Tax Accounting — Denial of Wrongful Calculations, Imputed Interest on Provisional Payments and Disallowed Interest

In transactions between a corporation and its related parties, such as the CEO, shareholders or affiliates, prices can be set at will to siphon income out of the corporation. Tax law recalculates such transactions at market value and taxes them, and even removes from deductible expenses the interest cost of a corporation that lends money for non-business purposes. Most of the resulting adjustments are disposed of as bonuses or dividends, so the recipient also pays income tax (chapter 1).

1. Denial of wrongful calculations

A. Conditions

The counterparty is a related party of the corporation (an officer, a controlling shareholder, an affiliate, etc.).
The transaction unfairly reduced the corporation’s tax burden.
For purchases of assets above market value, sales below market value and the like, the difference between market value and the transaction price must be ₩300 million or more or 5% or more of market value (with some exceptions, such as listed shares).

B. Main types and adjustments

Types of wrongful calculations
Type	Example	Tax adjustment
Purchase of assets above market value	Buying land owned by the CEO for more than market value	Deduct the excess over market value (negative retained) and add it back (bonus, etc.)
Sale of assets below market value	Selling a company building to the CEO for less than market value	Include the difference from market value in gross income (bonus, etc.)
Interest-free or low-interest loans	Lending to an officer interest-free for non-business purposes	Include imputed interest in gross income (bonus, etc.)
Free provision of services	Leasing a building to an affiliate free of charge	Include market rent in gross income (other outflow, etc.)

TQ sold a building with a market value of ₩1 billion to its CEO for ₩700 million. The ₩300 million difference is at least ₩300 million and 30% of market value, so the conditions are met. The ₩300 million is included in gross income and disposed of as a bonus to the CEO, who must pay earned income tax on ₩300 million.

2. Imputed interest on provisional payments

If a corporation lends money to a related party for non-business purposes (a provisional payment) and charges no interest or too little, the difference from normal interest is included in gross income.

Imputed interest on provisional payments

\text{Imputed interest} = \text{Provisional payment day-balance sum} \times \text{Interest rate} \times \frac{1}{365} - \text{Interest actually received}

The day-balance sum is the total of daily balances. The rate is in principle the corporation's weighted average borrowing rate; if that cannot be used, or the corporation so elects, the overdraft rate (currently 4.6% a year) is used.

TQ lent ₩500 million to its CEO for the whole year without charging interest. At the overdraft rate, imputed interest is ₩500 million × 4.6% = ₩23 million, which is included in gross income (bonus). Had it received ₩10 million of interest at 2% a year, only ₩13 million would be included.

Provisional payments are not recognized as bad debts and are also excluded from the receivables on which the bad debt allowance is set (chapter 6). If one is not recovered by the time the related-party relationship ends, the principal itself is included in gross income and disposed of as a bonus or the like.

3. Disallowed interest

Interest expense is normally deductible, but the following items are disallowed in the order below. The order matters because interest and borrowings disallowed at an earlier step are excluded from the later calculations.

Order of disallowance of interest
Order	Item	Income disposition
①	Interest on loans whose creditor is unidentified	Bonus to the representative (amount equal to withholding tax: other outflow)
②	Interest on bonds and securities whose recipient is unidentified	Bonus to the representative (amount equal to withholding tax: other outflow)
③	Interest on borrowings used for construction funds (specific borrowings)	Retained (added to the acquisition cost of the asset)
④	Interest attributable to non-business assets and provisional payments	Other outflow

Interest attributable to non-business assets, etc.

\text{Disallowed amount} = \text{Interest paid} \times \frac{\text{Non-business asset day-sum} + \text{Provisional payment day-sum}}{\text{Borrowings day-sum}}

The numerator cannot exceed the borrowings day-sum. Amounts already disallowed at steps ① to ③ are removed from both interest paid and the borrowings day-sum.

TQ had ₩2 billion of borrowings throughout the year, with interest expense of ₩100 million. It held non-business land of ₩300 million and a provisional payment to the CEO of ₩500 million throughout the year. There is no interest falling under ① to ③.

\text{₩100 million} \times \frac{300 + 500}{2{,}000} = \text{₩40 million}

₩40 million is disallowed (other outflow). Note that the single ₩500 million provisional payment triggers both ₩23 million of imputed interest included in gross income and ₩25 million of disallowed interest.

Check your understanding

TR has ₩1 billion of borrowings (throughout the year, interest expense ₩60 million), of which ₩200 million is a loan from an unidentified creditor with interest of ₩12 million. It had a ₩400 million provisional payment to the CEO throughout the year and received no interest. Applying the 4.6% overdraft rate, what are the tax adjustments?

① First disallow the ₩12 million of interest on the loan from an unidentified creditor (bonus to the representative; the amount equal to withholding tax is other outflow). ④ The remaining interest is ₩48 million and the remaining borrowings ₩800 million, so $4{,}800 \times 4/8 = 2{,}400$ , i.e. ₩24 million, is disallowed (other outflow). Imputed interest of ₩400 million × 4.6% = ₩18.4 million is included in gross income (bonus). Income rises by ₩54.4 million in total.

References

Corporate Tax Act, Article 28 (disallowance of interest paid) and Article 52 (denial of wrongful calculations) — Korea Law Information Center
Enforcement Decree of the Corporate Tax Act, Article 88 (types of wrongful calculations, etc.) and Article 89 (scope of market value, etc.)
Enforcement Rule of the Corporate Tax Act, Article 43 (calculation of the weighted average borrowing rate, etc.)