Sunday, December 04, 2016

Ruling of the Week 2016.23: Patents and Value

We don't talk enough about customs value here. It is important, complicated, and interesting. It deserves more attention. There are, however, also fewer rulings and cases on valuation questions. Happily, this one (HQ H233376, Sep. 19, 2016) caught my eye. The issue is whether a royalty paid to a U.S. patent holder who is unrelated to the importer is dutiable when the royalty is paid not by the importer but by the importer's parent company.

The patents at issue are all utility patents, meaning that they relate to new and useful inventions rather than to the design aesthetics of the item. A utility patent generally involves the critical technology that defines or empowers the invention. The license grants to the importer (via a predecessor company, just to complicate matters) "to make, have made, use, sell, offer for sale and import Licensed Devices" worldwide. The license also authorizes the licensee to disclose to the manufacturer, who is in Malaysia, the information that is necessary to manufacture the products. Similarly, the manufacturer is authorized to use the patented technology to makes the item and to apply related trademarks.

When goods are imported pursuant to a sale, the customs valuation is usually the "transaction value." That is defined at 19 USC 1401a(b) as the price actually paid or payable for the merchandise when sold for exportation to the United States, plus specified statutory additions including "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."

In 1993, Customs published an official notice detailing how it will analyze royalties for dutiability. We discussed that here. To summarize from my earlier post, under the test, Customs and Border Protection analyzes each royalty agreement on a case-by-case basis and asks three questions:

1. Was the importer merchandise manufactured under patent? If the answer is yes, then the payment is more closely tied to the production of the merchandise and is, therefore, more likely dutiable.

2. Was the payment involved in the production or sale of the imported merchandise? This question goes more deeply into the purpose of the payment. If the importer can show that the payment is for something other than the manufacture, production, or purchase of the imported goods, the payment may not be dutiable. Customs gave two examples in which the Court found that the putative royalty was for the use of the product in the United States, not for the patent rights related to the production or importation of the product. A positive answer to this question, therefore, leans toward dutiablity while a negative answer leans against.

3. Could the importer buy the product without paying the fee? If the fee is not optional and goes to the seller, it is more likely to be a dutiable part of the value of the merchandise. According to Customs, this question "goes to the heart" of whether the payment is a condition of sale. That means a negative answer to this question indicates dutiability.

In this ruling, Customs gave the short answer that the royalty is dutiable. The merchandise was manufactured under a patent and the patented technology is related to the production or sale of the imported item. Furthermore, Customs found that the importer could not buy the merchandise without paying the fee. Nevertheless, counsel for the importer (who was not me) argued against suitability of the royalty in this case.

Counsel first noted that the royalty is not paid to or for the benefit of the seller. This is a common argument and merits attention. How is a royalty part of the "price paid or payable" for the merchandise if it not paid to the seller? The answer is that the statute does not require that the royalty be paid to the seller to be dutiable. Rather, the statute requires that royalties be added to the dutiable value when they are "related to the imported merchandise" and when "the buyer is required to pay [the royalty], directly or indirectly, as a condition of the sale of the imported merchandise for exportation to the United States." Note that the statute does not say to whom the royalty must be paid to be dutiable.

The question is not how much did the seller receive in exchange for the goods. The question is what is the total cost to the buyer to acquire the merchandise. This is entirely consistent with other parts of the statute which, for example, add assists, selling commissions, and packing materials to the entered value for duty. If the buyer did not pay this patent royalty, the seller would have to do so to acquire the legal right to manufacture the item. Because the buyer's parent paid it, the cost to the seller is reduced below what it would otherwise have been. This is exactly why the value of buttons provided by the buyer to the manufacturer for use in the production of shirts must be added to the entered value of the shirts. If the seller had to go buy the buttons, it would increase the price to cover the additional expense. This, therefore, is a losing argument, even when the patent holder is in the U.S.

To stick to this conclusion, Customs had to distinguish several prior rulings that appear to have conflicting results. I'm going to spare you the details. It should suffice to say that a patent royalty might not be dutiable if it is not a condition of the sale to the United States or is not fundamental to the manufacturer of the item. For example, a patent license relating only to the use of some item, as opposed to the manufacturer of it, is less likely to result in a dutiable royalty. Similarly, a design patent is less likely to be dutiable than is a utility patent.

The other question is whether a royalty paid to a U.S. patent holder can be a condition of the sale for export from the foreign manufacturer. After all, what does the manufacturer care if the buyer fails to pay the royalty? That is not its problem. Customs' analysis is more nuanced than that. It held that a condition of the sale exists where the right to use the patent "must be secured, either by the buyer or the manufacturer because the patent is necessary to produce the merchandise to be sold for export to the United States. i.e., [sic] the imported merchandise would not exist it the rights to the patent were not obtained." This gives the requirement that the royalty be a condition of the sale a broad and flexible interpretation that can be interpreted practically as well as under the terms of an individual contract.

All of that led Customs and Border Protection to hold the royalty in this case to be dutiable.

I have a question. The ruling clearly says, "the royalty payments at issue are made to the licensor, [Company A] (a U.S. patent holder who is not related to the company or to the manufacturer of the imported merchandise_, by [Company B], the parent of the company's parent." [Emphasis added.] So am I correct that the buyer did not actually pay this royalty? It was paid not by the parent company but by the grandparent company. This should be discussed in the ruling. The company, presumably the importer, is not responsible for the payment of the royalty. It seems possible that the company did not even know about it.

The statute covers "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 . . . ." [Emphasis added.] It appears that Customs treated the royalty as indirectly paid, without stating so. Is that right?

I would read "indirectly" as relating to the method of payment to the seller, not to the party making the payment, which seems to be limited to the buyer. How do we know from this ruling that the buyer is required to make this payment, whether directly or indirectly? It seems clear that a related but legally separate entity is required to make that payment. I can see CBP's implied conclusion that this is an indirect payment by the buyer, but I think there needs to be some facts stated to support that conclusion. Otherwise Customs has effectively ignored the separate legal status of the companies and pierced a corporate veil without comment.

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