Korea: Interest deductions could be challenged on arm’s length grounds, but not wholly denied as tax avoidance

The Tax Tribunal held (2018 Jeon 3997) that while the tax authority could not recharacterize the taxpayer’s transaction on tax avoidance grounds, and accordingly deny the taxpayer’s entire interest deduction, the tax authority could challenge a portion of the interest purportedly paid by the taxpayer on the grounds that the interest rate was not arm’s length.

The taxpayer, a joint venture between a U.S. and Korean company, conducted a series of transactions pursuant to which the U.S. company acquired all of the equity interests in the taxpayer and also became a lender to the taxpayer. The taxpayer subsequently deducted interest expenses paid to the U.S. company. The tax authority denied the taxpayer’s interest deductions on the grounds that the transaction had a tax avoidance purpose.

The Tax Tribunal held that the tax authority did not have the right to disregard or recharacterize the transaction because taxpayers have the right to choose among various legal approaches to achieve the same economic objectives, unless the form of the transaction is chosen solely for tax avoidance purposes. Because the taxpayer’s transaction was not an unusual form of terminating a joint venture relationship, it would be difficult to conclusively determine that the transaction was an abnormal transaction that a rational economic actor would not choose. However, because the 8% interest rate on the taxpayer’s debt to the U.S. company appeared higher than the usual interest rate, the tax authority had the right to determine the arm’s length interest rate and adjust the taxpayer’s taxable base and tax amount accordingly.

Read an April 2024 report prepared by the KPMG member firm in Korea