Contributed By Lee & Ko
The Korean transfer pricing (TP) regulatory regime is set out in the Law for the Coordination of International Tax Affairs (LCITA), and the enforcement and interpretative regulations, namely the Presidential Enforcement Decree of the LCITA and the Ordinance of the Ministry of Economy and Finance (MOEF) of the LCITA.
In addition to the TP legislation, the commissioner of the National Tax Service (NTS) may issue administrative orders and rulings to ensure consistent application of the laws. These do not constitute binding authority in Korea. Instead, the courts have final authority in interpreting the tax laws, including those governing the TP regulatory regime.
Since its inception in 1990, the Korean TP regime under the LCITA has undergone continuous development, keeping pace with similar developments that have taken place in other OECD countries. Broadly, there were five major milestones, which are as follows.
The Origins of the Korean TP Regulatory Regime
The need for a TP regulatory regime first emerged against the backdrop of Korea’s rapid economic growth in the 1980s, and the ensuing increase in the volume of cross-border transactions by multinational businesses. The first TP regulations were introduced in 1988.
Initially, these TP regulations were contained within a provision of the Presidential Enforcement Decree of the Corporate Income Tax Law (“CITA”), under an article relating to the denial of unfair transactions. This article regulated unfair transactions among related parties (at that time, applicable to both domestic and cross-border related-party transactions). Subsequently, the TP regulatory regime was made more robust when, in 1990, the Ministry of Finance and the NTS introduced standalone TP rules and regulations, to assist with interpretation of the above-mentioned CITA provision.
The Emergence of a Separate Statute Regulating TP and international taxation
In the 1990s, there were significant changes to the US TP regime – ie, Section 482 and its subordinating regulations – as well as to the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the “OECD Guidelines”). To align Korea’s tax law and practices with international norms in anticipation of joining the OECD, the LCITA, a separate statute governing TP and international taxation, was introduced in January 1996. The then-existing TP regulations under the CITA were relocated to the LCITA to reflect these international changes, with the LCITA and its regulations adopting the main contents of the OECD Guidelines.
The Korean TP Regime Overhauled
In the 2000s, the cross-border transactions of multinationals became increasingly complex, and it became apparent that Korea’s TP regime lacked the sophistication and detail to keep pace with modern developments. As a result, disputes between taxpayers and tax authorities increased significantly during this period. To address this issue, the Korean government overhauled the TP regime in 2010. The new regime gave the NTS the right to adjust income and tax liability based on the arm’s length principle, abolished the preferential application of the traditional transaction methods, and introduced more sophisticated TP methods that entailed features such as integrated analysis and multi-year analysis of related transactions.
BEPS Actions 8–10 and 13 Codified into the Korean TP regime
With the emergence of the OECD’s base erosion and profit shifting (BEPS) project in 2015, the government codified the contents of BEPS Actions 8–10 and 13 into the Korean TP regime. Consequently, new taxpayer reporting obligations were introduced into the LCITA, including preparing and submitting a “local file”, “master file”, and country-by-country (CbC) reporting. In addition, in line with the core concepts introduced in the pertinent BEPS Actions, the concept and scope of intangible assets were refined, and the arm’s length principle was further refined.
OECD’s Transfer Pricing Guidance on Financial Transactions and the COVID-19 Pandemic Codified into the Korean TP Regime
The OECD’s recent developments on transfer pricing were partly transposed into the LCITA and its subordinating regulations in 2022. Newly codified intercompany loan pricing methodologies by reference to the OECD’s Transfer Pricing Guidance on Financial Transactions published in October 2020 have reinforced the LCITA’s existing regime, which lacked sophistication, and have provided specific guidance to allow for greater tax certainty. In addition, a cash pool arrangement provision has been created under the subordinating regulations of the LCITA, where it prescribes the definition of a “cash pool arrangement” and how to derive arm’s length remuneration for a cash pool leader and participants.
In line with the content of the OECD’s Guidance on the Transfer Pricing Implications of the COVID-19 Pandemic published in December 2020, starting from 2022, taxpayers in Korea are allowed to include loss-making companies in their benchmarking analysis, if deemed appropriate, since such provision has been adopted into the subordinating regulations of the LCITA. From this historical background, the modern Korean TP regime has emerged as one that is highly synchronised with the OECD Guidelines.
The basic test of whether the parties to a transaction are related is based on percentage of ownership, as follows:
De facto Control Test
In addition, a related-party relationship also exists when one party to a transaction has de facto control over the other party, in respect of the transaction being tested. Such control is deemed to exist if one of the following criteria is satisfied:
When assessing whether one party has the power to substantially determine the business policy of the other, the amount of borrowings, the level of dependency of one party on the other, the control of the board and management, and other similar factors should be considered under a general facts and circumstances analysis.
Article 8 of the LCITA lists six methods of calculating the arm’s length price, as follows:
The last category in 3.1 Transfer Pricing Methods, “other reasonable methods”, should be applied only when none of the first five TP methods can reasonably be applied to derive an arm’s length price. In this situation, other reasonable methods can be considered if their application can be deemed reasonable in the light of the customary practice and the substance of the transaction in question.
CUP, RPM and CPM are categorised as “traditional transaction methods”. By contrast, PSM and TNMM are categorised as “transactional profit methods”. Previously, the traditional transaction methods were applied first, taking priority over the transactional profit methods.
However, the LCITA was revised at the end of 2010, abolishing this prioritisation, and since that time taxpayers have been free to select the most reasonable method among the five TP methods available.
However, as described above, “other reasonable methods” can be applied only when none of the five specified TP methods can be reasonably applied. So, in that respect only, there is a limited hierarchy of methods.
It is possible for the NTS or taxpayers to adjust the tax base based on the arm’s length range, where the price applied to the cross-border related-party transaction is lower or higher than the arm’s length price. More specifically, the NTS cites the concept of “interquartile range” as an example of a reasonable method of calculating the arm’s length range.
Comparability Adjustments per the LCITA
When calculating the arm’s length price, if there is some factor that makes it difficult to compare directly between the related-party transaction and comparable third-party transactions, an adjustment can be made to take this factor into account. Such factors include:
Risk Analysis Framework from the OECD Guidelines
In addition, it is noteworthy that the risk analysis framework first introduced in Chapter 1 of the OECD Guidelines released in July 2017 was codified into the LCITA in 2019. The purpose of this framework is to identify and assess economically significant risks assumed by taxpayers and their foreign related parties by virtue of accurately delineating controlled transactions. By incorporating this into Korean domestic law, taxpayers now have more practical and detailed guidance on the comparability adjustments.
Definition of Intangibles in the Context of TP and Applicable TP Methods
The LCITA and its subordinating regulations provide a definition and examples of intangible assets, as well as stipulating factors to be considered when executing transactions involving intangibles with foreign related parties. CUP and PSM are given priority as the most appropriate TP methods for calculating the arm’s length price for such transactions. If these priority methods are difficult to apply, other reasonable methods, such as the “discounted cash flow” method, can be used.
The Concept of Economic Ownership
When calculating the arm’s length price for a transaction involving intangible assets between a resident taxpayer and foreign related parties, regardless of who legally owns the intangible assets, the allocation of excess profits created from the intangibles should be commensurate with the respective value contribution and the level of DEMPE (development, enhancement, maintenance, protection and exploitation) performed by each entity in the value chain. The focus is on the practical use and maintenance of the intangible asset; that is, economic ownership rather than legal ownership. This is consistent with the OECD Guidelines.
Classification of Hard-to-Value Intangibles (HTVI)
Intangible assets that satisfy all the following requirements are classified as HTVI:
Ex Post Outcomes: Presumptive Evidence
In situations involving the transfer of HTVI or rights in HTVI, an outcome where the actual price exceeds 120% of the price agreed upon by related parties prior to the transaction can create a rebuttable presumption. Specifically, the NTS will be entitled to presume and able to claim that the price agreed in advance did not appropriately take into account reasonably foreseeable developments. Therefore, the presumption will be that the transfer price is unreliable.
Taxpayers can rebut this presumption by producing evidence showing that:
A cost contribution arrangement (CCA) regime was initially codified into the LCITA in 2006, and since then, there have been several revisions to the provision.
The NTS’s Authority to Re-determine the Arm’s Length Deduction
The NTS has the authority to re-determine the tax base and tax liability of a resident company if:
The NTS will then adjust the resident’s share of the costs, based on the arm’s length principle.
The NTS is especially likely to wield this authority if there is a 20% or more difference between the benefit that is expected (i) at the time of executing the CCA agreement, and (ii) after the joint development.
Methods of Measuring the Expected Benefit
The expected benefit can be calculated by considering one of the following as a proxy for the benefit received:
NTS’s Viewpoint on the CCA
Despite the enactment of the CCA regime in the LCITA, in practice, tax auditors have often challenged the validity of the CCA and typically deemed the payments made under the CCA as royalties to assess withholding taxes in Korea. As intangibles and CCA-related provisions have been supplemented during recent years, it is expected that the NTS will acknowledge the existence and the importance of intangibles and shift its view and perception to better recognise the CCA in practice as well.
The Taxpayer’s Right to Make an Affirmative TP Adjustment
Taxpayers can make “self-initiated” TP adjustments, both downward and upward, provided there is a legitimate reason for doing so, such as, if there has been a deviation from an arm’s length price. One noteworthy point is that this particular taxpayer’s right was previously contained in the LCITA’s subordinating regulations, but in 2019 was moved into the LCITA, demonstrating the importance of this taxpayer’s right.
Circumstances That Warrant an Affirmative TP Adjustment
Taxpayers can make this type of adjustment by incorporating it as part of the tax return or filing a separate amended return, if the actual transaction price applied is lower or higher than the arm’s length price in a cross-border related-party transaction. The deadline for the adjustment, which is consistent with the statute of limitations, is five years for a downward adjustment and seven years for an upward adjustment.
Another circumstance in which the adjustment can be made is when a mutual agreement procedure (MAP) or advance pricing agreement (APA) has been concluded. In this case, an adjustment can be made to harmonise the reported tax base and liability with the MAP or APA. Such an adjustment should be made by filing a return within three months of the notice of conclusion of the MAP or APA.
As of December 2022, South Korea has signed 94 tax treaties and 12 “tax information exchange agreements”. South Korea is also one of 146 signatories to the Convention on Mutual Administrative Assistance in Tax Matters.
The exchange of more TP-specific information with other taxing authorities is facilitated by the Multilateral Competent Authority Agreement, which allows signatories to exchange CbC reporting. South Korea is one of 96 signatories, and it has also separately signed a CbC reporting exchange agreement with the USA, based on the existing tax information exchange agreement with the USA.
History of the Korean APA Programme
Korea launched its APA programme in 1995, and its first APA case was concluded with the USA in May 1997. Since then, of 832 APA applications (both unilateral and bilateral), 599 cases had been concluded as at 31 December 2021. As is apparent from these statistics, the Korean APA programme has been very active since its inception, and it is expected that the demand for APAs will gradually increase, as many Korean companies set up their manufacturing and distribution entities in other parts of the world.
Types of APAs
Korean taxpayers can apply for a unilateral or bilateral APA, depending on the objective of the taxpayers and availability of MAP provision (ie, a bilateral APA) per pertinent tax treaty. However, it is noteworthy that even though the NTS still accepts unilateral APA applications due to the shorter processing time, etc, unilateral APAs are somewhat less favoured due to their limitation as a double tax prevention measure, unless taxpayers have a particular reason to pursue a unilateral APA.
Simplified APAs for Foreign Invested Companies in Korea
One notable aspect of the Korean APA programme is that the NTS launched a simplified APA for small and medium-sized foreign invested companies in Korea in 2015. This programme was launched in order to reduce the burdens of small and medium-sized foreign invested companies in terms of uncertainties surrounding TP and tax audits. The revenue threshold to qualify as a small and medium-sized foreign invested company is set at KRW50 billion and the programme is applicable only to unilateral APAs. The simplified APA will be processed within one year and once it is approved, foreign invested companies can secure TP certainty for the three to five-year period that the APA covers.
A starting point for processing APAs in Korea is to file an application for a pre-filing meeting with the NTS officers at the APA/MAP office, which sits within the International Taxation Bureau of the NTS Head Office. After successfully completing a pre-filing meeting and receiving a go-ahead sign from the APA/MAP office, taxpayers become eligible to file an official APA application to the APA/MAP office. Once an APA application is filed and the negotiation with the competent authority of the other contracting state is completed, the commissioner of the NTS has the final authority to approve APAs.
As with many other countries, APA and MAP cases are assigned to sub-units within the APA/MAP team of the NTS, based on the counterparty’s jurisdiction. Usually, one sub-unit is responsible for a few different jurisdictions in relation to APAs and MAPs.
Since APA and MAP cases are assigned within the APA/MAP office based on the country of the counterparty, APAs and MAPs can sometimes be reviewed together, and merged cases tend to result in a speedier process, due to the overlapping circumstances.
Even though in theory there is no law requiring NTS officials working on APAs and MAPs to co-operate, in practice, there is definitely co-ordination between these NTS teams.
Technically, there is no restriction on which taxpayers or transactions are eligible for an APA, as long as the taxpayer in question is a Korean legal entity or a branch/permanent establishment of a foreign corporation.
In practice, however, only taxpayers with a material amount of cross-border related-party transactions find APAs useful, in light of the potential tax exposure that could arise from TP-based assessment. There is no rule of thumb as to what constitutes a “material amount”, as there can be substantial variation, depending on the industry and individual companies.
A taxpayer may file an application for an APA to the NTS at any point up to the day before the commencement of the first year of the proposed covered period. For example, if a taxpayer applies for a five-year APA to run from 1 January 2024 to 31 December 2028, then the application must be filed by 31 December 2023. However, in order to file the application in time, the preparation for the APA should proceed at least six months before in light of the time required to complete a pre-filing meeting and secure a go-ahead sign from the NTS.
There is no user fee that a taxpayer is required to pay to the NTS in connection with an APA application.
There is no statutory or other legal limit as to how many prospective years an APA can cover, but, in practice, taxpayers generally propose five-year coverage in their application.
Taxpayers can request in their APA application that their APA takes retroactive effect.
In the case of APA applications filed before 1 January 2021, a roll-back provision could allow the APA to cover a period of up to five years immediately preceding the covered period, whereas for a unilateral APA, the limit for a roll-back is up to three years.
For APA applications filed after 1 January 2021, a roll-back provision for a bilateral APA could allow the APA to cover a period of up to seven years immediately preceding the covered period under the APA, whereas for a unilateral APA, the limit for a roll-back is up to five years.
APA and Suspension of Tax Audit
In general, a tax audit is not suspended merely by virtue of the taxpayer under audit filing an APA application. The NTS head office, however, may suspend its audit on transactions during the APA-covered period if the taxpayer appropriately filed an APA on the transactions at issue before receiving pre-notice of a tax audit.
There are three main types of TP-related information that the NTS is entitled to request for submission.
A taxpayer that is not subject to the regulations in the Combined Report of International Transactions (CRIT), which is described in the following section, but which still conducts international transactions with foreign related parties must submit the following information within six months from the end of each fiscal year:
If any part of the international transaction statement is not submitted or is false, a fine of KRW5 million may be imposed on each foreign related party with which the Korean taxpayer had a transaction during the year.
The Combined Report of International Transactions
If a taxpayer is required to submit the CRIT (the threshold is explained in 8.2 Taxpayer Obligations Under the OECD Transfer Pricing Guidelines) – consisting of a master file, local file and CbC report – and the submission must be made within 12 months from the end of each fiscal year. If all or part of the report is not submitted or is false, a fine of KRW30 million is imposed for each such report. Additionally, for non-compliant taxpayers, the NTS may request the submission of missing reports with 30 days’ notice, and failure to comply within such timeframe can trigger interest, which could add up to KRW200 million.
Given the foregoing burden of penalties for non-compliant taxpayers, starting from 2022, taxpayers will be able to benefit from reduced penalties if taxpayers voluntarily take a pre-emptive measure (ie, submission of missing reports or rectifying false information) and the rate of reduction varies from 30% to 90% depending on how soon such measure is taken.
Request for the Submission of a TP Report During a Tax Audit and Contemporaneous TP Documentation
The NTS may request certain information relating to the basis of the arm’s length price calculation for TP purposes – ie, TP documentation – when a taxpayer is audited. If so, the taxpayer must submit it within 60 days of the request. If any part of the requested data is not submitted or is false, a fine of KRW30–70 million may be imposed, depending on the level of non-submission. As with the CRIT, the NTS can request the submission of missing reports with a 30-day notice period, where failure to comply within such timeframe can trigger interest, which could add up to KRW200 million.
If the NTS recognises that TP documentation is completed and maintained contemporaneously with a corporate tax return, and if the NTS also considers that the TP method has been carefully selected and applied in a reasonable manner, a taxpayer can receive a 10% under-reporting penalty exemption, if at some point that taxpayer is audited and additional tax is assessed based on TP. When contemporaneous TP documentation is requested by the NTS, a taxpayer must submit it within 30 days.
In order to avoid penalties arising from the NTS’s request for TP-related information, it is very important to comply with the submission deadline, and it is essential to include a reasonable explanation of the TP method applied by the taxpayer. This explanation should be supported by documentation and corroborating data. Moreover, the format of the TP documentation, and database used for benchmarking, should be in line with local practice and the NTS’s expectations, to ensure that it is considered to be substantial and persuasive.
Taxpayers with sales of KRW100 billion or more and KRW50 billion or more in cross-border transactions with their related parties in a given year are required to submit a master file and a local file. As for the CbC report, foreign parent companies with sales of KRW1 trillion on a consolidated basis in the immediately preceding year should submit a CbC report, provided that:
The CRIT – consisting of the local file, master file and CbC report – should be submitted within 12 months from the end of each fiscal year.
Contemporaneous TP Documentation
For those taxpayers not subject to the CRIT, there is still merit in having TP documentation ready, as the NTS may request it in the course of a tax audit, and if so, it should be submitted within 60 days of the request. Besides, by virtue of preparing contemporaneous TP documentation, taxpayers could benefit from the 10% under-reporting penalty exemption in the event that additional tax is assessed based on TP considerations.
As an OECD member country, the Korean TP regime is highly synchronised and well aligned with the OECD Guidelines. There may be some minor local tweaks but, by and large, most of the regime is identical to that contained in the OECD Guidelines. This is because the Korean legislature and the MOEF closely monitor developments at the OECD level and adopt them into the Korean TP regime in a timely manner. For example, the updated core transfer pricing concepts introduced in BEPS Actions 8–10 and 13 and transfer pricing guidance on financial transactions as well as the Guidance on the Transfer Pricing Implications of the COVID-19 Pandemic were promptly incorporated into the Korean TP regime.
The LCITA defines the arm’s length price as “the price that is to be applied or determined to be applied by a resident, a domestic corporation, or a permanent establishment in Korea in its ordinary cross-border transactions with third parties”.
Since the price applied in a related-party transaction is judged to be high or low based on the arm’s length price, the Korean TP regime has duly adopted the arm’s length principle, and any deviation from this principle – eg, formulary apportionment – is not allowed under any circumstances.
The major impact of the OECD BEPS project on the Korean TP regime was that the obligation to submit the CRIT on cross-border related-party transaction information was stipulated, and the regulations on intangible assets were significantly supplemented. Moreover, due to the BEPS project, the risk analysis framework and a safe harbour provision for low value-adding intra-group services have been also adopted into the Korean TP regime.
If a Korean taxpayer’s sales and cross-border related-party transactions exceed certain thresholds, the taxpayer is required to submit the CRIT, which consists of a local file, master file and CbC report. For detailed thresholds, please refer to 8.2 Taxpayer Obligations Under the OECD Transfer Pricing Guidelines.
See 4.1 Notables Rules and 4.2 Hard-to-Value Intangibles.
Risk Analysis Framework
See 3.5 Comparability Adjustments.
Low Value-Adding Intra-Group Services
As introduced in Chapter 7 of the OECD Guidelines, the safe harbour mark-up rate of 5% applicable to low value-adding intra-group services has been codified into Korean legislation, and taxpayers that meet a certain threshold requirement are allowed to apply it without having to conduct a separate benchmarking study. The threshold requirement is as follows:
If the cost plus the safe harbour rate of 5% exceeds the lesser of the following, then a taxpayer is not allowed to invoke and apply the safe harbour provision:
The definition of low value-adding services, and examples, are clearly set out in the legislation. See 11.1 Transfer Pricing Safe Harbours for further information on low value-adding intra-group services.
On 8 October 2021, the OECD/G20 Inclusive Framework on BEPS reached a final agreement on the two-pillar approach to address the tax challenges arising from the digitalisation of the economy. After the agreement, the MOEF announced its intention to codify the two-pillar approach, and execute and implement the multilateral agreement in 2023 as one of the signatories. In January 2022, the MOEF publicly put out a tender for research services on the codification plan for Pillars One and Two respectively.
However, as the development of Pillar One at the OECD level has been dragged on for quite some time and there are still many obstacles to overcome before reaching an implementation stage, it is highly likely that Korea’s transposition of Pillar One into its own law will also be delayed.
On the other hand, there has been significant progress with Pillar Two at the level of both the OECD and Korea. The OECD released the Global Anti-Base Erosion (“GloBE”) model rules in December 2021 and its commentary in March 2022. Also, it released an implementation package in December 2022. There has been significant progress in Korea in relation to Pillar Two as well. Korea is known to be the first country to codify the main elements of Pillar Two into its own international tax regime. More specifically, the MOEF announced the 2023 tax law changes in January 2023. Within this tax law update, to introduce the global minimum tax system of Pillar Two, extensive regulations such as the purpose of the global minimum tax, calculation of top-up tax, including the Income Inclusion Rule (IIR) and Undertaxed Payments Rule (UTPR), various special cases and reporting requirements have been newly established in Articles 60–86 of the LCITA. This new law comes into full effect starting from the fiscal year beginning on or after 1 January 2024 and the first information return is due within 18 months from the end of the first fiscal year, subject to the new law.
In general, the Korean TP regime, just like the OECD Guidelines, does not contain clear regulations that restrict the form of business operations to particular types of entities (such as “entrepreneur” and “limited-risk entity”). Nevertheless, it is very common practice to characterise an entity according to some conventional and widely accepted TP categories, such as “entrepreneur”, “entities performing and bearing routine functions and risks”, and “limited-risk entities”.
With regard to a limited-risk entity, the NTS may accept a guaranteed return by its parent company, but since the OECD Guidelines’ Risk Analysis Framework was adopted into the Korean TP regime, the NTS’s attention has been more focused on whether there is any discrepancy between the entity purported to be bearing economically significant risks (ie, the contractual arrangements) and the entity that is actually bearing those risks, as evidenced through its dealings and conduct (ie, substance).
As Korea’s economy opened up rapidly in the 1990s, the need to participate in a wide range of international co-operation systems emerged. Accordingly, Korea joined the OECD in December 1996.
In July 1995, the OECD Guidelines were issued, and at the end of 1995, when Korea was pursuing OECD membership, it proactively reflected the OECD Guidelines through domestic legislation. Subsequent revisions to the OECD Guidelines – in 2010, 2017 and 2022 – have mostly been reflected in the Korean TP regime.
As an OECD member country, Korea has based its TP regime on the OECD Guidelines, and except with respect to the definition of related parties, Korea has generally not adopted the principles from the UN Practical Manual on Transfer Pricing.
There are two main types of transactions where TP safe harbour rules may apply:
Low Value-Adding Intra-Group Services
If an intercompany service transaction within a multinational group is of a supportive and “back office” nature, rather than relating to the core business activities of the taxpayer, then this is deemed to be a “low value-adding intra-group service”. In this case, a 5% mark-up can be applied, without the need to conduct a separate benchmarking analysis.
In order for an intra-group service to be deemed as a low value-adding service, a unique and valuable intangible asset should not be used or created, and the service provider should not bear, manage or control any significant risk in the course of rendering the service.
The legislation provides the following as examples of services that do not constitute low value-adding intra-group services:
Intercompany Loan Transactions
When a taxpayer conducts a financial transaction with a foreign related party, the arm’s length interest rate can be calculated in two ways, as follows:
In the latter case, the regulations stipulate that the interest rate for an overdraft, which is 4.6%, is deemed as a safe harbour rate when a Korean taxpayer lends funds to its foreign related parties. Conversely, if a Korean taxpayer borrows funds from its foreign related parties, Risk Free Rates (RFR) for respective currencies, which are enumerated in the subordinating regulation of the LCITA, such as SOFR for USD and KOFR for KRW, plus 150 basis points is deemed as a safe harbour rate. In the case where a certain currency is not enumerated in the regulation, SOFR will be used as the base rate pursuant to the regulation.
Starting in 2022, as referred to in 9.1 Alignment and Differences, key points from the OECD Transfer Pricing Guidance on Financial Transactions have been codified into the subordinating regulations of the LCITA and the updated regulations supplement the aforementioned high-level regulations on intercompany loan pricing, with more detailed methodologies set out below:
Under the Korean TP regime, the concept of savings arising from operating in Korea is not specifically addressed. However, as Korea follows the OECD Guidelines, it would be difficult for the NTS or taxpayers to argue for the existence of such savings, and it is highly likely that such savings could be seen as part of a local market feature, which does not warrant any comparability adjustments, provided that reliable local market comparables can be identified.
Moreover, there has been no prominent case in which the location saving concept was disputed.
There are no unique TP rules or practices in Korea.
In the Korean TP regime, there is some co-ordination between transfer pricing and customs valuation, as follows.
TP Review Committee
The NTS is legally required to establish a TP Review Committee (TPRC) within each regional tax office to review proposed TP adjustments prior to the completion of a tax audit. The TPRC is designed to ensure that taxpayers are treated fairly and consistently with regard to TP assessments. The TPRC is responsible for reviewing proposed adjustments that are:
Review of Accuracy of Tax Imposition (RATI)
Once a tax audit has been completed, the tax auditor will provide a notice to the taxpayer of its findings and the proposed amount of additional tax that will be assessed. This notice is known as a Pre-Tax Assessment Notice (PTAN). Time limits are important, since the taxpayer has 30 days to appeal to an administrative body within the NTS to review the legal basis of the proposed tax assessment. This process is referred to as a request for a RATI.
Once filed, the tax auditor’s right to issue a formal Tax Assessment Notice (TAN), which crystalises the taxpayer’s obligation, is suspended until the RATI procedure is completed. The RATI is reviewed by a panel of reviewers comprised both of NTS officials as well as outside experts such as professors, accountants, licensed tax representatives and attorneys who have good standing with the NTS. However, a senior official of the NTS has the final say in all decisions and sometimes conducts several hearings, particularly where the senior official disagrees with the decisions reached by the panel.
The RATI procedure is informal and taxpayers are often provided with an opportunity to appear before the panel or submit additional documents, in support of their position that some or all of the proposed tax assessment is unjustified. The RATI process typically takes several months to complete.
If the taxpayer prevails, the RATI panel will issue a written decision that the proposed tax assessment should be cancelled and the tax audit will close.
Timing of the Disputed Tax Payment
If a taxpayer decides not to file a request for a RATI within 30 days of the issuance of a PTAN, or if the taxpayer receives an unfavourable decision in the RATI, the tax auditor will issue a formal TAN.
The issuance of a TAN formalises the taxpayer’s obligation to pay the amount shown on the TAN (ie, the deficiency plus interest and penalty). Such an obligation must be settled (by payment or other arrangement, such as posting a bond or obtaining a guarantee) within 30 days of receipt.
If the taxpayer’s obligation is not settled, additional interest can accrue, and depending on the facts and circumstances, the tax authority can seek to attach or freeze the taxpayer’s assets and bank accounts.
Appeal to Administrative Bodies of the Government
Time limits are also important for the TAN, because the taxpayer has 90 days after receipt to appeal to one of three administrative bodies of the government, namely the Tax Tribunal, the Board of Audit and Inspection (BOAI) or the NTS’s office of appeals. In the vast majority of cases, taxpayers appeal to the Tax Tribunal as it is considered more independent than the BOAI or the NTS. Another important reason to file an administrative appeal is that under the Korean tax dispute system, the taxpayer must file the appeal and wait at least 90 days before it can file a petition to the court.
The Tax Tribunal is established under the office of the prime minister and is administered by officials generally seconded from the MOEF and the NTS. Like the RATI panel, the adjudicators of the Tax Tribunal are comprised of NTS officials and outside experts, and a senior official at the NTS has the final say in all decisions. Tax Tribunal proceedings are less formal than court proceedings but more formal than RATI proceedings.
As in court proceedings, the taxpayer and the tax authority are expected to submit briefs with technical arguments and applicable evidence. The taxpayer will also be given a formal opportunity to speak and plead before the adjudicators, although recently some of these hearings have been held by videoconference.
A typical Tax Tribunal proceeding involving a foreign entity, or a Korean entity with foreign investment, or involving an international tax issue, may last six months, although a large or complex TP case can last a year or more. During the proceedings, it is also possible that the adjudicators may order a re-investigation, which is effectively a re-audit of the taxpayer. However, such a re-investigation is essentially a desk tax audit, which involves the reviewing of files prepared by the tax auditor, rather than undertaking another field examination at the taxpayer’s premises.
Once a written decision has been issued and received by the taxpayer, the statute of limitations for filing a petition to the court is 90 days. In addition, as noted above, as long as the appeal has been filed with the Tax Tribunal for at least 90 days, the taxpayer has the option to file a petition to the district court without waiting for a decision from the adjudicators.
Both the plaintiff and the defendant have the right to appeal decisions of the district courts that are wholly or partially unfavourable, and, in practice, the losing party is virtually certain to appeal a district court’s decision to the High Court that has competent jurisdiction. For example, a plaintiff appealing the decision of the Seoul Court for Administrative Matters can appeal to the Seoul High Court for Administrative Matters. The appeal period is two weeks from receipt of the written decision (unless extended due to a national holiday) and must be strictly adhered to.
Under the Korean judicial appeal system, all decisions of the High Court can be appealed to the Supreme Court within two weeks from receipt of a written decision by the appealing party. At all stages of tax litigation, the right of appeal is automatic, without having to seek permission, either from the original court or from the appeal court.
However, unlike the district court or the High Court, the Supreme Court does not have original jurisdiction and its role is limited to reviewing the technical accuracy of the legal analysis that formed the basis for the decisions rendered by the High Court. Moreover, after reviewing legal issues raised in the petition for appeal, the Supreme Court can decide to dismiss the petition without considering the merits of the appeal, on the basis that the same issue has already been decided several times by the Supreme Court or simply lacks technical merit.
Generally, this initial review process takes about four months, and if the appellant’s petition has not been dismissed, it is an indication that the Supreme Court will undertake a substantive review of the case, and it may take up to two or even three years before a decision is rendered.
Korea is not a common law country that follows the doctrine of precedent (or stare decisis). Instead, Korea has adopted the continental legal system. Hence, although, in practice, Supreme Court decisions are followed by lower courts, Supreme Court decisions do not create law in the form of legally binding precedents, as would be the case in a common law system.
Accordingly, although Supreme Court decisions are influential, the NTS is not obliged to follow them and sometimes differs from the Supreme Court in its interpretation of the law. However, the NTS will generally acquiesce after several consistent and uniform Supreme Court decisions have been issued.
Moreover, in practice, tax auditors are generally reluctant to progress cases to the court level unless there is some particular reason to do so, and prefer to negotiate and settle at a tax audit level. Hence, a majority of disputed cases involving TP issues are resolved at a tax audit level, and this results in relatively few TP court cases compared to common law countries.
Court Rulings on Financial Guarantee Fees
One of the high-profile TP court rulings involved a quantitative model developed and used by the NTS in making TP assessments. Specifically, this model was used for transactions involving financial guarantee fees paid to Korean companies by their foreign subsidiaries. Under this model, any deficiencies in financial guarantee fees received by those Korean companies were additionally included as taxable income and corresponding taxes were assessed in Korea. A number of Korean companies filed administrative appeals to the Tax Tribunal and judicial litigation to the administrative courts.
As a result, the lower court rendered a decision stating that the TP method using this NTS model cannot be considered to correspond to a reasonable TP method specified in the legislation (Seoul Administrative Court 2014 Guhap 54387; Incheon District Court 2014 Guhap 30712).
An alternative claim
After these decisions, the NTS developed an alternative claim that led to the successful argument that the Moody's RiskCalc credit rating model was one of the “other reasonable methods” specified in the legislation (Seoul Administrative Court 2014 Guhap 73968; Seoul Administrative Court 2015 Guhap 64480; Daegu District Court 2014 Guhap 21181).
Ultimately, the NTS closed the case through conciliation with a large number of taxpayers, but some taxpayers continued to pursue lawsuits and received decisions from the Supreme Court, to the effect that while the NTS model cannot be considered as a reasonable TP method, the TP method using the Moody's RiskCalc model is one of the “other reasonable methods” specified in the legislation (Supreme Court 2017 Du73983), except for the case where foreign subsidiaries subject to the credit evaluation are new entities that do not have enough historical financial records to use the Moody’s RiskCalc model.
The implication of this Supreme Court ruling is that taxpayers are not required to stick to the guarantee fee calculated by the NTS, which is readily available on the NTS portal, but have an option to calculate arm’s length guarantee fees by applying commonly accepted methodologies such as the yield curve or a loss-giving default approach, with credit evaluation conducted through Moody’s or potentially, through other major credit rating agencies’ methodologies.
Court Rulings on the Commercial Rationality Concept in the Arm’s Length Principle
Due to TP's inherent nature incorporating economics, there are not many relevant precedents and cases, and most disputes are resolved at the level of the Tax Tribunal. Also, the issue of disputes tends to be limited to the calculation method of the arm’s length price or judgment on the completeness of data. Given this, on 10 November 2021, the Daegu District Court, which is the lower court, released a judgment (2019 Guhap 22561) that could be of significant interest to taxpayers and practitioners.
The plaintiff, which is engaged in the city gas manufacturing and supply business both in and outside of Korea, lent funds to its overseas subsidiaries ("Subsidiaries"), established locally for overseas natural resource development projects, and decided to allow the Subsidiaries to repay the loan principal and interest when they obtained profits from successful natural resource exploration. The funds loaned to the Subsidiaries by the plaintiff consisted of the funds raised by the plaintiff by issuing bonds denominated in foreign currency (a "General Loan") and a loan received from the Korea National Oil Corporation, which is commissioned by the government to provide loans for overseas natural resource development projects (a "KNOC Loan"). In the case of the latter, if the exploration project did not reach production and was terminated, the loan principal and interest could be exempted in whole or in part, considering the high risk and government mandate – ie, public policy – for the resource exploration project.
Based on this, the plaintiff deferred the payment of the principal and interest in the same way for the General Loan to Subsidiaries until the time of successful exploration and profit generation. In response, the Korean tax office, the defendant, notified the plaintiff of the corporate tax for non-receipt of the loan interest as a result of its tax investigation, and the plaintiff filed a lawsuit to cancel the imposition of the corporate tax.
Unlike the KNOC Loan, where interest payment is deferred, the court is of the view that it is not commercially rational for the plaintiff to defer interest payment for the General Loan, in which the plaintiff's obligation to pay interest to a third-party financial institution is definitive. Moreover, the court reiterated that it was “unrealistic and irrational” that the plaintiff, which was only in the position of a creditor lending operational funds to the Subsidiaries, should directly bear the investment risk in relation to business failure that the overseas subsidiaries should bear, but for the special relationship between the plaintiff and the Subsidiaries. The terms and conditions of the transaction would not be observed among independent enterprises.
The plaintiff appealed to the High Court against the above-mentioned first trial decision, and the Daegu High Court cited most of the first trial judgments, saying that the “source of funding”, more specifically, the legal obligation of repayment and interest thereunder, is also an important factor to be considered when determining the arm’s length price of an intercompany loan transaction as in the General Loan. Also, the High Court added that the special terms and conditions under the KNOC Loan, which the plaintiff argued should be taken into consideration when deriving an arm’s length interest rate, are based on a special law called the “Overseas Resources Development Business Act” that reflects the specificity of overseas resource development projects being promoted. However, such special terms and conditions that allow the exemption of a part or a whole of the principal amount in the case of project termination without commercial success should not be taken into account when deriving an arm’s length interest rate. Therefore, the High Court upheld the judgment of the district court. (2021nu5308, 2022.07.22).
This particular case is highly intriguing, as the foregoing judgment at both levels of the court was predicated on the commercial rationality concept in cross-border related-party transactions stipulated in the arm’s length principle set out in Article 8 (2) of the LCITA. Until then, there had been no tax litigation case in Korea in which the commercial rationality concept in the context of the arm’s length principle was the main issue of the dispute. More specifically, in this case, the main focus of the dispute was around how the prevailing practices in the treatment of loans and interest in the natural resources development industry, and public policy to foster such industry, will affect the determination of the commercial rationality concept in TP. This particular case is very likely to set the tone for other similar cases in the future, as it underscores the importance of the commercial rationality concept under the arm’s length principle.
Restrictions on outbound payments relating to uncontrolled transactions apply to payments made both to related parties and to third parties.
A Korean resident or corporation intending to make outbound payments to any recipient, in a controlled or uncontrolled transaction, in excess of USD50,000 per transaction must submit documents to a foreign exchange bank, proving the reason and amount of the payment.
However, the converse does not apply: foreign funds remitted to Korea by a non-resident or foreign corporation are not subject to this regulation.
Upon the request of a taxpayer, the MOEF or the NTS can request that the competent authorities of another jurisdiction should initiate a MAP where:
Every year, the NTS publishes an APA Annual Report, which details the APA processing procedures and various statistics, and provides a description and history of the APA. The latest one available is the 2021 version published in November 2022.
Taxation with Asymmetry of Information
There is an NTS internal administrative order which states that when a taxpayer requests information necessary for the exercise of its rights during a tax audit, the NTS should provide the information in a timely manner. This means that the taxpayer has the right to review and dispute any evidence gathered by the NTS in support of its tax assessment. For this reason, it is difficult for the NTS to assess taxes through information that is not made available to taxpayers.
Secret Comparables in Limited Circumstances
In a bid to reduce the number of taxpayers that are non-compliant with BEPS Action 13, the MOEF recently changed the existing regulations to allow the NTS to determine arm’s length prices and make assessments based on non-public comparable data in cases where the local file, master file or CbC report is incomplete or absent.
In the past, taxpayers have challenged the NTS’s use of secret comparable data because of the asymmetry of information and the unavailability of the data to the public.
However, as the LCITA now allows the tax authorities to use secret comparable data to assess non-compliant taxpayers, the NTS can legitimately and more aggressively assess taxpayers’ TP when there is non-compliance.
There are no separate regulations or guidance for COVID-19 under the current TP regime. However, since the Korean TP regime is based on the OECD Guidelines, Korea is expected to respond to issues caused by COVID-19 by referring to the Guidance on the Transfer Pricing Implications of the COVID-19 Pandemic, published by the OECD in December 2020.
As referred to in 9.1 Alignment and Differences, the subordinating regulations of the LCITA have recently adopted a new provision allowing the use of loss-making comparable companies depending on the economic condition – eg, economic downturn – in benchmarking analysis in reflection of the recent OECD Guidance on the Transfer Pricing Implications of the COVID-19 Pandemic.
The MOEF extended the special tax reduction and exemption regulations, which were supposed to expire by the end of 2022, by three years to the end of 2023. The objective of this is to support the business recovery of many small and medium-sized companies post COVID-19. This special tax reduction scheme applies to qualified small and medium-sized enterprises engaged in certain industries and the reduction in income tax or corporate tax may vary from 5% to 30%.
At the general meeting of the NTS held in early February 2023, the following was mentioned about its plan and basic tone vis-à-vis tax investigations and audits.
As for the second point above, it is known that mostly small and medium-sized companies are likely to benefit from this initiative, while it is envisaged that the NTS will maintain the same level of scrutiny towards large corporations throughout 2023.