[Winning Strategy] Hwawoo Scores Comeback Victory in Global IT Service Tax Dispute

"Substance Over Contractual Terms and Form Must Prevail"

"The key was the argument that taxation must follow the principle of substance over form."

Ryu Seonghyun, an attorney (33rd class of the Judicial Research and Training Institute) in the tax group at Hwawoo Law Firm, explained this as the secret to his recent victory in overturning the first-instance judgment in a tax dispute over a service contract between a global IT company and a major Korean conglomerate. The 3rd Administrative Division of the Suwon High Court accepted Hwawoo's arguments, reversed the first-instance ruling that had dismissed the plaintiff's claim, and ordered the cancellation of the disposition rejecting the correction claim.

Ryu Seonghyeon (right) and Lee Hwangu, attorneys at Hwawoo Law Firm, are being interviewed by The Asia Business Daily. Photo by Yoon Dongju

The case began when a dispute arose with the tax authorities involving a U.S. IT company and a Korean smartphone manufacturer. The IT company entered into a contract to integrate caller identification and spam-blocking services into the smartphone manufacturer's models. It received a fixed fee in return. The company treated this fee as "royalty income" and, under the Korea-U.S. tax treaty, paid 15% corporate tax. However, the U.S. IT company argued that the fee was not a royalty but business income, and therefore not taxable because it had no permanent establishment in Korea. The court did not accept this argument. In the first instance, the tax authorities prevailed. The first-instance court interpreted the fact that the contract between the companies described the payment as a "license fee" as meaning that it was consideration for the provision of a royalty.

"Emphasis on 'access to a service,' not an independent technology"

The tax group at Hwawoo Law Firm (attorneys Ryu Seonghyun and Lee Hwangu), which represented the U.S. IT company on appeal, devised a new strategy. They put at the forefront the principle that the "substance" of the transaction must be examined rather than its "label." Hwawoo argued that the consideration in question was not a typical "running royalty" linked to smartphone sales performance, but a fixed annual amount. They also focused on the fact that, because profits generated in the future would be split 50:50, the arrangement had a strong "joint-business character."

In court, Hwawoo argued that the software installed on the smartphones was not a transfer of technology that had independent value in itself, but merely an interface for real-time access to the massive database on servers managed by the plaintiff. They contended that if the plaintiff stopped providing the service from its servers, the software on the smartphones would become an empty shell that could not perform any function. They also offered an intuitive analogy. For example, a construction company installs water purifiers in an apartment complex. The water purifier company supplies water to the residents. In this case, the money the construction company pays the water purifier company is not consideration for transferring technical "know-how." It is "consideration for the use of water purification services." In the same vein, they argued that this case was not about the smartphone manufacturer borrowing and using the U.S. IT company's technical know-how, but about using its services.

Presenting criteria for characterizing consideration for digital services

This favorable judgment is seen as having produced a precedent that can serve as a reference point for how to characterize consideration paid in an IT environment. Attorney Lee Hwangu (37th class) said, "It is meaningful in that it puts a brake on the practice of mechanically treating payments as royalties based solely on wording such as 'license' in the contract," adding, "The core logic in this case, that royalties are hard to recognize where the key technology is owned and used by the service provider and is not transferred to the counterparty, can serve as an important precedent."