Pharmaceutical Development Payments; Royalties; Milestone Payments; Valuation under 19 U.S.C. § 1401a

HQ H137435 January 5, 2012 OT:RR:CTF:VS H137435 BGK CATEGORY: Valuation Acting Field Director U.S. Customs and Border Protection Office of International Trade Regulatory Audit 499 NW 70th Avenue, Suite 201 Plantation, Florida 33317 RE: Pharmaceutical Development Payments; Royalties; Milestone Payments; Valuation under 19 U.S.C. § 1401a Dear Acting Field Director: This is in response to two letters from your office, dated December 6, 2010, and January 7, 2011, requesting internal advice on value issues regarding certain pharmaceutical development, royalty, and milestone payments made by the Importer. In issuing our response, we have given consideration to the submissions from your office, along with a submission from the Importer forwarded to us by your office. We also received additional submissions from the Importer on May 19, 2011, June 2, 2011, and November 14, 2011, and spoke with the Importer on June 2, 2011. FACTS: The Importer, a U.S. based subsidiary of the Parent, is importing the active pharmaceutical ingredient (API), also known as "the Compound,” from its foreign Parent, for a finished drug currently manufactured in the U.S.1 Once in the U.S., excipients are added in order to create separate doses in caplet or tablet form. The chemical formula in the License Agreement for the Compound is the same as the one provided in the drug facts information sheet in the "Prescribing Information" section. Two agreements were signed on December 15, 1998, between the 1 The Importer states that· they will begin using a different supplier for the imported merchandise; however, this ruling will not address this scenario. This is an internal advice request that has arisen in an audit situation. Additionally, no information or contracts have been provided for the new supplier. Parent and the Importer: The License Agreement, and the Development Agreement. On June 29, 2000, the Supply Agreement was signed between the same parties. The Parent has an exclusive license from a foreign third party for “. . . patents and know-how relating to the compound...” The Parent then granted to the Importer, in the License Agreement, "an exclusive license to manufacture, have manufactured, use, have used, distribute, have distributed, sell and have sold to SUBLICENSEES the COMPOUNDS and to develop, have developed, manufacture, have manufactured, use, have used, distribute, have distributed, market, have marketed, sell and have sold the LICENSED PRODUCTS in the TERRITORY under the PATENTS and KNOW-HOW.” The Agreements define "Compound” as “all compounds encompassed by the PATENTS ... and the free acid forms of such compounds and all other pharmaceutically acceptable salts of such free acid forms.” Licensed Products are defined as "human pharmaceutical products in ready-for-sale forms containing the Compound as the sole active ingredient” and “human pharmaceutical products in fixed dose ready-for-sale forms containing the Compound together with one or more other active ingredients.” "Patents” covers all patents listed in the License Agreement and any other patents related to the Compound or Licensed Products. The "Territory” is considered every country in the world. In consideration for these rights, the Importer agreed to pay both milestone payments and a royalty. The milestone payments are (1) a payment due 30 days after the execution of the Agreement, (2) all costs already incurred by the Parent in relation to the product up to the date of execution (minus milestone payments to the foreign third party), (3) a payment due 20 days after the initiation of the first phase Ill clinical trial, (4) a payment due 20 days after the first application is accepted for review by the appropriate health authority for any country, (4) a payment due 20 days after the first launch of the product in any country. The royalty payments are made by the Importer to the Parent at a rate equal to the royalty paid by the Parent to the foreign third party under the Head License Agreement, plus a certain percent mark-up. The Importer must continue to make the payments until the Parent's obligation to the third party expires. The Parent's royalty to the foreign third party is calculated based on a percentage of net sales of the Licensed Products. The License Agreement terminates when the Importer's obligation to make payments to the Parent under the royalties provision of the contract ceases or certain events occur with relation to the feasibility of development, launch, or sale of the Licensed Products, including adverse events relating to the Compound. Additionally, either party may terminate the Agreement should the other party become insolvent or commit a material breach of any of the terms of the Agreement. Under the Development Agreement, the Parent agreed to provide the Importer with services related to the development of "the Product,” as defined in the License Agreement, above. All information and know-how relating to the Product that arises out of the services provided under the agreement is owned by the Importer. The Development Agreement, by its terms, terminates automatically on termination of the License Agreement. In consideration for the development services, the Importer agreed to pay the Parent all costs related to the services plus a markup. The Development Agreement covers general development work, manufacturing development work, and regulatory development work, and “general services.” The general development work is related to the development of the Product, based on a development schedule. The development schedule covers from the initial formulation development, manufacturing, clinical testing, and further development to manufacturing. Manufacturing development includes, but is not limited to, general advice to the Importer in relation to manufacture and formulation, establishing and managing facilities not in the Importer's location, contractor assessment/selection and negotiation of terms, assistance in managing day to day issues as requested, and ongoing technical support. The manufacturing development also includes assisting the Importer in establishing manufacture and packaging of the dosage form at the Importer's facility in the U.S., assisting in the assessment/selection/negotiation for the manufacture and/or packaging of any commercial dose form, developing and maintaining expertise in the process and methodology required to support bulk drug and formulated product manufacture and packaging, and technical support and advice related to the compilation of the international chemistry and pharmacy documents _used for regulatory submissions worldwide and the subsequent maintenance thereof. This also includes maintaining a stock of the bulk drug to meet regulatory requests and development activities. Regulatory development includes, but is not limited to, the preparation of reports, meeting with agencies, preparing briefing documents, and reviewing documentation for the purpose of seeking agency approval to conduct clinical studies; providing regulatory input into the development team; compiling a dossier of the reports for submission to many different countries; acquiring certificates and preparing for inspection; and coordinating the provision of samples. The Development Agreement also includes “General" services like liaising with the foreign third party for disclosure of know-how to the Importer necessary for the development of the Licensed Product, as required by the License Agreement, and using the materials referred to in a provision of the License Agreement, for which payment is also covered by the License Agreement.   The possibility of the execution of a supply agreement in the future is set forth in Article Five of the License Agreement. Article 5.2 of the License Agreement sets the price at which the Importer may purchase the Compound from the Parent, should a supply agreement be entered. The Supply Agreement was signed on June 29, 2000 and begins with the following provision in the Preamble: “Whereas [the Importer] has rights under patents and know-how on a worldwide basis in respect of [the Compound.]” Under the Supply Agreement, the Parent contracted to sell, and the importer contracted to buy its requirements of the Compound at the price set by the License Agreement. The Compound is to be delivered in bulk form either CIF or CIP, depending on if it arrives by sea or air freight, respectively. The Importer must order its actual requirement of the Compound, giving at least twelve months’ notice of the actual delivery date. The Supply Agreement may be terminated upon written notice by either party in the event either party shall "withhold from the other for a period of two months any monies due to the other. . .” under the Supply Agreement. This termination clause is not limited to money due under the Supply Agreement.  ISSUES: I. Whether the payments for development should be included in, or added to the price actually, paid, or payable. II. Whether the milestone payments and/or royalty payments should be included in, or added to, the price actually paid or payable. LAW AND ANALYSIS: I. Development Payments 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; 19 U.S.C. § 1401a). The preferred method of appraisement is transaction value, which is defined as the "price actually paid or payable for the merchandise when sold for exportation to the United States" plus certain statutory additions. 19 U.S.C. § 1401a(b)(1). 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). For the purpose of this internal advice, we have assumed that transaction value is the appropriate basis of appraisement; however, this is not always the case in a related party situation such as this. While research and development (R&D) payments are not specifically listed under the statutory additions to the price actually paid or payable under 19 U.S.C. § 1401a(b)(1)(A)-(E), the development payments may still need to be included as part of the price actually paid or payable. I It is U.S. Customs and Border Protection's (CBP) 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). CBP has ruled that the price actually paid or payable for imported merchandise includes payments for tooling, research and development, testing, as well as payments for samples and prototypes. Headquarters Ruling Letter (HRL) 545998, dated November 13, 1996 (citing HRL 545320, dated February 28, 1995). In this case the development payments are made from the buyer, the Importer, to the seller, the Parent. Therefore, if the development payments relate to the imported merchandise, they will be included as part of the price actually paid or payable. However, 19 U.S.C. § 1401a(b)(3) provides that "[t]he transaction value of imported merchandise does not include any of the following, if identified separately from the price actually paid or payable and from any other cost or other item referred to in Paragraph (1) …” (emphasis added). This includes "[a]ny reasonable cost or charge that is incurred for (i) the construction, erection, assembly, or maintenance of, or the technical assistance provided with respect to, the merchandise after its importation into the United States…” 19 U.S.C. § 1401a(b)(3)(A)(i). Therefore, if the development payments are made for work provided with respect to the Compound after its importation, they will not be included in the price actually paid or payable. In HRL 548331, dated October 31, 2003, R&D expenses were shared, pursuant to an agreement, between a parent and its subsidiaries, and the importer purchased the imported merchandise from another subsidiary, not their parent. CBP held that the importer had not established that the payments made by it to the R&D pool were not indirect payments made by a buyer to or on behalf of a seller of merchandise exported to the United States. CBP also held that the relationship between the pool payments and the imported merchandise were sufficiently direct to conclude that they should. be included in the price actually paid or payable. In making this holding CBP also commented on how much of the pool payments should be included in the price actually paid or payable: CBP is of the understanding that sound corporate accounting can provide the importer with a basis for determining the percentage of R&D pool payments that were devoted to a specific R&D project, which percentage of pool payments are part of the price actually paid or payable for the developed, imported merchandise. The precise determination of the appropriate allocation of research and development payments to specific merchandise imported by [the importer] should be decided on a case-by-case basis. HRL 548331. In HRL 548306, dated July 9, 2003, CBP relied on the Court's comments in Generra regarding the limited resources available to CBP and the frequently complex financial relationships when placing the burden on the importer to prove that payments made to foreign sellers are not part of the price actually paid or payable, in holding that at least part of the R&D payments should be included in the price actually paid or payable. Our office left the determination of the appropriate allocation of the payments to the Port Director and counsel for the importer to resolve. In HRL 546012, dated May 6, 1996, concerning the design and importation of parts for construction of a ladle metallurgy facility in the U.S., CBP discussed the effect of Generra and Chrysler, as well as 19 U.S.C. § 1401a(b)(3), on the dutiability of development payments. CBP held that where the importer had adequately shown that the payments were "completely unrelated" to the imported merchandise or pertained to "construction, assembly, or technical assistance provided with respect to the merchandise after its importation, the payments should not be included as part of the price actually paid or payable. However, where the payments were "not 'completely unrelated” to the imported documents and did not pertain to construction, assembly, or technical assistance concerning the merchandise after importation, it was held to be appropriate to include those payments in the price actually paid or payable. CBP held that payments such as time scheduling, reporting services, basic engineering services related to the layout or arrangement of the merchandise at the U.S. facility, and supervision and technicalassistance related to the installation and erection of the merchandise of the U.S. facility were completely unrelated to the imported merchandise such that these payments could not be dutiable. Payments for services related to both the imported merchandise and its use at the U.S. facility were not considered completely unrelated to the imported merchandise nor pertaining to construction, assembly, or technical assistance concerning the merchandise after importation, and thus were held to be dutiable as part of the price actually paid or payable. These included payments for technical documentation, related to both imported and domestically sourced parts; detail engineering, including mechanical engineering related to components; electrical engineering related to control systems and control diagrams; instrumentation diagrams and equipment; utility supply services for control apparatus etc.; computer engineering services with regard to computer equipment; engineering relating to particular imported components; and software engineering. In HRL 545998, dated November 13, 1996, the importer imported a bulk API from an unrelated company to be manufactured into finished doses in the U.S. (Licensed Product). FDA approval was required for both products. The importer entered into five agreements with respect to the API, including a license agreement, supply agreement, and co-promotion agreement. All agreements besides the supply agreement were between the importer and the licensor, a party related to the seller, and the supply agreement was between the importer and the seller. Under the license agreement the importer agreed to pay the licensor a fixed sum within 60 days of receiving the results of two pre-clinical studies conducted by the licensor on the long­ term toxicity of the imported API. The importer also reimbursed the licensor for the results of carcinogenicity and toxicology studies conducted on the API. All the studies related to the general safety and were necessary in order to obtain FDA approval of the final product. Under the supply agreement, the importer agreed to purchase all of its requirements of the API for five years from the date of the first commercial sale of a Licensed Product. Under the co-promotion agreement, the licensor was permitted to assist the importer in marketing the finished drug in the United States. With regard to the payments for the clinical studies in HRL 545998, the importer argued against dutiability as part of the price actually paid or payable because the studies were conducted for the purpose of obtaining FDA approval of the finished product, which was manufactured in the U.S. The importer equated the payments to marketing payments, much like the argument of the Parent in the situation at issue. CBP, however, held that the payments were related to the imported merchandise and were part of their total payment. Therefore, the payments were dutiable as part of the price actually paid or payable. CBP came to this conclusion because they were essentially research and development costs relating to the product and an important element in the cost of the pharmaceutical, as tests of the API were necessary for the sale of the pharmaceutical. Also, of importance to CBP was the ability of the importer to terminate the license agreement if the results of the studies were unsatisfactory. In discussing the various ways for companies to recoup research and development costs, CBP stated that "[w]hen the seller or its related company passes along these costs to the buyer, they become part of the price actually paid or payable for the imported merchandise, or in the case of royalties, an addition thereto.” HRL 545998. The Importer in this case argues that HRL 545998 should be distinguished because the tests were pre-clinical studies on the API, whereas the tests in the situation at issue are clinical studies on the finished goods. In addition, the Importer argues the payments under the Development Agreement are not dutiable because they are payments for services that the Parent will provide to assist the Importer in future sales of the Licenses Product that the Importer will manufacture, and as such are more similar to the co-promotion payment in HRL 545998. The co-promotion payments in HRL 545998 resulteddirectly from the licensor's marketing and promotion efforts with respect to the finished drug, not th