Dutiability of royalty payments made by importer to related manufacturer for rights to patented process and associated trade secrets used in manufacture of finished product in United States.

HQ W544742 June 6, 1995 VAL CO:R:C:V W544742 ER CATEGORY: Valuation John M. Peterson, Esq. Neville, Peterson & Williams 39 Broadway New York, New York 10006 RE: Dutiability of royalty payments made by importer to related manufacturer for rights to patented process and associated trade secrets used in manufacture of finished product in United States. Dear Mr. Peterson: This is in response to your letters dated June 13, 1991, September 28, 1993 and April 25, 1994, on behalf of your client, Rhone Poulenc Inc. (hereinafter referred to as "RPI"), in which you request a ruling concerning whether certain royalties paid by RPI to a related foreign company, Rhone Poulenc Chimi (hereinafter referred to as "RPC"), are included in the dutiable transaction value of an imported chemical which RPI purchases from the licensor, RPC. We regret the delay in responding. FACTS: RPC, headquartered in France, is the developer and owner of proprietary technology used to manufacture a line of chemicals known by the trade name "Tolonates". This technology, and various Tolonate chemicals made therewith, are covered by numerous French and United States patents owned by RPC. Tolonate chemicals are used as additives in a range of paints and coatings. RPI, located in Texas, manufactures Tolonate chemicals, using the patented processes and associated trade secrets owned by RPC. RPC and RPI are "related" parties, within the meaning of section 402(g)(1) of the Tariff Act of 1930, as amended by the Trade Agreements Act of 1979 (19 U.S.C.§ 1401a (g)(1); TAA. RPC sells the imported product, chemical hexamethylene diisocyanate (hereinafter referred to as "HMDI"), to RPT. HMDI is used in the manufacture of Tolonate chemicals, and for other purposes. By written agreement in 1989, RPC gave to RPT the sole and exclusive license to use the Tolonate technology in the United States, and to manufacture, use, and sell Tolonate chemicals in the United States. In the agreement, the Tolonate processes and products are collectively referred to as the "Licensed Invention". RPT pays a royalty for the use of the Licensed Invention. A copy of the Technology License Agreement was submitted with the ruling request. The Agreement provides that: Royalty payments are made in exchange for the licensing and use of certain intellectual property rights (patents and trade secrets); Liability for royalty payments under the Agreement does not accrue until after the sale in the United States of Tolonate chemicals; Royalty payments made under the Agreement are calculated on the basis of the "gross margin" realized by RPI on the sale in the United States of Tolonate chemicals. The gross margin excludes the cost or value incurred by the licensee of any imported HMDI which might be used in the production of the Tolonate chemicals; Periodic minimum royalty payments are specified in the Agreement, which payments must be made without respect to whether any HMDI is imported or whether any Tolonate chemicals are manufactured or sold during the period in question; RPI must make royalty payments under the Agreement even if it produces Tolonate chemicals with the use of HMDI sourced from a supplier other than RPC; and RPI is free to purchase HMDI from RPC for any purpose, without incurring liability for royalties under the Agreement. RPI claims to purchase HMDI from RPC at an "arm’s length", freely negotiated price. No substantiating information was presented to Customs in support of this claim. ISSUE: Whether the payments made by RPT to RPC in exchange for the right to use patented processes and associated trade secrets in the manufacture of Tolonate chemicals in the United States are to be included in the transaction value of the imported merchandise as a royalty under section 402(b)(1)(D) or as a proceed of subsequent resale, disposal or use under section 402(b)(1)(E) of the Tariff Act of 1930, as amended. LAW AND ANALYSIS: For purposes of this ruling, we assume that transaction value is the proper basis of appraisement and that the "related" party status, within the meaning of section 402 (g) (1) of the TAA (19 U.S. C. 1401 a (g) (1)), does not influence the price actually paid or payable, as set forth in section 402 (b) (2) (B) of the TAA (19 U.S. C. 1401 a (b)(2)(B)). Under this assumption, the transfer price between the RPT and RPC is acceptable for transaction value providing it meets one of the tests set out in section 402 (b) (2) It should be noted that in view of the fact that additional payments in the form of royalties are paid by the buyer to its related seller, Customs may closely scrutinize whether these tests are met and whether appraisement under transaction value is acceptable. Transaction value, the preferred method of appraisement is defined in section 402 (b) (1) of the TAA as the "price actually paid or payable for the merchandise", plus five enumerated statutory additions. Two of the statutory additions are at issue here: sections 402 (b) (1) (D) and (E) of the TAA which provide for additions to the price actually paid or payable 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; and the proceeds of any subsequent resale, disposal or use of the imported merchandise that accrue, directly or indirectly, to the seller. RPI contends that the royalty payments it makes to RPC are not dutiable under either section 402 (b) (1) (D) or section 402 (b) (1) (E). RPI characterizes the payments made under the Agreement as bona fide royalties which relate to intellectual property rights, which rights can be distinguished from the imported goods. These property rights, RPI contends, include rights created and protected by law (patents) and rights which are not created by law (trade secrets). The Statement of Administrative Action ("SAA"), adopted by Congress with the passage of the TAA, explains that "[a]dditions 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. " See, C. S.D. 92—12 (Vol. 26 Cust. Bull. No. 18, published as HRL 544546 dated June 19, 1991) quoting from Customs Blue Book, 10/81, at p. 48. In this case, the royalties in question are paid by the buyer to the seller. In such circumstances, the SAA provides that an addition will be made "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.” Based on a review of the Agreement and the arguments presented, we believe that RPI has met this burden. Although no purchase agreement relating to the imported HMDI was submitted, for purposes of this ruling we assume that any such agreement does not contain any language which warrants a different result. By the Agreement terms, RPI may purchase the HMDI from RPC without payment of any royalty or license fee. RPT is also free to source HMDI from another supplier. The event that triggers
liability for a royalty, in excess of the minimum periodic payments, is RPT's sale in the United States of the finished product, the Tolonate chemicals. Because the imported HMDI is not the product produced by the patented processes and trade secrets being transferred, the value of the intangible rights at issue here
is readily distinguishable from the value of the imported goods. Nor are the royalty payments made under the Agreement a "condition" of the sale by RPC of HMDI for exportation to the United States. The payments are due even if RPI purchases no HMDI from RPC, sources HMDI from another supplier, or even if it sells no Tolonate chemicals during the period in question. RPI and other companies are free to purchase HMDI from RPC without payment of royalties. In fact, RPI obtains some of its HMDI supplies from a domestic manufacturer. When this domestically—made HMDI is used in the production of the Tolonate chemicals, RPI pays to RPC a technology royalty, in the same manner as when HMDI imported from RPC is used for this purpose. The event which triggers payment of the royalty is not the importation or use of HMDI, but rather is the sale in the United States of the finished products, the Tolonate chemicals. In C. S.D. 91—6 (25 Cust. Bull. 18; published as HRL 544436
(February 4, 1991)), commonly known as the "Hasbro ruling", the importer was required to pay a percentage of the "resale price" to the seller, for the imported merchandise, in addition to the price originally paid. The importer had been paying duties on these additional payments as "royalties" under section 402 (b)(1)(D). Customs held that the payments were not dutiable under this royalty provision, but were "proceeds of subsequent resales" of the imported merchandise that accrued to the seller and, accordingly were dutiable under section 402 (b)(1)(E). Customs subsequently reviewed HRL 544436, soliciting public comment thereon, and published a General Notice in the Customs Bulletin, commonly known as "Hasbro II, which incorporated Customs' analysis of the comments received. (Vol. 27 Cust. Bull No. 6 dated February 10, 1993). Hasbro II upheld the Hasbro ruling and modified it to the extent the subject payments were found to be dutiable as either royalties under section 402 (b) (1) (D) or as proceeds under 402 (b) (1) (E). In Hasbro II Customs set forth a three—part analysis designed to provide importers and Customs with a uniform approach to determining whether certain payments constitute dutiable royalties. The three—part analysis takes the form of the following questions: Is the imported merchandise manufactured under patent? Is the royalty involved in the production or sale of the imported merchandise? Can the importer buy the product without paying the fee? RPI submission pre—dates the Hasbro II decision. Nonetheless, the information contained in its submission is sufficient for Customs to answer the three questions. We also note that the facts in the instant case are similar to those in another recently issued royalty/ proceeds decision, HRL 545114 (September 30, 1993), where Customs ruled that the royalty payments were not dutiable. The response to the first question ("Is the imported merchandise manufactured under patent?”) is yes; however the patents covering the manufacturing process for HMDI are not implicated in the instant agreement. As in HRL 545114 supra, what is produced in the United States under the patent being transferred are the Tolonate chemicals, not the imported HMDI. The second question ("Is the royalty involved in the production or sale of the imported merchandise?”) is answered in the negative. Again, as in HRL 545114 supra, the imported HMDI is not the product produced by the patented processes and trade secrets being transferred. The event which triggers payment of the royalty is not the importation or use of the HMDI, but rather is the sale in the United States of the finished product, the Tolonate chemicals. Furthermore, minimum royalty payments are due even if RPI purchases no HMDI whatsoever from RPC, sources from another supplier, or even if it sells no Tolonate chemicals whatsoever during the Period in question. As set forth in Hasbro II, answers in the negative to questions one and two point to the nondutiability of royalty payments. The third question ("Can the importer buy the product without paying the fee?") goes to the heart of whether a payment is considered a condition of the sale. As already discussed above, RPI may purchase the imported HMDI from RPC or from any other available source without royalty payments becoming due or being related in any way. Hence, the answer to the third question is "yes"
The answers to these three questions demonstrate that the royalty payments, made in connection with RPI's use in the United States of the patented processes and trade secrets to manufacture Tolonate chemicals, do not constitute dutiable royalties under
section 402 (b) (1) (D) of the TAA. The next question is whether the payments constitute proceeds of subsequent resale, disposal or use, pursuant to section 402 (b) (1) (E) of the TAA. Regarding proceeds, the SAA provides the following: Additions for the value of any part of the proceeds of any subsequent resale, disposal or use of the imported merchandise that accrue directly or indirectly to the seller, do not extend to the flow of dividends or other payments from the buyer to the seller that do not directly relate to the imported merchandise. Whether an
addition will be made must be determined on a case—by—case basis depending on the facts of each individual transaction. The ruling request included copies of four United States patents issued to RPC, which describe the role of the imported HMDI in the production process to create the Tolonate chemicals. Unlike the Hasbro rulings supra, where the importer resold the merchandise in its condition as imported, the subject imported la-MDI is neither resold in its condition as imported, nor is its value included in the royalty payment calculations. After importation, substantial processing and manufacturing take place with the use of the imported (and other products). New products are created, the Tolonate chemicals, and it is on the sale of these new products that the royalty payments are based, not on the imported FMDI. Moreover, by the terms of the Agreement, the method of calculating the amount of royalty payments specifically excludes the cost or value incurred by RPI of the imported which might be used in the production of the final product. Here, the royalty payments are made for the right to use a patented process and know how necessary to manufacture the Tolonate chemicals. The royalty payments are based on the sale of the Tolonate chemicals and not upon the imported HMDI; accordingly, the payments made by RPI to RPC are not dutiable as proceeds under section 402 (b) (1) (E) of the TAA. HOLDING: The royalty payments made by RPI for the right to use the patented process and trade secrets necessary to produce the Tolonate chemicals do not qualify as statutory additions to the price actually paid or payable under either section 402 (b) (1) (D) or 402 (b) (1) (E) of the TAA, and are not to be included in determining the transaction value of the subject imported HMDI. In so holding, Customs points out that these determinations are to be made on a case by case basis, taking all relevant circumstances into consideration. Sincerely, John Durant, Director Commercial Rulings Division