SOUTH KOREA: An Introduction to Tax: Consultants

Key Trends in Tax Audits and Strategic Ways for MNEs to Navigate the Challenges

The National Tax Service (NTS) recently significantly intensified tax audit practices, reflecting the government’s broader efforts to combat declining tax revenues. This aggressive stance has placed multinational enterprises (MNEs) under greater scrutiny, making it increasingly challenging to maintain legal stability and predictability in TP policies. This article explores the key trends shaping Korea’s TP audit landscape and outlines strategic considerations to help MNEs navigate these challenges effectively.

Emerging trends in TP audits

The NTS has adopted an approach by focusing on the industries or businesses that experienced notable revenue growth during the COVID-19 pandemic. In particular, simply filing an Advance Pricing Arrangement (APA) application no longer automatically shields taxpayers from audits, which is a significant departure from previous practices. The APA must now be activated, not merely submitted, to qualify for an exemption from audit. This change highlights the NTS’s intention to scrutinise TP arrangements more closely.

Heightened reliance on the substance-over-form principle

Recent audits demonstrate that the NTS frequently applies the substance-over-form principle to assess the appropriateness of international transactions. In a number of cases, tax auditors re-characterise the supply chain and intercompany transaction structure of MNEs operating in Korea for the purpose of maximising the TP assessments. This approach often entails a comprehensive fact-finding process, including detailed requests for information from foreign affiliates and in-depth functional interviews with key personnel and even lower-level employees. The aim is to uncover discrepancies between documented TP policies and their actual implementation. For instance, tax auditors often investigate whether the roles and responsibilities of entities align with the declared functional profiles. Such detailed investigations frequently lead to challenges in the consistency and credibility of taxpayers’ TP documentation, heightening the risk of adjustments.

Reconstruction of TP policies

The NTS actively reconstructs taxpayers’ TP arrangements through scenario analyses and simulations. Specifically, the NTS has demonstrated a tendency to:

• revise the TP method (eg, by substituting the Transactional Net Margin Method with the Profit Split Method or the Resale Price Method);
• modify the profit-level indicator (eg, by replacing the Berry ratio with operating margin or cost-plus mark-up); and/or
• reassign the tested party (eg, by shifting from a Korean entity to a foreign affiliate).

These approaches are applied differently depending on the nature of the transactions. For outbound transactions, the NTS typically scrutinises the absence or underpayment of royalties or service fees, while inbound transactions often face challenges related to excessive payments for these services. Additionally, the NTS has increasingly focused on intangibles such as locally developed marketing intangibles or location-specific advantages. Tax auditors argue that these factors often necessitate higher profit allocations to Korean entities.

Strategic considerations for MNEs

Given the NTS’s intensified audit practices, MNEs must adopt proactive strategies to mitigate risks. This includes revising TP policies to reflect evolving internal and external factors. MNEs should regularly update their TP policies to account for changing business environments and tax regulations. Also, preparing robust documentation is necessary to adhere to the substance-over-form principle, which is increasingly emphasised during audits. In particular, MNEs should focus on providing clear and detailed evidence of transactions involving intangibles or services. Despite these efforts, taxpayers should remain prepared for differing interpretations by the tax authorities, necessitating a strong defence of their TP positions. Nonetheless, when a tax assessment during a tax audit is unavoidable, MNEs may consider a domestic tax appeal or mutual agreement procedure (MAP) application.

Utilisation of domestic tax appeals

When faced with tax assessments, domestic tax appeals at the tax tribunal (TT) level can be a viable alternative to the MAP application. While MAP typically resolves disputes through compromise between jurisdictions, domestic appeals offer the advantage of binding decisions, which may cancel a whole or significant portion of the tax assessment. A taxpayer-favourable TT decision is final and cannot be appealed by the NTS. Interestingly, the TT may also order a re-audit, limiting the scope to certain disputed issues with a higher possibility of favourable outcomes. Should the TT decision fail to fully resolve the controversy, taxpayers can escalate the matter to the administrative courts. Notably, Korean tax law permits taxpayers to pursue both MAP and domestic appeals simultaneously, allowing for strategic decision-making to maximise the likelihood of success, but this may require considerable time and costs on the part of the taxpayer.

A French luxury goods MNE made a successful domestic appeal at the TT. The case involved TP documentation prepared using the Resale Price Method (RPM) with brand value comparability adjustments, which the tax auditors challenged by applying a new adjustment based on the Compound Annual Growth Rate (CAGR) concept. The TT deemed this adjustment unlawful and ordered a re-audit to determine the arm’s length price while fully accounting for the taxpayer’s functions. Following this re-audit, the taxpayer secured a substantial tax refund by demonstrating that differences in reseller functions tied to brand values warranted adjustments to the RPM application.

Simultaneous MAP and APA Applications

The simultaneous use of MAP and APA applications offers an effective strategy for resolving TP disputes, particularly when tax assessments arise during ongoing APA applications or when MNEs seek to address both past and future tax periods comprehensively.

Based on the NTS’s most recent 2022 APA statistics, the number of APA applications and closing cases in recent years has continuously increased while the average time taken to conclude was 25 months for unilateral APAs and 29 months for bilateral APAs. Furthermore, based on the NTS’s most recent MAP statistics, TP cases (120 cases) account for approximately 67% of 178 total MAP cases in the NTS’s current inventory. Not surprisingly, for the cases closed in 2022, the MAP cases started before 2015 took 85 months, and the others started from 2016 took 32 months on average. This highlights the time-intensive nature of both processes, which can be a significant drawback for taxpayers.

By pursuing MAP and APA applications concurrently, taxpayers can streamline negotiations and reduce delays. Simultaneous MAP and APA applications are particularly beneficial when tax assessments occur during ongoing APA negotiations. For example, taxpayers can submit a MAP application to address past-year assessments while continuing their APA discussions for future years. This dual approach not only expedites resolution but also enhances the likelihood of reaching a favourable agreement. Additionally, the increased attention from competent authorities due to concurrent applications may prioritise the case, resulting in more timely outcomes.

An Italian luxury goods MNE has successfully concluded simultaneous MAP and APA applications. During the taxpayer’s audit, despite a pending bilateral APA application, auditors aggressively pursued the case, suspending the audit twice and requesting extensive information and multiple opinion letters. The auditors argued that the taxpayer’s locally developed marketing intangibles and location-specific advantages warranted higher profits, citing the luxury goods industry’s performance during COVID-19. Following the audit, a MAP application was submitted alongside the existing APA to address past assessments while continuing negotiations for future years. Through timely and transparent engagement with the Korean and Italian competent authorities, an agreement was reached at the first CA meeting. This resolved most of the tax assessments for prior years and applied the APA terms to future operations, enhancing the taxpayer’s legal stability and predictability.