Court: "Settlement for Trade Secret Infringement Is Not Intellectual Property Royalty"... Cannot Levy VAT

Seoul Administrative Court, Yangjae-dong, Seoul. Photo by Seoul Administrative Court

A court ruling has determined that it was incorrect for tax authorities to impose value-added tax (VAT) on a settlement payment received by a company, which had its trade secrets infringed, under the condition of exempting the infringing company, treating the payment as 'intellectual property usage fees.'

According to the legal community on the 12th, the Seoul Administrative Court's Administrative Division 5 (Presiding Judge Kim Sun-yeol) recently ruled in favor of plaintiff A, a subsidiary of a U.S.-headquartered silicone product manufacturing and sales company, in a lawsuit against the head of Yeoksam Tax Office seeking cancellation of a VAT imposition.

In April 2012, A requested an investigation into C, who had worked at A for 15 years before resigning to join competitor B as head of the silicone sales department at B's headquarters, along with B's executives and employees.

During the investigation, it was revealed that C had copied a total of 499 files containing A's important trade secrets related to silicone materials, LED industrial materials, and solar materials formulations and manufacturing processes onto his laptop before resigning, and that some of these trade secrets were leaked to B's technical team after his move to B.

C and D, a manager at B, were indicted in September 2015 for trade secret leakage under the Unfair Competition Prevention Act and were convicted.

On April 1, 2015, A and B signed a final settlement agreement related to intellectual property infringement. The agreement included provisions that ▲ A would waive all claims arising from B's infringement of confidential intellectual property prior to the agreement, ▲ unconditionally and irrevocably exempt B and its executives and employees from liability (except claims under patent, trademark, and copyright laws), and ▲ agree not to make any claims against B for intellectual property infringement even if B used A's intellectual property for research, development, and sales of agreed products until March 31, 2020. In return, ▲ B would pay a lump sum of USD 19 million within 30 days, and ▲ pay three annual installments of USD 5 million each from December 2015 to December 2017, totaling USD 34 million.

Following the agreement, B paid a total of USD 17 million to A over four installments from April 2015 to December 2017, and another USD 17 million to A's U.S. parent company, accounting for these payments as service fees (technical consulting fees) and withholding 15% corporate tax on royalty income.

However, the Seoul Regional Tax Office conducted a tax audit on B from December 5, 2017, to March 23, 2018, and notified B's jurisdictional tax office chief that the settlement payment corresponded to royalties for intellectual property use. The Yeoksam Tax Office chief was also notified of the VAT sales omission. Consequently, Yeoksam Tax Office imposed VAT of approximately 3.04 billion KRW on A, assuming the settlement payment was omitted royalty income. A filed a tax appeal with the Tax Tribunal, which was dismissed, leading A to file a lawsuit.

In court, A argued that "Article 4, Clause 1 of the Value-Added Tax Act defines the taxable object as the supply of goods or services by a business operator, and compensation for damages or penalties are not consideration for goods or services and thus cannot be included in the VAT taxable base." A claimed that considering the payment circumstances and calculation details, the settlement was merely compensation for B's illegal act of 'intellectual property infringement' and could not be regarded as 'consideration for the supply of services,' making the tax imposition unlawful.

The court cited Supreme Court rulings on VAT taxable objects.

The Supreme Court previously stated, "Article 29, Paragraph 1 of the Value-Added Tax Act stipulates that the VAT taxable base for the supply of goods or services is the total supply value of goods or services supplied during the taxable period, and Clause 1 includes 'consideration received in money.' According to the wording and structure of these laws, the supply value subject to VAT is the value corresponding to the consideration for the supply of goods or services when received in money; therefore, penalties or compensation for damages, which are not consideration for goods or services, cannot be supply values," a position reiterated multiple times.

The court concluded, "Considering the facts and legal principles above and the overall context of the trial, it is reasonable to view the settlement payment as compensation for damages due to intellectual property infringement, and it is difficult to regard it simply as future royalties for intellectual property use. Therefore, the tax imposition based on the premise that it was 'consideration for the supply of services' is unlawful," and found the plaintiff's argument valid.

The court based its judgment on the following points: ▲ The settlement aimed to compensate for damages caused by B hiring C and acquiring A's trade secrets and to exempt B and its executives from civil and criminal liability; ▲ If the settlement concerned 'intellectual property royalties,' the document would not mention the existence of disputes and uncertainties to be avoided; ▲ The payment was made to exempt B and its executives from liability for trade secret infringement occurring before the settlement; ▲ The clause exempting B from liability for acts until March 31, 2020, merely reflects A's decision not to challenge B's manufacture of silicone-based products using previously acquired trade secrets, and thus cannot be seen as future royalty payments; ▲ The settlement allows A to claim under patent, trademark, and copyright laws despite the exemption, indicating that A only exempted B from liability for past trade secret infringements and did not grant B full future usage rights to A's trade secrets.

Meanwhile, the defendant Yeoksam Tax Office chief argued, "Consideration paid for future use cannot be compensation for damages, and the effective date, guarantee period, and guarantee terms in the settlement would not exist in a typical compensation agreement." The argument was that at least the settlement payment received after April 1, 2015, as consideration for exempting B's infringement of A's intellectual property rights, should be regarded as intellectual property usage fees.

However, the court rejected this, stating, "Article 3 of the settlement stipulates that 'B is exempted from liability arising from infringement of A's confidential intellectual property before the effective date of this agreement,' and it is natural to include an effective date provision to define the temporal scope of exempted liability," thus dismissing the claim.

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