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.
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