1. Whether Income Taxes Apply in Regards to Damages

 

  1. Issues

Since the Corporate Tax Act is based on the theory of a net increase in assets (Article 15 of the Corporate Tax Act), damages compensation or default payments received by a corporation are treated as gross income if they result in an increase in net assets.  On the other hand, income tax is based on the theory of the source of income, and income other than the types prescribed by law is excluded from the scope of taxable income.  As a result, the taxation of damages compensation is an issue only in the case of income tax (in particular, whether damages compensation constitutes miscellaneous income).

[Income Tax Article 21 (Miscellaneous Income)]

Miscellaneous income shall mean income other than interest income, dividend income, business income, wage income, pension income, retirement income and transfer income, as prescribed in each of the following subparagraphs.

10. Default payments or damages received as a result of breach or termination of contract

  1. Requirements (Income Tax Act Enforcement Decree Article 41)

The requirements for damages compensation to constitute miscellaneous income are as follows: (a) damages compensation relates to property rights; (b) there is an existing contract; (c) there is a failure to perform an obligation; and (d) the compensation is of damages that exceed the amount originally payable under the terms of the relevant contract.

  1. Review of Individual Cases

 

  1. Statutory default damages received pursuant to a judgment or an order of a court based on a breach or termination of contract are taxed as miscellaneous income [Income Tax Act General Provisions (16-0…2)]. However, if a court orders the payment of money pursuant to a judgment or otherwise based on a failure to perform a contractual monetary obligation, out of the monies paid in addition to the principal amount only the default damages that arise after the due date for performance constitute miscellaneous income prescribed by Article 21(1)(x) of the Income Tax Act, and contractually agreed interest arising under the terms of the relevant contract and statutory interest arising under the relevant statutory provisions prior to the due date for performance are distinguished from damages compensation and may be taxed as interest income only if and to the extent that they are “in the nature of consideration for the use of money” (Supreme Court decision on case no. 96Nu16315 rendered on September 5, 1997).
  2. Compensation received for damage other than property damage, including bodily, reputational or mental damage, and amounts received as consolation money, are excluded from miscellaneous income [Income Tax Act General Provisions (21-0…1 Clause 5)]. Therefore, it may be possible to exempt the payor from his/her tax withholding obligation and the recipient from his/her income tax payment obligation by characterizing the amount paid/received as “consolation money” to the extent possible in adjusting the amount to be paid/received as damages compensation.
  3. Damages compensation resulting from tort under Article 750 of the Civil Code, which does not assume the existence of a contractual relationship between the parties, is excluded from miscellaneous income.
  4. The portion of the damages compensation paid to transfer from the breaching party to the injured party the actual damages resulting from a default in contractual performance is excluded from miscellaneous income since there is no increase in net assets, and only the portion of the damages compensation that exceeds the damages corresponding to the original contractually agreed payment amount constitutes miscellaneous income.  In this regard, in a case where the seller in a real estate sale and purchase transaction kept the contractual deposit amount in the process of terminating the real estate sale and purchase contract by mutual agreement with the buyer, the Supreme Court held that if the buyer was at fault and the seller spent a considerable amount of expenses to perform the contract, but it is not easy to prove the specific damages amount and, as a result, the real estate sale and purchase contract was terminated by mutual agreement while allowing the seller to keep the contractual deposit, then it is reasonable to view it as damages compensation paid to transfer [to the buyer] the actual damages incurred by the seller rather than constituting miscellaneous income as “money paid as compensation for damages that exceed the damages corresponding to the original contractually agreed payment amount” (Supreme Court decision on case no. 2002Du3942 rendered on April 9, 2004).

 

  1. Withholding Obligation at the Time of Payment of Damages Compensation

In principle, damages compensation that constitutes miscellaneous income is subject to tax withholding (Article 127(1)(vi) of the Income Tax Act; Supreme Court decision on case no. 94Da3070 rendered on May 24, 1994).  However, default payments or damages compensation under Article 21(1)(x) of the Income Tax Act which are substituted with payment (or forfeiture) of a contractual deposit is not subject to tax withholding (Article 127(1)(vi)(B) of the Income Tax Act).

  1. Whether Damages Compensation is Included in Real Estate Transfer Price (passive)

Since damages resulting from a delay in payment of a real estate sale price are not included in the real estate transfer price (Supreme Court decision on case no. 92Nu19613 rendered on July 27, 1993) and constitutes separate miscellaneous income, the seller is required to withhold income tax on the damages resulting from its delay in payment of the real estate sale price.

  1. Whether Damages are Subject to Value Added Tax (passive)

Since it is difficult to recognize a relationship of consideration between the supply of goods or services and damages compensation, damages compensation is not subject to the assessment of value added tax (Article 13(1) of the Value Added Tax Act; Article 48(1) of the Enforcement Decree of the Value Added Tax Act).