“Company D”, an auto parts manufacturer in Korea, entered into the Chinese market together with a Korean automaker, where it established “Company D1”, using the same structure as in Korea. Company D licensed certain patents and provided technical and business support to Company D1 in return for royalty payments.
Against this backdrop, the National Tax Service (“NTS”) argued that Company D1 and other Chinese affiliates of Company D (namely, Companies D2, D3, and D4) had ultimately obtained excess profits as a consolidated entity, by virtue of receiving the aforementioned technical and business support from Company D. In this regard, the NTS determined the excess profits enjoyed by these Chinese affiliates by comparing the “Combined Profits” (i.e. the operating profits that were a combination of the profits of Company D1, as well as other Chinese affiliates, as per the consolidation accounting method) with the operating profits of comparable companies in the Chinese market. Based on this logic, the NTS calculated the arm’s length royalty payments that Company D should (in their view) have collected from Company D1.
The tax team at Lee & Ko represented the client in filing a claim to dismiss this transfer pricing (“TP”) taxation, arguing that the concept of “Combined Profits”: (i) does not have any reasonable basis in law; and (ii) does not fully comply either with the Law for the Coordination of International Tax Affairs (“LCITA”) that governs the Korean TP regime, or with the OECD TP Guidelines for Multinational Enterprises and Tax Administrations. Moreover, for such taxation to be valid, the LCITA provides that each Chinese affiliate subject to the “Combined Profits” would have to constitute a foreign related party of Company D; however, some of the Chinese affiliates (namely D2 and D3) could not be considered as a foreign related party of Company D, based on a strict application of the relevant provisions of the LCITA.
The panel of Judges received and reviewed the expert opinions of three prominent tax law professors, and after over two years of legal battles between the parties, Company D’s argument was successfully accepted, and it finally obtained a complete dismissal of the TP taxation from the Court, with the Lee & Ko Tax team’s full support.
Recently, the NTS has had a tendency to assess taxes based on TP considerations, by introducing novel concepts such as “Combined Profits” when using the profit-split method, especially in relation to taxation for mid-sized companies such as auto parts manufacturers. Therefore, the above ruling was of great importance in that it was the very first to confirm that the taxation of TP according to the “Combined Profits” method was illegal, and it also clarified that the scope of foreign related parties should be strictly interpreted. In the future, this case will have great precedential significance, and furthermore, it will become an important guideline for the NTS in determining the legality of its taxation, especially in the context of applying relatively new methods in the field of TP.