The Supreme Court of Japan handed down a long-waited decision on June 24, 2004 in the case of Higashi Murayama Tax Bureau v. Silver Seiko K.K. The Court concluded that royalties paid by a Japanese licensee to a US licensor under a patent license agreement do not fall within the category of domestic source income to which the Income Tax Act is applicable. Based on the rationale that the payments were made as royalties under a US patent, the Supreme Court said that the Japanese law did not reach the income occurring in a different tax jurisdiction.
In June 1983, a US Patentee filed a Section 337 complaint against Silver Seiko K.K. under the Tariff Act of 1930. Silver Seiko decided to settle this dispute by obtaining the license under the disputed US patent and its foreign counterparts. The settlement agreement provided, among other things, that Silver Seiko paid the stipulated royalties without deducting withholding taxes. Payments were thus made without deducting the withholding taxes but, a year later, the tax authority issued a decision that Silver Seiko failed in paying the income tax for its royalties and that it should pay the missing taxes together with overdue penalties. Silver Seiko filed a suit with the Tokyo District Court seeking a declaratory judgment that the tax authority’s decision was void on the ground that the national tax law was inapplicable to the royalties paid to a US licensor on a US patent.
(Domestic Source Income or Not)
In its 1992 decision, the Tokyo District Court concluded that the royalties paid by Silver Seiko were free from the application of the withholding tax under the income tax law. In determining a source country where a taxable income generated, the District Court put more weight on the place where the US patent at issue existed. The tax authority appealed the District Court’s decision. On appeal, the High Court affirmed the District Court’s decision in 1999. The tax authority further appealed to the Supreme Court. In accepting this appeal, the Supreme Court concluded against the tax authority.
Arguments in the Silver Seiko case were focused on whether the fees paid under the settlement agreement amounted to a royalty as defined in the statute. The tax authority argued that the fees were taxable as income of domestic source in view of the place of actual production. In its argument, the tax authority focused on the fact that a Japanese counterpart patent was included in the license agreement and that the products in question were manufactured and sold in Japan.
(Deviation from Precedent)
In the Silver Seiko case, the tax authority basically followed the teachings of a precedent in which the court put more weight on the place of manufacture than the place of consumption in determining the source country for taxation. But the District Court deviated from its own decision in the precedent case. This deviation, provoking much criticisms and debates among practitioners and tax experts, caused this case to linger unusually long before the courts: actually for almost 17 years until the Supreme Court finally affirms the lower court decision. This conclusion put an end to the long-lasting arguments on taxes involving royalties.
( Jinzo FUJINO; Reproduced from a LES Japan Newsletter “WINDS from Japan #24”)