VAT Zero-Rating Risk on Head Office Charges in Korea

If your company is the Korean subsidiary of a foreign group, invoices go out to head office on a regular basis. They may be consideration for work performed on the parent’s behalf, or reimbursement of costs the subsidiary settled up front.

Those invoices usually carry no VAT. The customer is a foreign company, so zero-rating is taken as a given. The invoice is issued at zero percent, the amount goes into the zero-rated sales box on the VAT return, and that is the end of it.

So when, and by whom, was that determination actually made?

Review at the outset concentrates on entity form, capital, and the contractual structure with head office. How the transaction should be designed is the centre of the discussion, and how VAT attaches to the resulting charge tends to fall in behind it. Once the structure is settled and the first invoice goes out, the treatment applied at that moment becomes the standard.

The same holds as the business grows. When an item of a kind not previously charged is added to the head office invoice, that item calls for its own assessment. In practice it lands in the same box as everything else.

Look closely and there is a fair chance that determination was never properly made – not at the outset, and not along the way.

Zero-rating runs on two separate tracks

The understanding that supplying services to a foreign company means zero-rating is widely held. The rules are not that simple.

Where services are supplied outside Korea, zero-rating follows on its own terms. There is nothing to argue about.

The difficulty is that most Korean subsidiaries are not in that position. The work is performed in Korea and the consideration is received from head office abroad. That is not a service supplied outside Korea. It is a service supplied in Korea that earns foreign currency – a completely different track, and one on which zero-rating is granted as an exception.

Exceptions come with conditions.

The conditions are cumulative, and one gap defeats the rest

Several points can catch a company out here.

The answer turns on which industry the company actually falls within. It turns on how the consideration was received. And, depending on the industry, it turns on which country head office is located in. The same service for the same amount can produce a different conclusion if the parent sits somewhere else.

These conditions have to be satisfied together. Meet three and leave one open, and that one defeats the others.

None of them can be confirmed from the invoice. On paper, every invoice comes out looking the same.

If zero-rating is denied, the consequences run wide

Where zero-rating is denied, those sales are taxed at ten percent.

VAT ordinarily works by allowing one party to deduct what the other has paid. On a domestic transaction the recipient business deducts the amount as input VAT, so no tax finally rests anywhere. Charges to head office are different. The party paying is a foreign company with no Korean business registration, so there is no place for a deduction to sit. The ten percent is recovered nowhere and simply leaves. Where head office charges are cost plus a modest margin, that amount exceeds what the transaction earned in the first place. Penalty tax is added on top.

And the transaction does not happen once. Head office charges continue monthly or quarterly, and a determination made once is replicated. VAT returns are filed frequently, but whether zero-rating was correctly applied is not tested at the filing stage. On paper everything passes without incident.

It then surfaces all at once, in a tax audit or on correction. What is at issue is not the most recent invoice. It is ten percent of everything that has accumulated.

One misconception is worth addressing here. Companies sometimes assume that with little profit to show, an audit will not turn up much. For corporate income tax there is something in that. VAT, however, attaches to the supply value rather than to profit. Whether the year ran at a loss or barely recovered cost, the taxable amount does not shrink by a won.

If anything the opposite holds. VAT is examined closely in a Korean tax audit. The tests are relatively clear-cut, which makes conclusions easy to reach, and items that depend on conditions – zero-rating among them – can be verified from documents alone. Where thin margins leave little to find in corporate income tax, the weight of the audit shifts here.

And the thinner the margin, the deeper the mark an assessment of this kind leaves on the accounts.

Worth checking

There are two things, and they carry different weight.

First, did the substance satisfy the conditions?

These are the conditions set out above. Whether the consideration came in as foreign currency. Whether the company’s actual industry falls within the range where zero-rating is available. And, depending on the industry, which country head office is in. If any one of them is missing, zero-rating does not hold.

Where the head office invoice mixes items of differing character, the answer can differ item by item. It is worth asking whether the same rate has simply been applied across all of them.

If this is where things break down, the ten percent described above follows.

Second, is that substance reflected in the return as filed?

Even for a transaction that met the conditions, the filing has to match. The VAT return calls for the industry and the counterparty’s country to be stated. Is the industry you have just confirmed, and that country, what actually appears on the return?

Zero-rating turns on industry and on counterparty country. A single box completed incorrectly can itself become the basis for denying it.

If the first is wrong, the matter is serious. If only the second is wrong it is comparatively light, but not something to leave as it is.

If you can answer both, there is nothing to worry about. If “the customer is a foreign company” is the only basis, now is the time to look. For a review of how your head office charges are treated, please contact Star Tax & Legal at heebong@star-tax.kr.

Topics: VAT Zero-Rating · Head Office Charges · Foreign Currency Earnings · Intercompany Recharges · Tax Audit · Corporate Compliance