Procter & Gamble Case Holds Korean Withholding Taxes Were Compulsory

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By Lowell D. Yoder, Esq.
McDermott Will & Emery LLP, Chicago, IL

The Procter & Gamble Company ("P&G"), a domestic corporation, filed a refund claim based on foreign tax credits resulting from withholding taxes paid to Korea on royalties received. The IRS denied the refund claim on the basis that the tax payments to Korea were not "compulsory" and P&G sued in district court for a refund. The district court held that the Korean taxes were creditable, but reduced the amount of the refund by the amount of Japanese withholding taxes paid on the same royalty payments that had been previously allowed as a credit.1 

The royalties subject to the Korean withholding taxes were paid to P&G by P&G Northeast Asia ("P&G NEA"), a Singapore corporation. P&G NEA's principal office was located in Japan where it managed its Korean (and Japanese) operations.  P&G NEA sold products to Korean customers through a related Korean distributor. Some products were manufactured by contract manufacturers in Korea.

The products sold by P&G NEA were sold under trademarks owned by P&G and many of these products were made using patented technology owned by P&G. Pursuant to a license agreement, P&G NEA paid royalties to P&G based on a percentage of sales.  During the years 2001 to 2005, because P&G NEA conducted its business from Japan, it withheld and paid 10% of the royalty payments as tax in Japan on the amount of the royalties paid to P&G relating to all of its sales, including the Korean sales. The entire amount of the royalties paid to P&G apparently was deductible in Japan in computing taxable income of P&G NEA's Japanese branch, which income generally would be subject to a tax rate of at least 40%.

P&G NEA initially did not pay any tax to Korea with respect to the royalty payments because its operations were based in Japan and it had no employees in Korea. In 2006, the Korean National Tax Service concluded that the royalties paid by P&G NEA to P&G with respect to sales to Korean customers were Korean-source and subject to Korean withholding tax at a rate of 15%. In addition, P&G was required to pay a 1.5% local surcharge to the Chonan municipal authority.

P&G sought advice from Korean counsel concerning whether it had a basis for contesting the assessment. Korean counsel provided a written memorandum to P&G containing a detailed discussion of the relevant legal provisions, and concluded that P&G was liable for the tax under Korean law and the U.S.-Korea Income Tax Treaty.  Korean law provides that income associated with intellectual property is sourced based on the place where the property is used. The royalties on which the Korean withholding tax was assessed were considered Korean-source because they related to products sold to Korean customers.2  Accordingly, the memorandum concluded that a challenge to the assessment was unlikely to succeed. P&G therefore determined that there was no reasonable basis to appeal the assessment or pursue Competent Authority relief.

P&G paid the assessment to Korea and then filed a refund claim with the IRS based on foreign tax credits resulting from the payment of the Korean taxes. The IRS disallowed the claim.  It asserted that the payment of the Korean taxes was not a "compulsory payment pursuant to the authority of a country to levy taxes" as required by the regulations. The IRS argued that the payments to Korea were voluntary because P&G had not "exhaust[ed] all effective and practical remedies including invocation of competent authority procedures available under applicable tax treaties, to reduce, over time, the taxpayer's liability for foreign tax…."3 

P&G provided to the IRS the memorandum received from Korean counsel that concluded that a challenge to the Korean tax assessment was unlikely to succeed. The government did not believe this was sufficient to satisfy the requirements of the regulations.  The government argued that such taxes may not be claimed as a credit because P&G failed to seek a refund in Korea.

The court rejected the government's argument that the Korean taxes were not creditable. It relied on the memorandum from Korean counsel that concluded that the taxes were legally owed to the Korean government, and accordingly found the payments to be compulsory. The court refers to the following statement in the regulations: "In interpreting foreign tax law, a taxpayer may generally rely on advice obtained in good faith from competent foreign tax advisors to whom the taxpayer has disclosed the relevant facts."4 Therefore, even though P&G had not pursued a refund of the Korean withholding taxes nor requested Competent Authority relief, P&G was entitled to a credit for the Korean taxes.5 

P&G had previously claimed as a credit the taxes paid to Japan on the same royalty payments. The IRS had already audited those years before the Korean tax was imposed and did not challenge the creditability of those taxes. In response to the refund claim resulting from the Korean tax payments, the IRS argued that P&G should not be entitled to a credit for taxes paid to two countries on the same income stream. In any event, once Korea assessed taxes on the royalty payments, the IRS asserted that P&G should have sought remedies in Japan to reduce the double taxation of the same income.6 

The court disagreed with the assertion of the IRS that a taxpayer is precluded from claiming foreign tax credits for taxes paid to more than one country on a single stream of income.  The opinion states, "It may well be that multiple countries can claim tax on a single source of income and that the IRS is required to grant credits for these claims." Thus, it is possible to claim both Korean taxes and Japanese taxes imposed on the single royalty stream as foreign tax credits. This application of the foreign tax credit rules is important because countries may adopt different definitions of the place where intellectual property is used, or may source royalties on some other basis, and treaties often allow the laws of the country imposing the tax to determine the source of royalties (e.g., place of use may be where the products are sold, manufactured, or the operations are managed, or the country may source royalties based on the residence of the payor).

P&G argued that the IRS was procedurally barred from challenging the creditability of the Japanese taxes.  The refund claim related only to Korean withholding taxes and the government had not challenged the Japanese taxes on audit or in initially denying the refund claim relating to Korean taxes. P&G argued that the Japanese taxes were not at issue because the government's argument was in the nature of a "setoff" and was not raised early in the proceedings. The court, however, did not believe that the government's challenge with respect to the Japanese taxes was properly categorized as a "setoff" claim. In the absence of evidence introduced during the proceedings showing that P&G had pursued an analysis of its liability for the Japanese taxes or contested the Japanese taxes imposed on the same royalty stream after Korea asserted its claim, the court held that the amount of the refund based on the credit for Korean taxes was to be reduced by the amount of Japanese taxes already allowed as a credit. The legal basis for requiring a taxpayer to pursue remedies against a third country whose taxes are not at issue in the case is unclear.

The facts of the case illustrate that a payor of royalties for the use of intellectual property may be required to pay withholding taxes to the country in which the intellectual property is used, even though the payor is neither organized in, nor has any taxable presence in, that country. The facts also show that taxes may be required to be paid to more than one country on a single royalty payment. The holding of the case reconfirms that a taxpayer is not required to contest a payment of foreign tax or pursue Competent Authority relief if the tax has a reasonable basis in law. In this regard, the court found that a memorandum prepared by a Korean law firm was sufficient to sustain a payment of foreign tax as compulsory.  The district court also expressed its view that credits for taxes will not be denied on the basis that more than one country imposes tax on the same royalty payments. Nevertheless, where a taxpayer claims credits for taxes paid to two countries on the same income stream, a court may require evidence that the taxes in both countries were properly assessed, even where the taxes paid to one country were not challenged by the IRS on audit.

This commentary also will appear in the October 2010 issue of the Tax Management International Journal.  For more information, in BNA's Tax Management Portfolios, see DuPuy and Dolan, 901 T.M., The Creditability of Foreign Taxes — General Issues, and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation.

1 The Procter & Gamble Company v. U.S., No. 1:08-cv-00608 (S.D. Ohio 7/6/10) (order granting partial summary judgment).


2 Under the U.S.-Korea Income Tax Treaty, Korea is entitled to tax royalties for the "use of, or right to use" intellectual property in Korea. Since the treaty does not provide a definition of "source," the term is defined by reference to Korean law (Art. 2.2).


3 Regs. §1.901-2(a)(2)(i), (e)(5)(i).


4 Regs. §1.901-2(e)(5)(i).  SeeSchering Corp. v. Comr., 69 T.C. 579, 602 (1978) (petitioner not required to challenge lawful Swiss tax).


5 The court also found that the Chonan municipal tax was a tax imposed by a "political subdivision" of Korea, and therefore was a tax imposed by a "foreign country." §901(a), (b)(1); Regs. §§1.901-1T(a)(2), -2(g)(2).


6 The Japanese withholding taxes paid with respect to sales to Japanese customers were not in dispute.