Although it is common for the National Tax Service (NTS) to raise permanent establishment (PE) issues during an audit, past case law and practical experience suggest that tax assessments are more likely to arise out of and be based on transfer pricing (TP) issues. It is thus expected that TP will continue be a central focus of the NTS in the coming years.
In the post-BEPS era, the concept of “substance” in TP has become very important. Although this is not an entirely novel concept, it underpins the Organization for Economic Co-operation and Development (OECD) TP Guidelines (2017) (the TP Guidelines). These provide a more comprehensive framework by which a transaction can be recognized (or not), and an arm’s length range can be derived. Against this backdrop, the Ministry of Economy and Finance (MOEF) has recently adopted two related provisions in the Law for Coordination of International Tax Affairs (the LCITA). The first relates to non-recognition and re-characterization of transactions, and was effective from January 1, 2019. The second can be considered a South Korean version of diverted profits tax (DPT), effective from January 1, 2020.
Relevant Provisions in the LCITA
Non-Recognition/Re-Characterization Provisions in the LCITA
The MOEF has newly codified into the LCITA the concept of re-characterization of commercially unreasonable intercompany transactions. The new law is identical to Chapter I, D.2. of the TP Guidelines. These provisions therefore supplement Article 5 of the LCITA, which prescribes the arm’s length principle.
In some ways these new provisions are akin to a Specific Anti-Avoidance Rule (SAAR). The provisions are as set out below:
Article 5(2): the NTS shall clearly delineate the actual transaction (considering the commercial and financial conditions between a resident and its foreign related party/parties), as well as the critical terms of the transaction between them, and shall compare the controlled transaction with one that would have been made between independent companies under similar circumstances, in order to determine whether the controlled transaction is commercially reasonable.
Article 5(3): if the transaction considerably lacks commercial rationality and, therefore, it is highly difficult to derive an arm’s-length price, the NTS shall disregard such a transaction, or reasonably re-characterize it according to its economic substance, in order to derive an arm’s-length price.
In determining the “commercial reasonableness,” Article 4(6) of the Presidential Enforcement Decree (PD) of the LCITA prescribes that the following factors be considered:
- the transaction would have not occurred between non-related parties;
- it would have been more beneficial for related parties had they not engaged in such transactions; or
- but for the tax benefit or incentive, such a transaction would not have occurred.
DPT Provisions Under the LCITA
In the 2020 tax amendments, the MOEF introduced a South Korean version of DPT as part of South Korea’s General Anti-Avoidance Rule (GAAR). This was codified into the existing substance-over-form provision in the LCITA. (Specifically, the amendment can be found in Article 2-2(4) of the LCITA and Article 3-2 of the PD).
If the NTS take the view that the supply chain of a multinational has been structured in an artificial way so as to move profits out of South Korea and minimize South Korean taxation, the new provision allows the NTS to re-characterize that supply chain and bring the profits back within the scope of South Korean taxation. The taxpayer can only avoid this re-characterization by demonstrating that the transaction structure is based on genuine business reasons and is not motivated by the intention to avoid tax.
Implications of the Re-characterization Rule on TP
To demonstrate the impact of the new rule, two representative industries will be considered below, namely distribution and finance. In both cases, there will be significant implications for foreign companies.
Potential Impact on Distributors
Distribution businesses are one of the most common types of foreign business in South Korea. The foreign company will set up a South Korean subsidiary, which will then engage in buying and selling, as well as marketing activities. Sometimes, these marketing expenses are incurred beyond the level of market average or what is considered as a routine level, but they mainly benefit the foreign business, rather than the South Korean subsidiary. Of course, no third-party distributor would ever incur expenses to market the products of a foreign company without receiving proper reimbursement. For this reason, under the new rule, the NTS could impute a marketing services agreement between the foreign company and the South Korean subsidiary when incurred marketing expenses are more than a market average. This would be a far simpler way for the NTS to approach the situation, in contrast with the complex and somewhat subjective profit-split method that could be adopted under the concept of development, enhancement, marketing, protection, and exploitation (DEMPE) of marketing intangibles.
Potential Impact on Companies Engaging in Financial Transactions
As stated in the recent OECD TP Guidelines on Financial Transactions, published on February 11, 2020, financial transactions should be commercially rational in light of the realistic options available to each party to the transaction, just like other types of related party transactions. Even though the LCITA has yet to specifically incorporate this new guideline into its own law, the commercial rationality concept already exists within its provisions prescribing the arm’s length principle. The concept of commercial rationality should therefore be considered to apply to all types of transactions, including financial transactions.
Many foreign companies engage in intercompany loan transactions with their South Korean subsidiaries. Before this particular law came into effect, the only TP issue in intercompany loan transactions was the appropriateness of mark-ups charged between related parties. However, as the commercial rationality concept has been introduced, the existence or amount of intercompany loans are now also open to challenge. Specifically, the NTS might challenge whatever amount the South Korean subsidiaries could not have borrowed from external financial institutions. Ultimately, the arm’s length loan amount should be determined based on a “two-sided approach,” i.e. i) the maximum amount that an unrelated lender would be willing to advance; and ii) the maximum amount that an unrelated borrower would be willing to borrow.
Financial Guarantee Transactions
When a foreign company provides a financial guarantee to its South Korean subsidiary, the fee paid by the subsidiary is a deductible expense for South Korean tax purposes. However, if the guarantee increases the borrowing capacity of the South Korean subsidiary, then the portion of the loan that would not have been made without the guarantee could be re-characterized as a loan from an external financial institution to the foreign company, i.e., the guarantor, which is then contributed as equity to the South Korean subsidiaries, i.e., the guarantee.
As a result of this re-characterization, from the perspective of the South Korean subsidiary, a portion of the loan has been re-characterized from debt to equity. Therefore, not only will the amount of tax-deductible interest decrease, but so too will the tax-deductible guarantee fee.
A Potential Cause of Disputes
The re-characterization rule is highly subjective and abstract. In the absence of detailed guidance as to what constitutes “commercially irrational” transactions, therefore, it is very likely to cause disputes between the NTS and taxpayers in future audits. There is even a chance that the principle could be viewed as unconstitutional, pursuant to the principle of “no taxation without law,” which emphasizes the importance of clarity and detail in tax law.
Implications of the South Korean DPT on TP
There is no Ministerial Enforcement Decree or NTS internal ruling which might shed light on the intention behind the new South Korean DPT law. However, an MOEF document released in October 2018 suggests that it is closely modeled on the U.K.’s DPT, with MOEF officials visiting the U.K. to study and benchmark the U.K.’s DPT regime.
Therefore, to some extent U.K. DPT is a useful source of clarification for South Korean DPT. Section 86 of the U.K.’s Finance Act 2015 prescribes the following situation under which DPT could possibly apply:
“Where there is a person (company or individual) carrying on activity in the UK “in connection with” a trading activity (supplies of services, goods or other property) carried out by a foreign company, and it is ‘reasonable to assume’ that the arrangements are designed to ensure that the foreign company does not have a UK permanent establishment.”
Given the lack of detail in the South Korean law, it is important to consider this U.K. legal provision, as well as the relevant South Korean legal provisions, when considering the effects of the new law.
Risks for Indent Sales Transactions in South Korea
It is common for multinational enterprises (MNEs) distributing their products into the South Korean market to use indent sales structures. Specifically, the products will be sold to South Korean customers by a foreign distributor based in a low tax jurisdiction, with support services provided through a South Korean subsidiary entity. Thus, the MNE can attribute the majority of the profits to the low tax jurisdiction.
However, in such situations the substance and form are often misaligned. Specifically, there will be few staff based alongside the foreign distributor in the low tax jurisdiction, whereas the South Korean subsidiary, purportedly only for sales support, will employ many more sales and marketing staff, working in customer-facing roles. This sort of structure would be susceptible to challenges under the DPT law, because it could be difficult to counter the NTS if they alleged that there was no business reason for the foreign distributor being located in a low tax jurisdiction, other than tax avoidance.
The difficulty for taxpayers will be compounded by the fact that under the South Korean DPT law, the burden of proof has now shifted onto the taxpayers, who must prove that the transaction structure is based on compelling business reasons rather than designed for tax avoidance purposes. Prior to the enactment of this law, the NTS would often challenge taxpayers engaged in indent sales in the South Korean market by invoking the GAAR regime i.e., the substance-over-form rule per Article 2-2 of the LCITA. However, since the burden of proof under the existing GAAR regime lies on the NTS rather than the taxpayers, their attempts did not often come to fruition.
Consequently, the NTS is likely to enjoy more success in challenging such taxpayers at the tax audit level. This will result in greater risk for South Korean sales support service providers, who might now be deemed to be distributors, with the income recognized by their foreign distributors in low tax jurisdictions accordingly attributed to South Korea.
A Potential Point of Disputes
The new South Korean DPT law unquestionably makes it easier for the NTS to challenge taxpayers engaged in indent sales transactions. However, it is still based on the subjective concepts of substance and rationality, and as such there remains great scope for disputes between the NTS and taxpayers over the interpretation and application of the new law.
Considering the potentially significant impact of the aforementioned two regimes, it is critical that taxpayers increase the substance of their foreign distributors in low tax jurisdictions. Taxpayers should also carefully consider and document commercial reasons as to why the foreign distributors should be located in those jurisdictions.
Likewise, taxpayers should document the commercial justification underpinning every related party transaction, taking into account how independent companies in similar circumstances might have transacted. The mere fact that similar arrangements cannot be found among independent companies does not in itself constitute a prima facie case for the NTS to disregard it, providing that sound business reasons are well documented.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Steve Minhoo Kim is a U.S. CPA and transfer pricing specialist; and Tom Kwon is a Senior Foreign Attorney and Partner at Lee & Ko, South Korea.