Transfer pricing: Introduction of low value-adding intra-group services in 2020
Nature of intra-group services
Generally speaking, intra-group services between related parties in a multinational enterprise (MNE) group are provided for the improvement of cost-efficiency and effectiveness of business activities of such groups. For example, all the subsidiaries of a MNE group cannot hire their local lawyer for their legal issues in each jurisdiction from a cost-benefit perspective. Instead, the foreign headquarters can hire the in-house legal counsel in order to mitigate and manage the common legal exposures or issues of the group, which will provide some benefits to all the subsidiaries. In this regard, the costs for the in-house legal counsel, plus an arm’s length mark-up, need to be charged to the subsidiaries. As this is very natural, OECD Transfer Pricing (TP) Guidelines and also the Korean tax law basically allow a Korean subsidiary to bear such charges on that basis from the intra-group service centre of the headquarters, or regional headquarters, if some requirements are met.
Basic requirements for deductibility of intra-group service fee
Under the Korean International Tax Coordination Law (the ITCL), the intra-group service fee paid to the foreign related party can be deductible for Korean corporate income tax purpose when the following four conditions are met:
- The relevant service agreement should be made in advance of the provision of services and the service provider actually performing such services under the agreement;
- The service recipient should have an expectation of income generation or cost reduction from the services provided;
- The service fee is determined at the arm’s length price; and
- The service recipient should keep the evidence documents supporting the fulfilment of conditions of (1)-(3) above.
Introduction of Low Value-adding Intra-group Services in 2020
In accordance with the revision of OECT TP Guideline in 2017, the Korean tax authority introduced the concept of low value-adding intra-group services (LVIS) in 2020 through the revision of ITCL, which is as follows.
1. Deductibility of the fee for LVIS under the ITCL
Under the revised ITCL, where the taxpayer determines the arm’s length price of fees for the services satisfying all the following conditions (i.e. LIVS) as the amount of ‘their costs plus 5% mark-up’, it would be deemed that such fees are determined at the arm’s length price for Korean tax purposes:
- The LVIS are of a supportive nature, not directly related to the core business of the MNE group and not classified as any of following services:
a. Research and development services;
b. Extraction, exploration, or processing of natural resources, manufacturing and production services;
c. Purchasing activities relating to raw materials, manufacturing, sales, marketing and promotion activities; and
d. Financial transactions, insurance and reinsurance.
- In the process of providing LVISs, the service provider shall not qualify for any of following:
a. The use of unique and valuable intangibles or the creation of unique and valuable intangibles; and
b. The assumption or control of substantial or significant risk by the service provider, or the creation of significant risk for the service provider.
- The service provider and the service recipient do not make any service transactions similar to LVISs with third parties.
2. Another threshold for the deductibility of LVIS fee:
Where the service provider’s charge on providing the above LVIS (i.e. cost plus 5% mark-up) exceeds the smaller of i) 5% of the service recipient’s sales amount or ii) 15% of the service recipient’s operating expenses, the above simplified approach rule on LIVS will not be applied.
Documentation for deductibility of LIVS fees
Although the Korean tax law does not regulate the detailed documentation method for deductibility of LVIS fees, under the OECD TP guidelines, it is reasonably expected that at least the following documentation is required;
- A description of the categories of LVIS provided, etc.;
- Written contracts or agreements for the provision of LVIS, etc.;
- Documentation and calculations showing the determination of the cost pool as described in the paragraph above and of the mark-up applied thereon, etc.; and
- Calculations showing the application of the specified allocation key.
Min Jae Lee
Sung Soo Jin