Internal Advice, Focused Assessment Program, Royalty Payments

HQ H128018 April 6, 2011 OT:RR:CTF:VS H128018 BGK CATEGORY: Valuation Field Director Regulatory Audit Division U.S. Customs and Border Protection 1100 Raymond Blvd 4th Floor, Suite 402 Newark, New Jersey 07102 RE: Internal Advice, Focused Assessment Program, Royalty Payments Dear Field Director: This is in response to a letter forwarded from your office on October 15, 2010, requesting internal advice on behalf of [U.S. Company], regarding the dutiability of certain royalty payments. In issuing our response, we have given consideration to submissions on behalf of [U.S. Company], dated July 28, 2010 and July 27, 2010, as well as a submission from your office, dated December 7, 2010. Due to the confidential nature of the license agreements at issue, the name of the company has been withheld. FACTS: [U.S. Company] was the subject of a Focused Assessment conducted by your office. This internal advice was requested because the Pre-Assessment Survey Report (PAS) contained the conclusion that certain royalty payments made to [U.S. Company’s] parent company, [the Parent] were dutiable. [U.S. Company] disagrees. There are royalty payments made under four licensing agreements between [U.S. Company] and [the Parent] at issue. The licenses cover the technical know-how for manufacturing certain chemicals and the right to use that know-how in manufacturing the chemicals domestically. Some raw materials for each of these chemicals may be imported. The four agreements include the 1) Methionine Agreement, 2) the Hydrogen Peroxide Agreement, 3) the Isophorone Diisocyanate Agreement (IPDI Agreement), and 4) the Polyesters Agreement. All four agreements contain entirety clauses. A. Methionine Agreement The Methionine Agreement was signed on December 1, 1995. The agreement covers the right to “. . . manufacture, have manufactured, use, sell and have sold the Products of the Agreement” in North America. “Products of the Agreement” refers to both Methionine crystalline and Methionine liquid or dissolved. In consideration for these rights, [U.S. Company] owes [the Parent] a royalty of four percent on the “Net Sales Value” for sales of Methionine to third parties. This payment is due semi-annually. There is no minimum production requirement or minimum royalty requirement. There is also no requirement that [U.S. Company] source any raw materials from [the Parent]. In fact, only two of the ingredients used in the licensed-process are imported: antifoam and calcium stearate, and neither of the ingredients is imported from a related company. B. Hydrogen Peroxide Agreement The Hydrogen Peroxide Agreement was entered into on October 1, 1995, and licenses to [U.S. Company] the “. . . non-exclusive and non-transferable right (without the right to grant sublicenses) to make use of the Subject of the Agreement in the Territory of the Agreement . . ..” “Subject of the Agreement” is defined as “. . . the right to have used and use the Process of Agreement and Plant of Agreement, and to have used and use, have manufactured and manufacture, have sold and sell [hydrogen peroxide].” The Territory of the Agreement is defined as “. . . the U.S.A. with respect to the manufacture of hydrogen peroxide and the U.S.A., Mexico and Canada with respect to the use and sales of hydrogen peroxide.” In consideration for these rights, [U.S. Company] must pay [the Parent] four percent on the “Net Sales Value” for sales of hydrogen peroxide to third parties. The royalty payments are due semi-annually. There is no minimum production requirement or minimum royalty requirement. The Agreement does not contain any obligations regarding the sourcing of the ingredients. Like the Methionine Agreement, only two of the ingredients used in the U.S. production of hydrogen peroxide are imported: tetrabutyl urea and 2-Ethyl Anthraquinone, and neither of these ingredients is imported from a related company. C. Isophorone Diisocyanate (IPDI) Agreement IPDI is covered by the aliphatic isocyanates agreement, which came into force on January 1, 1996. The agreement grants to [U.S. Company] the know-how and “non-exclusive and non-transferable right and licence [sic]” to manufacture the product and to use and sell the product in the NAFTA countries. “The product” is defined as “aliphatic isocyanates and their derivatives containing 100% of aliphatic isocyanates” [hereinafter IPDI]. [the Parent] maintains the right of quality control over the product produced by [U.S. Company] using the licensed know-how and process, in addition to the right to stop the sale of product that does not meet the specifications. The license also covers the right to use [the Parent]’s trademarks in the sale and marketing of IPDI. The royalty owed to [the Parent] is one to two percent of a formula derived from the multiplication of the aggregate quantity of the product manufactured by [U.S. Company] in the calendar year and the annual turnover in US dollars, divided by the aggregate quantity sold by [U.S. Company] in the calendar year. [U.S. Company] is obligated to exploit the rights granted under the license and must pay an annual minimum royalty until the royalties total a certain amount. Royalties are due annually. Under the agreement, [U.S. Company] is required to buy 90 percent of their requirement of isophorone (an ingredient in the production of IPDI) from [the Parent] so long as [the Parent] can meet their requirements. This has not been the case, and isophorone has been sourced domestically since 1999. While not required under the agreement, [U.S. Company] does import two other chemical ingredients from [the Parent]: catalyst “A” and catalyst “B”. It is stated that together these constitute less than 3.5 percent of the total variable costs of the IPDI. D. Polyesters Agreement The Polyesters Agreement came into force June 1, 2000, and grants to [U.S. Company] the right to the know-how necessary to produce saturated polyesters (polyesters), along with the non-exclusive and non-transferable right to manufacture (in the U.S. only), use, and sell polyesters in the NAFTA countries. The agreement also grants the right to use the trademarks held by [the Parent] for the product. Like in the IPDI agreement, [the Parent] maintains the right of quality control over the final product. However, unlike the other agreements, [U.S. Company] is required to pay consideration for the right to the know-how, and for the technical assistance required in setting up the U.S. plant. [U.S. Company] also owes a royalty of two percent of the result of the same formula from above (the multiplication of the aggregate quantity of the product manufactured by [U.S. Company] in the calendar year and the annual turnover in US dollars, divided by the aggregate quantity sold by [U.S. Company] in the calendar year). Like the IPDI agreement, [U.S. Company] is obligated to exploit the rights granted under the license, and must pay an annual minimum royalty until royalty payments a certain amount. Royalty payments are due annually. Under the agreement, should the U.S. plant be unable to produce [U.S. Company]’s required quantity of the product, the company is required to purchase 90 percent of its requirement of polyesters from [the Parent] [hereinafter polyesters requirement clause]. However, it was stated by the company in their submission that “No agreement requires [U.S. Company] to purchase saturated polyesters from its parent or any other third party.” The company also stated that at no point has [U.S. Company] ever purchased polyesters from its parent or any other third party. The agreement does not require [U.S. Company] to import any of the raw materials necessary for production, however, some are imported. The statements on the imported chemicals vary. For example, in the submission with the request for internal advice, it was stated that only four chemicals were imported, and none were imported from related companies. These are isophthalic acid, terephthalic acid, hexahydrophthalic anhydride, and solvent naptha. In a submission to your office, it was stated that adipic acid, neopentylglycol, and trimethylolpropane were also imported. Their sources were not provided. It was stated by the company that the imported chemicals (or at least the first four), constitute less than six percent of the variable costs to produce the polyesters. ISSUE: I. Whether the royalty payments are dutiable as part of the price actually paid or payable for the imported merchandise? II. Whether the royalty payments are dutiable as additions to value? LAW AND ANALYSIS: Merchandise imported into the United States is appraised in accordance with section 402 of the Tariff Act of 1930, as amended by the Trade Agreements Act of 1979 (TAA) codified at 19 U.S.C. § 1401a. The preferred method of appraisement under the TAA is transaction value, defined as "the price actually paid or payable for the merchandise when sold for exportation to the United States," plus certain enumerated additions, including "any royalty or license fee related to the imported merchandise that the buyer is required to pay, directly or indirectly, as a condition of the sale of the imported merchandise for exportation to the United States; and the proceeds of any subsequent resale, disposal, or use of the imported merchandise that accrue, directly or indirectly, to the seller." 19 U.S.C. § 1401a(b)(1)(D) and (E). These additions apply only if they are not already included in the price actually paid or payable. For purposes of this ruling, we assume that transaction value is the appropriate method of appraisement. Although we recognize that the parties are related in some situations, this issue has not been raised in the internal advice request and we will not address it in this ruling. With regard to royalties, the Statement of Administrative Action (SAA), which forms part of the legislative history of the TAA, provides in relevant part: Additions for royalties and license fees will be limited to those that the buyer is required to pay, directly or indirectly, as a condition of the sale of the imported merchandise for exportation to the United States. In this regard, royalties and license fees for patents covering processes to manufacture the imported merchandise will generally be dutiable, whereas royalties and license fees paid to third parties for use, in the United States, of copyrights and trademarks related to the imported merchandise, will generally be considered as selling expenses of the buyer and therefore will not be dutiable. However, the dutiable status of royalties and license fees paid by the buyer must be determined on case-by-case basis and will ultimately depend on: (i) whether the buyer was required to pay them as a condition of sale of the imported merchandise for exportation to the United States; and (ii) to whom and under what circumstances they were paid. For example, if the buyer pays a third party for the right to use, in the United States, a trademark or copyright relating to the imported merchandise, and such payment was not a condition of the sale of the merchandise for exportation to the United States, such payment will not be added to the price actually paid or payable. However, if such payment was made by the buyer as a condition of the sale of the merchandise for exportation to the United States, an addition will be made. As a further example, an addition will be made for any royalty or license fee paid by the buyer to the seller, unless the buyer can establish that such payment is distinct from the price actually paid or payable for the imported merchandise, and was not a condition of the sale of the imported merchandise for exportation to the United States. Statement of Administrative Action, H.R. Doc. No. 153, 96 Cong., 1st Sess., Pt II, at 443 – 444 (1979). I. Price Actually Paid or Payable The first issue is whether the royalty payments are included in the price actually paid or payable for the imported raw materials. The “price actually paid or payable” means the total payment (whether direct or indirect, and exclusive of any charges, costs, or expenses incurred for transportation, insurance, and related services incident to the international shipment of the merchandise from the country of exportation to the place of importation in the United States) made, or to be made, for imported merchandise by the buyer to, or for the benefit of, the seller.” 19 U.S.C. § 1401a(b)(4)(A). It is CBP’s position that payments made by the buyer to a party related to the seller are indirect payments made to, or for the benefit of, the seller. All such payments are included in transaction value unless it is established that they were made in exchange for something other than the imported goods. See, Generra Sportswear Company v. United States, 905 F.2d 377(CAFC 1990), and Chrysler Corporation v. United States, 17 CIT 1049 (CIT 1993). The licensor is only the seller in the IPDI situation, and in the yet to be exercised polyesters requirement clause (which will be analyzed separately). Also, under the agreements at issue, the royalty is paid for the intellectual property rights to be able to manufacture and market patented chemicals in the U.S., not for the importation of the patented chemicals. In similar situations CBP has held that the royalties should not be included in the price actually paid or payable for the imported materials/raw ingredients. See Headquarters Ruling Letters (HRL) H024566, dated October 15, 2008; HRL W548649, dated September 15, 2006 (citing HRL 545951, dated February 12, 1988; and HRL 546660, dated June 23, 1999); and HRL H100056, dated November 15, 2010. Although in a few of the prior cases, this decision was based in part on the fact that the costs of the imported materials were backed out of the royalty’s formula, CBP has held that this factor is not determinative. See HRL W548649. Where, under the agreement, the royalty is clearly being paid for the use of intellectual property for domestic manufacturing and/or marketing of products, CBP has held that the royalty is not part of the price actually paid or payable. See HRL H024566, and HRL W548649. In HRL 545380, dated March 30, 1995, a royalty was owed from the buyer to the seller under a license agreement which provided for the license of technical information and know-how not just for the U.S. manufacturing process, but also for the technical information and know-how for the imported components. This is distinguishable from the situation at issue because in the case at issue the technical information and know-how is only provided for the U.S. manufacturing process and finished products, not the imported components, except in the case of the polyesters requirement clause. In the case of the polyesters requirement clause, where the U.S. company is required to purchase the polyesters if it is unable to produce the required quantity in the U.S., the royalty payment would be going to the seller for the imported polyesters. In addition, the evidence does not clearly establish that the royalty would be unrelated to the imported polyesters. The license is for the technical know-how for polyesters, and under the polyesters requirement clause, that is what would be imported. This would be similar to the situation in HRL 545380 in that the license covers the technical know-how for the imported good. Therefore, should polyesters be imported under the polyesters requirement clause from the parent company, the royalty payments made upon the sale of the polyesters are dutiable as part of the price actually paid or payable, and should be included as such. In the agreements at issue, it is clear that the royalty is being paid for the intellectual property rights to be able to manufacture and market a finished product in the U.S. Therefore, except where the polyesters requirement clause is triggered, the royalty is not part of the price actually paid or payable. However, the royalty may still be part of the transaction value as an addition to value. See 19 U.S.C. § 1401a(b)(1)(D) and (E). II. Additions to Value A royalty payment may be added to the price actually paid or payable as either a royalty payment, pursuant to 19 U.S.C. § 1401a(b)(1)(D), or as a proceed of a subsequent resale, disposal, or use of the imported merchandise, pursuant to 19 U.S.C. § 1401a(b)(1)(E). Under 19 U.S.C. § 1401a(b)(1)(D), an addition to the price actually paid or payable is made for any royalty or license fee "related to the imported merchandise that the buyer is required to pay, directly or indirectly, as a condition of the sale of the imported merchandise for exportation to the United States." As the relevant facts are different among the situations, Methionine and Hydrogen Peroxide will be analyzed separately from IPDI and polyesters. After reviewing the language of the statute along with the legislative history and prior case law, CBP looks to the following three questions as relevant in determining whether the requirements of 19 U.S.C. § 1401a(b)(1)(D) are met: 1) Was the imported merchandise manufactured under patent? 2) Was the royalty involved in the production or sale of the imported merchandise? and 3) Could the importer buy the product without paying the fee? Affirmative answers to questions one and two and a negative answer to question three suggest that the payments are dutiable; negative answers to questions one and two and an affirmative answer to question three suggest that the payments are nondutiable. Question three goes to the heart of whether the payment is considered to be a condition of sale. See General Notice entitled “Dutiability of “Royalty” Payments,” published in the Customs Bulletin and Decisions on February 10, 1993 (the “General Notice”; also sometimes referred to as “Hasbro II”) (stating these questions in discussing previously-issued HRL 544436, dated February 4, 1991). In analyzing these factors, CBP has taken into account certain considerations that flow from the language set forth in the SAA. These include, but are not limited to: (i) the type of intellectual property rights at issue (e.g., patents covering processes to manufacture the imported merchandise will generally be dutiable); (ii) to whom the royalty was paid (e.g., payments to the seller or a party related to the seller are more likely to be dutiable than are payments to an unrelated third party); (iii) whether the purchase of the imported merchandise and the payment of the royalties are inextricably intertwined (e.g., provisions in the same agreement for the purchase of the imported merchandise and the payment of the royalties; license agreements which refer to or provide for the sale of the imported merchandise, or require the buyer's purchase of the merchandise from the seller/licensor; termination of either the purchase or license agreement upon termination of the other, or termination of the purchase agreement due to the failure to pay the royalties); and (iv) payment of the royalties on each and every importation. HRL W548649 (citing HRL 546478, dated February 11, 1998; see also, HRL 546433, dated January 9, 1998; HRL 544991, dated September 13, 1995; and HRL 545951, dated February 12, 1998). Methionine and Hydrogen Peroxide Under both the Methionine and Hydrogen Peroxide agreements, the chemicals covered by the agreement are never imported. The agreements cover the rights to the technical know-how for manufacturing the named chemical in the U.S. In both cases the royalty is calculated based on a percent of the net sales of the finished chemical to third parties, and is paid semi-annually. Neither agreement covers anything regarding the sourcing of the raw materials necessary to manufacture the chemicals in the U.S., and the company is free to source all materials domest