HQ 544991 - Request for Internal Advice; Dutiability of Royalty Payments to the Seller - United States International Trade Commision Rulings

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HQ 544991

September 13, 1995

VAL R:C:V 544991

CATEGORY: VALUATION

Mr. Joseph Palmer
Regional Director, Regulatory Audit
U.S. Customs Service
Chicago, Illinois 60603

RE: Request for Internal Advice; Dutiability of Royalty Payments to the Seller

Dear Mr. Palmer:

This is in response to your memorandum AUD-1-0:A:CN V LMG, dated April 21, 1992, requesting advice on the dutiability of royalty payments made by LeBlond Makino Machine Tool Company. A letter dated July 2, 1992, stating the company's position, was also received. We regret the delay in replying.

FACTS:

LeBlond Makino Machine Tool Company ("LeBlond") manufactures and sells certain machines ("Makino Machines") using parts supplied by its parent company, Makino Milling Machine Co., Ltd. ("Makino") of Japan as well as parts supplied by others (including domestic parts). On January 1, 1988, Makino and another wholly owned subsidiary of Makino, Makino U.S.A., Inc. ("Makino U.S.A."), entered into a license agreement under which Makino granted Makino U.S.A. a non-exclusive license to use its "licensed technology" and trademark in the manufacture, marketing and use of Makino Machines in North, Central and South America. Under the agreement, "licensed technology" means "all technical information, knowledge, methods and experience for manufacturing and using the machines possessed by or to be developed by Makino, including the software to operate them." The license agreement authorizes Makino U.S.A. to sublicense the licensed technology and the trademark for the manufacture, marketing and use of Makino machines.

Makino U.S.A. and LeBlond entered into a sublicense agreement on January 1, 1988, under which Makino U.S.A. granted LeBlond a nonexclusive sublicense to use Makino's licensed technology and trademark in the manufacture, marketing, and use of Makino Machines in the United States and Canada.

The license and sublicense agreements provide for running royalties of from two to four percent of net sales of all Makino Machines manufactured and sold in the United States and Canada. The royalties are paid in consideration of the licensed technology and technical assistance provided by Makino to Makino U.S.A. and by Makino U.S.A. to LeBlond in order to manufacture the Makino Machines and for the license to use the Makino trademark in connection with the manufacture, use and sale of the Makino Machines. The two agreements are substantially similar.

The sublicense agreement provides that LeBlond can procure parts either from Makino or locally from third parties. Article 7 provides that "the Licensor [Makino U.S.A.] shall cause Makino to supply to the Licensee [LeBlond], in accordance with such terms and conditions as separately agreed to between Makino and the Licensee, such Parts as the Licensor and the Licensee shall from time to time agree to." Article 7 further provides that "if the Licensee plans to procure any Parts locally from third parties other than Makino, the Licensee shall submit to the Licensor in advance written information related to Parts to be procured locally, including but not limited to information concerning the quality of such Parts, the lead time of supply after placing an order and the prices of such Parts. The Licensee shall continue to provide the Licensor with the above mentioned information at such intervals as prescribed by the Licensor."

A separate agreement between Makino and LeBlond was entered into on January 1, 1988, the same date of the license and sublicense agreements. It makes reference to both the license agreement between Makino and Makino U.S.A. and the sublicense agreement between Makino U.S.A. and LeBlond and provides that:

[LeBlond's] use of our above technology related to the machines in question shall be governed by the provisions of the License Agreement and the Sublicense Agreement as if such technology had been originally made available to your company by our company through Makino U.S.A. Inc.

It is also understood that any future sales of the Parts (as defined in the Sublicense Agreement) from [Makino] to [LeBlond] will be effected in accordance with the terms and condition set forth in Appendix A attached to this letter.

Appendix A, entitled "Terms and Conditions of Supply of Parts" provides that LeBlond shall provide Makino with a semi-annual forecast of parts for machining centers from Makino and any changes thereto; that LeBlond shall place purchase orders for the Parts with Makino not later than three months before the scheduled shipment date; that LeBlond shall pay to Makino such purchase prices of the Parts to be procured from Makino as Makino from time to time prescribes in its price list; and that LeBlond shall pay to Makino the purchase price of the Parts procured from Makino by such term as from time to time agreed to between Makino and LeBlond.

You advise that LeBlond pays royalties directly to Makino. They are computed monthly, and LeBlond must show Makino the basis for the computation of the royalty by listing the model name and quantity of machines sold, as well as the customer name and date of sale. According to your memorandum, a comparison sheet for three different models of machines on which royalties are being paid revealed that the percentage of Makino material in each machine ranged from 36% to 52%.

It should be noted that no contracts or purchase agreements pertaining to the imported parts were provided other than the agreements referred to above.

ISSUE:

Whether royalty payments by the importer/buyer LeBlond to the seller/licensor Makino are included in the transaction value of the imported parts.

LAW AND ANALYSIS

The preferred method of appraising merchandise imported into the United States is transaction value pursuant to section 402(b) of the Tariff Act of 1930, as amended by the Trade Agreements Act of 1979 (TAA), codified at 19 U.S.C. ?1401a. Section 402(b)(1) of the TAA provides, in pertinent part, that the transaction value of imported merchandise is the "price actually paid or payable for the merchandise when sold for exportation to the United States" plus enumerated statutory additions, including 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 (section 402(b)(1)(D)).

The transaction value between a related buyer and seller is acceptable if an examination of the circumstances of the sale of the imported merchandise indicates that the relationship between such buyer and seller did not influence the price actually paid or payable or if the transaction value of the imported merchandise closely approximates certain "test values". In this case, the import transactions at issue involve Makino and its related company (wholly owned subsidiary), LeBlond. No information has been provided regarding the acceptability of the transfer price and we do not address this issue here. This ruling only addresses the issue of whether the subject royalties are included in the transaction value of the imported parts, assuming transaction value applies.

For purposes of transaction value, the "price actually paid or payable" is "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." Section 402(b)(4) TAA; 19 U.S.C. ?1401a(b)(4). The price actually paid or payable for imported merchandise shall be increased by the amounts attributable to the enumerated additions only to the extent that each such amount is not otherwise included within the price actually paid or payable; and is based on sufficient information. Section 402(b)(1) TAA. For purposes of this decision we assume that the subject royalties are not included in the price actually paid or payable and our analysis is limited to whether they are dutiable as an addition under section 402(b)(1)(D) TAA.

LeBlond contends that the royalty payments it makes to Makino are not dutiable as royalties because such payments are not a condition of the sale of the imported parts from Makino to LeBlond. It bases this conclusion on the fact that LeBlond is obligated to make the royalty payments even though it is not required to purchase or use parts from Makino for the manufacture of the machines in the United States; the fact that the royalties are calculated upon the net sales of the machines manufactured by LeBlond in the United States, instead of upon the sales of parts by Makino to LeBlond; and, that the payments relate to the use of the licensed technology and technical assistance rather than to the importation of parts.

LeBlond further contends that the payments are not dutiable as proceeds because that provision applies only if the payments were triggered by the domestic resale of the parts in their imported condition. It contends that here, the payments are based on the selling price of the finished product, and not the price of the imported parts.

The Office of Regulatory Audit is of the opinion that the payments are dutiable, either as royalties or as proceeds. In its view there is sufficient information to determine the percentage of the payment that is attributable to the imported parts. That percentage should represent the amount upon which duties should be assessed.

ROYALTIES

Under section 402(b)(1)(D) of the TAA, 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."

The Statement of Administrative Action (SAA), H.R. Doc. No. 153, 96 Cong., St. 1st Sess., reprinted in, Department of the Treasury, Customs Valuation under the Trade Agreements Act of 1979 (October 1981), at 48-49, which forms part of the legislative history of the TAA, distinguishes payments to third parties from payments to the seller of imported merchandise. It states:

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: (1) 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 for the United States (emphasis added).

After reviewing the language of the statute along with the legislative history and prior case law, Customs concluded that the following three question are relevant in determining whether the requirements of section 402(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. An affirmative answer to question 1 and 2 and a negative answer to question 3 points to dutiability. Question 3 goes to the heart of whether the payment is considered to be a condition of sale. See General Notice, Dutiability of Royalty Payments, Vol. 27, No. 6 Cust. B. & Dec. at 1 (February 10, 1993) ("Hasbro II ruling").

Although the SAA provides that determinations about the dutiability of royalty payments are to be made case-by-case, it is more likely that the royalty will be dutiable when the licensor and seller are one and the same and the royalty is paid directly to the seller. Under these circumstances, payment of the royalty is more likely to be a condition of the sale for exportation of the imported merchandise than when the royalty is paid to an unrelated third party. See HRL 545361, July 20, 1995 (trademark royalties dutiable when paid to the seller/licensor but not when paid to a third party unrelated to the seller).

In this case, the party to whom the royalties are paid is both the seller and the licensor. According to the SAA, any royalty or license fee paid to the seller is part of transaction value unless the importer can establish that it is distinct from the price actually paid or payable for the imported merchandise and that such payment was not a condition of the sale of the imported merchandise for exportation to the United States. In other words, there is a presumption that royalties paid to the seller are dutiable unless the importer can show otherwise.

Several recent rulings, including HRL 545361, supra, have addressed the question of whether royalty payments made by the importer/buyer to the seller/licensor were dutiable either as part of the price actually paid or payable or as an addition thereto. In most cases, Customs found that the royalties were dutiable.

In HRL 545380, March 30, 1995, the imported merchandise consisted of components for a mainframe computer system. The importer used the imported components to manufacture the computer system. At issue were royalties the importer paid to the seller pursuant to a licensing agreement for the use of technical information and know-how related to the development of a computer system. Under the terms of the agreement, the technical know-how was not limited to that which was required for the manufacture of the computer system but also pertained to technical know-how regarding the manufacture and development of the imported components. Under the terms of the licensing agreement, the importer was required to purchase the components for the computer system from the seller. Customs determined that under these circumstances the royalty was related to the production or sale of the imported merchandise. The agreement also provided that the license fee would be paid by way of an adjustment to the importer's costs of the computer system. Based on these facts Customs determined that the license fee was dutiable either as part of the price actually paid or payable for the imported merchandise or as an addition thereto.

HRL 544800, May 17, 1994, involved the importation of the pharmaceutical product, Magnevist. The importer and its related seller entered into an Option Agreement providing that the seller shall offer the importer an option with regard to each pharmaceutical product which the seller decides to market in the United States. Pursuant to the terms of the License Agreement between the parties, the importer has exclusive marketing rights for Magnevist in the United States. The License Agreement also specifies that the importer will purchase its Magnevist requirements from the seller. The Option Agreement provides that the amount of compensation payable by the importer will be fixed by the License Agreement and will be in the form of a royalty and may also include one or more down payments. Finally, the License Agreement specifies that compensation will be in the form of royalty payments at 7% of the importer's net sales, in addition to payment of an initial supply price for the merchandise.

Customs rejected counsel's arguments that because the License Agreement provided for an exclusive marketing arrangement between the parties, that the royalty payments described in the agreement were paid for the right to market the product and not as part of the price actually paid or payable or as a condition of sale. Customs disagreed, stating that the Option Agreement expressly defines compensation to include such payment and that nothing in the License agreement evidences that the royalty is paid for marketing rights as opposed to comprising part of the price actually paid or payable. Based on these facts, Customs determined that the payments at issue were dutiable either as part of the price actually paid or payable or as an addition thereto.

In HRL 545784, June 6, 1995, the imported product was a patented Net Making Machine which the importer purchased from its related parent. For the manufacturing know-how relating to the machine, the importer was to pay the seller royalties on all products manufactured using the imported machine. The supply agreement indicated that the importer shall not resell the machine because it includes the production know-how which is owned by the seller. Customs concluded that the sale of the machine to the importer is inextricably intertwined with the payment of the royalties and that in order to purchase and use this patented machine, the importer must pay the seller the royalties in question. Thus, Customs determined that the importer had not established that the royalty payment is distinct from the price actually paid or payable for the machine and that it was not a condition of importation. Therefore, Customs found that the royalties are to be added to the price actually paid or payable for the machine under section 402(b)(1)(D).

In another case involving royalties paid by the buyer to a related seller, HRL 544978, April 27, 1995, Customs found that royalties were dutiable as an addition to the price actually paid or payable based in part on the fact that the sales contracts relating to the imported merchandise are subject to or conditioned upon the license agreement. One of the purchase agreements at issue indicates that it was in force only for as long as the royalty is in force. The ruling states: "we find that in this case, the individual sales agreements... are subject to the terms and conditions of the [royalty agreement]. In the instant case, agreement to pay the continuing royalty payment was required of the buyer before the [the seller] would sell the production equipment...to the buyer because [the seller] required that the buyer enter into the [royalty agreement] as a condition of the ...Sales Contract."

Finally, in HRL 545307, February 3, 1995, we found that royalties paid to the seller of the imported merchandise were not a condition of the sale for exportation of the imported merchandise and thus, not dutiable. In that case, the imported merchandise was a chemical product used in the manufacture of a finished pharmaceutical preparation. The chemical was combined in the U.S. with other materials in order to produce the finished pharmaceutical product. Under the terms of a licensing agreement, the importer/buyer agreed to pay to the licensor/seller a royalty based on a percentage of net sales of the finished pharmaceutical product. The royalty was for the license to use certain technical knowledge, owned by the seller in connection with the manufacture and sale by the importer, in the U.S., of a finished pharmaceutical product.

Even though the royalties were paid to the seller/licensor, Customs determined that they were not dutiable under section 402(b)(1)(D) because they were not involved in the production or sale of the imported merchandise and because they are not a condition of sale of the imported merchandise. Customs noted that the royalties are paid for the right to use technical knowledge to make, use and sell finished pharmaceutical products containing the imported active ingredient and that under the agreement, the buyer can manufacture the active ingredient if the licensor is unable or unwilling to sell it. Based on the information presented there was nothing to indicate that the royalty payment is an explicit condition of sale between the buyer and seller. See also C.S.D. 92-12, HRL 544656, June 19, 1991 (royalty payments from the importer to its related seller for technical information and a license to make, use and sell a finished machine using the imported components not dutiable under section 402(b)(1)(D) because such payments are not related to the imported merchandise, nor are they a condition of sale).

As the above cases make clear, the dutiable status of royalties depends largely on whether they are a condition of the sale for exportation of the imported merchandise and that when the seller and the licensor are the same person, it is more likely that they are. Here, the royalties are paid in consideration of the licensed technology and technical assistance provided by Makino to Makino U.S.A. and by Makino U.S.A. to LeBlond in order to manufacture the Makino Machines and for the license to use the Makino trademark in connection with the manufacture, use and sale of the Makino Machines. The imported parts, used by LeBlond in the manufacture of the Makino machines, are purchased from Makino, who is also the licensor. As discussed below, we find that the payment of royalties is a condition of sale of the imported parts.

First, we note that the license and sublicense agreements specifically refer to the purchase of parts. Although the sublicense agreement provides that LeBlond can procure parts either from Makino or locally from third parties, Article 7 provides that "the Licensor [Makino U.S.A.] shall cause Makino to supply to the Licensee [LeBlond], in accordance with such terms and conditions as separately agreed to between Makino and the Licensee, such Parts as the Licensor and the Licensee shall from time to time agree to." Article 7 further provides that "if the Licensee plans to procure any Parts locally from third parties other than Makino, the Licensee shall submit to the Licensor in advance written information related to Parts to be procured locally, including but not limited to information concerning the quality of such Parts, the lead time of supply after placing an order and the prices of such Parts. The Licensee shall continue to provide the Licensor with the above mentioned information at such intervals as prescribed by the Licensor."

Also, the Makino/LeBlond agreement entered into the same date as the license and sublicense agreements makes reference to both the license agreement between Makino and Makino U.S.A. and the sublicense agreement between Makino U.S.A. and LeBlond and provides that:

[LeBlond's] use of our above technology related to the machines in question shall be governed by the provisions of the License Agreement and the Sublicense Agreement as if such technology had been originally made available to your company by our company through Makino U.S.A. Inc.

It is also understood that any future sales of the Parts (as defined in the Sublicense Agreement) from [Makino] to [LeBlond] will be effected in accordance with the terms and condition set forth in Appendix A attached to this letter.

Appendix A, entitled "Terms and Conditions of Supply of Parts" provides that LeBlond shall provide Makino with a semi-annual forecast of parts for machining centers from Makino and any changes thereto; that LeBlond shall place purchase orders for the Parts with Makino not later than three months before the scheduled shipment date; that LeBlond shall pay to Makino such purchase prices of the Parts to be procured from Makino as Makino from time to time prescribes in its price list; and that LeBlond shall pay to Makino the purchase price of the Parts procured from Makino by such term as from time to time agreed to between Makino and LeBlond.

The above provisions make clear that the payment of the royalties is closely tied to the purchase of the imported parts. Even though LeBlond is not required to purchase all the parts from Makino, the terms and conditions relating to the purchase of the parts, whether obtained from Makino or from third parties are set forth in the above agreements. Because the payment of the royalty and the purchase of the imported parts are so closely tied together, we find that payment of the royalties is a condition of the sale for exportation of the imported parts. This was not the case in HRL 545307 and C.S.D. 92-12, supra, involving non-dutiable royalties paid to the licensor/seller.

We disagree with the importer's contention that the royalties are not a condition of sale of the imported parts because they are calculated upon the net sales of the machines manufactured by LeBlond in the United States, instead of upon the sales of parts by Makino to LeBlond. Our position, as articulated in the General Notice, supra, at 12, is that the method of calculating the royalty, i.e., based on the resale price, is not relevant in determining its dutiable status. Thus, in HRL 545361, supra, the fact that liability for the payment of a trademark royalty was triggered by the resale of the products after importation did not preclude a finding that the payments are dutiable under section 402(b)(1(D). See also, HRL 545784, supra. We also disagree with the contention that the royalties have no relationship to the purchase of the imported parts. Although we agree that the royalties relate to the use of the licensed technology and technical assistance necessary for the manufacture of the Makino Machines, the language discussed above also ties the royalties to the purchase of the imported parts.

HOLDING:

Based on the information provided, the royalty payments made by LeBlond to Makino are to be added to the price actually paid or payable of the imported parts under section 402(b)(1)(D), TAA. Having reached this conclusion, it is not necessary to address the issue of whether the payments could alternatively be considered proceeds under section

Sincerely,

John Durant, Director

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