouse dominated by family-run entities known as chaebol. Now those groups, from global behemoths such as Samsung Electronics Co. to Korean household names like Dongsuh, are under increasing scrutiny for business practices that have kept the families in power for decades.

  Even if the commission manages to shut down the inter-group transfer route, families still have other ways to avoid paying inheritance taxes. One is to move money to charitable foundations.

South Korea’s inheritance tax of as much as 50 per cent is the second-highest among members of the Organisation for Economic Co-operation and Development, after Japan, and the rate can hit 65 per cent in the case of the largest shareholder. That means failure to plan the transfer of wealth to the next generation risks losing both a big chunk of that fortune and the family’s control of the company that created it.

As a result, the nation’s wealthy dynasties have developed circuitous ways to pass down money, such as directing lucrative deals from family businesses to affiliates controlled by heirs. But with the chaebol deeply unpopular after a series of bribery and corruption scandals, the government is working to close some of the biggest loopholes, potentially encouraging capital flight as families fight to preserve wealth.

“Companies where heirs hold significant stakes can grow in revenue and market value through inter-company transactions, and the wealth created in this way is not subject to tax,” said Kim Hai-ree, a lawyer with Seoul-based legal consulting firm Global & Case

Of 27 conglomerates with assets exceeding 10 trillion won (Dh30 billion or $9.4 billion), contracts between companies in that group reached 152.5 trillion won in 2016, according to South Korea’s Fair Trade Commission, the nation’s top antitrust watchdog. That represents 12 per cent of their deals that year.

The chaebols of fellow billionaires Chung Mong-koo of Hyundai Motor Co., Chey Tae-won of SK Corp., and Lee Kun-hee of Samsung Electronics Co. are the top three in terms of inter-company transactions: Hyundai reported 30.3 trillion won, followed by SK with 29.4 billion won and Samsung with 21.1 trillion won.

The FTC’s regulations for abusing intra-group business deals apply only to companies with more than 5 trillion won in assets and when owner families’ stakes in affiliates exceed 30 per cent. Hyundai in particular has faced mounting pressure to address intra-group transactions.

“There are many companies who have gotten away with regulations by adjusting the ownership stake at 29.9 per cent to avoid the threshold of 30 per cent,” FTC Chairman Kim Sang-jo said at a parliamentary hearing in June.

Two of Chung’s children reduced their stakes in Hyundai’s listed advertising agency, Innocean Worldwide Inc., to 29.9 per cent in 2015 when the FTC restriction took effect. The company’s revenue from sales to other Hyundai units made up 79.9 per cent of the total in 2016, according to its annual report. At logistics affiliate Hyundai Glovis Co., the combined amount of stock held by Chung and his son is just 9 shares short of the 30 per cent threshold.

At Dongsuh, Kim’s two sons have taken turns to lead the business, which they control through family stakes in publicly listed Dongsuh Cos., and the process of handing leadership to his grandchildren is underway.

Kim built his fortune on Koreans’ love of coffee mix — the sachets of powdered instant coffee, sugar and creamer that are found in almost every home and office. Flagship unit Dongsuh Foods Co. rolled out its first premixed products in 1976 and the company now supplies 85 per cent of South Korea’s instant coffee and has 1.5 trillion won in revenue.

The Kims own 66.1 per cent of Dongsuh Cos. A series of family transfers that began in 2006 left his two sons with 38.3 per cent of the business and his eldest grandson with 11.2 per cent, the third-largest stake.

The ownership structure caused controversy when a closely held Dongsuh affiliate came under scrutiny for gaining almost all of its revenue — 93.5 per cent — from other Dongsuh units. The dividend payout ratio reached 88.9 per cent in 2013, when the grandsons owned more than 50 per cent of the business. They have since transferred their stakes to the listed holding company.

“The money from companies owned by heirs also plays a crucial role in cementing family power, as the children can use it to buy stakes in other parts of the family business,” said Global & Case’s Kim.

The government is clamping down. The FTC “will conduct investigations and relevant actions regardless of company size, if issues related to inter-company transactions are found,” its chairman said in June. The watchdog hasn’t taken action against Dongsuh, which has about 2 trillion won in assets.

Even if the commission manages to shut down the inter-group transfer route, families still have other ways to avoid paying inheritance taxes. One is to move money, usually in the form of stakes held by family members in their business empires, to charitable foundations. Another is to combine business units, as Samsung did with its 2015 merger of Samsung C & T and Cheil Industries.

That deal allowed Samsung heir apparent Jay Y. Lee to reconstitute his hold on the conglomerate and avoid a hefty inheritance tax bill, according to prosecutors. (Lee was sentenced to five years in jail for bribery to secure government support for the merger.)

How companies manage to transfer wealth through generations is key to Korea’s long-standing business model. But it requires a close-knit family and the trust of the patriarch in handing over both power and money, something that doesn’t always run smoothly as the current feud between two sons at the giant Lotte retail group shows.

“There are cases in which owner families have no choice but to sell their companies to pay high tax bills,” said Lee Tae-kyu, a research fellow at the Korea Economic Research Institute in Seoul. “We might end up with a lack of companies with a long history and expertise as inheritance tax burdens could force them, especially those small and medium-size companies, to give up on succession planning.”