Supreme Court overturns and remands 2nd trial on MS 630 billion 'corporate tax refund'... "Insufficient review"

Supreme Court En Banc.

[Asia Economy Reporter Choi Seok-jin, Legal Affairs Specialist] The Supreme Court overturned the appellate court ruling that had favored Microsoft (MS) in a corporate tax refund lawsuit filed by MS against the Korean tax authorities. The lawsuit concerns corporate tax amounting to over 630 billion KRW withheld and paid on royalties paid by Samsung Electronics to MS from 2012 to 2015 under a patent license agreement.

On the 10th, the Supreme Court's 3rd Division (Presiding Justice Kim Jae-hyung) dismissed MS's appeal in the corporate tax reassessment refusal cancellation lawsuit filed by MS and its subsidiary MS Licensing against the Dong Suwon Tax Office, overturned the appellate court's partial ruling in favor of MS Licensing, and remanded the case to the Suwon High Court.

The court found that the appellate court erred by concluding that MS had no right to request reassessment without fully examining whether MS was the beneficial owner of the patent royalty income, which affected the judgment.

Additionally, the appellate court was found to have violated procedural rules by failing to consider the defendant's claim that the royalties in question included payments for rights other than patents, such as copyrights, know-how, and trade secrets, which are subject to withholding as domestic-source income.

Regarding MS's appeal against the lower court's dismissal on the grounds of no reassessment claim right, the court cited Supreme Court precedents, stating, "Withholding agents are generally obligated to withhold corporate tax based on the beneficial owner of domestic-source income according to the principle of substance over form, and the beneficial owner of income may request reassessment of the tax base and amount under Article 45-2, Paragraph 1 and 4, Subparagraph 3 of the former Framework Act on National Taxes."

It further explained, "The appellate court erred by not fully examining whether MS was the beneficial owner of the royalty income, which influenced the judgment," as the reason for overturning and remanding.

Regarding the tax authorities' appeal about whether royalties for unregistered domestic patents constitute domestic-source income, the court stated, "Whether income received by a U.S. corporation for patents registered abroad but not domestically, used in manufacturing or sales in Korea, constitutes domestic-source income must be determined according to the Korea-U.S. Tax Treaty."

It continued, "According to the Korea-U.S. Tax Treaty, only income received as consideration for the use of patent rights registered domestically and exercised in Korea is considered domestic-source income. If the patent is registered only abroad and not domestically, income received by the U.S. corporation for such use cannot be considered domestic-source income," and affirmed the appellate court's judgment that royalties for unregistered domestic patents do not constitute domestic-source income for foreign corporations.

However, the court found the appellate court's rejection of the tax authorities' claim that further examination was needed to determine whether the royalties included payments for intangible assets other than patent rights, such as copyrights and technology, to be erroneous.

The court pointed out, "MS filed the reassessment request on the premise that the royalties did not include payments for rights other than patents, and the tax authorities argued in the appellate court that the royalties included payments for copyrights, know-how, and trade secrets subject to withholding as domestic-source income, thereby adding or changing the grounds within the scope of maintaining the identity of the disposition," and emphasized, "The appellate court should have examined and judged MS's claim."

It added, "The appellate court's judgment that the tax authorities' claim was not subject to judicial review due to a different premise constitutes a legal error in the scope of judicial review, resulting in insufficient examination that affected the judgment."

In July 2011, MS entered into a contract with Samsung Electronics granting patent licenses necessary for Android-based smartphones and tablet businesses, agreeing to receive royalties. The contract covered patents currently owned or controlled by MS and its subsidiaries, as well as those to be owned or controlled in the future.

From 2012 to 2015, Samsung Electronics paid over 1 trillion KRW annually in royalties for 2013 to 2015, totaling approximately 4.3582 trillion KRW over four years. The royalties were deposited into MS Licensing's account.

Samsung Electronics withheld and paid approximately 653.7 billion KRW, 15% of the total amount, as corporate tax to the tax authorities under the Korea-U.S. Tax Treaty.

In June 2016, MS filed a reassessment request with the tax authorities, arguing that royalties for patents not registered in Korea are not domestic-source income and that the withheld tax should be refunded. The claimed reassessment amount was approximately 634.4 billion KRW.

The number of MS patents contracted with Samsung Electronics increased from 33,938 in 2012 to 54,675 in 2015, with only 1,733 patents registered domestically.

When the tax authorities took no action for two months, MS filed a tax appeal with the Tax Tribunal in October 2016. After the Tax Tribunal dismissed MS's appeal the following year, MS filed a lawsuit.

The court, applying Article 45-2, Paragraph 3, proviso of the former Framework Act on National Taxes, which allows a taxpayer to file an appeal if no notification is received within two months, deemed the tax authorities' reassessment refusal on August 29, 2016, and proceeded with the case.

The first-instance court dismissed MS's lawsuit as inadmissible.

Considering that Samsung Electronics paid royalties to MS Licensing's account and that notifications and royalty reports were addressed to MS Licensing, the court held that the recipient of the domestic-source income from patent royalties was MS Licensing, not MS.

Therefore, the court ruled that the entity entitled to exercise the reassessment claim right under Article 45-2, Paragraph 4 of the former Framework Act on National Taxes is MS Licensing. Even if MS effectively manages the patents and royalties, the allocation of refunded tax between MS and MS Licensing is an internal matter.

For these reasons, the court concluded that the tax authorities' refusal to recognize MS's reassessment claim right was not an administrative disposition subject to litigation, rendering MS's lawsuit inadmissible.

During the trial, whether income received for patents not registered domestically constitutes domestic-source income was a key issue.

MS argued, "According to Article 6, Paragraph 3 of the Korea-U.S. Tax Treaty, only income received for the use of patent rights registered domestically and exercised in Korea qualifies as domestic-source income. Income for patents not registered domestically cannot be considered domestic-source income and is not subject to withholding."

MS further claimed, "Therefore, the reassessment refusal based on the premise that royalties for unregistered patents are domestic-source income and subject to withholding is illegal and should be canceled."

The tax authorities countered, "Although the Korea-U.S. Tax Treaty adopts the 'place of use' principle for sourcing royalty income, it does not specifically define 'use.' Therefore, under Article 2, Paragraph 2 of the treaty, the meaning of 'use' should be interpreted according to domestic law."

They also argued, "Article 93, Subparagraph 8 of the former Corporate Tax Act stipulates that even royalties for patents not registered domestically are considered domestic-source income if the patents are used in manufacturing or sales in Korea. Therefore, the royalties in question are domestic-source income subject to withholding, and the reassessment refusal is lawful."

The court sided with MS, ruling that under the Korea-U.S. Tax Treaty, royalties for patents not registered in Korea cannot be considered domestic-source income.

The court noted that while the Corporate Tax Act treats royalties for unregistered patents as domestic-source income, the International Tax Adjustment Act prioritizes tax treaties in defining domestic-source income.

However, the court calculated the refundable corporate tax at 633.7 billion KRW, slightly less than MS's claimed 634.4 billion KRW, excluding 700 million KRW related to domestically registered patents.

The Suwon High Court's 1st Administrative Division, which handled the appeal, dismissed both MS's and the tax authorities' appeals in July 2019.

The tax authorities argued that MS bore the burden of proving the amount of royalties for unregistered patents that do not constitute domestic-source income and that any disadvantage from failing to calculate the refund properly should fall on MS.

However, the appellate court found that since the contract included patents to be registered in the future, objectively evaluating the value of individual patents among over 50,000 was technically and practically difficult.

The court also noted that when the tax authorities requested documents after MS's reassessment claim, MS explained why the patent list was not specified in the contract and why detailing patent specifics was difficult. Thus, the tax authorities were aware of the existence of unregistered patents and the need to identify royalties related to domestically registered patents. Therefore, the court concluded that the tax authorities' disposition without excluding non-domestic-source income portions was unlawful.

Meanwhile, the court rejected the tax authorities' claim that royalties included a mixture of know-how, trade secrets, and copyrights alongside patents, requiring MS to submit documents to distinguish royalties for domestically registered patents.

The court stated that although the first-instance court treated the case as a reassessment refusal cancellation lawsuit, the case essentially had the character of a lawsuit confirming illegality due to inaction. Since the tax authorities had a legal obligation to respond within two months but failed to do so, the binding effect of this judgment should be limited to directing the tax authorities to take appropriate action on MS's reassessment claim.

From this perspective, the court concluded that issues the tax authorities claimed required judicial examination should be addressed by the tax authorities when taking action in accordance with the judgment, not by the court.

However, the Supreme Court found the appellate court's ruling unlawful and remanded the case.

This content was produced with the assistance of AI translation services.