HQ W563382 - Request for Internal Advice; Dutiability of Royalty Payments; Trademarks. - United States International Trade Commision Rulings

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HQ W563382

May 25, 2006

RR:CTF:VS W563382 EAC

CATEGORY: VALUATION

Port Director
U.S. Customs and Border Protection
Port of Savannah
1 East Bay Street
Savannah, GA 31401

RE: Request for Internal Advice; Dutiability of Royalty Payments; Trademarks.

Dear Port Director:

This is in response to your October 16, 2005, memorandum forwarding a request for internal advice submitted by Sharretts, Paley, Carter, and Blauvelt, P.C., on behalf of Kmart Corporation (“Kmart”). The issue in the request for internal advice is the dutiability of certain royalty payments made by Kmart in relation to merchandise bearing the “Route 66” trademark.

FACTS:

Kmart (the “licensee”) has entered into a trademark license agreement with Route 66 (the “licensor”) to license the use of the “Route 66” trademark on wearing apparel and other miscellaneous product lines identified in the license agreement. Kmart will source the Route 66 merchandise from nearly one thousand vendors, both domestic and foreign. Kmart will pay a royalty to Route 66 for use of the trademark in accordance with the terms discussed below. We are informed that Kmart, Route 66, and Kmart’s vendors are not related and that none of the subject royalty payments inure to the benefit of the vendors. At issue in this case is the dutiability of the royalty payments paid by Kmart in connection with the Route 66 trademark license agreement.

An affidavit subscribed by the Divisional Vice President of International Operations for Kmart on August 19, 2005, affirms that Kmart sources Route 66 merchandise from almost one thousand vendors, both domestic and foreign; that Kmart, Route 66, and Kmart’s vendors are not related; and that none of the subject royalty payments made by Kmart inure to the benefit of the vendors. According to the affidavit, the fees paid by Kmart to Route 66 for the right to use the trademark are separate from the payments paid to the vendors for the merchandise. The affidavit further provides that Route 66 has no involvement in Kmart’s purchasing of the merchandise and that Kmart alone selects the vendors and negotiates and determines purchase prices. Moreover, it is affirmed that Kmart’s purchase orders with its vendors contain no requirement that a royalty payment be made to the licensor.

In support of the foregoing, we have been provided with the license agreement (with amendments) between Kmart and Route 66. It is claimed that this license agreement is the only such agreement between the parties. We have additionally been provided with a document identified as the “Kmart Corporation Purchase Order Terms and Conditions – Import” which is used in situations where Kmart imports goods from foreign vendors. It is claimed that this document constitutes the only such agreement between Kmart and the foreign vendors. Sample purchase orders, letters of credit, entry documents, and packing lists were also submitted for consideration.

The License Agreement

The license agreement was executed between the licensor and licensee on December 1, 1995. Incorporated into the license agreement are the “First Amendment to License Agreement” dated January 7, 1998, and the “Second Amendment to License Agreement” dated January 1, 2000. Relevant provisions of the license agreement, as amended, are summarized below.

In Section I of the license agreement, the licensor represents and warrants ownership of all rights with respect to the Route 66 trademark for use in connection with the licensed products. Section II of the license agreement, which sets forth the terms of the grant, was amended by the first amendment to the agreement. As amended, Section II provides:

Grant. Licensor grants to Kmart the exclusive right, in the United States of America, Puerto Rico and the U.S. Virgin Islands (the “Territory”), to utilize the trademark ROUTE 66 as more specifically set forth in Attachment A, attached hereto and by this reference made part hereof (the “Licensed Property”), in connection with apparel and sunglasses, excluding clothing and accessories made out of leather deemed as motorcycle wear, (the “Licensed Products”);

In Section III of the license agreement, the licensor agrees that the grant is exclusive within the designated territory, to the extent that the licensor shall not sell or use nor license others to sell or use the licensed property on any of the licensed products. Section IV of the license agreement sets forth restrictions and terms on the use of the subject trademark. In this regard Section IV(a) provides, in part, that the licensee shall use all licensed property in a prescribed format and that the licensor shall be entitled to change such prescribed format by providing the licensee not less than ninety days advance written notice. Section IV(b) requires the licensee to cause to appear on all licensed products and materials used in connection with the licensed property, such legends, markings, and notices as may be required by applicable law within the territory where sold in order to give appropriate notice of any trademark rights therein. Section IV(c) provides that the licensed property shall appear exclusively on all tags, labels, hang tags, or other indicia where such markings are used in connection with the sale to the consumer. Section IV(d) provides that the licensee shall not attempt to register or use the licensed property or any other name or mark confusingly similar thereto by themselves or in combination with any other words, symbols or designs, or as part of its company name or as part of the name of any company or corporate name of any corporation which it controls or is affiliated.

Section V of the agreement, pertaining to royalties and royalty payments, was amended by the first amendment to the agreement. As amended, Section V(a) provides that the royalty rate is two and one-half percent. Section V(a) further provides for the payment of a “minimum annual royalty” and sets forth certain conditions related thereto.

Section VII of the license agreement addresses quality control and provides, in pertinent part:

Quality Control. Kmart agrees to maintain the quality of the licensed products sold by it pursuant to this Agreement in conformity with standards set by and under the control of the Licensor, which standards shall be commensurate with the average of similar products currently being sold by Kmart. Licensor acknowledges that it has reviewed the current quality of such products. In order to assure such quality, prior to Kmart’s sale of Licensed Products, Kmart shall submit to Licensor samples of the same.

Licensor agrees that it will not unreasonably withhold its approval. Licensor and Kmart shall cooperate to develop a simplified and expeditious product approval process consistent with maintaining product quality standards. Kmart may assume approval by Licensor if no objection is received by Kmart within ten (10) business days after a given sample is received by Licensor.

Section IX of the license agreement sets forth provisions relating to the term and termination of the agreement and was amended by the first amendment to the agreement. As amended, Section IX(a) provides that the license agreement shall continue in force until April 30, 2006. As amended, Section IX(b) provides that the licensee may terminate the license agreement with or without cause at any time with one and one-half years advance written notice. Section IX(c) states that the licensor may terminate the agreement at the end of any contract year with ninety days written notice to the licensee in the event that the licensee’s net purchases of licensed products fails to exceed specified amounts. Section X of the license agreement pertains to property retention and provides, in part, that Kmart shall not acquire any ownership or proprietary rights in the licensed property.

Kmart Purchase Order Terms and Conditions

Relevant for this case is paragraph 5 of the purchase order terms and conditions which addresses Kmart’s right to cancel and states:

Buyer’s Right to Cancel. Buyer may, without notice and in addition to all other rights and remedies, cancel, terminate and/or rescind all or part of an Order (and other affected or related Orders) in the event Vendor breaches or fails to perform and of its obligations in any material respect, Vendor becomes insolvent or Vendor ceases its operation

As noted above, sample transaction documents have also been submitted for consideration. These transaction documents include purchase orders, vendor invoices, letters of credit, entry documents, and packing lists. A reference to payment of a “royalty fee” is annotated on the purchase orders between Kmart and its vendors. Counsel advises that this notation is relevant for Kmart’s internal accounting purposes only and has provided documentation (discussed, infra) in support of this claim.

Based upon such information, counsel contends that the royalty fees paid by Kmart to Route 66 do not constitute an addition to the price actually paid or payable for the imported merchandise under 19 U.S.C. §1401a(b)(1)(D).

ISSUE:

Whether the royalty fees or payments under consideration constitute an addition to the price actually paid or payable for the imported merchandise under 19 U.S.C. §1401a(b)(1)(D).

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 is transaction value. Under 19 U.S.C. §1401a (b)(1), the transaction value of imported merchandise is:
the price actually paid or payable for merchandise when sold for exportation to the United States, plus amounts equal to –
the packing costs incurred by the buyer with respect to the imported merchandise;
any selling commissions incurred by the buyer with respect to the imported merchandise;
the value, apportioned as appropriate, of any assist;
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.

Regarding the dutiability of royalty payments, 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.

In an effort to clarify the TAA and the SAA, U.S. Customs and Border Protection (“CBP”) published General Notice, Dutiability of Royalty, Vol. 27, No. 6 Cust. B. & Dec. at 1 (February 10, 1983). This issuance is commonly referred to as “Hasbro II.” In the General Notice, CBP articulated three questions to assist in determining whether royalty or license fees should be dutiable additions to the price actually paid or payable. The questions are:

Was the imported merchandise manufactured under patent?

Was the royalty involved in the production or sale of the imported merchandise?

Could the importer buy the product without paying the fee?

The General Notice indicates that affirmative answers to the first and second questions, and a negative answer to the third, points to dutiability. The answer to the third question goes to the heart of whether a payment is considered to be a condition of sale.

When analyzing the factors identified in the above-referenced general notice, CBP has taken into account certain considerations that flow from the language set forth in the SAA. These include, but are not limited to, the following:
the type of intellectual property rights at issue (e.g., patents covering processes to manufacture the imported merchandise generally will be dutiable);
to whom the royalty was paid (e.g., payments to the seller or a party related to the seller are more likely to be dutiable than are payments to an unrelated third party);
whether the purchase of the imported merchandise and the payment of the royalties are inextricably intertwined (e.g., provisions in the same agreement for the purchase of the imported merchandise and the payment of the royalties; license agreements which refer to or provide for the sale of the imported merchandise, or require the buyer’s purchase of the merchandise from the seller/licensor; termination of either the purchase or license agreement upon termination of the other, or termination of the purchase agreement due to the failure to pay the royalties); and
payment of the royalties on each and every importation.

See, for example, Headquarters Ruling Letter (“HRL”) 547148 dated September 12, 2002 and HRL 548552 dated August 19, 2004. Based upon the information provided in this case, the responses to each of the three above-referenced questions is set forth below.

Was the imported merchandise manufactured under patent?

With respect to the first question, the license agreement grants Kmart the exclusive right, in the United States, Puerto Rico, and U.S. Virgin Islands to utilize the “Route 66” trademark at retail. The royalty fees or payments relate to trademarks and not patents. Thus, the imported merchandise is not manufactured under patent.

Was the royalty involved in the production or sale of the imported merchandise?

With respect to the second question, Kmart is paying a royalty to an unrelated third party for the right to use the Route 66 trademark in the United States, Puerto Rico, and U.S. Virgin Islands in connection with the sale of certain merchandise. There is nothing in the license agreement that obligates or requires Kmart to purchase merchandise from a particular manufacturer or seller. Rather, the license agreement provides that Kmart will procure from sources of its own choosing. Moreover, the royalty payments are not made to the seller of the imported merchandise or to a party related to the seller. We further note that there is no evidence in the record before us to show that the subject royalty payments are involved in the production of the imported merchandise or are a condition of the sale of the merchandise for exportation to the United States. Accordingly, it is our opinion that the royalty is not involved in the production or sale of the imported merchandise.

Could the importer buy the product without paying the fee?

The answer to the third question goes to the heart of whether a payment is considered a condition of sale. Royalty payments and license fees are a condition of sale when they are paid on each and every importation and are inextricably intertwined with the imported merchandise. If the payments are optional and not inextricably intertwined with the imported merchandise, or are paid solely for the exclusive right to manufacture and sell in a designated area, they do not constitute additions to the price actually paid or payable under 19 U.S.C. §1401a(b)(1)(D). See, HRL 546675 dated June 23, 1999.

It should also be restated that the SAA notes a distinction between royalty and license fees paid for patents covering processes to manufacture imported merchandise, and royalty and license fees paid to third parties for use, in the United States, of copyrights and trademarks related to the imported merchandise. The SAA states that the former will generally be dutiable, whereas the latter will generally be considered as a selling expense of the buyer and therefore will not be dutiable. See, for example, HRL 548489 dated August 4, 2004.

It is claimed that Kmart is able to purchase the Route 66 merchandise without paying the royalty fee. Of potential concern in this regard, however, is the reference to payment of a “royalty fee” that is annotated on the purchase orders between Kmart and its vendors. Counsel states that this notation is relevant for Kmart’s internal accounting purposes only and has provided documentation in support of this claim. For example, we note that a purchase order identified as “Exhibit 2” was placed with a vendor for a certain number of jeans at a FOB price of $7.64 per piece and $110,291.04 for the entire order. In addition to the FOB price, the Kmart purchase order also displays fees related to duty, agent fees, harbor fees, ocean freight, user fees, import charges, as well as royalties. The FOB price and additional fees are used in the computation of the “landed cost” which is also indicated on the purchase order. Kmart additionally sets forth its selling price and profit on the purchase order. After placement of this purchase order, the vendor issued an invoice identified as “Exhibit 3” to Kmart for $110,291.04. By letter of credit, Kmart tendered payment of $110,291.04 against this invoice. Proof of this payment is documented on a Kmart “Letter of Credit Drawdown Report”, which is identified as “Exhibit 4.” The transaction documents show that Kmart remitted payment to the seller in an amount equal only to the FOB cost reflected on the purchase order, exclusive of the other fees (including royalties) used in the computation of the landed cost. Thus, it appears as if Kmart is able to purchase the Route 66 merchandise without paying the royalty fee.

It is our opinion that the affidavit, agreements, and transaction documents in this case demonstrate that the royalty payments are made to an unrelated third party licensor, are separate and distinct from the payments made to the vendors for the merchandise, and that Kmart is able to purchase such merchandise without paying the fee to the licensor. We recognize that the quality control provision in the license agreement requires Kmart to submit merchandise samples to the licensor to ensure the quality of such merchandise is maintained but note that the agreement does not otherwise give the licensor control in the actual production or sale of the merchandise. Therefore, we find that the royalty fees or payments made by Kmart to Route 66 pursuant to the above-referenced license agreement are not a condition of sale of the imported merchandise for export to the United States, and do not constitute an addition to the price actually paid or payable for the imported merchandise under 19 U.S.C. §1401a(b)(1)(D).

HOLDING:

Based upon the information provided, we find that the royalty fees or payments made by Kmart to Route 66 pursuant to the above-referenced license agreement do not constitute an addition to the price actually paid or payable for the imported merchandise under 19 U.S.C. §1401a(b)(1)(D).

You are to mail this decision to the internal advice applicant no later than 60 days from the date of the decision. At that time, the Office of Regulations and Rulings will make the decision available to CBP personnel, and to the public on the CBP Home Page on the World Wide Web at www.cbp.gov by means of the Freedom of Information Act, and other methods of public distribution.

Sincerely,

Myles B. Harmon, Director

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