Recent Korean TP precedents: insights into strategic tax audits and appeal preparation

According to the Ministry of Economy and Finance, South Korea’s national tax revenue in 2023 reached KRW 344.1 trillion, falling short by KRW 56.4 trillion of its budgeted amount of KRW 400.5 trillion. In the press release, the government explained that this drop can be attributed to a substantial decline in corporate operating profit and contraction in the value of assets, stemming from a drastic deterioration in international and domestic economic conditions. Constituting the major portion of the deficit, the insufficient corporate tax revenue raises anticipation of an upswing in aggressive tax audits throughout 2024 and beyond.

Furthermore, in the 2024 policy plan, the National Tax Service (NTS) announced its intention to maintain the current level of tax audits while bolstering efforts to promptly identify and challenge allegations of offshore tax evasion through increased workforce and enhanced information systems. As part of this initiative, the NTS will likely intensify its scrutiny of transfer pricing (TP) areas, which have traditionally been the primary focus during tax audits on multinational enterprises.

Simultaneously, observing a recent trend of opting for domestic tax appeal/litigation proceedings alongside mutual agreement procedure applications, noteworthy TP-related precedents have emerged in Korea. These cases provide valuable insights into the interpretation of legal principles, particularly in the application of the arm's-length principle. As this article delves into these precedents, it is imperative to examine the subject matters contested during tax audits, as well as the Korean courts and Tax Tribunal’s (TT’s) adjudication on these issues.

In the Supreme Court’s decision 2021Du42481 on October 14 2021, among multiple transactions, company A in Korea was mainly involved in providing sales support services for its overseas related party’s distribution of semiconductor equipment to domestic customers in the semiconductors manufacturing industry (T1). Company A also purchased semiconductor equipment parts from its overseas related party and resold the parts, mostly to domestic customers as part of repair and maintenance services within the warranty period. Depending on the level of inventory and market demand, company A occasionally resold parts to other related parties (T2).

Based on the concluded advance pricing agreement terms in the past, company A continuously applied the comparable uncontrolled price (CUP) method for T1 and the transactional net margin method (TNMM) with full cost plus mark-up (FCPM) for T2. However, after a revision of the group’s TP policy, company A applied the TNMM with the Berry ratio (BR) for T1 and T2. Rejecting the changed TP policy, the NTS imposed TP assessments based on the previous TP methods of the CUP method for T1 and the TNMM with an FCPM for T2. The key issue revolved around whether company A’s arm’s-length price was legitimately calculated after the TP policy change.

The Supreme Court ruled that company A’s arm’s-length price calculation after the TP policy change was illegitimate.

For T1, the court concluded that company A’s factual relations, size, and frequency of transactions had not changed to justify the newly adopted TP methods, considering the products, transaction period, customers, and functions performed. For T2, the court determined that because the transaction nature did not constitute a simple intermediary activity and company A performed additional functions such as sales support services and installation and warranty services, the BR was not an appropriate profit level indicator.

Therefore, according to this Supreme Court precedent, substantial changes and relevant rationale are required to justify a change of TP policy. In other words, a mere change in the TP method itself or immaterial changes in the relevant facts will not be sufficient to convince the court or the NTS in future events. Also, the Supreme Court applied very strict standards for the BR application that, along with other requirements, only companies engaged in simple intermediary activities may consider the BR.

In the Seoul Administrative Court’s decision 2019Guhap83489 on July 19 2022, company B was involved in the importation of different product types, including medical equipment, from its overseas related party and resale of the products in Korea. Due to the characteristics of medical equipment, company B also provided maintenance services to domestic customers. Under this business structure, company B selected comparables and calculated the arm’s-length price by applying the TNMM with an operating margin (OM) for each business unit, including the medical equipment.

For TP analysis purposes, when selecting comparables, company B classified itself as a limited risk distributor because it did not own any valuable intangible assets, while performing only limited functions, according to the overseas related party’s management, and assuming limited risks.

The NTS, however, classified company B as a full-fledged distributor on the basis that company B owned intangible assets such as engineers’ technical skills and exclusivity of parts supply, and that company B assumed major entrepreneur risks such as inventory risk, exchange rate risk, receivables collection risk, and after-sales risk. Among other issues, the main issue was whether the comparables selected by the NTS were legitimate to calculate the arm’s-length price of company B, the tested party, economically classified as the full-fledged distributor.

The Seoul Administrative Court ruled that it was reasonable to define company B as the full-fledged distributor because company B performed a significant decision-making function for its local business and assumed significant entrepreneur risks. Also, the court viewed that the engineers’ technical skills, exclusivity of parts supply, and marketing activities were regarded as company B’s intangibles, which should be considered for the arm’s-length price calculation. Thus, the court determined that the NTS’ selected comparables, which could be defined as full-fledged distributors and owned significant intangibles, were reasonable for the arm’s-length price calculation of company B.

Due to a number of TP issues intricately linked in this case, currently pending at the Seoul High Court, the Seoul Administrative Court did not specify whether a Korean entity economically defined as the full-fledged distributor could still be the tested party. However, the court provided some defined characteristics of the full-fledged distributor based on the analysis of functions, risks, and assets. Because the economic characterisation is critical for the selection and application of the most appropriate TP method during the overall TP analysis process, including the tested party selection, such characteristics may be relevant for Korean entities of multinationals mostly engaged in distribution activities.

In the Seoul High Court’s decision 2022Nu47935 on June 14 2023, company C in Korea was involved in the importation of high-value brand watches from its overseas related party. Company C resold these watches in Korea and offered warranty and overhaul services to customers who had purchased the same brand watches from any country without charging any fees. Separately analysing the free services, the NTS imposed TP assessments that company C did not receive reimbursements from the overseas related party, as the overall OM, encompassing the free services, was managed based on the group TP policy’s application of the TNMM. The key issue revolved around whether company C’s TP analysis should be conducted on a separate or combined transactions basis.

The Seoul High Court interpreted the case by recognising that customers purchase expensive luxury-brand watches not only to obtain product ownership but also to receive dedicated after-sales service. The court also acknowledged that the high sales price of the products includes the value of services to be provided to customers in the future. Consequently, company C’s group implemented a ‘worldwide service’ policy, allowing customers to receive free warranty and overhaul services, irrespective of the country of purchase. Moreover, the group mandated that company C and other overseas distributors adhered to the same policy without settling fees separately among the overseas related parties for the free services.

Thus, the court ruled that, considering the substance and practice of the transaction, company C’s free services are closely related to the importation and sale of the brand watches. The court recognised company C’s status as an exclusive importer of the group’s brand watches in Korea and guarantee of company C’s OM based on the group TP policy as reimbursements for expenses related to the free services.

Therefore, in consideration of the substance or practice, TP transactions, such as the importation and sale of products and the provision of services, can be evaluated on a combined basis if they are closely related. In this case, it may be relevant that an exclusive importer’s status and sales profit should guarantee compensation for any expenses related to various services.

On the other hand, the Seoul Administrative Court in the aforementioned case 2 provided a basis for a separate transaction analysis for company B’s medical equipment purchase and maintenance service transactions.

The primary reasons were that company B’s customers entered into a medical equipment purchase contract with company B, not necessarily including a maintenance contract, and the maintenance service fee is determined through negotiations with customers on a separate basis from the sales price of the medical equipment. Additionally, company B possessed its own engineers’ technology for the maintenance services, distinct from its overseas related party’s medical equipment-related technology.

As a result, careful distinction of the bases for separate or combined transactions analysis is recommended, considering the courts’ different interpretations in cases 2 and 3.

In the TT’s decision 2020Seo2311 on June 9 2022, company D in Korea was engaged in the distribution of automotive and industrial semiconductors sourced from its overseas related party. Specifically, company D sold these products to third-party sales agents in Korea, which subsequently resold them to ultimate customers in the automotive and electronics manufacturing sectors, sharing profit margins with these agents. While generally supportive of company D’s TNMM application with an OM, the NTS imposed TP assessments by reselecting comparables. The main issue was whether company D’s comparables selected by the NTS reasonably aligned with overall comparability factors.

The TT emphasised that differences in transaction structure or stage between the tested party and comparables inevitably lead to variations in sales and marketing functions or distribution margins. Despite the NTS’s comparability adjustment to mitigate such differences, the reselected comparables’ profit margins increased. Consequently, the TT issued a ‘re-audit’ decision, instructing the NTS to comprehensively consider comparability factors – such as the transaction stage, sales volume, customers, and business environment – when selecting comparables with similar functions and recalculating the arm's-length price accordingly.

In practice, the TT’s re-audit decision is generally considered favourable for taxpayers. This is because the TT typically directs the NTS to re-evaluate its initial assessment, aiming for a possible legitimate reduction rather than imposing a higher amount. Given the intricacies and challenges in determining a precise arm’s-length price during proceedings, taxpayers usually prefer re-audit decisions in domestic tax appeal cases, especially those involving TP issues.

This case holds significance as the TT underscored the importance of a comparability analysis, which lies at the heart of applying the arm’s-length principle. According to the TT’s decision, when applying the most appropriate TP method, particularly in the selection of comparables, a meticulous examination of all relevant comparability factors is imperative.

The above TP cases covered major TP issues such as reasonableness of the TP policy change, tested party selection, combined transactions analysis, and comparability factors that are commonly targeted during tax audits and controversial during the appeal process. Although not all the cases led to results favourable to taxpayers, the above precedents have provided some level of guidance for multinationals to reconsider their TP strategies.

Expecting aggressive challenges on TP areas, multinationals’ preparation will be critical, taking precedents into account for every level of TP management, from TP policy (re-)design through tax audit defence, tax appeal/litigation proceedings, and even determination of means of remedies. From the precedents, potential TP risks and double taxation issues may be predicted and prevented.