Anatomy of transfer pricing
Currently 15,980 foreign companies are operating in Korea. While hiring workers and producing goods and services, foreign investors encounter numerous difficulties and experience a variety of grievances. One particular grievance brought to our attention is that they suffer from a discrepancy between the value of imported goods assessed by the Korea Customs Service (KCS) and the value of the same goods calculated by the National Tax Service (NTS). They request that the two prices be the same, but this is not easy although not impossible.
Multinational enterprises (MNEs) engage in cross-border transferring of goods between affiliated companies. For this sort of transaction, the parent company usually controls the transfer price which may at times significantly deviate from a fair market value. They try to reduce their overall tax liability to a minimum by using international double taxation agreements and other strategies. They keep their tax liabilities low in high-tax countries and high in low-tax countries.
Jerry Carter of Tax and International Finance at IDEX Corporation recently explained the ethical and practical aspects of transfer pricing. He said if a company uses a fair market value as the transfer price and pays lower taxes in another country, their transfer pricing is not violating any ethical standards or laws. Foreign companies are required to prepare justifications and keep supporting documents on record for future use. This is because the parties involved may apply different definitions or measurements of fair market value.
Carter cited Japan and Australia as bad examples where companies exercise an unfair transfer price. A Japanese company out of a sense of patriotism overcharged its Australian subsidiary so that it would pay more taxes to Japan. That company ultimately paid the Australian government a $250 million settlement. Similarly, a British pharmaceutical firm overcharged its U.S. subsidiary for inventory and eventually paid $3.5 billion in penalties to the Internal Revenue Service of the U.S.
When the transfer price is significantly above the fair value, the NTS tries to adjust it by applying the arm’s length principle of the OECD Guidelines to ensure a fair market value. The OECD strongly recommends that the arm’s length principle be used to determine the transfer price.
Similarly, the KCS checks the appropriateness of the transfer price, if it is significantly below the fair market value. Customs authorities usually follow the WTO Customs Valuation Agreement which states that all imported articles must be valued in accordance with one of five valuation methodologies: (1) transaction value; (2) transaction value of identical or similar merchandise; (3) deductive value; (4) computed value; and (5) derivative value. This must be applied in sequential order.
Even though the OECD guidelines and the WTO Customs Valuation Agreements share similar goals, there are significant differences in application. The customs office inherently tends to overrate the transfer price to maximize its tariff revenue whereas the national taxation office tends to underrate the transfer price to maximize its profit tax revenue.
The OECD and the World Customs Organization have held joint international conferences to discuss various ways of reducing the discrepancy between the customs value and the taxation value. It should be noted that a fair market value is interpreted as a range of numbers rather than as a point number, in order to provide some flexibility on which the different parties involved can rely.
The convergence of the two values can be reached if the transfer price is determined within the range of the fair market value. This can be achieved if the parent company of an MNE enjoys a good reputation as a practitioner of fair transfer pricing.
If the transfer price is way out of the fair value, the KTS or the NTS charges ex-post penalties to foreign-invested companies after adjustments. This puts foreign companies in a difficult situation. Consequently the foreign company brings their grievances to the attention of the Foreign Investment Ombudsman for settlement.
To resolve such grievances, the Ministry of Strategy and Finance has established the Tax Adjustment Review Committee for International Trade Price. It went into operation on July 1, 2012. The committee made up by lawyers, CPAs, and tax specialists settles disputes over the appropriateness of transfer prices.
Jeffrey I. Kim is the foreign investment ombudsman, a presidentially appointed troubleshooter for investors and entrepreneurs from overseas. He earned his Ph.D. in economics at the University of Chicago and has taught at the University of Colorado, Boulder, and Sungkyunkwan University.