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.

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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.

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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.

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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.

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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

Haggling over fiscal policy training

I just visited Pyongyang to check in on ongoing training programs, and to start preparing our partners for a major ramp-up of programs in 2013 and the conversion of our Beijing presence (i.e. Peter) into a full-time office. Program frequency and size continues to increase, and we are expanding coverage of topics and organizations. We will also be launching our flagship Women in Business training program targeting female entrepreneurs and managers. The most amusing training discussion award goes to the incredibly tenacious but good-humored negotiator from the Ministry of Finance. Typically, we try to keep workshops inside the DPRK short and focused, with a one-week session covering a specific topic in-depth. Short sessions in the initial phase help us understand what the learning needs are before we commit more resources to a topic area or organization. There are also budget reasons for keeping programs short. In terms of good topic areas, there was no shortage of them as the Ministry had a well-prepared list of areas that they wanted us to focus on. This was the easy part.

Our partner (rightly) insisted that longer sessions are much more effective. Our discussions became a see-saw battle in which I pushed for short sessions on a specific topic at this phase while he kept pushing for programs ranging upwards of 2 months and stretching to 9 months. When we had agreed that the majority of participants would be under 40 and moved back to discussing the program length, he mentioned that short programs would be suitable only for more senior people and we ended up discussing the participant ages again. It seemed like whack-a-mole as issues kept popping back up even after I thought I had resolved them.

Not wanting to commit to something without having had time to think it over and discuss it with the team, I explained that we might explore doing something in middle of 2013 with them, but that we are not ready to commit to anything yet. Our partner, who was enjoying himself, good-naturedly suggests that it was alright not to commit to anything yet, as this would be the first of many discussions. Perhaps next time Andray will get to enjoy negotiating with this partner!

First ever positive mention of "entrepreneurs" in North Korean press?

Three years ago, I worked with some North Koreans to have some candidates sent to a highly-prestigious conference overseas. The theme for the year was “entrepreneurship” and that partner told us that the theme was not suitable for North Koreans as it was a socialist economy. Given our focus on business innovation and talent in North Korea, entrepreneurship is always a cornerstone of our programs and we are launching an education program specifically focused on female entrepreneurs next year. We have a team in Pyongyang, that includes some very successful entrepreneurs and venture capitalists, running some programs this week . I am also visiting Pyongyang next week to discuss a venture capital idea we have been mulling over for more than a year, and we have been placing young North Koreans at start-up incubators overseas for internships.

However, I still do not know how North Koreans understand the term “entrepreneurship” or how they would react to it. Past mentions of the word in KCNA have either been neutral, used in reference to situations in external countries, or negative. Hence, I almost did a double-take when I saw the term “entrepreneur” on the front-page of Rodong Sinmun’s website recently:

Favor Shown to Small Entrepreneur

 

Immediately after the liberation of Korea from the colonial rule of Japan, Kim Jong Suk, woman General of Mt. Paektu, was engaged in revolutionary activities in Kyongsong County to arouse the people to the building of a new society. One day, a brewer came to see Kim Jong Suk.

 

Kim Jong Suk kindly greeted him.

 

After hearing out his career and present difficulties, Kim Jong Suk said: "Now, some people are finding fault with small entrepreneurs, labeling them as objects of overthrow or bourgeoisie. But, their accusation is an idle talk made by factional elements who act contrary to the will of General Kim Il Sung. From the period of the anti-Japanese armed struggle, Kim Il Sung trusted not only in small entrepreneurs and tradesmen, but national capitalists. In the liberated country today too, he believes in them as ever. You should more positively turn out in nation building for the country".

 

Keeping her instructions deep in his heart, he urged his fellow businessmen in the Kyongsong area to turn out in the construction of the country. A few days later, Kim Jong Suk called on the brewer at his house. Learning about his business in detail, she said; "Only when you run your enterprise for the country and people, can you be highly trusted by General Kim Il Sung and enjoy the respect of the people."

 

She went on to say: "General Kim Il Sung shows deep trust to small entrepreneurs and tradesmen who render cooperation to nation building. No matter who may say what, you should not vacillate at all, but trust and follow the General. He does not discriminate those who love the country and nation". In this way Kim Jong Suk implanted an unshakable faith in his mind.

 

Thanks to such a great loving care and trust of Kim Jong Suk, the brewer who was wandering at the crossroads in his life found out the path of a new life and turned out together with his colleagues in the general ideological mobilization movement for nation building. Afterwards, he was elected a deputy to a local power organ.

 

Paek Yong Mi

So remember, the President wants you to go forth and be entrepreneurial. Now if only policymakers chip in with policy changes that help make life easier for entrepreneurs. You might also be interested in this interview I gave at Knowledge@Wharton on entrepreneurship in North Korea.

Is "reform" talk too late and too muddled?

We have been mentioning since early last year that North Korea has a renewed focus on economic development which marks a break from its rhetoric of belt-tightening and self-sacrifice for the good part of the decade. We said that and still say it because it was mentioned consistently in government rhetoric and triangulated well with the policies, which we knew from our programs, that were being debated and considered. Hence, all the recent talk about “reform” seems rather belated. . That said, I dislike the word “reform” as it conflates too many issues. At the broadest level, it conflates changes in the political with those in the economic sphere. While there are issues with disentangling changes in both areas, it seems that talking heads tend to use changes or the status quo in one area to argue that similar things are happening in the other area. Some refer to the “status quo” political system or a tightening of border security as a sign that economic “reform” does not exist. Or some would link economic “reforms” with North Korea “opening up”, which carries connotations of a sort of rapid political change which may not happen at the same rate as the economic changes.

But at least people are starting to pay attention to the idea that top-down change can happen in North Korea. CE advisor Andrei Lankov, long a vociferous opponent to the idea that the North Korea’s elite will institute any form of economic “reform”, might actually be the canary in the coal mine. We like his work because he is close to the action in the North, willing to look at evidence and make a call even if it goes against everything he has said before.

The term “reform” is also conflated with a linear process. Critics of the idea of North Korea instituting economic “reform” point to contradictory policies or to non-performance as signs of non-reform. There is a tendency to conceptually link all market liberalizing actions as “reform” and to see greater state involvement in some areas as a sign of “non-reform”. Each policy on its own does not indicate a direction – there can be simultaneous moves to increase the role of the markets in some areas, while strengthening state supervision in others and policy mix matters.

Also, “reforms” can fail. Intention does not imply capacity. But that does not mean an attempt was not made. Both China and Vietnam had to feel their way through in their transitions (or as the Chinese described it “feeling one’s way across the river by touching the stones”). And just because they have done it does not mean that North Korea policymakers are fully aware of how it was done, or that the experiences of those countries are fully transferrable to North Korea.

From a practitioner point of view, if there is an intention in place to focus on economic development, there is a need to increase Choson Exchange efforts to reap a higher return from our education programs (yes! we do believe passionately in our mission). This month, we are making two trips to North Korea specifically to track workshop and global internship programs we have in place this year, to discuss expanded programs in business and economics training next year, and most importantly, to prepare our partners for the increased frequency of programs that will come as we convert our part-time Beijing office into a full-time office next year.

No More Bangapsimnida in Amsterdam

This was pointed out to us by Hamel, who 6 months ago guest blogged about Pyongyang's first foray into the European restaurant scene. Well, it turns out the Noord-Koreaans restaurant failliet. Accusations and counter-accusations abound: the Dutch partner says the restaurant was drained of money by the Koreans so they could start over without him, the Koreans say the Dutch guy didn't pay his share, including wages. Indeed, a court ruled yesterday that the employees are owed ​​payment by the Dutch company.

Whatever the cause of this messy divorce, we're going to go ahead and make a lazy joke suggesting that the Dutch partners were too high to run a business.  Wait, no we won't.

In a more significant conflict, JVIC responded to charges recently made by a Chinese mining company that North Korea had illegally kicked it out of the country and broken their contract. It was unusual for Xiyang - the Chinese company - to so publically air its greivences in the first place, especially while criticizing its own government's Korea-policy. For North Korea to respond is also highly unusual. Disputes like this should be resolved in international, public fora - hopefully soon it will be through arbitration rather than the media.

H/T to Hamel.

Rason Report: "The Honeymoon is Over"

"The honeymoon period is over,” was the summary of 2012 in Rason by one investor. This wasn’t meant to reflect an end to investors’ dreaminess about Rason, but of Rason’s honeymoon with itself, so to speak. With the recent legal changes, road construction and a series of meetings between high officials over the last couple years, it was imagined that big-time investments would come flooding in. Investment does continue into the SEZ, but mostly from small- and medium-sized businesses that lack truly transformative power. This does not mean, however, that development is not taking place. A key piece of infrastructure is finished, while both local administrators and foreign investors eagerly anticipate other pieces.

Choson Exchange visited Rason during the 2012 Rason International Trade Fair with Hanns Seidel Foundation to explore the potential for joint projects.

This report, while far from comprehensive, outlines the major changes (or lack thereof) that have taken place in the last year.

Here is our report from last year, upon which this year's builds.

Rason Pictures

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Some snapshots of the trade fair and other developments in Rason.

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2nd Rason International Trade Fair

We just got back from Rason, where CE attended the 2nd  - and now officially annual - Rason International Trade Fair. Organizers stated that the trade fair had roughly the same number of exhibitors as last year: 130 in 2012 compared to 126 in 2011. There was no complete published list, however.

There was much more retail activity at this year's fair. After experiencing last year, local people clearly realized the fair is an unparalleled opportunity to shop - the equivalent of having a shopping mall come to town for 3 days. One T-shirt company brought a number of shirts to their booth based on his experience last year. They sold out within a few hours and had to spend two days apologizing. Carpets were the hottest seller, with a steady stream being carried out by shoppers.

At the same time, there were probably triple the amount of heavy machines on display as last year. Motorcycles, cars, tractors, trucks and heavy lorries filled the parking lot, which was considerably emptier last year. Hand tractors started at about 1000 USD, while a North Korea-assembled three-wheeler pickup was about 6000 USD, in case you're in the market.

It was slightly more international this year, with Czech, Swedish and Taiwanese companies adding to the milieu. There appeared to be more Russian participants, also.

Overall, Rason is experiencing some positive development, though things are not moving as fast as many would like. Look for a longer report about the past year's changes in Rason soon. We'll also have some pictures up in the next few days.