When it comes to the taxation of trademark royalties paid between affiliates, the lack of specific standards for determining which cases require payment of trademark royalties has resulted in many disputes between taxpayers and tax authorities.
In a case involving the non-receipt of trademark royalties by a trademark holder from a trademark licensee, the Supreme Court recently held that the mere fact that the trademark owner did not receive royalties does not automatically lead to the conclusion that this non-receipt lacks economic rationality and constitutes a violation of the arm’s length principle applicable to domestic transactions between related parties (i.e., domestic transfer pricing rules, referred to as “Denial of Unfair Transaction” rules in Korean tax laws). The Supreme Court ruled that whether there is a lack of economic rationality should be determined by taking into account all relevant facts and circumstances surrounding the registration and use of the trademark, including functions performed by each party related to the trademark and their levels of contribution to revenue generation.
This case involved a registered owner (the “Plaintiff”) of trademark “A” and trademark “B” for a duty-free store. Although its affiliate C used trademark A, the Plaintiff did not receive any royalties from affiliate C for the use of trademark A. In addition, while the Plaintiff entered into a duty-free shop management agreement (which includes the use of trademark B) with affiliate D, the Plaintiff only received management service fees from affiliate D and did not separately receive any royalties for the use of the trademark B. Accordingly, the Korean tax authorities concluded that the Plaintiff’s non-receipt of trademark royalties from affiliates C and D constitutes a violation of the arm’s length principle under Article 52 of the Corporate Income Tax Law (i.e., Denial of Unfair Transaction rules). Based on the foregoing conclusion, the authorities imposed a corporate income tax on the deemed royalty amount, which was calculated by multiplying the net sales of affiliates C and D earned from using each trademark by a certain trademark royalty rate.
The Supreme Court reaffirmed that the legal principle established by precedents (i.e., the economic rationality condition), which is required to apply the Denial of Unfair Transaction rules, should be determined by taking into account various facts and circumstances. Specifically, the Supreme Court ruled that the value of the trademark, which is derived from the amount of capital and efforts made in connection with use of the trademark, may change depending on the degree of usage of the trademark, market circumstances, and general recognition of the trademark, and the fact that no royalties were paid for the use of the trademark does not necessarily mean that there was a lack of economic rationality.
Moreover, the Supreme Court stated that this determination should be made by taking into account all of the circumstances surrounding the registration and use of the trademark and set forth the following specific standards:
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Legal/contractual grounds for the use of trademark and contents/terms thereof;
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Relationship between the trademark holder and the trademark licensee;
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Functions performed by both parties related to the development of the trademark and enhancement/maintenance/protection/exploitation of the trademark value;
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Magnitude of the capital and efforts contributed in performing the above functions;
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Whether the functions performed by both parties contributed to revenue generation through the trademark and the degree thereof;
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Awareness of ordinary consumers regarding the trademark at issue; and
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All other circumstances surrounding the registration and use of the trademark.
Thus, in light of the above standards, the Supreme Court ruled that the Plaintiff’s failure to receive royalties for the use of its trademarks did not constitute a ground to apply the Denial of Unfair Transaction rules because (i) the Plaintiff did not make any effort to use trademark A for its business or increase its value, and most of the proprietary value of trademark A was generated by affiliate C, and (ii) it is reasonable to view that the management fee received by the Plaintiff from affiliate D under the management agreement also included royalties for the use of trademark B.
This is a leading case where the Supreme Court established the standards for determining economic rationality, which are required to apply the Denial of Unfair Transaction rules, for cases involving the non-receipt of trademark royalty. This decision confirms that a trademark holder does not always have the right to receive royalties, and presents the possibility of disputing the “lack of economic rationality” argument raised by the Korean tax authorities depending on the individual and specific facts surrounding the registration and use of a trademark, such as the grounds for usage of the trademark, the relationship between the trademark holder and the licensee, and the functions performed by both parties in relation to the trademark.
