South Korea: Court Holds Royalties For Foreign-Registered Patents Are Not Subject To Withholding Tax In Korea

Last Updated: 25 January 2017
Article by Jay Shim and Sung Hyun Ryu

Court adhered to the existing position on the determination of royalty payment

In May 2016, a Korean taxpayer won its victory over the Korean tax authority when the Seoul High Court overruled the tax authority's assessment against the taxpayer in connection with its royalty payments made with respect to non-Korean registered patents. The tax authority challenged against the Supreme Court's well-established position on the determination of source with respect to royalty payments and the tax payer, represented by Lee& Ko, successfully persuaded the Seoul High Court to adhere to the Supreme Court's existing position.

Issue was about the assessment of the Korean tax authority as to the consideration paid for non-Korean registered patents

Factual background of this case starts from a licensing agreement entered between Company S, a Korean company and Company B, an Irish subsidiary of a US company("Company A"). Company B, the Irish company, was established by Company Ain order to carry out Company A's previous licensing business in countries outside the The establishment of Company B occurred 'during' the period when Company A requested Company S to pay consideration for Company S's infringement against Company A's patent rights. The Company S did not withhold taxes on its royalties paid to Company B, Irish entity, based on its determination that Company B was not liable for withholding taxes as a beneficial owner under the Korea-Ireland Tax Treaty.
However, the Korean tax authority determined that the beneficial owner of the royalty payment was Company A, not Company B, and thereby assessed the taxes in the amount of approximately USD60,000,000 based on Korea-US Tax Treaty.
In June 2012, Company S, represented by Lee & Ko, initiated an administrative suit seeking review of the tax authority's assessment. This law suit garnered significant attention as the tax authority centered its arguments on challenge to Supreme Court's interpretation of the source with respect to royalty payments to foreign company and this court's decision may have serious implications to many Korean companies that pay their royalty to the foreign company.

Supreme Court's previous decisions clearly supported the Lee &Ko's argument that consideration paid for non-Korean registered patents should not be subject to a withholding tax in Korea

Lee & Ko, in arguing on behalf of Company S, presented arguments that (i) Company S is not liable to withhold the taxes pursuant to the Korea-Ireland tax treaty and (ii) even if Company A were to be treated as the beneficial owner, the withholding tax liability still cannot be imposed as the royalties were paid as to those registered outside of Korea and such payment cannot be considered as Korea source income. The Supreme Court already made its position clear from its previous rulings that the consideration paid for non-Korean registered patents cannot be subject to withholding tax in Korea.

In principle, Article 98 (1) of the Corporate Income Tax Law (CITL) stipulates that when a domestic entity pays domestic source income including interest, dividend, royalties, etc., it should withhold the certain amounts from the relevant income.

With respect to determining the domestic source income, the Supreme Court held that the right to exercise a patent is only effective as to the jurisdiction in which the patent has been registered and that a foreign entity's patent not registered in Korea cannot be taxed as royalty income in Korea (Supreme Court Decision 2005Du8641, dated September 7, 2007).

In December 2008, Korean legislature amended the relevant section of the CITL in order to address the problem of Korea's inability to tax the consideration paid for the right to a non-Korean registered patent by adding the provision stating "patent registered outside of Korea but has been used in manufacturing or sale shall be treated as patent used in Korea regardless of whether the patent is registered in Korea."

However, the Supreme Court reaffirmed its previous position (Supreme Court Decision 2012Du18356, dated November 27, 2014) by ruling that a tax treaty shall override the CITL in case of conflict regarding the classification of foreign corporation's source of income with respect to Korean company's royalty payment to the U.S. company for the patent registered only in the U.S. It reasoned that the only income received by a U.S. entity in consideration for the right to exercise a patent with respect to the U.S. entity's patent that is registered in Korea should be treated as the U.S. entity's Korean source income as neither the issue of exercising a patent right nor patent infringement can be triggered in a country where the patents are not registered.

In response to the tax authority's challenge to the Supreme Court positions, Lee & Ko successfully countered the tax authority's arguments

The tax authority, citing some scholars' opinions, disagreed with the holding of the Supreme Court on the basis that since the word "use" under the Korea-US tax treaty is not defined in the treaty, the interpretation of the word "use" shall follow the domestic law of Korea, which according to the tax authority's reading, allows for the imposition of withholding tax against consideration paid for the use of non-Korean registered patents. The tax authority has further argued that any determination made by the Supreme Court against this rationale should be treated as a determination inconsistent with the existing law.

In response, Lee & Ko's international tax team argued that the meaning of the word "use" was sufficiently provided for within the language of the Korea-US tax treaty. "Use" under the treaty means the use of property within the country. More specifically, this signifies use of property registered or recorded within the country as the property such as patents requires a recordation or registration in order for the holder of such property to exercise its rights to the property. Accordingly, the consideration paid for the use of non-Korean registered patents cannot constitute Korea source income. Based on Lee & Ko's vigorous arguments presented at court, Lee & Ko was able to reach the court's decision in favor of the taxpayer.

The case is meaningful in that Lee & Ko successfully argued in line of and in support of the Supreme Court previous decision and principle

Lee & Ko's international tax team successfully presented and argued the matters on behalf of the tax payer, ultimately resulting in its victory. Despite the tax authority's attempt to challenge the Supreme Court's decision through utilizing amendment made to the CITL along with some scholar's views on the rulings, Lee & Ko successfully persuaded the Seoul High Court that those grounds were not sufficient to render its decision not consistent with the Supreme Court ruling. Lee & Ko clearly showed that Supreme Court still adhered to its previous position despite the amendment of the CITL and abided by the basic principle that treaty supersedes the domestic law when in conflict. Even though the tax authority filed this case to the Supreme Court and still maintains its arguments in the hopes of overruling the Supreme Court's previous decision, the tax authority's such endeavor is unlikely to succeed before any amendments are made with respect to the Korea-US tax treaty. Lee & Ko international tax team will continue to respond to the tax authority's arguments on the basis that the Supreme Court's previous decision is proper.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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