07.06.

2013

Application of Arms Length Standards to Intra-company Transactions between Foreign Head Office and its Korean Branch
Tea Heun Kim , Director of Transfer Pricing at Lee & Ko, A series of new regulations have been introduced to the Korean corporate tax regime with regards to intra-group dealings between the multinationals head offices and their Korean branches. These new regulations reinforce the application of the arms length standards as the guiding principle for determining the appropriateness of income attributable to Korean branch. The following is a summary of the new regulations promulgated in February 2013 as Presidential Decrees (CITA-PD) and Enforcement Rule (CITA-ER) of the Corporate Income Tax Act (CITA), which will become effective from 1st January 2014: 1) Any domestic source income of the foreign head office derived from internal transactions with its Korean branch, which serve as the basis for calculation of the profit attributable to the branch, shall be determined by applying, the transfer pricing methodologies applicable for inter-company transactions. (Article 130, CITAPD) 2) The expenses incurred by the branch in the transactions with the foreign head office will be deductible only to the extent that such expenses are actually disbursed in accordance with a written agreement and they fall within the range of the arms length prices determined under the transfer pricing methodologies. However, interest expenses incurred in connection with intra-company loans (except for Korean branch of foreign banks) or guarantee fees disbursed by the domestic branch to the head office are disallowed as deductible expense (Article 130, CITA-PD and Article 64, CITA-ER) 3) The arms length prices applicable for transactions between the foreign head office and its domestic branch shall be determined based on the branchs functions performed, risks assumed and assets employed (Article 64, CITA-ER). This development is significant as the Korean tax authorities now have clear guidelines and/or legal grounds when asserting that the domestic source income earned by the foreign head offices and paid by their Korean branches by virtue of intra-company services, investments and/or cost allocation arrangements is unreasonable. In the past, a number of tax assessments were unsuccessful because the tax authorities sought to apply controversial methodologies (e.g., the force-of-attraction principle) which resulted in allocating excessive amount of income of the entire enterprise to its branch. Such assessments triggered tax appeals by the taxpayers, resulting in the total or partial annulment or substantive revision of tax assessments at the level of either judiciary or administrative proceedings. The enactment of the above regulations may also be viewed as an indication that the Korean tax authorities have begun to adopt (at least marginally perhaps) the Authorized OECD Approach (AOA as documented under the 2010 OECD Report on Attribution of Income to Permanent Establishment, whose conclusion has been incorporated in the Commentary on Article 7 of the 2010 version of the OECD Model Tax Convention) to attributing income to permanent establishments (PEs). This can be alarming to many multinationals with branch
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offices in South Korea as it implies aggressive scrutiny in the future of intra-company transactions. Unlike the scrutiny placed on related-party transactions between two legal entities, the AOA-based scrutiny on PEs could trigger an endless chain of inquiries and challenges by the tax authority as regards the correct arms length assumptions and/or hypothesis on the branchs transactions with the head-office. This may also call for more or less the same level of contemporaneous documentation as in the related-party transaction context in the near future. Lastly, some serious concerns have been raised lately in regards to the new regulations where the deduction of guarantee fees and interest payments for intra-company loans is disallowed in the context of intra-company transactions. This is quite contradictory to the spirit of the AOA where it should be applicable for all types of intra-company transactions undertaken between the enterprise and its permanent establishment(s) for income attribution purposes. The new regulations also make it slightly complicated to discern whether the AOA-based approach or the common expense allocation approach should be applied to an intra-company transaction, while the regulations still retain the allocation approach as an acceptable approach to determine deductible expenses by the branch. Some fear that these issues may cause unnecessary conflicts and disputations between tax authorities and taxpayers in the next couple of years. Authors : Tea Heun Kim is a Director of Transfer Pricing at Lee & Ko. He may be contacted at: teaheun.kim@leeko.com.

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