Transaction value; Related buyer and seller; Royalties; Research and Development; Import and Export Commissions

HQ W548649 September 5, 2006 RR:CTF:VS 548649 GG CATEGORY: Valuation Mr. R. Keith Richard Field Director Regulatory Audit Division U.S. Customs and Border Protection 1901 Crossbeam Drive Charlotte, NC 28217 RE: Transaction value; Related buyer and seller; Royalties; Research and Development; Import and Export Commissions Dear Mr. Richard: This is in response to your internal advice request dated February 25, 2005, which raises certain appraisement issues concerning Company A. The issues emerge as a result of a focused assessment of Company A conducted by U.S. Customs and Border Protection’s (“CBP”) Charlotte Field Office of the Regulatory Audit Division. The focused assessment examined transactions that occurred during the 2002 calendar year. Our response takes into account the comments of Company A’s counsel, Barnes Richardson & Colburn, in letters dated May 3, 2004 and November 16, 2005. We grant Company A’s request that its name and certain business sensitive information be kept confidential. FACTS: Company A is a wholly owned subsidiary of Company B, a Swiss Company. It has five divisions: Textile, Leather & Paper Chemicals; Pigments & Additives; Masterbatches; Functional Chemicals; and Life Sciences & Electronic Chemicals. Company A imports and manufactures a wide range of chemicals for various industrial applications. For example, Company A makes pigments for paints and lacquers and plastics, and supplies special chemicals and dyes for the textile, leather and paper industries. Company A sources over XX% of its imported merchandise from related affiliates, including its parent company, Company B. In addition to paying for the imported merchandise, Company A also makes royalty and export and import commission payments to Company B. Company B in turn pays Company A for research and development (R&D) expenses that Company A incurs on behalf of Company B. These various payments are the focus of this internal advice request. The facts surrounding each category are set forth below. Royalties Company A submitted a letter dated May 3, 2004 to the Charlotte Regulatory Audit Division in response to a request for information about the royalty payments. A copy of the License Agreement between Company B and Company A, entered into on July 1, 1995, and amended and restated on July 1, 1997, was enclosed. The letter noted that there are no sales agreements between Company A and its foreign suppliers. Relevant sections of the License Agreement are as follows: ARTICLE 1: DEFINITIONS 1.01 “Industrial Chemicals” means all chemical compounds and products made therefrom including but not limited to: textile dyes ... textile chemicals ... leather dyes and chemicals ... paper dyes and chemicals ... pigments ... additives ... masterbatches ... surfactants ... and fine chemicals ... 1.02 “Proprietary Rights” means all United States patents, including reissues and extensions thereof, patent applications (including divisions continuations and continuations-in-part thereof), inventions and copyrights that pertain to the composition, preparation, manufacture, packaging use or sale of Industrial Chemicals and which are owned by or otherwise subject to license by or at the direction of Company B at the date of this Agreement or which Company B hereafter owns or acquires the right to license. 1.03 “Proprietary Information” means knowledge, expertise, ability and other information, whether published or secret and whether or not patentable, which constitutes know-how applicable to or useful in the composition, preparation, formulation, processing, manufacture, packaging, use or sale of Industrial Chemicals which Company B owns or has the right to license at the date of this Agreement or hereafter develops or acquires the right to license, other than materials or process technology services subject to a cost sharing agreement between the parties. 1.04 “Trademarks” means all trademarks, service marks, trade names, label filings, logos and applications therefor, whether registered or unregistered, which Company B owns or has the right to license at the date of this Agreement or which Company B hereafter acquires. 1.05 “Net Sales” means total gross sales of Company A reduced by cash and trade discounts, returns and allowances actually granted and sales, excise, turnover or similar taxes. However, the term Net Sales shall not include amounts paid to Company A for intermediates purchased for resale from Company B, nor shall it include resales by Company A of Industrial Chemicals purchased by Company A from Company B affiliates or third parties. ARTICLE 2: LICENSE OF PROPRIETARY RIGHTS 2.01 Company B hereby grants or agrees to have granted to Company A, and Company A accepts, the non-exclusive, indivisible and non-transferable license to use any and all of the Proprietary Rights. ARTICLE 3: LICENSE OF PROPRIETARY INFORMATION 3.01 Subject to Section 6.03 hereinafter [no such section in License Agreement], Company B hereby grants or agrees to have granted to Company A, and Company A accepts, a nonexclusive, non-transferable license to use and have used any or all of the Proprietary Information in the composition, formulation, preparation, manufacture, processing, packaging, use or sale of Industrial Chemicals in the United States. ARTICLE 4: LICENSE OF TRADEMARKS 4.01 Company B hereby grants to Company A, and Company A accepts, a non-exclusive, non-transferable license to use the Trademarks in connection with the advertising, promotion, sale and marketing of Industrial Chemicals sold and distributed by Company A in the normal course of its business. ARTICLE 7: COMPENSATION 7.01 In consideration of the licenses granted under Articles 2, 3, 4 and 5 of this Agreement, Company A shall pay to Company B a royalty equal to XX percent (XX%) of Net Sales during the continuation of this License Agreement. The parties may agree to reduce or suspend such royalty on a product category by product category basis during such times as the sustained profitability of the applicable business unit is breakeven or negative due to factors or conditions not related to the Proprietary Rights, Proprietary Information or Trademarks licensed hereunder. The auditors would like clarification of whether the royalties are indirect payments or are statutory additions to the price actually paid or payable for the imported merchandise. Company A’s position is that the royalties are not dutiable because they relate only to manufacturing and marketing activities that take place in the United States, and are not a condition of the sale for export to the United States of the imported merchandise. They become due even in those instances when Company A sells goods that it has manufactured exclusively with domestically sourced intermediates. The auditors question why Company A has continued to pay royalties in those years when the company was unprofitable, instead of taking advantage of the clause in the License Agreement that forgives such payments during lean periods. They posit that this may be an indication that royalty payments are required as a condition to purchase imported merchandise from its parent and affiliated vendors. They also highlight the manner in which the royalties are calculated as a possible indicator that the royalties relate to the imported chemicals, because it appears that they are based on more than just the value added by the U.S. manufacturing. They also question why R&D payments are recorded along with royalty payments in Company A’s royalty expense account. Research and Development Company A conducts R&D at its various divisions in the United States. Pursuant to a Research Agreement entered into between Company A and Company B on July 1, 1995, Company B reimburses Company A for this R&D activity. It does so because Company B owns the rights to any intellectual property or other results of such development efforts. Company B agrees to pay Company A an amount equal to the sum of all budgeted costs and expenses incurred by Company A plus XX% of internal costs and expenses. In 2002, Company A was not fully reimbursed by its parent for R&D expenses incurred. Its records reflect that it received only $XX million of the $XX million that it had spent on R&D. The auditors question whether the non-reimbursed expense is an indirect payment or, alternatively, a statutory addition to the price actually paid or payable for merchandise imported from Company B and related vendors. The more general issue as to whether the research costs are applicable to imported merchandise under the Research Agreement is also raised. Export Commissions Company A pays export commissions to Company B. The auditors were concerned because the only documents relating to the export commissions were an Export Commission Agreement entered into between Company C and Company D on March 6, 1985, and assorted correspondence primarily discussing amendments to the Agreement regarding Canada and Hong Kong. In an internal Company A memorandum dated May 18, 1999, it was explained that the 1985 Agreement remained in effect after a 1995 spin-off and name change. Counsel in its letter dated November 16, 2005 provided a copy of the Certification of Name Change issued by the New York Department of State, which certified that Company C changed its name to Company A on June 30, 1995. The 1985 Export Commission Agreement establishes that Company C [Company A] will pay Company D [Company B] a XX% commission on all sales to “takers outside the United States and Canada” in exchange for Company D [Company B] canvassing orders for Company C [Company A] products from outside the United States and Canada. In addition to their concerns about the Export Commission Agreement being in the name of companies other than Company A and Company B, the auditors expressed concern that Company A booked royalty and R&D expenses in an account for export commissions. Import Commissions Company A pays import commissions to a related company in China, Company A China (also called “Company A Hong Kong” by counsel for Company A). The audit team verified import commission payments of approximately $XX in 2002, but was not provided with an agency agreement and thus was unable to distinguish between buying and selling commissions. Company A’s position is that the commissions were paid to Company A China for its assistance in procuring merchandise from unrelated vendors, and as such are buying commissions. To support this claim counsel enclosed Company A’s “Principles For Sourcing Centres of China and India for Raw Materials and Intermediates” (“the Principles”) with its letter of November 16, 2005. This document, adopted in 1996, indicates that the objective of a Sourcing Centre is to provide service to the Company A Group by exploring and finding third party sources for raw materials and intermediates at the lowest total cost level (considering quality, price, packaging, inventory level, customs duty etc.). In furtherance of this objective the Sourcing Centre will, among other things, establish a working relationship with the selected suppliers, communicate requirements, and help to negotiate prices and secure quality. It will assure logistics support and supply information to enable timely delivery. The Sourcing Centres are described as “true cost centres and can charge up to XX% based on supplier invoices for their services in order to cover their costs.” The Principles require the Sourcing Centres “to provide full transparency.” Although it was disclosed that Company A computes import commissions based on XX% of the invoice price of the imported merchandise, the auditors discovered that several of the commission calculations were based on a lower price and one on a higher price. In its letter dated November 16, 2005, counsel explains that the discrepancy is due to the fact that the agent estimated eventual sales prices that in fact differed from the prices ultimately charged by the manufacturers. Counsel also wrote that “Company A US is not privy to the communications between the agent and the Chinese manufacturers, so Company A US does not know the precise volumes and unit price quoted before the goods were shipped.” Where the difference between the agent’s estimated price, which is used as the basis for its commission fee, and the actual price is less than XX%, Company A does not consider it worthwhile to make corresponding adjustments to the commissions. ISSUE: 1) Whether the royalty payments made by Company A to Company B are included in the transaction value of the imported merchandise as part of the price actually paid or payable, or whether they are additions to the price actually paid or payable pursuant to 19 U.S.C. § 1401a(b)(1)(D) or (E), respectively. 2) Whether the R&D expense is included in the transaction value of the imported chemicals. 3) Whether the export commissions that Company A pays to Company B are part of the price actually paid or payable for the imported merchandise. 4) In the circumstances described, whether Company A China functions as Company A’s bona fide buying agent in the purchase of the imported chemicals and if so, whether payments for such services are non-dutiable buying commissions. 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 if they are not already included in the price actually paid or payable. These additions include any selling commission incurred by the buyer with respect to the imported merchandise, any royalty or license fee related to the imported merchandise that the buyer is required to pay as a condition of the sale for export 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)(B), (D) & (E). However, as you know, transaction value is an acceptable basis of appraisement only if, inter alia, the buyer and seller are not related, or if related, the relationship did not influence the price actually paid or payable, or the transaction value closely approximates certain “test values.” 19 U.S.C. § 1401a(b)(2)(B). In the instant case, the buyer and seller are related in most of the transactions. The internal advice request indicates that Company A’s cost accounting manager informed the auditors that affiliate pricing is done according to the methodology set out in Company A’s transfer pricing agreement, and that Company A had recently undergone an IRS audit focused on transfer pricing in which Company A passed with no findings. The internal advice request also states that CBP auditors did not review Company A’s transfer pricing agreement or the IRS report. At this juncture we would merely note that IRS approval of an importer’s transfer pricing methodology might satisfy IRS arm’s length pricing requirements but not necessarily CBP valuation requirements. Company A would still have to satisfy one of the two related party tests – circumstances of sale and test values – to demonstrate that its goods were properly appraised under transaction value. The provision in Article 7 of the License Agreement that allows the suspension of royalty payments if profits are breakeven or negative might be indicative of an absence of arm’s length dealings between Company A and its parent company. Since there was no review of the acceptability of the related party pricing and no further information on this issue has been presented we are unable to determine here if transaction value is an appropriate basis of appraisement. Nevertheless, assuming that transaction value is the appropriate basis of appraisement, the following constitutes our position on the dutiability of the royalty, R&D and various commission payments. Royalty Payments In regard to the dutiability of royalty payments and license fees, 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 a 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 were they 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 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 2, reprinted in, Department of the Treasury, Customs Valuation under the Trade Agreements Act of 1979 (October 1981), at 48-49. As the language of the SAA makes clear, 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. The term “price actually paid or payable” is defined as “the total payment (whether direct or indirect…) 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). Thus the first inquiry is whether the payments at issue are part of the price actually paid or payable for the imported merchandise. Based on Generra Sportswear Co. v. United States, 905 F.2d 377 (Fed. Cir. 1990), U.S. Customs and Border Protection (“CBP”) presumes that all payments made by the buyer to the seller or to a party related to the seller are part of the price actually paid or payable for imported merchandise. In Generra, the Court of Appeals held that the term “total payment” is all-inclusive and that “as long as the quota payment was made to the seller in exchange for merchandise sold for export to the United States, the payment properly may be included in transaction value, even if the payment represents something other than the per se value of the goods.” The court also stated: Congress did not intend for the Customs Service to engage in extensive fact-finding to determine whether separate charges, all resulting in payments to the seller in connection with the purchase of imported mer