[Customs-Driven Corporate Tax Confusion]③To Avoid Double Taxation..."The Key Is Arm's Length Pricing and Royalties"

As major countries’ tax authorities are strengthening their taxation rights to protect domestic companies and secure tax revenue, Korean companies also need to take proactive measures to avoid double taxation. In the case of parent companies and subsidiaries, that is, related parties, it is necessary to set export and import prices for products at reasonable arm’s length prices and to receive appropriate royalties for technology and service usage when establishing local production facilities and selling products. This can minimize the risk of double taxation.

On November 3, the National Tax Service will hold a ‘Tax Issues Seminar’ for companies expanding overseas, in cooperation with the Korea Chamber of Commerce and Industry. Transfer pricing experts from the National Tax Service will attend the event to discuss tax issues that companies need to review in advance to prepare for potential double taxation.

The core issue in double taxation is the appropriateness of transfer pricing. Transfer prices applied to transactions of raw materials, products, and services between companies are directly linked to corporate profits. Since profits are the basis for taxation, tax authorities in each country verify the appropriateness of transfer prices to impose corporate taxes. If a parent company charges a higher export price to its subsidiary, the subsidiary’s profit margin decreases, and conversely, if the price is lower, the parent company’s profit decreases. As a result, the amount of corporate tax payable to the tax authorities in the respective countries where the parent company and subsidiary are located will differ.

Tax authorities believe that transactions between parent and subsidiary companies, that is, related parties, may not reflect market principles and are likely to be set higher or lower than arm’s length prices. Therefore, companies must prove and document that transactions between parent and subsidiary companies are conducted at arm’s length prices, as would be set between independent enterprises.

To achieve this, parent companies and subsidiaries must first review in advance whether their prices are at arm’s length and conduct transactions based on this assessment. The arm’s length nature of prices can be reviewed through various procedures. Companies should analyze the business environment based on the relevant industry, competitors, and regulatory factors, collect and review data on transactions with independent third parties, and select the most reasonable method for calculating arm’s length prices.

The key to proving arm’s length prices is the comparability analysis. Whether transactions between independent enterprises used for calculating arm’s length prices are truly comparable is often a point of contention during tax audits. Companies must demonstrate that the prices set between parent and subsidiary companies were determined through the same process as transactions with unrelated third parties.

Companies must retain documentation proving that their prices are at arm’s length. Supporting documents related to the method of calculating arm’s length prices may be requested by tax authorities during a tax audit, and if requested, companies must submit the relevant documents to the tax authorities within 60 days. Commonly requested documents during tax audits of international transactions between related parties include: ▲ the company’s organizational chart and work assignment table ▲ details of business activities of the parties involved in the transaction ▲ product price lists, manufacturing cost statements, and itemized transaction statements distinguishing between related and unrelated parties ▲ documents supporting the determination of international transaction prices ▲ economic analyses and forecasts supporting the selection of the method for calculating arm’s length prices. In addition, taxpayers conducting international transactions with overseas related parties above a certain scale must submit international transaction statements and reports on methods for calculating arm’s length prices to the National Tax Service.

If the parent company provides manufacturing technology to its subsidiary for local production and sales, rather than exporting or importing products, the parent company must receive reasonable royalties from the subsidiary. If the parent company does not receive royalties or receives too little, its profits will decrease, leading to tax risks from the tax authorities in the parent company’s country.

An industry expert stated, “Large companies that already have significant overseas operations and exports are aware of the risks of double taxation and are responding through internal reviews and other measures. However, many small and medium-sized enterprises lack awareness and preparation for these issues. Companies need to build capabilities and prepare in advance for potential tax issues that may arise from exports and overseas expansion to minimize the risk of unexpected double taxation.”

Companies must also prove that the compensation for transactions involving intangible assets, like product transactions, was determined through a reasonable process. In addition to reviewing arm’s length pricing procedures, conducting comparability analyses, and retaining supporting documents, companies must also examine the expected income or cost savings from technology and services, as well as fulfill obligations to submit documentation related to international transactions.

A representative from the National Tax Service stated, “Recently, practical negotiations with foreign tax authorities to prevent double taxation related to transfer pricing have become more active, and more companies are resolving double taxation concerns in advance through these negotiations. We plan to continue expanding the number of countries we negotiate with so that companies expanding overseas can operate in a stable tax environment.”