A Korean group that builds or buys a plant in Europe acquires two tax administrations with an interest in the same number. Seoul wants to know that the price at which the Korean parent sells components to the European plant, or buys finished goods back from it, is the price independent parties would have used. The European state wants to know the same thing from the other side. Neither is obliged to agree with the other, and neither will accept a margin that was set for the convenience of the group’s internal reporting.
The disputes that follow are rarely about whether transfer pricing applies. They are about what the plant does, who bears the risk of it standing idle, and whether anyone wrote that down while it was still true.
What makes the plant a related party in Korean terms
The Adjustment of International Taxes Act and its Presidential Decree govern the analysis on the Korean side. Article 2 of the Act defines a foreign related party as a non-resident or foreign corporation, excluding its Korean place of business, standing in a special relationship with a resident, a domestic corporation or a domestic place of business, and the special relationship is defined mechanically before any question of influence arises.
Direct or indirect ownership of at least 50 per cent of the voting stock of the other party, equity interests included, creates the relationship. So does common ownership, where a third party together with the relatives the Decree identifies holds, directly or indirectly, at least 50 per cent of the voting stock of both. Beyond the ownership tests there are two substance tests, and each of them has two limbs that must both be present: a common interest of a kind that allows income to be adjusted, arising from capital contribution, trade in goods or services, lending and similar relations, together with the power of one party to determine substantially the whole or an important part of the other’s business policy, or the same power held by a third party over both.
The Decree does not leave that power to impression. Where it is held by one party over the other, it is present where the other company’s representative officer, or officers making up half or more of all its officers, hold a post as officer or employee of the first party or held one within the three years counted back from the year end; where one party holds at least 50 per cent of the other’s voting stock through a partnership or a trust; where the other depends on transactions with the first for at least half of its business activity; where the other borrows at least half of the funds its business needs from the first or raises them under its guarantee; or where the other depends for at least half of its business activity on intellectual property supplied by the first. Where it is held by a third party over both, the Decree sets out the ways in which it is present: the third party owns, directly or indirectly, at least 50 per cent of the voting stock of one party and determines the whole or an important part of the other’s business policy in one of those five ways; or it determines the whole or an important part of the business policy of both in one of those ways; or, for a company inside a Korean business group, one party is an affiliate of a business group under the competition legislation and a different affiliate of the same group owns, directly or indirectly, at least half of the voting stock of the other. Each of those is a way of meeting the second limb of the third party test in the Act, so the common interest that forms its first limb still has to be present. Where the relationship rests on either substance test, article 7 of the Act disapplies the tax authority’s determination or correction at the arm’s length price if the taxpayer presents a clear reason why it does not stand in that relationship.
The indirect ownership computation is not a simple multiplication in every case. Where one side holds 50 per cent or more of the company that is itself a shareholder in the target, that shareholder company’s stake in the target is attributed in full. Where it holds less than 50 per cent, the two percentages are multiplied. Where there are two or more shareholder companies the ratios computed for each are added, and where the chain runs through further companies the same rules are applied down the chain. A group with a European sub-holding between the parent and the plant should run that calculation rather than assume the answer.
The functional question the plant raises first
Once the relationship is established, everything turns on what the European entity is. A plant that receives designs, tooling, materials specifications and production schedules from Korea, converts inputs it does not own, and is paid for conversion is one thing. A plant that develops its own process technology, chooses its own suppliers, holds inventory at its own risk and sells to European customers on its own account is another. Most real plants sit somewhere between the two and drift over time.
The drift is the problem. A facility set up as a contract manufacturer, priced on a cost plus basis, frequently acquires a local engineering team, a local supply chain and a degree of commercial autonomy that nobody records. The intercompany agreement continues to describe a converter. The routine return continues to be paid. The inspector who visits in year six meets engineers who describe their work as product development.
The answer is not to redraft the agreement retrospectively. It is to review the functional analysis on the same cycle as the business plan, and to change the remuneration when the functions change, with a dated record of why. A group that repriced in the year the functions moved is in a very different position from one that repriced after the audit letter arrived.
Choosing a method, and the criteria Korea applies
Article 8 of the Act lists the comparable uncontrolled price method, the resale price method, the cost plus method, the transactional net margin method, the profit split method, and other methods recognised as reasonable under the Decree. The sixth is not a free alternative to the rest: by the proviso to the same paragraph it applies only where the arm’s length price cannot be produced by the first five. The list is familiar. The selection rule is where attention should go, because the Korean formulation is explicit about what the taxpayer has to demonstrate.
The most reasonable method must be selected against five standards, and those standards sit in the Decree rather than in administrative practice: high comparability between the controlled and the uncontrolled transaction, a high likelihood of securing and using the data relied on, a high degree of correspondence to reality in the assumptions made about economic conditions and the management environment, little effect on the computed arm’s length price from defects in the data or in the assumptions, and a high degree of suitability between the controlled transaction and the method. High comparability is itself defined, and it is satisfied either where a difference between the compared circumstances has no material effect on the price or the net profit of the compared transaction, or where that effect can be removed by a reasonable adjustment.
The comparability factors the Decree names, with the detail left to ministerial rules, are the types and characteristics of the goods or services, the functions of the business activity, the risks accompanying the transaction, the assets used, the contractual terms, the economic conditions and the business strategies, in each case as they may affect price or profit. A study that runs a European comparables screen and produces an interquartile range without addressing those factors answers a different question from the one the Act asks. The Decree also settles what a range is for: it may be built from two or more transactions between unrelated parties, and where the controlled price falls outside it the filing or the correction has to be made by reference to the average, the median, the mode or another reasonable specific price drawn from the transactions in the range.
The Dutch side, where documentation has no size threshold
If the European entity is Dutch, article 8b of the Wet op de vennootschapsbelasting 1969 applies to the same transactions from the other direction. Where one body participates directly or indirectly in the management, control or capital of another and the conditions agreed between them differ from those independent parties would have agreed, profit is determined as if the arm’s length conditions had applied. The second paragraph extends the rule to the case where the same person participates in both bodies, which is the ordinary position of two subsidiaries of one Korean parent.
The third paragraph of article 8b is the one groups underestimate. The bodies concerned must include in their records the information showing how the transfer prices were arrived at and from which it can be established whether the conditions are those independent parties would have agreed. There is no turnover threshold and no exemption for small volumes. A Dutch plant with modest revenue carries the same duty as a large one.
The tiered documentation sits above that. Article 29g requires a Dutch group entity to include a Master File and a Local File in its records within the period set for filing the corporate income tax return, drawn up in Dutch or English, where the multinational group achieved consolidated group revenue of at least 50,000,000 euro in the reporting year immediately preceding the year the return relates to. The country-by-country report under article 29c is owed within twelve months of the last day of the reporting year by an ultimate parent entity resident for tax purposes in the Netherlands. A Dutch group entity of a group whose ultimate parent is not Dutch provides it only in the cases listed in the second paragraph of that article, and even then not where another group entity resident in a member state of the European Union has been designated on the terms of the third paragraph to provide it for all the group’s entities resident in the Union, or where the group makes the report available through a surrogate parent entity on the terms of the fourth paragraph. None of that applies to group entities of a multinational group whose consolidated group revenue in the immediately preceding reporting year was below 750,000,000 euro. A Korean group above the first figure and below the second keeps two documents in the records of its Dutch entity and owes no country-by-country report in the Netherlands; above the second, whether the Dutch entity provides one depends on those listed cases, not on its size.
The downward adjustment the Netherlands will not accept
Article 8bb changes the arithmetic of one-sided corrections. A downward adjustment of Dutch profit in respect of a legal relationship with a related body is disregarded to the extent the taxpayer does not make it plausible that a corresponding upward adjustment is taken into account at that related body in a tax levied on profits.
The third paragraph carves out one case, and it is narrow because its two conditions are cumulative. The taxpayer has to make plausible both that the related body is not treated, in the state under whose law it was incorporated, as the body entitled to the income or liable for the expense because it is not resident there and is not resident elsewhere either, and that a holder of an interest in that body is so treated where it is established and does take the corresponding upward adjustment into account in a tax on profits or on income. Outside that case the constraint is practical rather than theoretical. If the Netherlands is asked to accept a lower Dutch margin because the Korean side has taken more, the Dutch position depends on the Korean side having taken it and being able to show so. Corresponding adjustments have to be real, documented and taxed.
The secondary adjustment and the ninety day window
Korea attaches a second consequence to a primary adjustment, and it is the one that surprises groups most. Where an amount has been included in the gross income of the Korean company, whether by its own filing at arm’s length prices or by a determination or correction from the tax authority, and it is not confirmed that the foreign related party has returned that amount to the Korean company, article 13 of the Act treats the amount as a dividend to the foreign related party or adjusts it as an investment in it.
What has to be confirmed, and within what time, is where the mechanism bites. The Decree asks for a repatriation confirmation showing that the amount has been returned together with return interest computed under its formula, filed with the tax authority within 90 days. The 90 days run from the date of filing where the company itself made the adjustment, and from the day it receives the provisional reserve disposition notice where the tax authority made it, with the clock instead running from notification of the outcome where a mutual agreement procedure is opened within those 90 days.
Which of the two characterisations applies depends on the direction of the shareholding. Where the foreign related party is a shareholder of the Korean company, the amount is treated as a dividend vested in it. Where the Korean company is an investor in the foreign related party, it is treated as an increased investment. Where neither applies, it is treated as a dividend.
The consequence of the dividend characterisation is Korean withholding tax on an amount that was never distributed, on top of the primary adjustment, and the Decree fixes the moment, in the ordinary case, by deeming the dividend paid on the day the transfer income notice is received. Ninety days is short for a group that has to obtain a board decision, a payment instruction and a European treasury approval, and it does not start when the group decides to accept the adjustment. The repatriation route should be planned when the audit opens, not when it closes.
What non-compliance costs, and the fifteen requests
The tax authority may request data on the method of computing transaction prices and other material it needs to apply the pricing and cost sharing articles. The taxpayer has 60 days from the request, extendable once by up to 60 days for reasons the Decree accepts. Where a taxpayer fails to submit the data by the deadline without justification, or submits false data, the taxpayer is subject to an administrative fine not exceeding 100 million won, and that is not the ceiling of the exposure: the authority may then set a 30 day period to produce the data or correct it, and where that period passes unmet a further fine of up to 200 million won may be imposed according to the length of the delay.
Two further consequences are worse than the fine for a group that intends to litigate. Data withheld without justification and produced later, in an objection or in a mutual agreement procedure, may be refused as taxation data. And where the master and local file, or the requested material of the kind the Decree specifies, is not produced by the deadline without a justified reason under the Decree, the authority may estimate the arm’s length price and the arm’s length cost contribution from what it can obtain elsewhere, including data from businesses in similar lines, and assess on that estimate.
What can be requested is enumerated in fifteen categories, and the list describes the file a well run group already keeps: the organisational chart and the table of assignment of duties, the business activities of the parties to the transaction, the status of mutual investments with related parties, contracts on the transfer and purchase of assets, price lists, statements of manufacturing costs, schedules of transactions by item separating related from unrelated parties, documents of the same order for services and other transactions, the data used to determine international transaction prices, internal guidelines on pricing between related parties, the accounting standards and methods applied, the material identifying the content of intra-group service transactions, the cost sharing agreement and its supporting material, forms or items omitted from the corporate or income tax return, and an income statement and balance sheet drawn up separately for each international transaction.
Two of those categories are the ones manufacturing groups struggle with under time pressure: the statement of manufacturing costs reconciled to the intercompany price, and the table of assignment of duties that shows who in the plant decides what. Both are easy to assemble while the year is being closed and expensive to reconstruct three years later. The Decree adds a practical burden that catches groups running the file out of Europe, because the requested material has to be submitted in Korean unless the tax authority allows English.
The Korean filing thresholds are not the Dutch ones, and a group that has cleared the Dutch test has not thereby cleared the Korean one. The master and local file go to the Korean tax office within twelve months of the last day of the month in which the fiscal year ends, and are owed by a taxpayer that meets both of two tests in the year: revenue above 100 billion won, and aggregate transactions with foreign related parties in goods, services, intangibles and lending above 50 billion won. They are filed in Korean, with the master file allowed in English provided a Korean version follows within one month. The country-by-country report is owed by a Korean ultimate parent whose consolidated revenue in the preceding year exceeded 1 trillion won. Where the ultimate parent sits abroad, the Korean affiliate is drawn in once consolidated revenue passes the threshold the parent state applies, or 750 million euro where the parent state imposes no such obligation, and, provided it has submitted within six months of the last day of the month in which the fiscal year ends the information on the reporting entity that the Decree and the ministerial rules require, it is relieved of the report itself where, among other cases, the parent state requires one and that report reaches Korea by exchange under a treaty.
Where certainty can be bought in advance
The advance pricing arrangement is not a later addition to the Korean Act. The provision was in the Act as enacted on 6 December 1995, although the addenda to that Act deferred its entry into force to 1 January 1997, and it now sits in articles 14 and 15. The arrangement is initiated by the taxpayer, who applies to the Commissioner of the National Tax Service by the day before the first taxable year of the period to be covered, and the approved method has to be complied with by the taxpayer and by the Commissioner for that period, save in the cases the Decree specifies, with an annual return on the approved basis and a report on the prices produced by it within twelve months of the last day of the month in which each year ends.
The trade off between the two routes is in the procedure itself. A bilateral arrangement is reached through the mutual agreement procedure with the competent authority of the treaty partner, which is also the route by which Korea adjusts the other side of a foreign correction, since the corresponding adjustment in article 12 follows a concluded mutual agreement. A unilateral arrangement spares that negotiation and binds only Korea: the Commissioner has to decide within two years of the application, but the Commissioner may attach to the approval a condition that it can be cancelled if a mutual agreement procedure is opened, so the certainty it buys is certainty against one administration only. Rolling the method back to earlier years is available, but only where it is applied for at the same time as the arrangement, and only so far as the relevant period under the Framework Act on National Taxes has not expired for those years: for a bilateral arrangement the period within which tax may be assessed, and for a unilateral one the period within which the taxpayer may itself claim a correction.
For a group with a single significant European plant and a stable pricing model, the bilateral route is usually worth the delay, because the alternative is defending the same margin twice with no guarantee the two answers match. For a group in the middle of a reorganization it is premature, since an arrangement negotiated on a functional profile that is about to change buys certainty about the wrong facts. Which comes first, the restructuring or the arrangement, is the question to settle at the outset.
This article is informational and does not constitute tax or legal advice. The treatment of any structure depends on its facts and on the law of each jurisdiction involved. Each engagement is subject to scope and applicable regulation.