Transaction value; royalty payments to the seller; pharmaceuticals

HQ W545331 January 19, 1996 VAL RR:IT:V W545331 IOR CATEGORY: Valuation Matthew T. McGrath, Esq. Barnes, Richardson & Colburn 1819 H Street, N.W. Washington, D.C. 20006 RE: Transaction value; royalty payments to the seller; pharmaceuticals Dear Mr. McGrath: This is in response to your letter dated May 28, 1993 on behalf of your client, Mallinckrodt Medical, Inc. (hereinafter referred to as the “buyer”), a pharmaceutical products manufacturer. In your letter you request a ruling concerning whether certain royalties paid by the buyer to Guerbet S.A. (hereinafter referred to as the “seller”), an unrelated foreign manufacturer and licensor, are included in the transaction value of imported merchandise, under §402(b) of the Tariff Act of 1930, as amended (“TAA”; 19 U.S.C. §1401a). This decision follows a September 14, 1995 meeting between you, representatives of the buyer and members of the Value Branch in the Office of Regulations and Rulings, and your supplemental submission of October 17, 1995. We regret the delay in responding. FACTS: The seller manufactures Ioxaglic Acid (“IOA”), which is covered by patents. The buyer imports IOA from the seller pursuant to a supply agreement dated December 8, 1981, entered into between the buyer and the seller. The parties have also entered into a license agreement dated December 8, 1981, which grants the buyer an exclusive right to manufacture and sell Hexabrix®, and a license for the use of IOA for the sole purpose of the manufacture and sale of Hexabrix®. The License Agreement also provides for the seller to furnish trade secrets, know-how and technical assistance regarding the manufacture and sale of Hexabrix®. License Agreement, Art. I. Under the license agreement the buyer agrees to pay a specific royalty advance and a continuing royalty to the seller, based on a percentage of all net sales of Hexabrix® in the U.S. License Agreement, Arts. III and IV. The License Agreement states that the royalty is paid in consideration for the patent rights, trade secrets, know-how, technology and technical assistance provided by the seller to the buyer, associated with the manufacture of Hexabrix®. License Agreement, Art. IV. The advance and the continuing royalty are due whether the buyer purchases the IOA from the seller or another supplier approved by the seller. License Agreement, Art.V. Article V of the License Agreement provides that the buyer shall purchase the IOA from the seller, or from another licensed manufacturer, as approved by the seller, and that a supply contract covering the buyer’s needs of IOA for purposes of the License Agreement “shall” be executed. As of the date of the last communication with you, the buyer has not purchased IOA from any supplier other than the seller. The License Agreement contains a minimum sales clause, pursuant to which the buyer is required to pay the seller additional royalties representing the difference between the royalties actually paid and the amount of royalties that would have been paid had the net sales reached the minimum required. License Agreement, Art. IV. In the event the seller becomes unable to meet the buyer’s requirements of the IOA, the seller is to grant the buyer a temporary license for the manufacture and use of the IOA for manufacturing Hexabrix®. License Agreement, Art. V. In the event the temporary license provision becomes applicable, the royalty rate payable to the seller shall be increased, and will remain based upon the net sales of Hexabrix®. According to you, this provision has never been utilized. Also you state that the buyer can use the IOA and Hexabrix® for its own purposes that do not involve a sale of Hexabrix®, such as giving away samples, and selling IOA for use as a separation media in centrifuges, without paying a royalty. The IOA Supply Agreement provides that the buyer shall purchase its total requirement of IOA, for purposes of manufacturing Hexabrix®, from the seller. Supply Agreement, Para. 2. The Supply Agreement will remain in force “as long as the license agreement for Hexabrix remains in effect and [the buyer] continues to pay all fees and royalties due thereunder.” Supply Agreement, Para. 6. The buyer takes the position that the subject royalty payments are not dutiable either as royalties or proceeds of subsequent resale, disposal or use. The buyer claims it pays a royalty for the rights obtained from the seller, which payment is separate and apart from the price paid for the IOA. In support of this position, in your October 17, 1995 submission you have provided us with affidavits and exhibits documenting the processing and transformation undergone by the IOA in the U.S. and affidavits indicating that the price paid for the IOA under the supply agreement, not including any royalty amount, provides full and fair compensation for the imported IOA. ISSUE: Whether the royalty payments made by the buyer to the seller are included in the transaction value of the imported merchandise. LAW AND ANALYSIS: For the purpose of this ruling, we assume that transaction value is the proper basis of appraisement. Transaction value, the preferred method of appraisement, is defined by §402(b)(1) of the Tariff Act of 1930, as amended by the Trade Agreements Act of 1979 (TAA, 19 U.S.C. 1401a(b)) as "the price actually paid or payable for the merchandise when sold for exportation to the United States..." plus certain additions specified in §402(b)(1) (A) through (E). Here, two of the five statutory additions are at issue. Sections 402(b)(1)(D) and (E) of the TAA provide for additions to the price actually paid or payable for: (D) 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. (E) the proceeds of any subsequent resale, disposal, or use of the imported merchandise that accrue, directly or indirectly, to the seller. The buyer takes the position that the royalty payments are for the right to manufacture and sell Hexabrix®, and are not paid as a condition of the sale of the IOA. In support of its position that the royalty payments are not included in the transaction value of the imported merchandise, you cite Headquarters Ruling Letters (HRL) 544102 dated August 16, 1988, 544105 dated May 29, 1988, 544129 dated August 31, 1988 and 544351 dated October 29, 1990. In these rulings Customs held that the royalty payments were not dutiable under §402(b)(1)(D). The bases of the holdings were that the payments were not a condition of the sale of the imported merchandise and the payments were for rights that were separate and apart from the right of ownership on payment of the purchase price. One of the factors for determining whether the royalties were not dutiable under §402(b)(1)(D) was whether the royalty payments were calculated on the basis of sales that occurred subsequent to the importation of the merchandise. Customs has since concluded that the method of calculating the royalty--e.g. on the resale price of the goods--is not relevant to determining the dutiability of the royalty payment. See, General Notice on the Dutiability of “Royalty” Payments, at p. 12 (Vol. 27 Cust. Bull. No.6 dated February 10, 1993) (hereinafter referred to as the “General Notice”). In HRL 544436 (C.S.D. 91-6; Vol. 25 Cust. Bull. No.18 dated 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 §402(b)(1)(D). Customs held that these 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 §402(b)(1)(E). Customs subsequently reviewed the Hasbro ruling, soliciting public comment thereon, and published the General Notice, referred to above and commonly known as the “Hasbro II” decision, which incorporated Customs’ analysis of the comments received. Hasbro II upheld the Hasbro ruling and modified it to the extent the subject payments were found to be dutiable as either royalties under §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 identifies three questions, the answers to which assist in determining whether a royalty payment is related to the imported merchandise and is a condition of sale: 1) Was the imported merchandise manufactured under patent? 2) Was the royalty involved in the production or sale of the imported merchandise? 3) Could the importer buy the product without paying the fee? General Notice, pp. 9-12. Your answers to the three questions were provided in the ruling request. With regard to the first question, whether the imported merchandise was manufactured under patent, you respond “yes, but the royalty paid by Mallinckrodt does not compensate the licensor for the patented manufacture of Ioxaglic Acid” (emphasis supplied). In Hasbro II Customs stated that a “yes” answer to this first question requires further examination of the royalty to confirm that the payment is dutiable, citing the SAA in which Congress addressed this point by stating that “royalties and license fees for patents covering processes to manufacture the imported merchandise will generally be dutiable....” SAA at 48. In response to the second question, whether the royalty is involved in the production or sale of the imported merchandise, your response is “no.” You state that the royalty is paid to the seller for valuable rights granted by the seller, and as such is in addition to and separate from the purchase price for the merchandise. According to the language in the license agreement the license is for the right to use the IOA as well as the right to manufacture Hexabrix®. You state that the payment is for the exclusive right to manufacture and sell Hexabrix® in the U.S. and is unrelated to the importation of the “raw material,” the IOA. Nonetheless we find that the royalty is involved in the sale of the imported merchandise because the supply agreement provides that it is only in effect as long as the license agreement is in effect, and there would be no sale for exportation to the importer without the license agreement. In addition, the license agreement provides that the buyer shall purchase IOA from the seller or from another licensed manufacturer approved by the seller and that a supply contract for the buyer’s needs of IOA for purposes of the license agreement “shall” be executed. Thus, the payment of royalties under the license agreement is closely tied to the sale of the imported product. The facts in this case are similar to those which were considered in HRL 545114 dated September 30, 1993. However, in HRL 545114, although the buyer had entered into a supply agreement which required that it purchase the imported ingredient from the seller, under the facts presented there was no indication that the existence of the supply agreement was conditioned upon the existence of the license agreement. Your statements and supporting evidence that the amount paid for the IOA under the supply agreement, not including any royalty, is full and fair compensation for the IOA, does not overcome our finding that due to the language of the supply agreement and the license agreement, the royalty is involved in the sale of the IOA. Further, under 19 U.S.C. 402(b), whether a payment constitutes full and fair compensation for imported merchandise, is not a factor applied in determining the appraised value of the subject merchandise. In response to the third question, whether the buyer could purchase the product without paying the fee, your response is “yes.” According to the Hasbro II analysis, this third question goes to the heart of whether a payment is considered a condition of sale. You take the position that the answer to this question is “yes” because the buyer imports and uses IOA without incurring any royalty, until it sells Hexabrix® in the U.S. We disagree. According to the language of the supply agreement, the supply agreement terminates upon the termination of the license agreement. Therefore, without the license agreement, there would be no sale for exportation of IOA to the importer. Secondly, the supply agreement requires that the importer purchase all of its requirement of IOA from the seller. We find that for these reasons, the importer is unable to purchase the IOA for the manufacture of Hexabrix® without paying the fee, and this third question is answered with a “no.” In support of the position that the royalty is not a condition of the sale of the IOA, you argue that the royalty does not apply to the buyer’s purchase of IOA for the ultimate sale of the IOA for use as a separation media in centrifuges. Even if the IOA as a separation media were sold pursuant to the same supply agreement, insufficient evidence has been provided to establish that the amount sold is anything but a de minimis amount, as is the amount of IOA used by the buyer in giving away samples of Hexabrix®. Therefore, this is not determinative of the dutiable status of the royalty at issue. You also set forth that the IOA undergoes substantial processing and chemical reaction in the U.S. before the Hexabrix® is sold. We find that the processing undergone by the imported merchandise has no bearing on whether the royalty is paid as a condition of the sale of the IOA. See HRL 544991 dated September 13, 1995. In HRL 544991 a royalty paid by a U.S. manufacturer of machines made from parts, to the seller of imported parts (which made up 36% to 52% of the material used in the machines), was found to be paid as a condition of the sale of the imported merchandise. HRL 544991, citing the General Notice, p. 12 (the method of calculating the royalty, i.e., based on the resale price, is not relevant in determining its dutiable status). As in the instant case, in HRL 544991, based on the provisions of the applicable agreements between the parties, payment of the royalties was found to be closely tied to the purchase of the imported parts. The foregoing answers to the three questions posed in Hasbro II demonstrate that the buyer’s royalty payments made in connection with its use in the U.S. of the patented process to manufacture Hexabrix®, constitute dutiable royalties under §402(b)(1)(D) of the TAA. We conclude that because the supply agreement is conditioned on the existence of the license agreement, and the license agreement sets forth the terms of the supply agreement, the importer has not established that the royalty is distinct from the price actually paid or payable for the imported merchandise, or that the royalty was not a condition of the sale of the imported merchandise for exportation to the U.S.  HOLDING: Based on the information provided, the royalty payments made by the buyer to the seller are to be added to the price actually paid or payable for the imported IOA under §402(b)(1)(D) of the TAA. Having reached this conclusion, it is not necessary to address the issue of whether the payments could alternatively be considered proceeds under §402(b)(1)(E) of the TAA. Sincerely, Acting Director International Trade Compliance Division