Ryu Seong-hyeon, an attorney at Yoon & Yang LLC, explained the corporate tax lawsuit between Hiya, a U.S. information technology (IT) corporation, and the domestic tax authorities this way in an interview with ChosunBiz on the 28th of last month. It means that it is not royalty income just because the contract says "license fee" or because the program is installed on domestic smartphones.
Hiya is a corporation that provides caller ID and spam blocking services. Domestic smartphone manufacturers used Hiya's software and services, and withheld corporate tax from the consideration and paid it to the tax authorities before remitting the remainder.
This is because, under the Korea-U.S. tax treaty, Korea can collect corporate tax on royalty income at a rate of up to 15%. In contrast, as a rule, business income earned in Korea by a U.S. corporation without a domestic permanent establishment cannot be taxed.
Hiya filed a lawsuit against the domestic tax authorities, saying the payments from domestic smartphone manufacturers constituted business income and seeking a refund of corporate tax.
The first-instance court found the taxation justified based on terms such as "license" in the contract. The appellate court, however, held that Hiya operated the databases and algorithms directly and deemed the entire payment business income. The Supreme Court finalized the ruling by dismissing the tax authorities' appeal without a hearing. A dismissal without a hearing is a system in which the Supreme Court, if it finds no legal error in the appellate ruling in cases other than criminal matters, dismisses the appeal without full briefing or oral argument.
Yoon & Yang LLC represented Hiya starting at the appellate stage. In the Supreme Court appeal, attorneys Ryu Seong-hyeon (Judicial Research and Training Institute class 33), Lee Hwan-gu (class 37), and Lee Won-young (Bar Exam 9th) participated. The following is a Q&A.
—What fact played a decisive role in overturning the first-instance ruling?
(Attorney Lee Hwan-gu) "That Hiya was the party that actually provided the service. When the user enables the feature, the Whitepages client installed on the smartphone connects to Hiya's servers in the United States. Caller identification and spam assessment occur on the server, and only the results are delivered to the smartphone.
Domestic manufacturers could not directly access Hiya's databases and did not control how the algorithms operated. The program installed on the smartphone also could not independently identify callers or determine spam. It was closer to a gateway to access Hiya's service."
—How did you prove this on appeal?
(Attorney Lee Hwan-gu) "In the first instance, the wording used in the contract was treated as important. On appeal, we focused on the actual transaction structure rather than the contract title. We showed that even if a program is embedded in the smartphone's phone app, it cannot perform core functions on its own, and that both caller data lookup and spam assessment occur on Hiya's servers.
We also emphasized that the core value of the service comes not from the installed program but from the databases and algorithms that Hiya directly builds and operates. We relied as well on the commentary to the Organisation for Economic Co-operation and Development (OECD) Model Tax Convention, which distinguishes transactions in which technology is transferred to other corporations from transactions in which the technology holder provides services directly."
—In September last year, the Supreme Court en banc changed precedent by holding that even a domestically unregistered patent used by SK hynix could be taxed if the technology was actually used in Korea. Similar rulings have followed. What distinguishes the SK hynix case from the Hiya case?
(Attorney Ryu Seong-hyeon) "In the SK hynix case, there was no dispute that the payment was royalty income. The issue was whether technology registered only in the United States could be viewed as used in Korea. In contrast, the Hiya case turned on the nature of the income itself—whether the money paid by domestic manufacturers was technology royalties or consideration for service provision.
SK hynix received the right to use patented technology and used it directly in domestic manufacturing processes. But Hiya's databases and algorithms were not transferred to domestic manufacturers. Hiya retained them and operated them directly on overseas servers.
Because the Supreme Court did not present separate reasoning, it is hard to see this as a ruling that announced a new general legal principle. Still, it is a reference case when distinguishing between transactions in which technology is transferred for use and transactions in which foreign corporations provide services directly."
—Can software royalties and service consideration be separated for taxation?
(Attorney Lee Won-young) "If the installed program can independently perform core functions without connecting to the server, one can separately assess compensation for software use. You also have to examine whether it can be traded as a separate product and whether the contract or objective materials allow you to distinguish software royalties from service fees.
In this case, the client program was merely a means to access Hiya's service, and there were no materials to separate the prices of the program and the service.
It is also difficult to conclude that copyright was commercially exploited solely because the program was copied or stored on the smartphone. The fact that the payments were fixed annually regardless of production or sales also served as supporting grounds for treating them as business income."
—Can this apply to overseas software as a service (SaaS), cloud, and application programming interface (API) contracts?
(Attorney Lee Hwan-gu) "A similar standard can be applied. You cannot deem it royalty income solely because the functions of a foreign corporation are included in domestic products.
You have to determine whether the core technology was transferred to domestic corporations so they directly control and use it, or whether the foreign corporation retains the technology and performs the service directly on overseas servers.
However, if the program installed on domestic devices can independently perform core functions without overseas servers, or if domestic corporations directly control and operate transferred technology, it can be treated as royalty income."
—How do you assess the likelihood of refunds for withholding taxes already paid?
(Attorney Ryu Seong-hyeon) "You do not need to forgo refunds just because the contract says "license" or "royalty." If the core service occurs on overseas servers, the domestic program is merely a means to connect to the server, and the technology or know-how was not transferred to domestic corporations, you can consider the possibility of a refund.
Conversely, if domestic corporations directly control the software, or if the program itself has independent functions and economic value, it is likely to be considered royalty income.
This does not mean all SaaS fees can automatically be refunded. You must prove, for each transaction, how the technology operates, the contract structure, and the pricing method, and you must also check the statute of limitations for amended refund claims for each fiscal year."
—What materials should corporations keep?
(Attorney Lee Won-young) "System architecture diagrams and data flowcharts, server operation records, API specifications, and pricing documents are important. You must be able to show which server processes user requests, who produces the final results, and whether the program installed on domestic devices has independent value.
In digital services tax disputes, the key is to understand how the technology actually works and connect that to the tax-law categories of income."