By Jay Shim & Steve Minhoo Kim, Lee & Ko, South Korea
Important amendments to South Korea’s international tax and transfer pricing laws became effective on January 1 that will be of interest to multinational groups.
The new laws include a Korean version of a diverted profits tax, new simplified transfer pricing rules for intra-group low value-adding services, simplified disclosure requirements for taxpayers subject to country-by-country reporting, new penalties for taxpayers non-compliant with transfer pricing documentation, and improvements to the mutual agreement procedure (MAP) in tax treaties.
Korea diverted profits tax
In an effort to secure the tax base, Korea’s Ministry of Economy and Finance introduced a diverted profits tax by tacking it onto an existing but somewhat overbroad substance-over-form provision in the Law for Coordination of International Tax Affairs (LCITA).
The main objective of the Korea diverted profits tax is to combat base erosion and profit shifting by Korean taxpayers through, among other things, interposing an entity in a tax haven country or other low tax jurisdiction. The new provision also seeks to clarify the application of the existing, overbroad substance-over-form provision in the LCITA.
Under Article 2-2(4) of the LCITA and Article 3-2 of its presidential enforcement decree, the Korea diverted profits tax applies if profits are diverted to a foreign jurisdiction and, as a consequence, taxes that should be paid to Korea are reduced by 50% or more.
Moreover, any unnecessarily interposed party without substance will be disregarded for Korean tax purposes unless the taxpayer can provide compelling reasons why the transaction has a genuine business purpose and if no tax avoidance motive is present. This provision is in line with the principal or main purpose test in general anti-avoidance regimes.
Burden of proof
One notable aspect of the new Korea diverted profits tax is that the burden of proof has been shifted from the Korea tax authorities to taxpayers.
Traditionally, under Korean tax law, tax authorities have the burden of proof, and it is rarely shifted to taxpayers.
This has been debated for many years due to the notion that it may be too onerous for tax authorities to prove the wrongdoings of taxpayers when there is an asymmetry of information between tax authorities and taxpayers.
Now, with this new provision, Korean tax authorities can challenge taxpayers on a more aggressive basis.
However, for the efficient execution and administration of the new law, Korea added a safe harbor rule in Article 3-2 of the presidential enforcement decree of the LCITA where that lays out some thresholds that must be met for tax authorities to invoke the new Korea diverted profits tax.
The thresholds provide that the amount of diverted profit must be less than KRW 1 billion (USD 800,000 ) and that the amount of reduced taxes to be paid to Korean tax authorities as a result of the diverted profit must be less than KRW 100 million (USD 80,000).
Korea transfer pricing rules for intra-group low value-adding services
Korea also enacted new simplified transfer pricing rules for intra-group low value-adding services that became effective January 1.
These new rules aim to align with Action 9 of the OECD/G20 base erosion profit shifting (BEPS) project and to ease the burden on Korean taxpayers, especially burdens imposed on MNEs that have intercompany service transactions with foreign affiliates.
The new Korea transfer pricing rules have been added to existing LCITA rules that set out the transfer pricing methodology for service transactions.
An intercompany service transaction between a Korean tax resident and a foreign related party is considered a low value-adding intra-group service if the service is supportive or back office in nature.
The transaction must also not fall into the category of research and development, manufacturing, sales and purchase of raw materials, marketing, finance/insurance, and extraction/exploration/processing of natural resources.
Also, the service must not require the use of unique and valuable intangibles or lead to the creation of unique and valuable intangibles.The service should also not be redundant with services provided by a third party.
If all of the foregoing requirements are satisfied, Korea taxpayers are not required to conduct or have their external advisors conduct a separate benchmarking study for an arm’s length mark-up for such services, provided that the mark-up, i.e., full cost plus mark-up, is maintained at 5% or lower.
As stated above, the new simplified transfer pricing rule is added to existing provisions of the LCITA setting forth transfer pricing methodology for intercompany service transactions where such methodologies shall be adopted for Korean tax deduction purposes.
The new simplified transfer pricing rule could, therefore, be interpreted as being acceptable for inbound intercompany service transactions where Korean taxpayers need to deduct service fees charged by their overseas affiliates.
That being said, as far as Korean tax is concerned, if a more lenient interpretation is applied, the new rule could be applicable to outbound intercompany service transactions due to the equity among Korean taxpayers who engage in either type of transaction.
These new rules follow a significant revision to the arm’s length principle at the end of 2018, which provided a legal basis for Korean tax authorities to challenge and re-characterize or reconstruct intercompany transactions lacking commercial rationality.
Transfer pricing compliance burdens
Since BEPS Action 13 compliance was first implemented in South Korea in 2017, there have been trials and errors in implementation.
During this period. Korea’s Ministry of Economy and Finance weighed the benefits of BEPS Action 13 compliance against the increased burdens imposed on taxpayers.
Some information required in the local file, master file, and country-by-country reports was redundant with other documents that taxpayers were required to submit with their tax returns. After hearings with taxpayers, Korea’s Ministry of Economy and Finance decided to mitigate burdens on taxpayers by simplifying transfer pricing reporting requirements for taxpayers who are subject to BEPS Action 13 compliance in South Korea. This new provision also became effective as of January 1, 2020.
Taxpayers are relieved from the requirement to submit the summary of cross-border intercompany transactions and the declaration of the selected transfer pricing method, which should be attached to their annual tax returns due within three months from the end of each fiscal year anyhow.
However, taxpayers should invoke and declare the exemption in their tax return filing.
Action 13 noncompliance penalties, secret comparables
In a bid to reduce the number of taxpayers that are non-compliant with BEPS Action 13, Korea’s Ministry of Economy and Finance changed Article 11 of the LCITA to allow the tax authorities to determine arm’s length prices and make assessments based on secret comparable data in cases where the local file, master file, or country-by-country reporting is incomplete or absent.
Traditionally, Korean tax law has been silent on Korean tax authorities’ use of secret comparable data in a tax audit.
Taxpayers have challenged Korean tax authorities’ 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 tax authorities to use secret comparable data to assess non-compliant taxpayers, the Korean tax authorities can legitimately and more aggressively assess taxpayers’ transfer pricing when noncompliance is present.
Also, to reduce noncompliance with BEPS Action 13 and other transfer pricing documentation requirements, Korea has revised the penalty clause in the LCITA.
Pursuant to Article 12 of the LCITA and Article 51 of the presidential enforcement decree thereof, the maximum penalty for failing to comply with transfer pricing documentation requirements is increased up to KRW 300 million (USD 240,000) (the existing maximum penalty of KRW 100 million (USD 80,000) plus additional penalty up to KRW 200 million (USD 160,000)).
The additional penalty is determined based on the number of days of delayed submission the maximum delay for the penalty calculation purposes is thirty (30) days, in which case the penalty should not exceed KRW 200 million (USD 160,000).
MNEs that intentionally and strategically do not submit transfer pricing documentation to Korean tax authorities will now be under heightened pressure as the penalty amount is not nominal, and Korean tax authorities may use their own secret comparable data to the detriment of non-compliant taxpayers.
South Korea Mutual agreement procedure (MAP)
Taxpayers can choose among several different avenues to appeal a tax assessment, including using Korea’s domestic appeal procedures, or, if Korean tax authorities and a foreign country’s tax authorities are involved, the mutual agreement procedure (MAP). The latter is a more effective way to resolve double taxation issues.
The new law amends the rules pertaining to MAP regarding the calculation of interest imposed upon a delay of tax collection or postponement of disposition in arrears. Under prior law, taxpayers could opt to defer a tax payment, subject to applicable interest of 9.125% per annum for late payment, if a tax audit is concluded and the taxpayer decides to appeal the additional tax assessment.
However, as of January 1, taxpayers who defer the tax payment and proceed with MAP are required to pay only 2.1% per annum after two years from MAP initiation
Korea’s Ministry of Economy and Finance designed this rule to alleviate the interest burden of taxpayers whose MAP cases persist more than two years as well as to encourage Korean tax authorities to shorten the period of resolving MAP cases.
However, the benefit of this rule from a taxpayer’s perspective is now somewhat limited because Korean tax authorities’ average period to resolve a MAP case has decreased significantly as a result of OECD recommendations. The timeline set for resolving MAP cases received on or after January 1, 2016, is set at 24 months.
The new law also addresses the execution of the MAP result. This change is most noteworthy for taxpayers who are considering both MAP and tax litigation.
Under prior law, tax litigation in South Korea took precedence over MAP in a sense that the latter was usually nullified when the court ruling derives a different result than the agreement made in MAP. However, the new law has eliminated that hierarchy to strengthen the effectiveness of MAP and to deter unnecessary court appeals.
The new law also alters the timeline of the transfer pricing income adjustment resulting from MAP.
The LCITA now prescribes that the additional income attributable to Korean taxpayers as a result of MAP be returned within ninety (90) days from the next day following the MAP conclusion date.
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