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viable option a taxpayer may take to thwart a tax audit on its cross-border inter-company transactions, or transfer pricing is entering into an Advance Pricing Agreement (APA). Below is a real-life case in which an APA was used as an effective strategy to keep the taxman at bay.

  The Problem
  ABC Company (ABC) is a foreign-invested company that sells, installs and services manufacturing equipment built by its American parent company. The foreign parent is the legal and economic owner of all valuable intangible properties relating to its products.

  In early 2003, the tax authorities informed ABC that it would be subjected to an audit because of its transfer pricing practices. A risk analysis revealed that ABC was potentially liable for approximately 11.4 billion won ($9.5 million) in additional taxes. If ABC were to be assessed this amount, it would not only be detrimental to the financial performance of the company it would also threaten its survival. Given the gravity of the situation, ABC top management began considering an appropriate response.

  The Options
  ABC could have chosen the traditional route and fight the tax audit (in itself, an arduous process). Were an acceptable outcome not be reached, it could have sought relief via a tax appeal or the mutual agreement procedure (MAP) process (see box). The downside of this approach was that the tax authorities must first hand down their tax assessment.

  A more viable option, and one that ABC chose, was to seek a bilateral APA. Both ABC and its U.S. parent filed for an APA with their respective tax authorities. The APA was rolled back to cover all ABC¡¯s five previous, and five future open tax years. Thus, the APA covered ABC¡¯s transfer pricing activities for 10 years in all. More importantly, by filing for the APA, the tax authorities had no choice but to stay the audit and allow the APA to proceed in order to deal with the company¡¯s transfer pricing issues.

  ABC¡¯s decision to take this approach was greatly influenced by the active promotion of the use of APAs by the National Tax Service (NTS). In an APA conference held Nov. 19th 2002, the NTS guaranteed that APA applicants would not be subject to transfer pricing tax audits (provided that an audit had not already been initiated) to encourage taxpayers to apply for APAs should they feel at risk.

  Applying for an APA provided ABC with the following advantages:
   By adhering to the terms and conditions of the finally agreed APA
    (negotiations are still ongoing), ABC is safeguarded from tax audits during
     the APA period - saving ABC both time and costs in defense work.

   APA proceedings are less confrontational compared to those for a tax
     audit defense. Whereas in tax audit situations the taxpayer is held liable
     for the burden of proof, the APA process takes more the form of
     negotiation where each side presents its position. In this case, the tax
     authorities are more open to methodologies presented by taxpayers.

   There are generally differences in both the purpose of investigation
     involved in a tax audit and an APA, as well as the level of experience of
     the respective NTS staff members responsible for them. Since the aim of
     the APA staff is to secure the taxation rights of Korea in the specific area
     of transfer pricing, they pursue such agreements on the basis of a clearly
     defined and rational procedure. By contrast, since the main purpose of a
     tax audit team is to impose additional taxation on a targeted company, an
     audit often results in aggressive tax assessments.

  In such cases, the parties resort to a tax appeal or MAP process for final assessment. By seeking an APA, ABC can bypass these difficulties.

   Tax assessments as a result of MAP proceedings can be potentially be
     disadvantageous to the taxpayer since the final agreed amount is based
     on arbitrary negotiations between the two tax authorities and not
     necessarily on the facts at hand.

   An APA allows ABC to maintain and foster good relations with the tax
     authorities, which may otherwise be impaired if the company finds itself in
     the position of appealing a tax assessment following an audit. By applying
     for an APA, ABC demonstrated good faith since it is proactively complying
     with Korean tax rules.

  Concluding Remarks
  The above case is a good example of an APA as a defense strategy by a foreign-invested company faced with a transfer-pricing audit. Of course, an APA is not applicable to every situation but it does have many advantages and should be considered as a first line of defense when a tax audit looms.

By Lee Heui-Tae (htlee@samil.com)
Director, Transfer Pricing Team,
Samil Accounting Corporation
+ 82-2-3781-9083