International Transactions in Korea (Part 1): The Arm’s Length Principle and Transfer Pricing

Part 7 of 20 · Beginner-friendly guide

International Transactions in Korea: Arm’s Length Principle & Transfer Pricing

Preventing profit shifting across borders. What the arm’s length rule means, how to find fair prices, and how to stay compliant in Korea.

Contents 1) What is transfer pricing? 2) The arm’s length principle (ALP) 3) Who is a “special related party”? 4) Five key pricing methods 5) Compliance, documentation & APA 6) Mini examples (quick checks) 7) Summary & next topic 8) Disclaimer

1) What is Transfer Pricing (TP)?

A transfer price is the price used when related parties trade goods, services, or IP—e.g., a Korean subsidiary selling to its overseas parent. If the price is set too low (or high), profits can shift out of Korea. Korean tax authorities may adjust the domestic tax base to the fair price.

Plain-English idea: TP tries to make related-party deals look like deals between strangers.

2) The Arm’s Length Principle (ALP)

The ALP requires that related parties transact at a price that independent, unrelated companies would use under similar conditions. If not, authorities may recalculate income using arm’s length data.

Analogy: If you sell your friend a rare card, you must charge what you’d charge a stranger in a normal marketplace.

3) Who is a “Special Related Party”?

Rules apply when there is a special relationship—commonly where one party directly/indirectly owns a significant portion (e.g., ≥50% of voting shares) of the other, or where control exists through contracts or management influence.

Exact thresholds and control tests are technical; check the current statute/decree for your facts.

4) Finding the Arm’s Length Price — Five Key Methods

1. Comparable Uncontrolled Price (CUP): Compare to a truly comparable price between two independent companies. Gold standard when good comparables exist.
2. Resale Price Method (RPM): Start from the third-party resale price and subtract a normal gross margin for the reseller.
3. Cost Plus Method (CPM): Start with supplier’s cost and add a normal mark-up for functions/risks.
4. Profit Split Method (PSM): When both sides contribute unique value (IP, key functions), split the combined profit based on contributions.
5. Transactional Net Margin Method (TNMM): Compare the tested party’s net margin (to sales or costs) with that of similar independent companies.

If none fit well, a reasonable alternative consistent with substance can be used.

5) Compliance, Documentation & APA

• Information returns: Taxpayers with cross-border related-party deals must submit prescribed forms (e.g., statements of international transactions, summaries of overseas related-party results).
• Documentation: Maintain robust files (intercompany agreements, functional & risk analysis, comparables, pricing policies, benchmarking, and invoices). Thresholds and formats may differ by year/type.
• Advance Pricing Arrangement (APA): You can request advance approval from the NTS for your TP method going forward. An approved APA provides certainty and can reduce audit risks.

Practical tip: Align finance, logistics, and legal. Ensure the story (functions/assets/risks) matches the numbers (margins and mark-ups) and the paperwork (contracts and invoices).

6) Mini Examples — Quick Checks

Example 1: Undervalued exports to parent

Facts: KR Sub sells devices to Foreign Parent at KRW 90; comparable third-party export price is KRW 100.

Risk: Margin too low. CUP suggests arm’s length is KRW 100 → NTS may adjust KR Sub’s income upward.

Example 2: Distributor using RPM

Foreign Parent sells to KR Distributor (related). KR Distributor resells to independent customers for KRW 1,000. Comparable distributors earn a gross margin of ~20%.

Arm’s length transfer price ≈ KRW 800 (1,000 × (1 − 0.20)). Pricing below this may inflate KR margin; above this may erode it.

Example 3: Contract manufacturer using CPM

KR manufacturer performs limited functions with low risk. Comparable mark-up on total cost is ~8%.

Arm’s length price ≈ Cost × (1 + 8%). Track cost base definition to avoid disputes.

Example 4: Unique IP on both sides → PSM

KR Sub and Foreign Parent co-develop IP and co-own trademarks. Both perform high-value functions.

Split combined operating profit by contribution metrics (people, assets, risks) rather than forcing a one-sided margin.

Example 5: TNMM sanity check

KR entity’s operating margin is benchmarked against comparable independents’ interquartile range of 3%–6%.

If KR margin is 1%, a secondary adjustment may be needed to bring it within the range.

7) In Summary

• ALP = price between related parties should match what independent firms would use.
• Choose the most reliable method based on functions, assets, and risks.
• Document your story and numbers; consider an APA for certainty.

Next (Part 8): Thin Capitalization and other debt restrictions—interest deduction limits and related-party financing traps.

8) Disclaimer

This post is for general information only and not legal or tax advice. Rules evolve; outcomes depend on your facts. Consult a qualified professional.

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Transfer Pricing Arm’s Length Principle International Tax Korea APA TNMM Korean Taxation Series

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