Kim & Chang prevailed in an administrative litigation where the appropriateness of a variable rent for land rent paid in a long-term land lease between specially related corporations with a 100% parent-subsidiary relationship was at issue.  The court rendered a decision in favor of the taxpayer that it was difficult to determine the calculated amount pursuant to Article 89 (4) 1 of the Enforcement Decree of the former Corporate Income Tax Law (the “CITL”) which had been applied by the tax authority as the “market price” under the CITL which considered the special nature of the lease relationship.

Background

Company A leased land owned by its wholly-owned subsidiary, Company B, to construct a new building and operate a business leasing the building.  The two companies set the lease term as the life of the building (50 years), and Company A paid Company B a variable rent for land by paying a certain percentage (i.e., ratio of the construction cost of the building incurred by Company A to the land value borne by Company B) of the profits earned from the lease of the building by Company A as rent. 

The tax authority deemed that Company A’s payment of the land rent to Company B, which is a related party to Company A, was unfair because it was in excess of the “market value” calculated pursuant to Article 89 (4) 1 of the Enforcement Decree of the CITL, and the excess amount had been treated as non-deductible.

Case Details

In this case, the issue was whether the provisions suggested by the tax authority were appropriate to calculate the “market price” that may be formed in the case of a general and arm’s length transaction in light of the uniqueness of the lease relationship and the substance of the transaction between the two companies.  An additional issue was whether economic rationality was recognized in a lease relationship where parts of the profits earned from the lease of the building is paid in proportion to the land rent. 

The lower court (Seoul Administrative Court) accepted the Defendant’s position to dismiss the Plaintiff’s claims on the ground that Article 89 (4) 1 of the Enforcement Decree of the CITL is a provision that prescribes a statutory fair market value if the market price is unclear, and thus, the market price should be calculated based on this provision.  Therefore, in order to distribute profits such as rent according to a predetermined ratio, an association should be formally formed. 

However, the appellate court (Seoul High Court) held that it is difficult to conclude that the amount calculated according to the provision asserted by the Defendant for the transaction between Company A and Company B to fall under the scope of “market price” as set out under the CITL, and that it is abnormal and lacks economic rationality in light of sound social norms or commercial practice for the parties to set the rent in the form of a distribution of profits proportionate to their investment ratio, even if they did not formally form an association.  The Supreme Court affirmed the case and dismissed the appeal without further deliberation. 

Kim & Chang represented Company A in this case and achieved a successful outcome.

Implications

This case has precedential value in that the underlying transaction was between specially related corporations that: 

• in the case of a lease agreement where there are special circumstances to guarantee the right to use and benefit from the land for the life of the building, the provision on the market value of the rent for land under the Enforcement Decree of the CITL cannot be applied as is, and the tax authority should substantiate a separate market value; and 

• in the case where the specially related corporations that do not engage in a joint business allocate the gross profit generated from the entire transaction proportionate to their allocated investment ratio through a variable rent, the transaction is an economically rational transaction where both parties provide additional profits to each other, and the provision of denial of unfair transactions under the CITL does not apply.