Multinational firms and transfer pricing
A multinational enterprise (MNE) is a business entity comprising of a group of associated companies with establishments in two or more countries according to the OECD definition. Its share in international transactions takes approximately 75 percent of the total world trade.
Through an MNE’s worldwide business activities and international distribution and allocation of its income and costs including taxes, it seeks to maximize after-tax profits of the MNE group.
An MNE’s high degree of knowledge on tax matters also makes it possible for tax planning using tax benefits or loopholes in each different tax jurisdiction.
As MNEs can easily be in a monopolistic structure in the market, they could make an arbitrary decision when setting a market price ― so called “transfer price” ― in international transactions between related parties and thus could control profit allocation within the MNE group.
For instance, MNEs may generate relatively low profits in a country with a high corporate tax rate whereas they could make high profits in another country with a low corporate tax rate.
Customs duty, exchange rates, and other factors can also be a possible determinant of setting a transfer price.
To cope with such tax avoidance which unfairly reduces tax revenues of a country, a number of countries have adopted the transfer pricing regime.
Korea also enacted the Law for the Coordination of International Tax Affairs in 1995 and introduced transfer pricing.
As domestic tax laws of each country as well as tax treaties dictate the transfer pricing regime, application of transfer pricing follows as stipulated in tax treaties and each country’s tax law.
The transfer pricing regime refers to a taxation system where tax authorities regulate the transfer price policies in order to prevent MNE’s tax avoidance acts through manipulation of the transfer price between its foreign related parties.
To be more specific, it is a system in which tax authorities re-calculate taxable income based on an arm’s length price and impose taxes on a company when its taxable income is reduced by applying prices different from the arm’s length price.
Since the 2008 global financial crisis, many countries have strengthened transfer pricing policies on MNEs to tackle their fiscal deficit.
Through this transfer pricing regime, MNEs undertaking international transactions with foreign related parties are often exposed to the risk of tax audits and double taxation. In order to resolve such risks, MNEs can avail themselves of appeal procedures provided in domestic tax laws or Mutual Agreement Procedures specified in income tax treaties.
However, they usually take a considerable amount of time and no small sum of expenses before reaching a conclusion.
In view of such circumstances, most tax authorities in developed countries including Korea, are involved in Advance Pricing Arrangements (APAs) to minimize double taxation issues in advance.
APA allows taxpayers to reach an agreement in advance with tax authorities on an appropriate transfer pricing methodology to determine an arm’s length price.
If a taxpayer satisfies the agreed APA, the taxpayer can concentrate on the business without worrying about a possible transfer pricing audit, by reducing potential tax uncertainties.
According to recent statistics, the National Tax Service (NTS) receives more than 30 APA requests annually, and the number of APA requests increases ever year.
For unilateral APAs which do not need mutual agreement procedures between tax authorities, the average time to conclusion is 1 year and 8 months, and that of bilateral APAs is two years and five months, which is far shorter than those of the U.S. (three years and seven months), Canada (four years and one month), and other advanced countries.
The renewal of an APA took only about 1 year and 1 month as of 2009.
The NTS is dedicated to minimizing tax disputes that foreign corporations in Korea may experience due to transfer pricing audits, making transfer pricing regimes and domestic tax laws accord with OECD standards to prevent double taxation, and expediting APA processing time.
The NTS also publishes the APA Annual Report which contains various statistical data such as the number of APAs received by year, APAs by industry, etc. and posts it on its website (www.nts.go.kr) as a means to transparently administer the regime.
Contributed by Yunjun Park, Assistant Commissioner for International Taxation of the National Tax Service of the Republic of Korea.