HQ 545710 - Internal Advice concerning dutiability of royalty payments for pharmaceuticals incorporating patented antibacterial compounds; 19 U.S.C. ?1401a(b)(1)(D) - United States International Trade Commision Rulings

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HQ 545710

October 30, 1998

RR:IT:VA 545710 LR

CATEGORY: VALUATION

Port Director
U.S. Customs Service
605 W. Fourth Ave
Anchorage, AK 99501

RE: Internal Advice concerning dutiability of royalty payments for pharmaceuticals incorporating patented antibacterial compounds; 19 U.S.C. ?1401a(b)(1)(D)

Dear Director:

This is in response to your memorandum dated June 24, 1994, forwarding a request for internal advice, submitted by counsel on behalf of Merck & Co, Inc. (Merck), concerning the dutiability of royalty payments made in connection with the use of patented compounds. Counsel has made several submissions regarding this matter. The most recent, dated February 4, 1998, was submitted following a meeting at Headquarters on January 21, 1998. Confidential treatment has been granted to the information designated as such in counsel's submissions. This information is bracketed and will be deleted from the public version of this ruling. We apologize for the delay in responding.

FACTS:

Merck imports a patented antibacterial compound, known as AM-715 or Norfloxacin ("Licensed Compound") from the patent holder Kyorin Seiyaku K.K. (Kyorin) of Tokyo, Japan to be incorporated in the pharmaceutical preparations Noroxin and Chibroxin ("Licensed Products"). The Licensed Compound is the active ingredient of the Licensed Products. In a License Agreement, dated September 4, 1980, it is stated that ["

A copy of the License Agreement was submitted.

Specifically, Kyorin granted Merck, an "exclusive license (in certain countries, including the United States), with the right to sub-license, under Licensed Patents and Know How, to make, have made, use and sell Licensed Compound and to make, have made, use and sell Licensed Products from Licensed Compound". License Agreement ?2.01. Licensed Patents are specified patents relating to the Licensed Compound. License Agreement ?1.01(a) Know-how means all information not generally known and which is available to Kyorin now and at any time during the term of this Agreement regarding the preparation of the manufacture of Licensed Products including the chemical, pharmacological, biological and clinical properties of Licensed Compound and Licensed Products. ?1.01(f)

As consideration for these rights, Merck agreed to pay Kyorin a royalty based on a specified percentage of net sales of the Licensed Products sold by Merck or its sub-licensees or subsidiaries. The percentage depends on whether or not there was a valid enforceable Licensed Patent in effect in the country of sale. See License Agreement ?3.01. The royalties are calculated and remitted semiannually. ?3.04 [

On September 4, 1980, the date the parties signed the License Agreement, [

.

Counsel contends that the royalty payments do not relate to the imported merchandise and are not a condition of the sale of the imported Licensed Compound and thus do not constitute royalties to be added to the price actually paid or payable of the imported Licensed Compound. Counsel also provided various arguments in support of the position that the royalty payments would not be dutiable as proceeds of the subsequent resale, disposal, or use of the imported Licensed Compound. It is your position that the royalties, or at least the portion of the royalties attributable to the sale of the Licensed Products manufactured from the imported Licensed Compound, are dutiable either as royalties or proceeds.

ISSUE:

Whether the subject royalty payments constitute an addition to the price actually paid or payable for the imported merchandise as either royalties or proceeds of subsequent resale.

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. 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, including any royalty or license fees related to the imported merchandise that the buyer is required to pay as a condition of the sale for export to the U.S.; 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)(D)&(E). These additions apply only if they are not already included in the price actually paid or payable. For the purposes of this ruling we have assumed that transaction value is the appropriate method of appraisement.
Royalties

Under section 19 U.S.C. ?1401a(b)(1)(D), 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.

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).

After reviewing the language of the statute along with the legislative history and prior case law, Customs concluded that the following three questions are relevant in determining whether the requirements of 19 U.S.C.?1401a(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").

In the Hasbro II ruling, we determined that the royalty, paid to the seller, was involved in the sale of imported merchandise because the individual sales agreements and purchase contracts were subject to the terms of the royalty agreement. In HRL 544991, September 13, 1995, we held that a royalty was involved in the sale of the imported merchandise payment of the royalty was closely tied to the purchase of the imported product. For example, in that case, the terms and conditions related to the purchase of the imported products were set forth in the license agreements. See also HRL 545380, March 30, 1995 (royalty related to the production or sale of the imported merchandise where under the terms of the licensing agreement, importer was required to purchase components from the seller).

Some factors which Customs has considered in answering question three, i.e., could the importer buy the product without paying the fee, include to whom the royalty is paid (e.g. payments to the seller, as opposed to a unrelated third party, are generally dutiable); whether the purchase of products and the payment of royalties are inextricably intertwined (e.g. are they set forth in the same agreement, do the agreements make reference to one another, is the purchase agreement terminated if the buyer fails to pay the royalties); and whether royalties are paid on each and every importation. See HRL's 544991, 545380; 545361; and Hasbro II ruling, supra.

In this case, the answer to the first question is "yes". The Licensed Compound (i.e., imported product) is manufactured by Kyorin who holds a patent for that product. Thus, the Licensed Compound was manufactured under patent. Royalties and license fees for patents covering processes to manufacture the imported merchandise will generally be dutiable. See SAA, supra, at 48. See also HRL 545998, November 13, 1996, (patent covering chemical composition of imported product is type of patent intended to come within the purview of question one).

With regard to the second question, counsel states that the answer is "no". Counsel contends that the royalty is not involved in the production or sale of the imported product. Rather, the claim is made that the royalties are involved only in the production or sale of the Licensed Products produced by Merck in the United States. It notes that the Merck's obligation to pay royalties arises only upon the sale of the Licensed Products, not the imported Licensed Compound. Counsel also indicates that the Licensed Products are physically distinct from the Licensed Compound and that the Licensed Compound is not physically identifiable nor segregable from the other ingredients comprising the Licensed Products. Counsel analogizes the instant situation to that discussed in section 152.103(b)(3), Customs Regulations (19 CFR 152.103(b)(3)), where it is explained that when a royalty, "is based partially on other factors which have nothing to do with the imported merchandise (such as if the imported merchandise is mixed with domestic ingredients and is no longer separately identifiable, or if the royalty cannot be distinguished from special financial arrangements between the buyer and the seller); it will be inappropriate to attempt to make an addition for the royalty."

Counsel also cites to HRL 545307, February 3, 1995 in support of its position. There, the importer paid the seller a royalty for the right to use technical knowledge to make, use and sell finished pharmaceutical productions containing the imported active ingredient. The licensed product was the finished product, and the royalties related only to the manufacture of the finished product in the United States. Although the active ingredient was patented, the patent had expired. Moreover, no royalties were paid for technical know-how relating to the imported active ingredient. Customs determined that the royalties did not relate to the imported merchandise and thus were not dutiable under 19 U.S.C. ?1401a(b)(1)(D).

Based on our review we conclude that the royalty was involved in the production and sale of the imported merchandise. First, Customs has determined 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 "Hasbro II ruling", supra. Thus, in this case, the fact that royalty is based on a percentage of the sales price of the Licensed Product is not relevant. Second, despite the further processing of the imported Licensed Compound, it is clear that the royalties paid relate to the production and sale of the imported Licensed Compound. This stems from the fact that the imported Licensed Compound is specifically covered by the License Agreement. Under the License Agreement, Kyorin granted Merck an exclusive license with the right to sub-license under Licensed Patents and Know How to make, use and sell the imported Licensed Compound and Licensed Products from the Licensed Compound within the U.S.

Also, the imported Licensed Compound is "manufactured under patent" and the license for which royalties are paid specifically covers those patent rights. This shows that the royalty is involved in the production and sale of the imported merchandise. See HRL 545998, supra.[

The facts here are distinguishable from HRL 545307, the ruling cited by counsel. As indicated above, there, the importer paid the seller a royalty for the right to use technical knowledge to make, use and sell finished pharmaceutical products containing the imported active ingredient. The finished pharmaceutical product, not the imported active ingredient, was the licensed product for which royalties were paid. Customs determined that the royalties related only to the manufacture of the finished licensed product in the United States and were not dutiable. In contrast, the imported active ingredient in this case (referred to in the License Agreement as the Licensed Compound) is one of the licensed products for which royalties are paid. See ?2.10 License Agreement granting Merck an "exclusive license .... under Licensed Patents and Know How, to make, have made, use and sell Licensed Compound . . .". Thus, the royalties relate to the manufacture of the imported product. In addition, as this provision makes clear, the royalties in this case relate to patents covering the imported Licensed Compound. See also [ ]. In HRL 545307, the royalties paid did not relate to patents covering the imported product. Although the imported product was manufactured under patent, the patent had expired.

The terms of the License and [ ] demonstrate that the sale of the imported product and the payment of royalties is closely related. Again, the imported product is the Licensed Compound as that term is defined in the Agreements for which royalties are paid. Also, the [

].See HRL 545998, supra, HRL 546038, July 19, 1996 and HRL 544991, September 13, 1995. Also, [

]. These facts demonstrate that the royalties are involved in the production and sale of the imported merchandise.

The third question, can the importer buy the product without paying the fee, goes to the issue of whether payment of the royalty is a condition of the sale for exportation of the imported product. Counsel argues that the payment of the royalty is not a condition of sale of the Licensed Compound and that Merck can buy the product without paying the royalty. Again, counsel points to the fact that under the License Agreement royalties accrue only on the sale of the Licensed Products and not on the sale of the Licensed Compound by Kyorin to Merck. Counsel also indicates that there are numerous occasions where no royalty accrues. For example, when the importer fails to produce the royalty product with the imported product, no royalty payment will be owing to the licensor; if no sale of the finished products occurs, no royalty is owing. Counsel also indicates that no royalty accrues on the manufacture by Merck or any of its sublicenses of Licensed Compound which is used to make Licensed Products.

Despite these arguments, we conclude that Merck could not buy the product without paying the royalties. First, we note that the royalties covered by the License Agreement are paid by Merck to Kyorin, the seller of the imported Licensed Compound. 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); HRL 545752, April 1, 1996; HRL 544991, supra.

Second, although there could be some instances where no royalties are paid in connection with imported Licensed Compound, we conclude that there would be no sale of the imported product unless Merck agreed to pay the royalties provided for in the License Agreement. This is evidenced by the fact that the payment of the royalties is closely tied to the sale of the imported product: [

]. Under these circumstances, Customs has considered the payments of royalties to be a condition of the sale of the imported merchandise. See 545998, supra. In that case similar arguments were raised (e.g., that some of the imported merchandise was not subject to royalties because it was not sold). Nonetheless, Customs determined that payment of the royalty was a condition of sale of the imported product. See also HRL 544991, supra.

Based on the above considerations, we find that the royalties at issue relate to the imported merchandise and that Merck is required to pay them as a condition of the sale for exportation to the United States of the imported Licensed Compound. Accordingly, we find that they are additions to the price actually paid or payable as royalties under 19 U.S.C.

Counsel further contends that if Customs determines that the royalties are dutiable, the issue of apportionment must be addressed since the royalty is paid partially for the imported Licensed Compound and partially for the exclusive territorial rights and rights granted with respect to the finished product. In this regard, counsel claims that under the terms of the License Agreement, the amount of the royalty is dependent upon the net sales worldwide of pharmaceuticals and is further dependant on where the finished product is sold. In countries where exclusive territorial rights are granted, such as the U.S., the royalty is higher than in countries where no exclusive territorial rights are granted. Since the difference is attributable to exclusive territorial rights in the U.S. it is claimed that this portion should not be dutiable. Counsel also states that Merck has expended considerable costs in developing the finished products made from the imported Licensed Products and that any royalty paid must be allocated by differentiating between the cost of the imported Licensed Compound and the cost of the Licensed Products made from the imported Licensed Compound.

Previous rulings have not addressed the issue of apportionment of royalties. While apportionment may be appropriate in cases where it is clear that a portion of the royalty payment does not relate to the imported product, this is not the case here. First, it appears that the different royalty amount paid in the different countries is attributable to whether there is a valid enforceable Licensed Patent in effect in the country of sale. See ?3.01a & b, License Agreement. [

]. Under these circumstances, no apportionment is warranted.

HOLDING:

Based on the information provided, the subject royalty payments constitute an addition to the price actually paid or payable for the imported merchandise under 19 U.S.C. necessary to address the issue of whether the payments could alternatively be considered proceeds under 19

This decision should be mailed by your office to the internal advice requestor no later than 60 days from the date of this letter. On that date the Office of Regulations and Rulings will take steps to make the decision available to Customs personnel via the Customs Rulings Module in ACS and the public via the Diskette Subscription Service, Freedom of Information Act and other public access channels.

Sincerely,

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