Tax Audits of Foreign-Invested Companies in Korea: What Standard Preparation Misses

When a foreign-invested company in Korea receives notice of a tax audit, the usual first step is the one any company would take: put the books and supporting documents in order, and check for unrecorded sales or unsupported expenses. That work is necessary. It is not enough. For a foreign-invested company, the heart of the audit lies not in domestic transactions but in transactions with the overseas head office and other group companies.

Why these audits are different

A large share of a foreign-invested company’s revenue and costs flows to and from head office. Goods are bought and sold, service fees are paid, royalties and interest are remitted, and staff are seconded from abroad. Each of these head office transactions carries several tax questions at once. Is the payment deductible? Was tax withheld? Is zero-rated VAT correctly applied? Were the international transaction filings made? Is the price at arm’s length? A single transaction is examined from several angles.

An answer given on one point can also become the basis for a finding on another. Dealing with each transaction in isolation is therefore a mistake.

Items that come up repeatedly

• Head office service and management fees – whether they are recognised as consideration for services actually received, and whether tax was withheld
• Recharges of head office costs – whether zero-rated VAT was correctly applied
• Royalty and interest remittances – whether the withholding rate and treaty relief were correctly applied
• International transaction filings – whether any of the annual forms were missed
• Transfer pricing – whether intercompany prices fall within the arm’s length range
• Also interest on loans from head office, pay for seconded staff, and whether head office has a permanent establishment in Korea

Zero-rated VAT and withholding tax in particular are levied on the full transaction amount, not on profit. A single invoice may look minor, but head office transactions recur every month. Several years of them, with penalty tax on top, can easily produce an assessment far larger than expected.

These problems usually arise because the position was never properly reviewed when the company entered Korea, or because it was reviewed but the structure has since changed and no one revisited it.

A well-drafted contract is not enough

It is tempting to think that a carefully drafted intercompany agreement settles the matter. The tax authorities look past the wording to what was actually done. The account given by head office and by the Korean company has to be consistent, and it has to be supported by objective internal and external evidence. Where the answers of head office staff and the Korean team diverge, the divergence itself invites further questions.

Because the review extends beyond Korean tax law to treaties and to head office’s own records, it matters that an adviser with international tax experience aligns the explanation with head office in advance.

Sometimes the basic records are the obstacle

Many foreign-invested companies run on the group’s ERP system and keep no separate Korean-language books. When the auditor asks for general ledgers by account and transaction listings by counterparty, they have to be rebuilt from raw data. Time runs short before the substantive issues are even reached, and much of a fixed audit period goes on preparing documents.

Accruals booked for management reporting purposes can also build up to the point where even revenue cannot be reconciled with the VAT tax base. As these differences accumulate year after year, the result is that no one can explain the Korean books. This is why the adviser needs to understand how foreign-invested companies actually operate, group ERP systems included.

Low profit is no reason to relax

Companies with little profit, or a loss, often assume there is little corporate tax at stake. Withholding tax and VAT, however, are levied on transaction amounts regardless of profit. A loss-making company is not shielded from assessments.

If your company is part of a foreign group, we recommend reviewing the head office transactions with an adviser experienced in international tax before an audit notice arrives. Knowing where to look is half the preparation. For a review, please contact Star Tax & Legal at heebong@star-tax.kr.

Topics: Tax Audit · Head Office Transactions · Withholding Tax · VAT Zero-Rating · Transfer Pricing · Permanent Establishment · Corporate Compliance