1. Introduction
In Korea, what taxation would be levied on foreign corporations that do not have a permanent establishment in Korea if they receive royalties from Korean domestic corporations in exchange for the transfer (or licensing) of patents and other intangible assets?
The domestic corporation will most likely withhold part of the royalties to pay to the Korean government, which would be unproblematic if the foreign corporation was established in a country other than the U.S. Most tax treaties signed between Korea and foreign countries, with the exception of the U.S., are based on the place of "payment." Therefore, if a foreign corporation receives royalties from a Korean domestic corporation, the royalties are considered a domestic source income, and the foreign corporation becomes subject to taxation. (Regulations for tax rates may differ according to the tax treaty.)
However, the situation is different for U.S. businesses. The U.S.-Korea Income Tax Convention uniquely levies tax based on the place of "use," which means if an intangible asset, such as a patent, is not used in Korea, the royalty paid will not be considered a domestic source income, thereby exempting the concerned U.S. business from any tax obligations. In this situation, it would be wrong for a Korean corporation to withhold tax. Either the Korean corporation or the U.S. corporation can submit a request for correction to the Korean tax authority. If the tax authority refuses the request, the matter can be settled through administrative litigation.
The problem is that when a patent of a U.S. corporation is registered only in the U.S and not in Korea, it is not always clear as to what it means to "use" the patent in Korea. This is an issue that the Korean courts and tax authorities have been fervently debating over for more than 30 years. The following is an introduction to a basic outline of this "30 Years' War," which will be followed by an explanation of a Significant Supreme Court ruling that took place at the beginning of the year and recent legislative amendments.
2. Previous Events: ① Initial Ruling (1992) ② Amendment (2008) ③ Second Ruling (2014)
[Initial Ruling] In 1992, regarding a case where a U.S. corporation claimed that a Korean domestic corporation infringed on its patent rights by selling electronic products to the U.S. and received settlement payment in consideration of granting the Korean corporation the license of the patent, the Supreme Court ruled in favor of the U.S corporation by exempting the settlement money from taxation on the grounds that U.S. patents are territorial. As rights granted by a U.S. patent extend only throughout U.S. territory and have no effect in countries where the patent was not filed, if the U.S corporation did not register the patent in Korea, the patent cannot be deemed to have been "used" in Korea. Accordingly, the royalties thereof cannot be considered a domestic source income, and the U.S corporation is exempted from Korean tax obligations.
[Amendment] Following the recurring rulings by the Supreme Court of Korea stating that domestically unregistered patents cannot be deemed to have been "used" in the domestic country, Korean tax authorities established a new regulation that stipulates that the "relevant patent rights, etc. shall be deemed to have been used in the Republic of Korea, irrespective of whether they were registered in the Republic of Korea, in cases where the relevant patent rights, etc. were registered out of the Republic of Korea and have been used for manufacture, sale, etc. in the Republic of Korea." This Amendment seemingly aims to establish that a U.S registered patent can be considered to be "used" in Korea if the "technical idea" of the patent was used for manufacture or sale, regardless of whether the patent right was registered domestically. However, the actual amendment still stipulates instances where the "right," not the "technical idea," was used in manufacture, sale, etc. Due to this problem, the subsequent Court decisions did not turn out the way the tax authorities hoped.
[Second Ruling] Regarding a dispute in 2014 where a U.S. corporation filed a patent infringement claim in the U.S. against a Korean conglomerate and received a settlement in exchange for granting patent licensing to the conglomerate, the Supreme Court again ruled that "pursuant to the U.S.-Korea Income Tax Convention, patent infringement cannot be recognized in countries other than the country where the patent is registered, thereby rendering the act of using the patent or paying patent royalties impossible in principle." Despite the amendment of the domestic taxation law, the Court reaffirmed that gains from a domestically unregistered patent cannot be considered a domestic source of income. This ruling made it evident that the tax authorities' effort to use legislation to reverse the Court's stance from preceding decisions was ineffective.
3. Recent Developments: ① Re-Amendment of the Law ② Supreme Court Decision in 2022
[Re-Amendment of the Law] At the end of 2018, the Korean tax authority deleted Article 28 of the Adjustment of International Taxes Act, which applies the Korea-U.S. Tax Treaty in preference to domestic tax laws, such as the Corporate Tax Act, regarding the classification of a domestic source income for foreign corporations. In addition, at the end of 2019, the government re-amended the Corporate Tax Act to impose taxes on patents that are being actually implemented or used in Korea if the manufacturing method, technology, information, etc. are related to the manufacturing and production in Korea despite the patents not being registered in Korea, constituting the gains from the patents as a domestic source income. Furthermore, damages paid by a Korean corporation for the infringement on the rights of patents registered abroad but not in Korea will be taxed as 'other domestic income.' These provisions of the amended Corporate Tax Act will be applied to royalties paid after 1 January, 2020.
[Supreme Court Decision in 2022] Along with the amendment of the law, the tax authority continuously endeavored to overturn previous Supreme Court decisions and maintain justification for taxing royalties for patents not registered in Korea before the amendment of the law by proposing new viewpoints and reasonings. In this regard, a meaningful judgment was recently sentenced in February 2022 about a case where a U.S. corporation with intellectual property rights of iris recognition technology granted a license to a Koren conglomerate for patent rights registered in the U.S. and software that includes other inventions. The Korean corporation integrated the software into its products, which were manufactured in Korea, and sold it globally. The main issue of the case was whether the royalties the Korean corporation paid to the U.S. corporation as consideration for the license would be considered domestic source income, which is subject to taxation.
(1) The court confirmed that royalties for patents unregistered in Korea are not subject to taxation.
The tax authority continued to stress more strongly than ever that the Supreme Court's decision should be changed, citing opinions from the tax law academia who are critical of the reasoning behind the Supreme Court's previous ruling. However, the Supreme Court ended further disputes over patent rights by clarifying that according to the principle of territoriality applied to patent rights, income that a U.S. corporation receives as consideration for patents registered abroad but not in Korea cannot be deemed as a payment for its usage, thereby, the income cannot be regarded as domestic source income, and thus cannot be subject to taxation.
(2) The possibility has been raised that intangible assets other than patents registered abroad but not domestically may be subject to taxation.
However, in the mentioned case, the software that the U.S. corporation allowed the Korean corporation to use included not only patent rights but also copyright, secret processes, secret formulae, an invention in the patent application stage, an invention with a provisional patent application, and technologies with ambiguous legal status. The tax authority asserted that aside from the patent itself, at least the said intangible assets fall under taxation.
The Supreme Court acknowledged the tax authority's claim, judging that in this case, the "royalties for using undisclosed information, such as the invention, technology, etc., among the intangible assets that should be paid" correspond to using "information or know-how related to industrial, commercial, or scientific knowledge and experience" under the Corporate Tax Act and "copyrights, secret processes, secret formulae, or other like property or rights, or knowledge, experience, or skill (know-how)" under the U.S.-Korea Income Tax Convention, thereby constituting domestic source income. Accordingly, the Supreme Court annulled the original verdict made by the High Court and ordered the court to deliberate and judge the case again. In other words, according to the Supreme Court's decision, royalties as consideration for the use of technologies disclosed as patents cannot be subject to taxation, but other undisclosed technologies can be subject to taxation as consideration for the use of "know-how" rather than "patent rights."
Accordingly, many other follow-up issues will be followed as to whether "royalties for the use of patents registered in the U.S. but not in Korea," which are not subject to taxation, and "royalties for the use of intangible assets other than patents registered in the U.S." can be clearly distinguished, and who will bear the burden of proof if patents and intangible assets are not classified under contracts, implying that the Supreme Court Decision on the case in question is not the complete conclusion of the dispute, but the beginning of another issue.
4. Conclusion: Implications of Recent Trends in Korea for Foreign Corporations
- In cases where a U.S. corporation received royalties as consideration for the use of intangible assets of patents before 1 January, 2020, (i) although it has been confirmed that royalties for the use of patents registered in the U.S. but not in Korea do not accrue, (ii) royalties in exchange for the use of other undisclosed intangible assets may still be taxed, so it is necessary to review the scope of the taxation. Of course, (iii) in either case, if the intangible assets are not used for manufacturing and sales in Korea, the royalties are not subject to tax.
- In cases where a U.S. corporation received royalties in exchange for the use of intangible assets of patents after 1 January, 2020, in accordance with the amended Corporate Tax Act of Korea, patents registered in the U.S. but not in Korea will be taxed. However, with fundamental questions about whether the terms and conditions of the Treaty agreed upon by the two parties can be interpreted differently by the amendment of domestic laws by one party, controversies are still expected to continue over whether this will change the formerly unyielding stance of the Supreme Court.
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.
