Transfer Pricing, Tax Evasion and Kaesong's New Tax Policy

North Korea recently made some tax changes to firms operating in the Kaesong Industrial Complex. As tax policy is one area we will be covering in our training programs in North Korea (read this and this), the tax changes were interesting to us. You can read more about the package of changes at Korea Times and Joongang Ilbo. Key related points include:

1. North Korea can reassess tax rates based on its own calculation of output prices and input costs if it deems the reported profits artificially depressed

2. North Korea can impose up to 200 times the amount of money involved for companies caught committing accounting fraud

3. North Korea dropped clauses prohibiting retroactive taxation

Given that the changes are recent, it remains to be seen how these will be implemented in practice. At the heart of the dispute appears to be transfer pricing and tax evasion. Transfer pricing is a practice whereby companies sell to their subsidiaries or entities overseas at depressed prices or purchase input from subsidiaries overseas at inflated prices, moving profits to more favorable tax regime. Given that this is an intra-firm transfer, companies can theoretically optimize their tax burden. Many countries have adopted rules governing transfer pricing to prevent such activities.

It is uncertain if the firms engaged in transfer pricing in Kaesong actually report their profits overseas – falling more into the tax evasion category of things. While South Korea reports the earnings of firms in Kaesong, and quite a few North Korea analysts have taken these reports at face value, I am somewhat suspicious of these reported numbers. Having talked to some businesspeople in the zone who claimed to be doing well, I would not be surprised if some firms in Kaesong artificially depress their reported earnings to minimize their tax burden.

While transfer pricing is definitely an issue, these changes are business unfriendly, especially the incredibly punitive fines it allows North Korea to levy. Systematically, North Korea needs upgrades to its audit infrastructure, including encouraging or even subsidizing auditors to set up shop in the country. Without such firms, there is significant room for disputes over the appropriate taxes companies need to pay.

Size Matters: Benchmarking Rason against other Port Cities SEZs

In 2010, a promotional video of Rason’s urban masterplan was released. Focusing on the Rajin District, there were extensive computer generated images and fly-through, taking viewers through monumental avenues and attractive landscapes while elaborating on the importance of an urban development plan in order to create a well-functioning city. The plan divides the Rajin District into various areas: Central, Ansu, Changpyong, Sosang, Geokjeon, Dongmyong, which contain specific functions. Government buildings are located in the Central and Sosang area while exhibition halls are located in Changpyong and factories in Yeokjeon.

CE_RasonUrban_00

The biggest part of the video was dedicated to Ansu, which aims to be a hub for finance and tourism. The area will be divided into six smaller zones (commercial, financial, cultural, housing, foreign residence, sports) stringed together linearly along the narrow eastern coastline of Rajin bay. Compared to the industrial facilities of Rajin Port on the opposite side of the bay, Ansu by contrast aims to attract foreigners by providing a mixture of financial center with spaces of leisure and entertainment along the waterfront.

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While the video expresses the grandambitions of Rason, the complexity in realizing it is equally immense. There are various factors that urban planners need to consider, ranging from the development of technological infrastructure required of a contemporary networked city to the physical size of the city, which will determine its fundamental characteristics.

In general, the physical nature of Rason is governed by its hilly geographical terrain, which may limit the future expansion of the city. Given such constraints, what can we infer from the current boundary of the city? Is it an optimum size for accommodating a suitable population density and does it have good quality urban spaces which in turn attract people to work and live in the city? Does its physical size need to grow or is it already too large and sparse?

Perhaps we can have better glimpse into Rason’s future by benchmarking its size against other cities, economic zones and hubs. The following diagrams compare the size of Rajin district to other port cities, SEZs within North Korea, foreign specialized SEZs/research hubs and mixed-used SEZs.

The district is 16.66km2 large, about a tenth of the size of Pyongyang.

CE_RasonUrban_01

It is approximately the same size as other SEZs in the DPRK, both proposed and in operation.

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It is also not dissimilar to other North Korean port cities.

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However, when compared to cities overseas, one can start identifying stark differences. Cities with specialized services, such as the financial hub of Canary Wharf in London, research hub in One North Singapore and Masdar City in Abu Dhabi, are all at least 50% smaller than Rajin District.

CE_RasonUrban_04

However, when compared to other mixed-use economic zones, such as Songdo City, Tianjin Eco-City and Suzhou Industrial Park, Rason’s development is smaller in scale.

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Another important characteristic of these developments is the close proximity to airports which provides easy access for business travelers. Songdo is 14km away from Incheon Airport, Canary Wharf is 4km away from London City Airport, and Masdar City is right beside Abu Dhabi Airport.

In general, we get a few takeaways from benchmarking Rason against other cities and SEZs. Firstly, Rason being a mixed use economic zone is not large when compared to the Chinese examples. Ansu which is planned to be a specialized financial and tourism hub is about a fifth of the entire Rajin district and is comparable in size to the specialized hubs of One North or Masdar City. Secondly, most of these developments, especially the mixed-use economic zones develop in phases over at least a 20 year time period. Finally, the development of an airport could be a very important factor to ensure the accessibility of the city, which Rason is currently lacking, given its geographical isolation.

The Importance of Urban Management Systems for North Korea

Dolphinariums excluded, perhaps the newest tourist attraction in Pyongyang is the recently completed neon lit residential complex in the Mansudae district. Comprising of several high rise apartment blocks and communal facilities, the project was part of the leadership’s plan to build 100,000 new apartment units by 2012 to mark the 100th year anniversary of Kim Il Sung’s birth. While the number of actual built apartments ranges from 25000 to 30000, the neon lights nonetheless reveal attempts at developing Pyongyang into a “world-class city”.[i] However, its ambitions are not equally matched by its efforts in urban planning. Although urban development in North Korea has been relatively successful in providing basic housing and civic amenities for the past 50 years, it lacks the dynamism and technological infrastructure required of contemporary cities. Increasingly, cities are becoming more complex and developing the software infrastructure (data cables, monitoring systems, green technologies, etc) is becoming as equally important as developing the physical infrastructure (buildings and roads). New business parks are fully wired up and monitored jointly by IBM and Cisco, while the Senseable City Lab in MIT is developing tools for managing urban traffic.[ii] The recent proliferations of urban related indexes ranging from livability to sustainability are a testament to the growing importance of urban design and management in providing the suitable environment to attract foreign investments and professionals.

Mansudae_Night

Major economic cities in North Korea (such as Pyongyang and Rason) are far less sophisticated than some other development zones around the world.  In order to be well-functioning and be economically competitive, they need to provide better urban management systems beyond physical infrastructure. They would need to consider projects on a longer term basis since the urban infrastructure provided today will have social and economic ramifications in future. For example, to rewire or install new technological infrastructure in future would cost much more than planning for future expansion.

However, developing these infrastructures is very capital-intensive and North Korea would need to depend on external organisations for expertise and investments. While China and Russia have been investing in the physical infrastructure of Rason, the DPRK will need committed partners to develop its technological infrastructure. Already, as mentioned in previous posts, during a meeting on Land Management, Kim Jong-Un called on relevant institutions to conduct “joint study … with scientific research institutions of other countries and take part in international meetings and symposiums to introduce advanced science and technology.”[iii] As such, while the leadership understands the importance of advancing their technology to better manage the city, they need to identify Songdo’s IBM-Cisco equivalent for North Korea.

Such developments do come with strings attached for the DPRK, as the outside companies involved may possibly retain a monopoly over the infrastructural services after partially bearing the initial costs of development. But before North Korea worries about an external organisation monopolising its infrastructural services, it needs to take the first step in developing better urban management systems in order develop more competitive cities. Neon lights alone will not draw in investments but better infrastructure that intelligently manages the lighting systems in the city will.

[i]

“Kim Jong Un Indicates Tasks for Land Management” in

KCNA

, 8 May 2012,  

http://www.kcna.co.jp/item/2012/201205/news08/20120508-30ee.html

[ii] “Urban Research: The Laws of the City” in The Economist, 23 Jun 2012,  http://www.economist.com/node/21557313

[iii] “Kim Jong Un Indicates Tasks for Land Management” in KCNA, 8 May 2012, http://www.kcna.co.jp/item/2012/201205/news08/20120508-30ee.html