Tightened regulations on multinational intercompany transactions in Korea 2015

Like most countries, Korea has long regulated MNE intercompany transactions to discourage tax avoidance between MNEs and their local subsidiaries by requiring disclosure of the MNE’s relevant financial information, adopting the Thin Capitalisation Rule, etc. These regulations have been tightened by the recent amendments of the Act.

New sanction for failing to submit Simplified Income Statement of foreign related party
Since its amendment in 2009, the Act has provided that where a local Korean subsidiary is engaged in international trade with foreign parties that have a special relationship with the Korean subsidiary (e.g. where either party owns 50 percent or more shares of the other or when a third party owns 50 percent or more shares of each respective party etc.), the local subsidiary in Korea must submit a Simplified Income Statement (SIS) of the foreign related party, attached to a Specification of International Trade when filing its tax return for the relevant FY (Article 11, Section 1). However, submissions of the required SIS were far below the compliance expectation due to the information holder’s reluctance to provide the disclosure and the lack of direct sanctions for not submitting the documentation. The Act provided that Korean tax authorities might impose an administrative penalty of 70,000,000 KRW, but only if the foreign related party failed to respond to the tax authority’s separate additional request for the SIS, which generally accompanied tax audit procedures against the local subsidiary in Korea. Unless a tax audit had been initiated, which generally happens only about once every five years, there were no sanctions for failing to submit the SIS.

Recognising this problem, the recent amendment allows the tax authority to impose an administrative penalty of 10,000,000 KRW on the local Korean subsidiary for not submitting an accurate SIS of the foreign related party on time, without any additional submission request and regardless of the existence of tax audit procedures. The sanction is designed to secure compliance with the SIS submission requirement, providing basic information from which to determine arm’s length pricing in intercompany transactions. Accordingly, Korean tax authorities now have the ability to impose annual sanctions for failure to submit an SIS.

Changes to the Thin Capitalisation Rule
A thin capitalisation rule (TCR) was also adopted when the Act was created in 1995 to discourage tax avoidance. The rule prohibits interest arising from excessive debt over a stipulated ‘debt-to-contribution ratio’ from being deducted as expenses, if the debt was from a foreign controlling shareholder, “lender”. Large debt and small contribution schemes have operated to minimise taxable income, ultimately resulting in tax avoidance. Hence, interest from excessive debt is deemed to be a dividend to the controlling shareholder for tax purposes.

Before the recent amendment, the ‘debt-to-contribution ratio’ was three. However, the recent amendment changed the ratio from three to two (Article 14, Section 1).

Simultaneously, the recent amendment broadened the types of lenders who are subject to the application of the TCR. Before the amendment, it was unclear whether entities subject to the TCR would include those who have a special relationship with a foreign controlling shareholder. The recent amendment makes it clear that lenders subject to the TCR include those who have blood or marriage relationships, or business relationships (Article 14, Section 1). For blood or marriage relationships, the relevant presidential decree enumerates the spouse, blood relatives to the 6th degree, relatives by marriage to the 4th degree and biological children adopted to another family. For business relationships, the relevant presidential decree enumerates, officers, employees, households of the controlling shareholder, and relatives who are living together with any of those mentioned above.

Implications
The recent amendment of the Act has tightened the regulations on multinational intercompany transactions in Korea. Penalties for failing to submit an SIS can now be imposed annually, and the changed TCR ratio will directly influence a company’s tax liabilities. For those reasons, multinational companies operating in Korea need to reconsider their policies and financial structures to address these changes.