In the latest in a series of Korean Supreme Court decisions ruling on the issue of whether royalties paid by a Korean licensee for patent rights owned by a U.S. licensor are subject to withholding tax in Korea, the Supreme Court has again reaffirmed its precedents by holding in two recent cases that such royalties paid by a Korean licensee for patents not registered in Korea do not constitute Korean source income, and therefore are not subject to Korean withholding tax. However, the Supreme Court clarified that consideration paid for know-how used in Korea does constitute "domestic source income" subject to withholding tax, and remanded both cases to the lower court to determine whether any portion of the royalties at issue was paid for know-how or other non-patent rights provided by the licensor.

The Supreme Court previously ruled in 2007 that under the Korea-U.S. Tax Treaty ("Tax Treaty"), royalties received by a U.S. taxpayer for patents licensed to a Korean corporation should only be treated as domestic source income in Korea to the extent paid for patents registered in Korea and intended for use in Korea (Case No. 2005du8641, decided on September 7, 2007). In 2014, the Supreme Court affirmed this position in another case by ruling that royalties received by a U.S. licensor from a Korean licensee for patents registered only overseas and not in Korea did not constitute domestic source income (Case No. 2012du18356; see our Spring 2015 IP Newsletter here).

However, in the two recent Supreme Court cases (Case Nos. 2019du50946 and 2018du36592), the Court was again asked to review the issue of withholding tax on royalties for foreign patents, in the context of denials by the Korean tax authority of requests for refunds of withholding tax on royalties. The U.S. patent owners in these cases ("Plaintiffs") sought refunds of withheld corporate tax on royalty income paid by their Korean licensees for patents not registered in Korea. However, the Korean tax authority ("Defendant"), relying on ambiguous language in the Corporate Tax Act, interpreted these royalties as domestic source income and rejected the refund requests. The Plaintiffs appealed these rejections, and won favorable decisions at the district court and then appeal court, but Defendant appealed the decisions again for a final determination by the Supreme Court, which looked at two main issues in these cases.

Issue 1: Whether royalties paid for patents not registered in Korea constitute domestic source income if the patents are "used" in Korea

Article 2(1), Item 2 of the former Corporate Tax Act (amended by Act No. 13555, Dec. 15, 2015) provides that a foreign corporation is required to pay corporate tax in Korea only if it has domestic source income, while Articles 2(5) and 98(8) of the same Act provide that a person who pays a foreign corporation funds constituting domestic source income must withhold corporate tax on such income. While previous Supreme Court cases made it clear that royalties paid solely for licensing foreign patent rights could not be considered domestic source income, in the two recent Supreme Court cases, Defendant pointed to Article 93, Item 8 of the former Corporate Tax Act as raising an ambiguity, because this provision states that even if a foreign company had registered patent rights only outside of Korea, if such patent rights were used for manufacture, sale in Korea, any income paid for such use must be deemed Korean source income. Defendant interpreted this to mean that as long as the technology embodied in a foreign patent was used in Korea, royalties paid to license the patent would constitute domestic source income regardless of whether the patent was actually registered in Korea.

Because Article 28 of the former Adjustment of International Taxes Act (amended by Act No. 16099, Dec. 31, 2018) provides that the Tax Treaty governs whether income to a foreign entity constitutes domestic source income "[n]otwithstanding Article 119 of the Income Tax Act and Article 93 of the Corporate Tax Act," it was necessary for the Supreme Court to decide whether Defendant's interpretation of Article 93 of the former Corporate Tax Act was consistent with the Tax Treaty. The Supreme Court decided that in view of its precedents on this issue, and the context and ordinary meaning of the language of the Tax Treaty, a patent holder's exclusive right to exercise a patent by producing, using, transferring, leasing, importing, or exhibiting patented goods is effective only in the territory of the country where the patent right is registered, meaning that patent license royalties paid to a U.S. entity can only be defined as domestic source income if the U.S. entity has registered the patent right in Korea and holds the patent license in Korea (see, e.g., Supreme Court Decision 2005du8641, Sept. 7, 2007). The Supreme Court further affirmed that a patent right cannot be considered "used," nor can consideration be paid for its "use," in a country where the patent right is not registered, because infringement can only occur in a country where the patent right is registered. Therefore, if a U.S. entity has registered patent rights only outside of Korea, income paid to the U.S. entity for those right cannot be deemed domestic source income under the Tax Treaty (see Supreme Court Decisions 2012du18356, Nov. 27, 2014; 2016du42883, Dec. 27, 2018). 

Issue 2: Whether royalties paid for the use of non-public information and know-how under a licensing agreement not involving any Korean-registered patent rights constitute domestic source income

However, the two cases involved additional issues relating to royalties paid for non-patent rights, including non-public know-how, leading the Court to remand both cases. The 2019du50946 case was remanded to determine whether the royalties at issue included consideration for non-patent rights, such as copyright, trade secrets, or know-how, contrary to what the Plaintiff claimed. The 2018du36592 case looked specifically at whether royalties paid for non-public know-how, rather than patents, were subject to withholding taxes as domestic source income.

Article 93, Item 8(b) of the former Corporate Tax Act provides that "[t]he consideration paid for the use in Korea of information or know-how on industrial, commercial, or scientific knowledge and experience shall be deemed a domestic source income." This refers to the consideration paid for the use of non-public information regarding an invention, technology, manufacturing method or management method, even if such information cannot be formally registered as intellectual property rights (see Supreme Court Decision 2005Du8641, Sept. 7, 2007). In addition, according to Articles 6(3) and 14(4)a of the Tax Treaty, royalties paid for the use of, or the right to use, a copyright, secret process, secret formula or other similar property rights, knowledge, experience, skill, etc., shall be treated as income sourced from one of the Contracting States under the Tax Treaty if paid for the use of, or the right to use, such property in that Contracting State.

The Supreme Court in the 2018du36592 case held in view of the above that if the Korean licensee used non-public information relating to the patents licensed from the U.S. patentee to manufacture the licensed product in Korea and paid royalties to Plaintiff accordingly, the Plaintiff's royalty income would constitute domestic source income subject to withholding tax to the extent paid for such non-public information. The Court remanded the 2018du36592 case to the lower court to review and determine the amount of royalties paid for the use of such know-how.

Key implications

As the above series of Supreme Court cases clearly shows, the Korean tax authority has been very persistent in adopting aggressive interpretations of the relevant tax laws to require tax withholding on any IP royalties paid by Korean companies to foreign entities, despite the Supreme Court's repeated affirmation of the general principle that only royalties paid for Korean patent rights should be taxable in Korea. Thus, as a practical matter, it is important when drafting licensing agreements with Korean entities to clarify in the agreement whether royalties are also being paid (or not being paid) for the use of know-how or other non-public information, in addition to patent or other formal IP rights, and to distinguish any such royalties, to ensure that unnecessary withholding taxes are not assessed on royalties paid for purely foreign IP rights.