When a Korean subsidiary distributes (resells) intangible digital products or services to Korean customers and pays distribution fees or reseller fees to its affiliate(s) overseas, a frequent question is whether the fees should be classified as royalties or as business profits.
In a recent case examining whether distribution fees paid to a foreign affiliate (the “Fees”) constitute royalties for the use of a copyright under a tax treaty, the Tax Tribunal (i) ruled that whether the Fees constitute royalties should be determined in accordance with the Copyright Act of Korea, and (ii) concluded that the Fees do not constitute royalties for the use of copyright unless the taxpayer used the copyright as defined in the Copyright Act (Tax Tribunal Decision 2022Seo6549, November 8, 2023).
Pursuant to a service agreement with the foreign affiliate, the taxpayer obtained the right to distribute digital products (the “Products”) in Korea and engaged in the business of selling the Products to customers in Korea and receiving subscription fees. The taxpayer then paid the Fees to the foreign affiliate, calculated by deducting the taxpayer’s operating expenses and an arm’s length margin from the subscription fees. The Korean tax authorities concluded that the Products sold by the taxpayer constituted copyrighted works under the Copyright Act. Consequently, the Fees, which were paid as consideration for licensing of the Products, constitute copyright royalties. Based on this conclusion, the Korean tax authorities imposed a withholding tax on the Fees.
In this regard, the Tax Tribunal first set forth the legal principle that for the Fees to be considered copyright royalties under a tax treaty, the taxpayer must have had used copyrights (such as the right of transmission, right of reproduction, etc.) prescribed under the Copyright Act and paid the Fees as consideration for such use. The Tax Tribunal then ruled that the Fees paid by the taxpayer to the foreign affiliate for distributing digital products in Korea do not constitute royalties. This decision was based on the following grounds: (i) the taxpayer did not use the right of transmission (while the term “transmission” under the Copyright Act means uploading information to a server and providing it for public use, the Products in this case were provided directly to domestic customers from servers in the US that were owned and managed by the foreign affiliate), (ii) it is difficult to deem that the taxpayer used the right of reproduction (while the Copyright Act defines the term “reproduction” as reproducing a copyrighted work in tangible form, there are no servers in Korea that store the information relating to the Products), and (iii) the Commentary on the OECD Model Tax Convention states that if an intermediate distributor is granted only the distribution right without the right of reproduction, the consideration for such right is deemed “business profits.”
This decision is meaningful because it clarifies the legal principle that “whether a certain fee constitutes a copyright royalty under the tax treaty should be determined in accordance with the Copyright Act of Korea.” It establishes that the relevant fee cannot be deemed as a copyright royalty if the rights defined under the Copyright Act, such as the transmission and reproduction rights, are not used.
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