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

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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)

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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 ‘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 × 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.

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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

「Regulation on Business Delegation of Financial Institutions」.

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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.

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<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.

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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.