Does the U.S.-Korea Tax Treaty Offer Relief from Double Taxation of Income Received from U.S. Patents?

The major purpose of an income tax treaty is to mitigate international double taxation through tax reduction or exemptions on certain types of income derived by residents of one treaty country from sources within the other treaty country. Recently, the Korean Supreme Court determined that income derived by a U.S. patent holder has its source in Korea and is subject to Korean withholding tax. Under U.S. tax law, income received from a U.S. patent is typically U.S. source income for U.S. taxation purposes. The holding of the Korean Supreme Court means that income sourced from a U.S. patent will likely be taxed in both the United States and Korea.

The Korean National Tax Service (“NTS”) has historically taken the position that royalty income derived  by a U.S. patent holder has its source in Korea, and is subject to Korean withholding tax. The applicable withholding rate under Korean law is 20 percent. However, the withholding rate may be reduced to 15 percent under the U.S.-Korea Income Tax Treaty. The issue of whether income derived from a U.S. patent was first litigated before the Supreme Court in 1992. In that year, the Korean Supreme Court determined that the royalty income received by a U.S.-based oil company from Hyundai Motor Co., a Korean manufacturer, was not sourced in Korea and was not subject to Korean withholding tax. In the aforementioned case, a U.S. company held a U.S. patent that was not registered in Korea. Hyundai Motors made use of the material protected by the U.S. patent in the production of its vehicles. These vehicles were sold in the United States by Hyundai Motor America Co., a subsidiary of Hyundai Motor Co.

On September 18, 2025, the Korean Supreme Court issued the en banc decision which held the “place of use” of a patent no longer determines the taxation of income derived from a patent. The 2025 Korean Supreme Court decision is important for U.S. patent holders because the decision implies that now the NTS and the U.S. Internal Revenue Service (“IRS”) could both tax income derived from U.S. patents. This article discusses if the U.S.-Korea income tax treaty can abrogate (override or modify) the source rule for U.S. foreign tax credits to offer relief from double taxation of income derived from U.S. patents.

Overview of Foreign Tax Credit Rules

U.S. taxpayers are generally subject to U.S. tax on their worldwide income, but may be provided a tax credit for foreign taxes paid or accrued. The main purpose of the foreign tax credit is to mitigate the double taxation of foreign source income that might occur if such income is taxed by both the United States and a foreign country.

Credit Versus Deduction

Taxpayers have the option of deducting foreign income taxes in lieu of taking a credit.  Generally, a credit is more advantageous than a deduction because it reduces a person’s tax dollar for dollar as opposed to a reduction in taxable income. For example, if a domestic corporation is subject to U.S. tax at a 21% rate, deducting $1 of foreign income taxes saves only $0.21 in taxes, compared to $1 in tax savings from a credit.

The choice between a deduction and a credit applies to all foreign income taxes paid or accrued during the year. In other words, a taxpayer cannot claim a credit for a portion of the foreign income taxes incurred in a taxable year and deduction for the remaining foreign income taxes. However, taxpayers can change their election from year to year. In addition, taxpayers can change their election any time before the expiration of the statute of limitations, which is 10 years in the case of a refund claim based on the foreign tax credit.

Who Can Claim a Foreign Credit

Taxpayers entitled to claim a foreign tax credit primarily include U.S. citizens, resident aliens, and domestic corporations.  A U.S. citizen, resident alien or domestic corporation that is a partner in a partnership may claim a credit for a proportionate share of the creditable foreign taxes incurred by the partnership. The rules applicable to partners in a partnership also apply to shareholders in an S corporation.

Creditable Foreign Income Taxes

The foreign tax credit is intended to mitigate international double taxation of U.S. person’s foreign-source income. Therefore, the United States restricts the credit to foreign income taxes that duplicate the U.S. income tax against which the credit is taken. Specifically, to be creditable, a levy must satisfy the following two requirements:

1. The levy must be a “tax” paid to a foreign country, a political subdivision of a foreign country, or a U.S. possession, and
2. the predominant character of the tax must be that of an income tax in the U.S. sense.

If a foreign tax satisfies the first requirement but not the second, the levy may still be creditable if the tax is imposed “in lieu of” an income tax. The most common in-lieu-of-tax is the flat withholding tax that countries routinely impose on the gross amount on royalty payments. Withholding is required because it is the only sure way to collect the tax. A withholding tax generally does not qualify as an income tax because no deductions are allowed in computing the tax base.  A withholding tax is creditable, however, if it is imposed in lieu of the foreign country’s general tax, which is generally the case. See Treas. Reg. Section 1.903-1(b)(3), Example 2.

Sourcing Rules Applicable to Claim a Foreign Tax Credit

The United States taxes U.S. persons on all their income, from whatever source derived. Therefore, the source of income generally has no effect on the computation of a U.S. person’s taxable income. However, the source of income is essential to the calculation of the foreign tax credit. Because the foreign tax credit is intended to limit or mitigate double taxation of foreign-source income, the credit is generally accorded only with respect to foreign taxes on foreign-source income and is primarily applicable to U.S. persons.

The source rules for gross income are organized categories of income, such as interest, dividends, personal services, rentals, royalties, and gains from disposition of property. See IRC Sections 861 and 862. The first step in the sourcing process is to determine the applicable statutory category a U.S. patent holder holds. A patent holder typically grants a licensee the right to use, manufacture, or sell a patented invention in exchange for payments which for U.S. tax purposes is often referred to as royalty income. In essence, this means that a U.S. patent holder receives royalty payments for purposes of the sourcing rules. The source of royalty income is determined by the place where the patent is located. See IRC Section 861(a) and IRC Section 862(a)(4). Accordingly, the source of royalty income for intangible property such as patents, depends on where the rights are used, which is generally the country in which the patent derives its legal protection. In cases where U.S. patent holders license patents for use in Korea, the income the patent holder receives is typically U.S. source. In cases involving patent infringement suits recovering damages in Korea from U.S. patents is also generally U.S. source under the U.S. sourcing rules. For U.S. tax purposes, U.S. source income is not generally creditable for U.S. foreign tax credit. See Rev.Rul. 84-78, 1984-1 CB 173. There is a key exception to this general rule when a U.S. tax treaty allows for U.S. source income to be re-sourced as foreign income.

Claiming a Deduction for the Foreign Withholding Tax

As indicated above, if a foreign tax is not credible for purposes of the foreign tax credit rules, a U.S. taxpayer may claim a deduction instead of a foreign tax credit. Internal Revenue Code Section 162 provides the general rule for deducting “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” This provides a broader framework for business deductions, including certain taxes. A deduction for foreign taxes is specifically discussed in Section 164 of the Internal Revenue Code. Section 164(f)(h)(3) specifically permits a deduction of foreign taxes imposed by the authority of a foreign country as long as the tax was incurred in a trade or business. In most cases, a U.S. patent holder can claim a deduction for foreign taxes that are not credible because of the U.S. sourcing rules. However, claiming a deduction in connection with a foreign tax is not nearly as beneficial as a foreign tax credit. The next subsection of this article will discuss the U.S. sourcing rules in more detail and if a treaty can abrogate the U.S. sourcing rules for purposes of claiming a foreign tax credit.

U.S.-Korea Income Tax Treaty and the Foreign Tax Credit Sourcing Rules

Some bilateral tax treaties that the United States has entered into with foreign countries permits the reclassification of income that is considered U.S. sourced under the U.S. Internal Revenue Code as foreign sourced for purposes of the U.S. foreign tax credit. This mechanism is primarily used to prevent double taxation when the U.S. and a treaty country have different rules for determining the source of income. For example, the Internal Revenue Code may source certain income as domestic while under the relevant foreign country’s tax law may characterize the same income as domestic. In such a situation, both countries could tax the same income and a foreign tax credit would not be available to avoid double taxation.

Some tax treaties provide a “resourcing” rule. In such a case, a U.S. taxpayer can take a treaty position to treat the item of U.S.-sourced income as foreign sourced for U.S. foreign tax credit purposes. Such a position would permit the U.S. taxpayer to include the “resourced” income for purposes of qualifying for a foreign tax credit.

For example, Article 24(2)(a) of the U.S.-U.K. Income Tax Treaty allows for resourcing of income that the U.K. is allowed to tax. Article 24(2)(a) provides “For purposes of applying paragraph (1) of this Article [i.e., U.S. allowing a credit]..an item of gross income is determined under the laws of the United States, derived by a resident of the United States that, under this Convention, may be taxed in the United Kingdom shall be deemed to be income from sources in the United Kingdom.

Similar language is included in U.S. tax treaties between China, Canada, Germany, and Japan.

The Convention Between the United States of America and Republic of Korea (hereinafter referred to as the U.S.-Korea Income Tax Treaty) does not contain the same clear and unambiguous language regarding sourcing of income. The remaining portion of this section of this article will discuss how the U.S.-Korea Income Tax Treaty interprets the sourcing and resourcing rules.

As discussed above, income generated from a U.S. patent is treated as royalty income. The U.S.-Korea Income Tax Treaty defines royalties as being derived from copyrights, or rights to produce or reproduce any literary, dramatic, musical, or artistic work, by a resident of one contracting state, as well as royalties received as consideration for the use of, or the right to use, motion picture films including films and tapes used for radio or television broadcasting, may not be taxed by the other Contracting State at a rate of tax which exceeds ten percent of the gross amount of the royalties.

Article 6(3) of the U.S.-Korea Income Tax Treaty discusses sourcing for royalty income, including income from patents. When it comes to the classification of royalty income, Article 6(3) of the treaty provides as follows:

Royalties described in paragraph (4) of Article 14 (Royalties) for the use of, or the right to use, property (other than as provided in paragraph (5) with respect to ships or aircraft) described in such paragraph shall be treated as income from sources within one of the Contracting States only if paid for the use of, or the right to use, such property within that Contracting State. [Emphasis added].

According to this provision, “royalties .. for the use of, or the right to use” patents should be considered as sourced in one of the contracting states in which the patents are “used” or to be “used.” Against this backdrop, for purposes of Korean tax, the issue narrows down to whether a U.S. patent is “used or to be used” within Korea or the United States under the fact pattern in question. The term “place of use” is not clearly defined in the treaty. In the past, Korean law has interpreted the term “place of use” of a patent based on the principle of territoriality as referring to the exercise of rights conferred through registration within the patent’s exclusive effect. Based on this interpretation, the Korean Supreme Court held that patents unregistered in Korea could not be exercised or infringed in Korea, and thus the “use” or “payment for use” of such patents in Korea could not be contemplated. See Korean Supreme Court decision 91Nu6887, dated May 1992, Korean Supreme Court decision 2005Du8621, dated September 7, 2007.

In an effort to overturn this interpretation, the Korean government amended Korean tax law in 2008 to broaden the definition of patent “use.” The new law includes where manufacturing methods, technologies, or information contained in unregistered intellectual property are actually implemented or used in Korea, thereby allowing royalties paid for such rights to be treated as Korean source income. Based on this amendment, the Korean tax authorities impose withholding tax on royalties paid to U.S. entities for patents not registered in Korea, as will take place in this case. On September 18, 2025, the Korean Supreme Court overturned its longstanding interpretation of the term “place of use” for patents under the U.S.-Korea Income Tax Treaty, marking a significant change in Korean law. The Korean Supreme Court held that the actual use of patented technology in Korea, regardless of the patent’s domestic registration status, constitutes “use” for purposes of determining Korean source income under both Korean law and the treaty. The Korean Supreme Court has clearly abrogated the sourcing rules.

Although the Korean Supreme Court has changed the definition of the sourcing rules for purposes of Korean law, it has not overridden the U.S.-Korea Income Tax Treaty. As of this date, there is no Internal Revenue Code provision, case law, Treasury Regulation, Revenue Ruling, or IRS guidance as to if there will be any changes in U.S. sourcing laws in response to the Korean Supreme Court’s “place of use” interpretation for purposes of the treaty. Although the Korean Supreme Court’s 2025 decision will result in a number of cases of the double taxation of U.S. patented technology, as drafted, the U.S.-Korea Income Tax Treaty and its technical explanation do not contain an express provision permitting the resourcing of income for purposes of claiming a foreign tax credit. As a matter of fact, Article 6 utilizes much of the same sourcing rules discussed above for purposes of determining the validity of a foreign tax credit in the context of royalty income received from a patent.

Although Article 6 of the U.S.-Korea Income Tax Treaty does not offer relief from the U.S. sourcing rules for U.S. foreign tax credits, Article 5 of the treaty is less clear on this topic. The Technical Explanations for Article 5 of the U.S.-Korea Income Tax Treaty indicates that U.S. holders of U.S. patents that derive income from Korea may have the ability to claim for foreign tax credit for the withholding tax. This provision states in relevant part that for purposes of the U.S. foreign tax credit, an item of gross income of a U.S. resident that “may be taxed” in Korea under the terms of the treaty is treated as gross income from sources within Korea. This so-called resourcing rule is significant because it appears to override the normal U.S. domestic sourcing rules (found in the Internal Revenue Code, primarily Section 861-865) to ensure that a U.S. taxpayer can claim a foreign tax credit for Korean taxes paid on income that U.S. Internal Revenue Code might otherwise treat as U.S.-source. The Technical Explanations for Article 5 also states the United States agrees to allow a United States citizen or resident as a credit against the United States tax the appropriate amount of Korean tax in accordance with the provisions and subject to the limitations of the law of the United States (as it may be amended from time to time without changing the principles of paragraph (1)).

However, the precise meaning of the above discussed language contained in the Technical Explanations is unclear. The Technical Explanations clarifies that the treaty permits the resourcing income. But, the Technical Explanations for Article 5 of the treaty conflicts between U.S. sourcing rules for purposes of the U.S. foreign tax credit limitation and the treaty clearly provides that conflicts are resolved in favor of U.S. law. The treaty clarifies that conflicts are resolved in favor of U.S. law by stating “a credit against the United States tax … are subject to the limitations of the law of the United States law.” Since Article 5 is subject to the limitations of law, one interpretation could be that Article 5 does not negate the U.S. sourcing rules. In the alternative, it could be argued that such a broad interpretation of Article 5 would negate the general purpose of the resourcing provision of the treaty. Given the ambiguity of Article 5, any case involving a U.S. patent that derives Korean source income that is subject to Korea withholding taxes should be carefully analyzed to determine if Article 5 of the treaty can be utilized to prevent double taxation.

Conclusion

The major purpose of an income tax treaty is to mitigate international double taxation through tax reductions or exemptions on certain types of income derived by residents of one treaty country from sources within the other treaty country. The U.S.-Korea Income Tax Treaty is almost 45 years old. At the time the treaty was negotiated, the treaty was designed to encourage capital contribution into Korea. Since that time, some of the largest technology companies in the world have emerged in Korea. Unfortunately, the U.S.-Korea Income Tax Treaty has failed to develop with Korea’s economy. Korean law. With the recent change in Korean law regarding the taxation of foreign registered patents, U.S. patent holders conducting business in Korea will face challenges to avoid double taxation. U.S. patent holders deriving income from Korean sources should consult with a qualified international attorney to determine how to best plan in this changing global market.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony, based in San Francisco, California, maintains a national and international tax practice, focusing on most areas of federal income tax, state income tax, and federal gift and estate tax law. Anthony is the author of a number of published articles addressing cross-border taxation. Anthony also frequently provides continuing educational programs regarding various international tax topics.

Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.