Intercompany Loan Transactions: Recent Developments in South Korea’s Transfer Pricing Regime

The 2015 Final Reports of the Organization for Economic Cooperation and Development (OECD)/G-20 Base Erosion and Profit Shifting Project on Action 4 (Limiting Base Erosion Involving Interest Deductions and Other Financial Payments) and Action 8–10 (Aligning Transfer Pricing Outcomes with Value Creation) mandated followup work on the transfer pricing aspects of financial transactions.

As a result, the OECD announced, in October 2020, the Transfer Pricing Guidance on Financial Transactions: Inclusive Framework on BEPS Actions 4, 8–10. The focus of the Guidance is the accurate delineation and analysis of underlying financial transactions and how best to derive an arm’s-length price for particular financial transactions.

Against this backdrop, the Ministry of Economy and Finance of Korea (the Ministry) has recently released a new amendment to its existing transfer pricing regulatory regime in an effort to keep pace with the OECD’s mandate. The existing Korean transfer pricing regulatory regime, which is set out in the Law for Coordinating International Tax Affairs (the LCITA) and the subordinate Presidential Enforcement Decree (the Decree) and Prime Ministerial Regulation, includes a provision prescribing the arm’s-length interest rate for intercompany loan transactions, specifically in Article 11 of the LCITA.

However, there were limits to the practical application of Article 11 of the LCITA, mainly because the provision was not sufficiently specific and detailed for taxpayers to follow and comply with.

Accordingly, in January 2022, the Ministry announced an amendment to the Decree. The amendment both specifies and diversifies the method of calculating the arm’s-length interest rate for intercompany loan transactions and reflects the contents of the OECD Guidance and its clear objective to rationalize the transfer pricing regulatory regime for financial transactions.

History of Transfer Pricing Regulatory Regime for Intercompany Loan Transactions—and its Limitations

The LCITA was first enacted at the end of 1995 in response to a need for a separate and independent law for cross-border transactions. It was difficult to apply the logic of the existing tax law to such transactions because it was more or less geared toward domestic transactions. However, when the LCITA was first created, it did not include any provision setting out intercompany loan transactions.

Subsequently, in the Decree, which amended the LCITA in August 2006, a new provision was added to the LCITA. That provision provided that an arm’s-length interest rate for intercompany loan transactions between a Korean tax resident and its foreign related party(ies) was the interest rate that was—or was reasonably expected to be—applied in conventional loan transactions among independent parties, and it should be calculated in consideration of the amount and tenor of the debt, the existence of any guarantee, and the creditworthiness of the borrower.

In a 2010 amendment to the LCITA and the subordinate regulations, a new provision was included to regulate accounts receivable and payable whose collection period went beyond what was considered to be a conventional receipt and payment period. The provision stipulates that such arrangements are deemed to be de facto loan transactions and should be regulated by the transfer pricing regulatory regime, i.e., the LCITA.

In 2017, a safe-harbor rule for intercompany loan transactions was introduced to the LCITA by a Ministerial Regulation. It stipulates that 4.6%, which is the overdraft lending rate, shall be applied for outbound transactions (where a Korean tax resident lends funds to its foreign related party(ies)) and a rate equal to the 12-month LIBOR plus 1.5% shall be applied for inbound transactions (where a Korean tax resident borrows funds from its foreign related party(ies)). The safe-harbor provision was designed to enhance the convenience of taxpayers and is still valid under the current version of the LCITA and its subordinate regulations.

However, the safe-harbor rule has the following problems:

• The overdraft interest rate of 4.6% stipulated under the LCITA and the Korean Corporate Tax Law is relatively high in the current era of low interest rates. Korean tax residents could possibly charge a high interest rate of 4.6% in an effort to avoid any challenges by Korean tax authorities, but this may be an issue for the contracting state where the borrower is domiciled. Particularly this may be the case when the borrower could have secured a loan from a local independent financial institution at a much lower interest rate.
• In addition, a Korean tax resident applying the 4.6% interest rate to a loan made to a foreign related party with a low credit rating who, had they been independent parties, the Korean tax resident might not have lent to, or, even if they had been willing to lend, would have charged a much higher interest rate than 4.6%, might be at risk of not receiving adequate interest and/or a return of the principal of the loan.

Notwithstanding the benefits of the safe-harbor rule—namely simplicity and convenience for taxpayers—its application without any further consideration of the commercial rationality concept and the two-way approach that the OECD Guidance introduced has the potential to trigger transfer pricing issues in jurisdictions where the other contracting related parties are domiciled.

Due to this inherent risk, either an updated safe-harbor rule or a more specific rule (the existing provision is described at a high level of abstraction without any details) prescribing how to derive an arm’s-length interest rate was needed.

The 2022 Amendment

In January 2022, responding to the need to diversify the calculation method of the arm’s-length interest rate that would enhance the convenience of Korean taxpayers, the Ministry announced an amendment to the Decree of the LCITA, adding a provision setting out the following detailed methods for calculating an arm’s-length interest rate, based on the contents of the Guidance.

Utilization of Credit Default Swap

A credit default swap (CDS) contract is a contract between a lender and a third party whereby the latter guarantees the repayment of the debt (by transferring the credit risk) to the third party in case the debtor defaults. In return, the lender pays a CDS premium to the third party, which is akin to an insurance premium.

A CDS reflects and represents the creditworthiness of the debtor in that the CDS premium is set in such a way as to reflect the credit risk linked to an underlying financial asset. CDS spreads may be used by taxpayers and taxing authorities to calculate the risk premium related to intragroup loans.

There are many types of CDS and it may be somewhat challenging to use them as proxies for measuring credit risk associated with a particular investment in isolation, because they reflect not only default risk but also other factors such as liquidity and the volume of CDSs negotiated.

Utilization of Economic Modeling

Economic modeling is a method of calculating an interest rate by adding a number of premiums related to various aspects of a loan, such as default risk, liquidity risk, expected inflation, or maturity, to a risk-free interest rate. A risk-free rate refers to the theoretical rate of return expected from an investment when there is no risk of loss.

The reliability of the economic modeling calculation depends on the parameters factored into the specific model and the underlying assumptions adopted, which do not represent actual transactions between independent parties, but are a useful means of application in situations where reliable comparable independent transactions cannot be found.

Implications of 2022 Amendment and Some Unresolved Issues

Benchmark Rate or Risk-Free Rate

Both methods introduced by the amendment calculate an arm’s-length interest rate by adding a risk premium to a risk-free rate. The remaining task is to determine what to use as a risk-free rate.

From our observations of the recent tax audit trends of the Korean National Tax Service, when it makes assessments on cross-border intercompany loan transactions conducted by Korean taxpayers, the one-year LIBOR is used as a benchmark rate to which a risk premium is added on the basis that a taxable year is usually one year.

When it comes to the risk premium, the National Tax Service refers to a recent Supreme Court case (2017 Du73983, March 29, 2018) where the judges opined that the method of calculating the credit rating and expected default rate for overseas subsidiaries using Moody’s RiskCalc™ model and calculating the arm’s-length guarantee fee based on the risk approach (the LGD model) was reasonable.

Since the Supreme Court ruling, the National Tax Service has adopted the LGD model for its assessment of financial guarantee service transactions. Due to the fact that the LGD model is based on expected default rate and loss given default, the National Tax Service also leverages the LGD model for its calculation of a risk premium that becomes a building-block of an arm’s-length interest rate.

Since the LIBOR rate that the National Tax Service uses for risk-free rate purposes reflects both credit and liquidity risks in and of itself, it is difficult to consider it as a kind of risk-free rate. Moreover, as an expected default rate reflects both credit and liquidity risks, it would be considered as double-counting on these risks if the LIBOR rate were to be used as a risk-free rate when calculating an arm’s-length interest rate.

In addition, there is no clear regulation and/or rulings as to which tenor of LIBOR (e.g., one-week, one-month, three-month) should be used as a base rate (i.e., risk-free rate) and, more importantly, considering that there is a rapid transition away from LIBOR rate and the cessation of most LIBOR rates is expected in 2021–2022 , it would be difficult for the NTS to use the LIBOR rate as a base rate going forward when calculating an arm’s-length interest rate for its assessment purposes.

Just like the Secured Overnight Financing Rate (the SOFR) that the U.S. will use as an alternative to the LIBOR rate, the Financial Supervisory Service of Korea has developed a Korean Secured Oversight Financing Repo Rate (the KOFR) and has published the KOFR rate since Nov. 26, 2021. Theoretically, since the KOFR is the average funding cost without credit and liquidity risks, it is expected that a new safe harbor rule based on the KOFR may be proposed by the Ministry in the near future.

Even when a CDS or economic modeling is used to calculate an arm’s-length interest rate, the KOFR could be considered as a good candidate for a base interest rate, as it is a good proxy for a risk-free rate. However, since the KOFR is a new risk-free rate that has been developed by the Financial Supervisory Service, how successful and widely used it will be still remains to be seen.

Selection of Credit-Rating Database

As mentioned earlier, the National Tax Service prefers to use, and thus subscribes to, the RiskCalc database due mainly to its reference to the Supreme Court ruling that deriving a credit rating and expected default rate using the Moody’s RiskCalc database is reasonable. There are many options available in the market other than the RiskCalc database, such as S&P Capital IQ database or Moody’s Rating Methodology, which considers both quantitative and qualitative factors in credit ratings. However, it is true that the National Tax Service’s preference for the RiskCalc database limits taxpayers’ options.

That said, when there is an implicit consensus on the selection of database between taxpayers and the taxing authorities, it is possible for taxpayers to predict to some extent the arm’s-length interest rate to be adduced by the National Tax Service in audit, and this could be advantageous. Therefore, when it comes to the calculation of the arm’s-length interest rate in Korea, it is highly recommended to use the Moody’s RiskCalc database to the fullest extent possible, to avoid any redundant work and to save the costs involved in an analysis.

Commercial Rationality in Context of Financial Transactions

In the process of reviewing whether to carry out a financial transaction, independent companies would review all other realistic options available to them and execute the financial transaction only when there is no clearly more advantageous option in the context of commercial rationality. That is, independent lenders and borrowers would not lend or borrow any funds if it does not make sense to them in terms of the commercial rationality concept.

This means that before the terms and conditions of interest charged between related parties are reviewed, the intercompany transaction itself could be reviewed from the perspective of commercial rationality, and when there is a lack of such commercial rationality, the loan transaction in question could potentially be re-characterized or reconstructed as a contribution of capital rather than a loan transaction.

In order to assess the commercial rationality of an intercompany loan transaction, the Guidance stresses that an accurate delineation of the commercial and financial relations surrounding the intercompany transaction in question is necessary.

The existing LCITA before the 2022 amendment does not stipulate commercial rationality that can be directly applied to loan transactions and the 2022 amendment to the Decree of the LCITA does not include such provision either. However, due to the nature of the law itself, which is described at a high level of abstraction, and in light of the fact that the National Tax Service closely refers to the Guidance when it audits taxpayers, it is safe to say that there is a possibility that it could cite the commercial rationality concept in intercompany loan transactions.

Besides, there is a “general” commercial rationality provision in Article 8 of the LCITA where the arm’s-length principle is prescribed; this makes it even more possible for the National Tax Service to challenge with the commercial rationality concept when assessing whether a transaction in question is indeed a loan transaction.

Therefore, in addition to calculating a reasonable arm’s-length interest rate, taxpayers are recommended to carefully review commercial rationality from both borrower’s and lender’s perspective and accurately delineate the details of the financial transaction before conducting loan transactions with foreign related parties.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Tom Kwon is Senior Foreign Attorney, co-head of international tax practice; Steve Minhoo Kim is Senior Foreign Attorney, international tax and transfer pricing; and Gijin Hong is a Korean Certified Tax Attorney, transfer pricing, with Lee & Ko.

The authors may be contacted at: tom.kwon@leeko.com; steve.kim@leeko.com; gijin.hong@leeko.com