A Korean subsidiary of a Dutch multinational electronics group imported medical equipment, small household appliances, and lighting products from related parties and sold them in Korea. The company also provided after-sales maintenance services for medical equipment. For FY 2012 to 2015, the company applied the transactional net margin method separately to each business division and reported its corporate tax accordingly, using operating profit margin as the profit level indicator. Following an audit the tax authorities reclassified the company’s activities into four segments. They concluded that in the medical equipment, small household appliances, and automotive lighting segments, the transfer prices paid to foreign related parties exceeded arm’s length levels, while no upward adjustment was needed for the general lighting segment. On that basis, they issued a tax assessment. The authorities treated maintenance service activities in the medical equipment segment as closely linked to product sales and selected comparable companies largely based on similarity to domestic maintenance service businesses. The taxpayer challenged the assessment and the Tax Tribunal partly upheld the challenge and ordered a re-examination of the lighting segment, which resulted in a partial refund. Litigation continued regarding the remaining adjustments, particularly for the medical equipment and small household appliance segments. The High Court ruled that the tax authorities’ selection of comparables and calculation of arm’s length prices were unlawful for both segments, mainly due to insufficient comparability analysis and improper functional characterization. Judgment The Supreme Court partially disagreed with the High Court. It held that for the small household appliance segment, the authorities’ selection of full-fledged distributors as comparables was inappropriate given the taxpayer’s limited functional profile, and therefore the High Court’s conclusion of illegality could be upheld. However, for the medical equipment segment, the Supreme Court ruled that the High Court had misapplied transfer pricing principles. It found that maintenance service support from foreign affiliates did not constitute a separate international transaction with a material impact on profitability and that the transactional net margin method is less sensitive to differences in transaction stages and product characteristics. The Supreme Court concluded that the tax authorities were not required to perform a separate comparability analysis for maintenance service support and that the selection of comparables could be considered reasonable. As a result, the Supreme Court set aside the High Court judgment in its entirety and remanded the case for recalculation of the proper tax amount in line with its reasoning. Click here for English translation. Click here for other translation ...

A Korean subsidiary of a multinational electronics group imported medical equipment, small household appliances and lighting products from related parties abroad and sold them in Korea. It also provided after-sales maintenance services for medical equipment. The taxpayer segmented its activities by business line, applying the transactional net margin method separately to each segment and using operating profit margin as the profit level indicator. Maintenance services relating to medical equipment were treated either as a distinct activity or as a routine function with limited profitability. Following an audit, the tax authorities rejected the taxpayer’s segmentation and functional analysis. They reclassified the taxpayer’s activities into four segments, treating the maintenance services for medical equipment as economically integrated with the sale of medical equipment. Based on this, they concluded that the prices paid to foreign related parties for medical equipment, small household appliances and automotive lighting products exceeded arm’s length price, while no adjustment was required for the general lighting segment. The authorities selected comparables that included domestic maintenance service companies and issued a tax assessments. The taxpayer challenged the assessment in the Tax Tribunal, which partially upheld the challenge and ordered a re-examination of the lighting segment. This resulted in a partial refund. However, disputes remained regarding the medical equipment and small household appliances segments, particularly with regard to the functional characterisation of the taxpayer, the treatment of maintenance services and the selection and application of comparables. The taxpayer therefore pursued the case in the courts. Judgment The High Court ruled that the tax assessments for the disputed segments were unlawful. It found that the tax authorities had failed to conduct a proper comparability analysis in line with the transactional net margin method. The authorities had also not adequately demonstrated that the taxpayer’s segmentation and functional analysis were inappropriate. Furthermore, they had relied on comparables whose functions and risk profiles were not sufficiently similar to those of the taxpayer. The court also criticised the authorities for effectively substituting their own assumptions without providing a reasoned justification under the International Tax Coordination Law. Consequently, the court annulled the remaining transfer pricing adjustments. Click here for English translation. Click here for other translation ...

For purposes of this section, the interquartile range is the range from the 25th to the 75th percentile of the results derived from the uncontrolled comparables. For this purpose, the 25th percentile is the lowest result derived from an uncontrolled comparable such that at least 25 percent of the results are at or below the value of that result. However, if exactly 25 percent of the results are at or below a result, then the 25th percentile is equal to the average of that result and the next higher result derived from the uncontrolled comparables. The 75th percentile is determined analogously ...

If there are no uncontrolled comparables described in paragraph (e)(2)(iii)(A) of this section, the arm’s length range is derived from the results of all the uncontrolled comparables, selected pursuant to paragraph (e)(2)(ii) of this section, that achieve a similar level of comparability and reliability. In such cases the reliability of the analysis must be increased, where it is possible to do so, by adjusting the range through application of a valid statistical method to the results of all of the uncontrolled comparables so selected. The reliability of the analysis is increased when statistical methods are used to establish a range of results in which the limits of the range will be determined such that there is a 75 percent probability of a result falling above the lower end of the range and a 75 percent probability of a result falling below the upper end of the range. The interquartile range ordinarily provides an acceptable measure of this range; however a different statistical method may be applied if it provides a more reliable measure ...

The arm’s length range will consist of the results of all of the uncontrolled comparables that meet the following conditions: the information on the controlled transaction and the uncontrolled comparables is sufficiently complete that it is likely that all material differences have been identified, each such difference has a definite and reasonably ascertainable effect on price or profit, and an adjustment is made to eliminate the effect of each such difference ...

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Uncontrolled comparables must be selected based upon the comparability criteria relevant to the method applied and must be sufficiently similar to the controlled transaction that they provide a reliable measure of an arm’s length result. If material differences exist between the controlled and uncontrolled transactions, adjustments must be made to the results of the uncontrolled transaction if the effect of such differences on price or profits can be ascertained with sufficient accuracy to improve the reliability of the results. See § 1.482-1(d)(2) (Standard of comparability). The arm’s length range will be derived only from those uncontrolled comparables that have, or through adjustments can be brought to, a similar level of comparability and reliability, and uncontrolled comparables that have a significantly lower level of comparability and reliability will not be used in establishing the arm’s length range ...

In order to be considered comparable to a controlled transaction, an uncontrolled transaction need not be identical to the controlled transaction, but must be sufficiently similar that it provides a reliable measure of an arm’s length result. If there are material differences between the controlled and uncontrolled transactions, adjustments must be made if the effect of such differences on prices or profits can be ascertained with sufficient accuracy to improve the reliability of the results. For purposes of this section, a material difference is one that would materially affect the measure of an arm’s length result under the method being applied. If adjustments for material differences cannot be made, the uncontrolled transaction may be used as a measure of an arm’s length result, but the reliability of the analysis will be reduced. Generally, such adjustments must be made to the results of the uncontrolled comparable and must be based on commercial practices, economic principles, or statistical analyses. The extent and reliability of any adjustments will affect the relative reliability of the analysis. See § 1.482-1(c)(1) (Best method rule). In any event, unadjusted industry average returns themselves cannot establish arm’s length results ...