U.S. Customs Service 1300 Pennsylvania Avenue, N.W. Washington, D.C. 20229 HQ W548055 March 14, 2002 RR:IT:VA W548055 AH Category: Valuation Port Director U.S. Customs Service 101 E. Main St. Norfolk, VA 23510 Dear Port Director: This is in response to your November 6, 2001 memorandum wherein you requested internal advice regarding a letter dated September 8, 2000 submitted by Meeks & Sheppard (hereinafter “Counsel”) on behalf of xxxxxxxx (hereinafter “Company A” or “importer'”) requesting prior disclosure of royalty payments. Pursuant to 19 C.F.R, 177.11(a), you request that we consider and rule on whether certain royalty payments constitute part of transaction value under section 402 of the Tariff Act of 1930, as amended (“TAA”; 19 U.S.C. §1401(a)). You submit that royalty payments paid for patent and trademark rights by Company A are dutiable under both Sections 402(b)(1)(D) and 402(b)(1)(E) of the TAA. In addition, you request advice as to whether an importer, in an effort to offset any duties that may be owed as part of a prior disclosure, can concurrently seek partial duty relief by utilizing offsetting duty reductions relating to entries that have already been fully liquidated. FACTS: According to Counsel’s submissions, Company A discovered, incident to a periodic, internal review of its compliance with Customs laws and regulations, that royalty payments made to parties related to the seller of imported xxxxx (hereinafter “stanol product”) were not disclosed to Customs, nor were quarterly adjustments to the invoice price that were in Company A’s favor. The entries, which are the subject of this disclosure were all liquidated in 1999. Prior to 2000, Company A purchased and imported the stanol product from xxxxxx (hereinafter Company B), a company incorporated and located in a European country. Company A also purchased stanol product manufactured in the United States by xxxxxx. (hereinafter Company C), a subsidiary of Company B. Company A continues to purchase the stanol product from the U.S. manufacturer. The stanol product is an ingredient that Company A uses in producing and marketing its finished product sold under the xxxxxxx® trademark (hereinafter “trademark”). The trademark is licensed by Company B to its subsidiary xxxxxxxx (hereinafter “Company D”). Company A entered into a Supply Agreement with Company C, which governs the production and sale of the stanol product to Company A. Pursuant to the provisions of the Supply Agreement, Company C agrees to fill Company A’s orders for the stanol product. Counsel tells us that Company C fills Company A’s orders either by producing the product in its facilities located in the United States or by forwarding Company A’s orders to Company B, which produces the product in its facilities. For our purposes, we are only concerned with those products produced by Company B and imported into the United States. In addition, Company A entered into a License Agreement with Company C and Company D wherein Company A agrees to pay certain royalties on a quarterly basis based on the net invoice price of Company A’s sales of the finished stanol product. According to the License Agreement, Company C agrees to grant Company A an exclusive sublicense to sell the patented stanol product. In addition, Company D agrees to grant Company A an exclusive sublicense to sell the stanol product under the trademark. Although Company B is not party to either agreement, both make reference to the fact that Company B developed the stanol product and is the original patent and trademark holder with respect to the stanol product. In addition, the Supply Agreement and the License Agreement reference each other, and subject to a limited exception, both stipulate that Company A must purchase all of its required stanol product from Company C or its related parent company, Company B. Disclosed Royalty Payments According to the License Agreement, Company A is obligated to pay Company C 3% of the net invoice price of trade sales of the finished product for the use of the patent on the stanol product. This 3% payment on the sale of the finished product must be paid whether or not it contains the stanol product produced domestically or imported. The royalty is only due if Company A’s finished product contains the stanol product. In addition, Company A must pay 2% of the net invoice price of trade sales of the finished product to Company D for the use of the trademark. The 2% payment on the sale of the finished product must be made whether or not the product contains the stanol product, or if it does whether or not it was imported or produced domestically. According to Company A’s disclosure, total royalties accumulated through the 1st quarter, 2000 on sales of Company A’s product using the stanol product purchased and imported by Company A were $1,340,000. The patent royalty accounted for $803,300 and the trademark royalty accounted for the remainder of $536,700. In addition to its disclosure regarding the royalty payments, Company A also notes that it received a total refund of $654,262 in 1999 and 2000, representing quarterly adjustments to the invoice price of the imported stanol product. Company A explains that its Supply Agreement provides for price reductions in the event that the weighted average of the price of raw sterol decreases. ISSUES: Whether the royalty payments made by Company A to Company C and Company D are included in the transaction value of the imported product under § 402(b)(1)(D) of the TAA. Whether the royalty payments made by Company A to Company C and Company D are included in the transaction value of the imported product as proceeds of subsequent resale under § 402(b)(1)(E) of the TAA. Whether price adjustments resulting in refunds for payments made on imported merchandise may be used to reduce duty liability insofar as to offset duties owed as part of a prior disclosure. LAW AND ANALYSIS: The preferred method of appraising merchandise imported into the United States is transaction value pursuant to § 402(b) of the 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 certain statutorily enumerated additions. § 402(b )(1) of the T AA provides 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; and (E) the proceeds of any subsequent resale, disposal or use of the imported merchandise that accrue, directly or indirectly, to the seller. Royalty Payments With regard to royalties, the Statement of Administrative Action (“SAA”), adopted by Congress with the passage of the TAA, provides that: [a]dditions 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, or 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 they were paid. Statement of Administrative Action, H.R. Doc. 153, Pt 11, 96111 Cong., 1st Sess. (1979), reprinted in Department of the Treasury, Customs Valuation under the Trade Agreements Act of 1979 (October 1981), at 48-49. In General Notice, Dutiability of Royalty Payments, 27 Cust. Bull. 12 (1993), Customs articulated three factors, based on prior court decisions, for determining whether a royalty was dutiable. These factors were whether: 1) the imported merchandise was manufactured under patent; 2) the royalty was involved in the production or sale of the imported merchandise; and 3) the importer could buy the product without paying the fee. Affirmative responses to factors one and two and a negative response to factor three would indicate the payments were related to the imported merchandise and a condition of sale and, therefore dutiable as royalty payments. Royalty Payments Pertaining to Patent In regard to our case, Company B has developed a combination of certain ingredients, which constitute the stanol product and are used as ingredients by Company A in manufacturing its finished products. The License Agreement indicates that Company B is the owner of the patent rights relating to the stanol product and that Company B has licensed its exclusive use in the United States to its subsidiary, Company C, which in turn granted a sublicense to Company A. Insofar as the imported stanol product was manufactured under a patent held by Company B, the seller, the first factor is satisfied. As to whether the royalty was involved in the sale of the imported product, Counsel points out that the 3% royalty is paid on the sale of the finished product produced by Company A whether or not it contains domestically produced or imported stanol product and that in the event that the finished product is not sold, no royalty is due, regardless of the amount of the stanol product imported. Thus, Counsel argues that the sale of the imported stanol product and the payment of royalties are mutually exclusive. It is our opinion that the payment of royalties are involved in the production and sale of the imported product. As stated, Company B is the patent holder for the stanol product and has granted an exclusive license to its subsidiary, Company C to use the patent in the United States. As both Company B and C hold rights as to the use of the patent relating to the stanol product, it is logical that Company A would be obligated to make royalty payments on sales of its finished products containing either domestically produced or imported stanol product. The fact that Company A pays royalties as to both domestically produced and imported stanol product does not vitiate the claim that the payment of royalties is closely related to the sale of the imported product. Counsel also notes Section 3 of the Supply Agreement insofar as it affects the quantity of the stanol product ordered, without affecting the royalty payments. Counsel has not stated what effect such an observation should have on our determination as to the dutiability of the royalty payments, however, we deduce that Counsel endeavors to demonstrate that royalty payments are not related to or conditions of sale for the importation of the stanol product. As noted, however, royalty payments are a function of Company A’s eventual sales to third party customers. Accordingly, quantities ordered do not have a bearing on the royalty payments, as agreed by the parties to the importation transactions. This arrangement does not affect the relationship between the royalty payments and the importation of the stanol product or the conditionality of the promised royalty payments as a condition precedent to the sale for exportation of the imported stanol product. In addition, Counsel asserts that the provisions of section 11 of the Supply Agreement illustrate that the sale of the imported stanol product and the payment of royalties are unrelated. Counsel asserts that this provision allows Company A to forego Company B and C as their stanol product supplier and to manufacture their own or purchase it from a third party. In response, we note that Company A is granted this exception only under very limited circumstances. According to Section 11(a) of the Supply Agreement, Company A is only permitted to seek third party suppliers in the event that Company B and C are unable to fulfill at least 50% of Company A’s orders with complying goods for a full fiscal quarter. However this exception may only be exercised for a maximum duration of one year, after which time Company A is obligated to buy the stanol product exclusively from Company B and C. See Section 11(f)(1) and section 11(g)(5) of the Supply Agreement. Even during this period of exception, Company A is obligated to purchase a certain minimum quantity from Company B and C, which the companies are able to manufacture for Company A. See Section 11(f)(3) of the Supply Agreement. Moreover, Company A is contractually obligated to minimize its third party transactions as much as possible during this period of exception. See Section 11(f)(1). Given the very limited nature of the exception contained in Section 11, it is our opinion that the sale of the stanol product is, for all intents and purposes, conditioned on the payment of certain royalties for patent rights and that Company A is precluded from seeking alternative sources. Royalty Payments Pertaining to Trademark With respect to royalty payments for the use of the trademark, Counsel points out that pursuant to Section 5 of the License Agreement the royalty payment is based on sales of the trademarked products in the United States, not the quantity of the stanol product imported. However, we note that it is our opinion that the payment of royalties need not occur at the exact time of importation for the sale of the imported product and the payment of royalties to be deemed related and for the royalty payments to be considered a condition of sale. See Headquarters Ruling Letter (HRL) 546034, dated May 6, 1997. The basis upon which a royalty payment is calculated, whether it is quantities ordered or percentage of sales to third parties is merely a contractual decision between the parties as to what constitutes sufficient remuneration for use of the patent and trademark holder's intellectual property rights and does nothing to lessen the relationship between the sale of the imported product and the payment of royalties. In addition, Counsel asks us to note that Section 3 of the License Agreement provides for possible alternative arrangements concerning the trademark that are not contingent on the amount of the stanol product imported. Pursuant to Section 3 of the License Agreement, Company A is permitted to seek certain alternatives upon the occurrence of particular events. Section 3(a) of the License Agreement provides for alteration or termination of the relationship between the parties to the agreement in the event that certain regulatory obstacles to the sale of the product are imposed by the United States government. In addition, Section 3 of the License agreement also permits Company A to market its product under an alternative trademark in the event that certain defects are discovered in Company B’s trademark. This section also provides Company A with the option of purchasing the rights, title and interest of Company B’s trademark, but at a date no earlier than December 31, 2018. In our view, these alternative arrangements are not material to a determination of the dutiability of the royalty payments. In consideration of the possibility that certain exogenous forces to the agreement and the parties may hamper Company A’s use of the trademark, these provisions provide certain protections to Company A in order to preserve Company A’s interest in selling the product under the trademark. The provisions do not alter the related nature of the sale of the imported product and the payment of royalties, but instead underscore the relationship in providing certain limited exceptions and alterations to the established relationship in the event of unforeseen and uncontrollable events. A review of both the Supply Agreement and the License Agreement leads to the conclusion that the payment of the royalties was a condition of sale of the imported stanol product. The Supply Agreement requires Company A to purchase all of its requirements from Company B and C, subject to a limited exception. Moreover, the License Agreement and the Supply Agreement reference each other and were executed the same day, which is another indication that the payment of royalties was a condition for the sale of the imported product. In addition, it is our opinion that the fact that the royalties were not paid directly to the seller of the imported product is not material since they were paid to a party related to the seller. In conclusion, we find that the payment of royalties cannot be separated from the sale of the imported product and that, accordingly, the royalty payments are included in the transaction value of the imported product under § 402(b)(1)(D) of the TAA. The payments are related to the imported merchandise which Company A is required to pay as a condition of sale. Proceeds of Subsequent Resale You have also inquired as to whether the royalty payments constitute proceeds of a subsequent resale, disposal or use, pursuant to § 402(b)(1)(E) of the TAA. The SAA addresses the dutiability of proceeds of subsequent resale as follows: Additions for the value of any part of the proceeds of any subsequent resale, disposal, or use of imported merchandise that accrues directly or indirectly to the seller, do not extend to the flow of dividends or other payments from the buyer to the seller that do not directly relate to the imported merchandise. Whether an addition will be made must be determined on a case-by-case basis depending on the facts of each individual transaction. Congress has recognized that at times, “certain elements called ‘royalties’ may fall within the scope of language under either new section 402(b)(1)(D) or 402(b)(2)(E) or both.” See The General Notice on the Dutiability of “Royalty” Payments. First, we note that, in accordance with the standard articulated in Generra Sportswear Co. v. United States, 8 CAFC 132, 905 F.2d 377 (1990), there is a rebuttable presumption that all payments made by a buyer to a seller, or party related to a seller, are part of the price actually paid or payable. See Headquarters Ruling Letter (HRL) 545663, dated July 14, 1995. In our case, where the licensor receiving the payment and the seller are related, the royalty payments are considered to be an addition to the price actually paid or payable as proceeds of a subsequent resale pursuant to section 402(b)(1)(E) unless the buyer establishes that no portion of the proceed accrues directly or indirectly to the seller. See HRL 545361, dated July 20, 1995. Given the circumstances of the instant case, that the seller of the imported product, Company B, is related to the parties receiving the royalty payments from Company A, namely Company C and D, and absent evidence to the contrary, it is our opinion that we may infer that the proceeds inure to the benefit of the seller. Accordingly, it is our decision that the royalty payments are, alternatively, statutory additions to the price actually paid or payable as proceeds of a subsequent resale pursuant to § 402(b)(1)(E) of the TAA. Use of Offsetting Duty Reductions You have also requested our advice as to whether you can reduce the appraised value of the imported product based on reimbursements made to Company A for overpayments made in accordance with a fluctuating price structure agreed to prior to importation. Counsel has demanded that these reimbursements be taken into account so as to offset any duties that may be owed on the disclosed royalty payments. As to rebates received subsequent to importation by a buyer/importer, 19 U.S.C. §1401a(b)(4)(B) provides that: “Any rebate of, or other decrease in, the price actually paid or payable that is made or otherwise effected between the buyer and seller after the date of the importation of the merchandise into the United States shall be disregarded in determining the transaction value ... “ Despite this language, we note that there are instances in which price adjustments made subsequent to importation, which result in a reduction in the price paid or payable to the seller for the imported product will not be regarded as a rebate. In order for a price which requires adjustment subsequent to importation to be determined to represent transaction value, the price must be determined pursuant to a formula that was in existence prior to the date of exportation. See HRL 543352 dated March 30, 1984. It does not appear that the method and process by which this price adjustment was made qualifies it for consideration in determining transaction value. Even if this price adjustment did qualify, there is no basis for offsetting the alleged overpayments of duties against amounts owed in connection with the prior disclosure. The alleged overpayments relate to entries liquidated for which the protest period has expired. Pending Protest of Classification Issue We note that Counsel has also called attention to a pending protest before Customs regarding the duty classification of the stanol product. Counsel contends that the imported product may be eligible for a duty-free classification in which case Company A may receive a duty refund. Counsel has asked that in the event that Company A receives a favorable response to its protest, that any duty refund be used to offset possible duties owed for royalty payments. Although also involving the issue of an offsetting duty reduction this, however, is a separate issue from the price adjustments to which you refer. As to the issue of Company A’s protest, we note that a decision has been rendered denying Company A’s request for a duty-free classification. Insofar as a duty refund is no longer a possibility, the offset question is moot. HOLDING: Based on the information provided, including the Supply Agreement and License Agreement furnished by Company A, it is our decision that the royalty payments made to Company C and D are included as statutory additions to the price actually paid or payable under § 402(b)(1)(D) of the TAA, or under § 402(b)(1)(E) of the TAA. In addition, reimbursements effected after importation may not be used to reduce the price actually paid or payable in an effort to offset duty liability. This decision should be mailed by your office to counsel 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 this decision available to Customs personnel via the Customs Ruling Module in ACS and the public via the Diskette Subscription Service, Freedom of Information Act and other public access channels. Sincerely, Virginia Brown Chief, Value Branch