Hanul Systems: Installation PE, Software Royalty and Profit Attribution
Korea-based Hanul Systems Co. contracts with a Mongolian copper smelter to install and commission a control system. The contract is signed in Seoul, the price is USD 4.2 million, and Hanul's engineers are on site in Mongolia for eight consecutive months in 2024. The contract also licenses Hanul's proprietary software for a separate annual fee of USD 300,000, paid directly to Seoul. Hanul has no Mongolian office or bank account and argues that (i) it is a non-resident with no permanent establishment, (ii) the installation is a single project under six months if only 'active' work is counted, and (iii) the software fee is business profit, not royalty. The Mongolian smelter did not withhold tax on the software fee. The Mongolia–Korea tax treaty has a six-month construction/installation PE threshold and a 5% royalty rate.
1. Does Hanul have a permanent establishment in Mongolia? Address each of Hanul's arguments.
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Yes. The treaty's construction and installation PE threshold is six months. Hanul's engineers are present and working on the site for eight consecutive months. That exceeds the threshold, so a PE exists.
The 'active work only' argument fails. Treaty time tests for construction and installation PEs are generally measured by the duration of the site or project, not by counting only hours of physical installation while excluding mobilisation, testing, commissioning or standby. Splitting the project into active and inactive phases would let contractors defeat the threshold artificially. The eight-month presence is the relevant fact.
The absence of an office or bank account is not decisive. A PE can arise from a building site, construction, installation or assembly project, and from a dependent agent. Hanul has a fixed-place project PE. Once the PE exists, Mongolia may tax the business profits attributable to it, and Hanul must register and file in Mongolia.
2. What are the Mongolian tax consequences for the installation profit and the USD 300,000 software fee, and what should the smelter have withheld?
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Installation profit. Because Hanul has a PE, Mongolia taxes the profit attributable to the PE, not the gross contract price. Hanul must register, keep Mongolian accounts for the PE, and file CIT. The attributable profit is computed on an arm's-length functional basis. The CIT rates are 10% on the first MNT 6 billion of taxable income and 25% above that, applied to the PE's taxable profit.
Software fee. A payment for the right to use proprietary software is a royalty, not business profit. The domestic withholding rate on royalties to non-residents is 20%, reduced to 5% under the treaty. The smelter should have withheld 300,000 × 5% = USD 15,000 and remitted it. Because it failed to withhold, the smelter as withholding agent is liable for the tax, plus interest and possible penalty, and may have a contractual right to recover from Hanul.
Interaction. The royalty is dealt with under the royalty article and is not automatically part of the PE's business profit. The two streams should be reported separately.
3. Hanul allocates only 30% of the installation price to Mongolian activities. Is that acceptable, and how should the tax office test it?
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A 30% allocation is not acceptable merely because Hanul proposes it. The allocation must be arm's length and must reflect the functions performed, assets used and risks assumed in Mongolia. The PE is doing the on-site installation and commissioning, which carries significant project risk, labour cost and technical responsibility. A 30% share may understate the Mongolian profit if the offshore head office is merely providing management or procurement support.
The tax office should apply a functional analysis and one of the accepted transfer-pricing methods, such as a cost-plus or transactional net margin approach, using comparable independent installation contractors. It should examine the contract, project budget, employee time sheets, procurement invoices and intercompany charges. If Hanul cannot support the 30% split with contemporaneous documentation, the tax office may adjust the PE's profit upward.
The same arm's-length principle applies to any management fee or cost recharge from Seoul. The burden of proof is on Hanul to demonstrate that the allocation is consistent with the arm's-length principle, not merely with its internal accounting.