Best Practice for Transactions between Domestic Business Units of Foreign Financial Firms and Specially Related Parties
September 2007
Financial Supervisory Service
< Contents > Chapter 1 General Rules ·············································································· 1 1.1 Purpose ···································································································1 1.2 Nature of best practice ·······································································1 1.3 Scope of application ··········································································· 2 1.4 Application ···························································································2 1.5 Definition ······························································································2 Chapter 2 General Principles ···································································· 4 2.1 Establishment of equal relationships ············································· 4 2.2 Arm's Length Principle ······································································4 2.3 Fair allocation of profits and expenses ·········································5 2.4 Sharing of common expenses ·························································5 2.5 Objectivity of transactions ·······························································5 Chapter 3 Prior Review ·················································································6 3.1 Validity of transactions ····································································· 6 3.2 Precondition for Requirements for permission/approval ··········6 3.3 Adherence to Business Delegation Regualtion ···························· 6 3.4 Rejection of unfair requests from specially related parties ········· 7 3.5 Allocation of shared expenses ······················································· 7 Chapter 4 Contracts with Foreign Related Parties ······························· 8 4.1 Principle of transaction ····································································8 4.2 Form of transaction ·············································································9 4.3 Preparation of written agreement ··················································· 9 4.4 Calculation of transaction price ······················································ 9 4.5 Renewal of contract ········································································· 11 Chapter 5 Post-Transaction Management ·············································· 11 5.1 Transaction records ··········································································· 11 5.2 Maintenance of transaction evidence ········································ 13 5.3 Cancellation/termination of contracts ········································ 13
Chapter 1 General Rules
1.1 Purpose In the process of transaction between domestic business units of foreign financial firms and specially related parties, there have been increased violations of domestic laws, regulations and distortions of P&L structure. This has led to the need for the provision of best practice on desirable objectives in the conduct of business. By providing detailed best practice on rules that should be adhered to when domestic business units of foreign financial firms transact with specially related parties, the goal is to encourage voluntary adherence to legal procedure and establishment of fair transaction practices. The best practice is based on the OECD's 「Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations」, 「Report on the Attribution of Profits to Permanent Establishments」, and domestic regulations such as the 「Corporate Tax Act (including Enforcement Decree and Enforcement Rule)」, 「Ruling of Corporate Tax Act」, 「Adjustment of International Taxes Act (including Enforcement Decree and Enforcement Rule)」, Korea's Tax Service Notification 2001-10 「Common Cost for Foreign Corporation Branc h」, 「Regulation on Business Delegation of Financial Institutions」, and「Results of Inspections of Financial Firms by the Financial Supervisory Service」.
1.2 Nature of best practice The best practice presents the principles that are necessary for the prevention of possible illegal or inappropriate activities in transactions between domestic business units of foreign financial firms and specially related parties. The best practice cannot include all related laws and regulations, and therefore, along with this best practice, care must be taken to adhere to other relevant laws and regulations.
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1.3 Scope of Application The best practice is to be applied to transactions that are conducted between domestic business units of foreign financial firms and specially related parties.
1.4 Application When the aforementioned laws and regulations conflict with the best practice as a result of revisions, the revised areas must be taken into consideration when the best practice is applied. For issues not presented in the best practice, other best practice established by financial industry sector can be applied considering nature of transactions.
1.5 Definition 1.5.1 Foreign Financial Firms "Foreign financial firms" refer to legal entities established by foreign decree providing financial services overseas. These include financial firms that are providing financial services in Korea, over * which foreigners have actual control , such as holding a majority in the Board of Directors or being the largest shareholder. <Example> Korea Exchange Bank, SC Korea First Bank, Citi Bank Korea, Prudential Investment and Securities are all regarded as foreign financial firms. 1.5.2 Financial Groups "Financial groups" refer to groups consisting of multiple financial and non-financial firms engaged in various financial industries, internationally controlled by a single entity. <Example> Hong Kong Shanghai Financial Group (Hong Kong Shanghai Bank, Hong Kong Shanghai Securities) - 2 -
1.5.3 Domestic Business Units "Domestic business units" refer to all organizations within a single financial industry established in Korea for foreign financial companies' business purposes, regardless of form and name, including corporations, branches, agents, sales offices, liaison offices. <Example> When taking the form of a corporation, the corporation and its domestic branches are regarded as one domestic business unit (eg. In the case of Korea Exchange Bank, the head office and domestic branches are regarded as a single business unit.), when in the form of a branch, the branch is viewed as a business unit. If there are at least two branches domestically, all the branches in a single financial sector are viewed as a single business unit. (eg. In the case of HSBC, other branches in Korea are included). However the branches of Hong Kong Shanghai Bank and Hong Kong Shanghai Securities are considered as separate business units as they are in different financial sectors. 1.5.4 Overseas Business Units "Overseas business units" refer to all forms of organizations established overseas, including head office established overseas by a foreign financial firm for the conduct of business. Moreover, this includes the foreign financial firms and branches located overseas of the same financial group that the foreign financial firm is part of. 1.5.5 Head Offices, etc "Head Offices, etc" refer to overseas headquarters (including head office) of the domestic business units of foreign financial firms, regional headquarters, major shareholders, and firms exercising substantial management right.
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1.5.6 Specially Related Parties "Specially related parties" of domestic business units of foreign financial firms are as the following: 1. Domestic business units of different business types within the same financial group 2. Overseas business units 3. Non-financial firms of the same financial group 1.5.7 Normal Price "Normal price" refers to the level of price generally applied in transactions with independent third parties that are not specially related parties. 1.5.8 Service Transaction "Service Transaction" refers to business management, financial advisory, payment guarantee, IT support, technological support or other similar transactions.
Chapter 2 General Principles
2.1 Establishment of Equal Relationships Domestic business units of foreign financial firms should be able to conduct business on a mutually equal relationship with specially related parties(e.g. head offices) and establish a mutually equal relationship so that it is possible to reject inappropriate requests.
2.2 Arm's Length Principle Domestic business units of foreign financial firms should conduct business with specially related parties under conditions generally applied in transactions with independent third parties that are not specially related parties.
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Normal prices should be calculated with considerations to comparability to the price of a transaction among independent parties; functions that are implemented through the transaction; contract terms on allocation of responsibility, risk, profit; economic environment such as market situation; and business strategies of respective companies.
2.3 Fair Allocation of Profits and Expenses In engaging in direct transaction or jointly conducting business with specially related parties, domestic business units of foreign financial firms should fairly allocate profits and expenses based on actual relevance and contribution, such as assets used, degree of risk shared, etc. , which can be calculated through functional and factual analysis. <Example> In accordance with â&#x20AC;&#x2DC;Regulation on Business Delegation of Financial Institutions', when fundamental businesses are conducted jointly between the overseas head office and domestic branch, profit should be allocated according to actual contributions, such as services provided or risks shared by the domestic branch rather than simply allocating profit amount by adding the labor cost of the relevant personnel of the domestic branch to a certain amount (labor cost Ă&#x2014; add ratio) without consideration of the contributions of the domestic branch. 2.4 Sharing of Common Expenses Domestic business units of foreign financial firms should share common costs related to the business management or general administrative expenses of specially related parties only when these costs are reasonably related to the profit creation of units.
2.5 Objectivity in Transactions Domestic business units of foreign financial firms should have objective data that can prove to any third party the fact that transactions with specially related parties are normal. - 5 -
Chapter 3 Prior Review
3.1 Validity of Transactions In conducting transactions with specially related parties, domestic business units of foreign financial firms should implement a comprehensive prior review on the necessity of the transaction, analyses of cost and benefit, and adherence to relevant laws and regulations. However, prior reviews can be omitted for frequent and standardized financial product transactions. <Example 1> When a claim is made for expenses from a specially related party, the expenses should not be paid if it is acknowledged after review that the claim is unjustifiable or evidential data are insufficient. <Example 2> When domestic business units of foreign financial firms fund from or grant credit to overseas specially related parties, a review should be also conducted on the possibile violation of Foreign Exchange Transaction Act and related regulations.
3.2 Precondition for Requirements for Permission/Approval In conducting business jointly with specially related parties, domestic business units of foreign financial firms should conduct a review on whether both parties have acquired permissions or approvals necessary for the conduct of business. In case that permissions or approvals have not been acquired, contracts should not be established under the condition that they will be acquired in the future.
3.3 Adherence to Business Delegation Regualtion Domestic business units of foreign financial firms should not establish any consignment contract for businesses of which consignment is prohibited, such as fundamental affairs prescribed in Article 3 of the ă&#x20AC;&#x152;Regulation on Business Delegation of Financial Institutionsă&#x20AC;?.
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3.4 Rejection of Unfair Requests from Specially Related Parties 3.4.1 Prohibition of Illegal/Unfair Transactions In conducting a transaction with specially related parties, domestic business units of foreign financial firms should not engage in actions to indemnify losses or overstate profits of specially related parties. 3.4.2 Prohibition of Inappropriate Financial Support to Specially Related Parties Domestic business units of foreign financial firms should neither provide inappropriate assistance in human resources, expenses, offices, etc, to business and non-business activities with specially related parties nor assume costs of human resources of head office and others not related to the profits of the units.
3.5 Allocation of Shared Expenses 3.5.1 Expenses for Allocation Domestic business units of foreign financial firms assume common expenses only when it cannot independently conduct the business, or when the receipt of services is in the interests of the units, in accordance with the results of cost-benefit analyses. However, expenses should not be assumed for the following: a. In regard to the affairs conducted by specially related parties, expenses that are incurred in the process of conducting businesses unique to the head office, such as accounting audits, preparation of various financial statements, issuance of stock. b. Expenses incurred only for specific divisions or branches of specially related parties c. Expenses incurred in relation to investment by specially related parties in other legal entities
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d. Other expenses not reasonably relevant to the creation of profit of the domestic business units 3.5.2 Allocation of Expenses Domestic business units of foreign financial firms should allocate shared expenses through allocation by items or lump sum allocation. a. Expense Allocation by Items After classifying shared expenses subject to allocation by items, the expenses are allocated according to the criteria. The criteria used for allocation are reasonably acknowledged in accordance with the nature of the expenses, such as revenues, gross margin, asset value, labor cost, etc. b. Lump Sum Expense Allocation When it is not appropriate or beneficial to use the method of allocation by items, the lump sum allocation method is used. Shared expenses that belong to domestic business units of foreign financial firms are the amount equivalent to the ratio of units' income amount over total income amount in the total amount of shared expenses subject to allocation.
Chapter 4 Contracts with Foreign Related Parties
4.1 Principle of Transaction In principle, domestic business units of foreign financial firms are to enter into a contract in regard to transaction with specially related parties.
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4.2 Form of Transaction In case that domestic business units of foreign financial firms enter into a contract with specially related parties, in principle, an agreement in document should be drawn. If an agreement is established via telephone due to unavoidable reasons, a written form(including electronic document) should be immediately produced as back-up.
4.3 Preparation of Written Agreement In establishing a transaction agreement with specially related parties, domestic business units of foreign financial firms should prepare an agreement or tantamount document(hereunder referred to as "Agreement") which contains information such as the purpose of the contract, transaction amount, implementation period, risk bearing, method of income or expense allocation, and other necessary items. However, when the amount per transaction is KRW 5 million or less, documents such as written estimates, written consents, and bills are allowed to replace the Agreement. In the case of frequent and standardized financial product transactions, internal authorization requests or settlement documents can be recognised as the Agreement.
4.4 Calculation of Transaction Price In case that domestic business units of foreign financial firms conduct a transaction with specially related parties, in principle, the normal price should be used as the transaction price, and calculated in a method considered most appropriate in light of the pertinent transaction, among the methods used in the OECD's 「Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations」 or 「Law for the Coordination of International Tax Affairs」. However, if it is impractical to apply these laws or regulations, other methods considered reasonable can be applied. In this case, the reasons for application of a specific method should be documented and objective data acquired to prove that the method selected produces normal price. - 9 -
<Example> Method for Calculation of Normal Price Prescribed in the Law for the Coordination of International Tax Affairs
a. Comparable uncontrolled price method b. Resale price method c. Cost plus method d. Profit split method
e. Transactional net margin method f. Berry ratio method g. Other methods
4.4.1 Considerations in Calculating Price for Service Provided a. Scope for Services Domestic business units of foreign financial firms should make the service payment only when services contribute to the profits of the units and it is acknowledged that a similar service would have to be purchased from a third party, or performed internally without related party. b. Selection of Calculation Method Domestic business units of foreign financial firms should use a method that verifies that the normal price is applied, considering that it could be difficult to acquire data regarding calculation of transaction price due to the nature of service transaction. 4.4.2 Considerations in Calculating Price for Intangible Assets In calculating the normal price for intangible assets, domestic business units of foreign financial firms should take into account the expected improved profits or reduced expenses expected from the assets, limitations on the exercise of rights, and permissions to transfer to or reuse by a third party.
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4.4.3 Considerations in Determining Interest Rate for Monetary Transactions In case that domestic business units of foreign financial firms conduct monetary transactions with specially related parties, interest rates applied to transactions should be determined reasonably based on the actual interest rate* of the international financial markets by region. In addition, debt amount, debt maturity, guarantee, debtor's credit, etc. should be considered. <Example> LIBOR, SIBOR, closing rate announced by Reuters 4.4.4 Other Transactions When engaging in transactions other than those mentioned above, domestic business units of foreign financial firms should consider functions to be conducted by the transaction party, risk associated with the transaction, changes in market conditions, and degree of responsibility pursuant to a transaction.
4.5 Renewal of Contract When renewing contracts with specially related parties due to expiration of contracts, domestic business units of foreign financial firms should conduct a review on the appropriateness of contracts. Contracts are renewed only when they are judged as appropriate. Other requirements for contract renewal are same with those for new contracts.
Chapter 5 Post-Transaction Management
5.1 Transaction Records Domestic business units of foreign financial firms should record the details of all transactions conducted with specially related parties, and transaction records should not be omitted through methods such as offsetting. - 11 -
However, in the case of frequent and standardized financial product transactions, electronic files can be used. For cases when related laws and regulations permit offsetting or for items of which the annual transaction amount is KRW 5 million or less, the transaction record can be omitted.
5.1.1 Separation of Transaction Records In regard to transactions with specially related parties, domestic business units of foreign financial firms should manage the books by dividing them into books that make a comprehensive record of transactions, and books that make a detailed record of individual contracts. However, the latter can be replaced with individual agreements. 5.1.2 Scope of Transaction Records Considering the natures of individual transactions, domestic business units of foreign financial firms should record transactions including data on the overall status of the financial group that the units belong to, such as business overview, organization structure, ownership structure within the financial group, etc. Such records can be organized by fiscal year. 5.1.3 Evidential Documentation on Service Provided In case that services are provided to or received from specially related parties, domestic business units of foreign financial firms should acquire data that can prove that services were actually provided. 5.1.4 Evidential Documentation for Sharing of Expenses When sharing expenses in relation to activities of the entire financial group that the units belong to, domestic business units of foreign financial firms should acquire data that can prove the list of cost sharing affiliates, a description of the total common expenses subject to allocation, and criteria for expense allocation and the amount assumed by the units.
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5.2 Maintenance of Transaction Evidence Domestic business units of foreign financial firms should maintain evidential data on transaction records such as terms of transaction, appropriateness of profit and expense allocation, etc. for at least five years. <Reference> Commercial Law stipulates that important documents related to trade books and business must be maintained for 10 years, while bills and similar documents must be maintained for 5 years.
5.3 Cancellation or Termination of Contracts In case that contracts which domestic business units of foreign financial firms have with specially related parties are cancelled or terminated without just cause: i.e. through unilateral instructions of specially related parties, a clear evidence should be maintained. If loss is incurred to the units, they need to claim reasonable compensation to the specially related parties.
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