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Royalties – A Common Source of Problems in Customs Valuation
As Nike Thailand wins the case against Thai Customs over royalty dispute, will Thai Customs' treatment of royalties becomes a little clearer? Customs is increasingly taking a strong stance in valuation matters and has in some instances sought to widen the category of payments that would normally be relevant. Importers should therefore be conscious that in the event of an audit any royalty arrangements are likely to be scrutinised by Customs. Taxand Thailand analyses the landslide customs case and examines whether the outcome is likely to make the treatment of royalties by Customs any easier to understand.
Valuation and Royalties
Why royalties? There are many reasons why companies pay royalties. Royalties or license fees include payments for patents, trademarks, and copyrights in respect of the imported goods that the buyer must pay, directly or indirectly, as a condition of sale of the goods for export to Thailand, exclusive of charges for the right to reproduce the imported goods in Thailand.
The dutiable value of imported goods is the basis on which the Customs assesses tariffs and other taxes linked to imports, and firms submit to Customs dutiable values based on the invoices they receive. This manner of reporting does not lead to very big problems when the transaction model is relatively simple. But for more complex transactions, there is a risk of underreporting the dutiable value. Once a firm is found to have underreported, it will have to pay heavy fines on top of the duties it owes.
When considering whether to include royalties in dutiable value, it helps to be clear about a few concepts. First, even the royalty payment is not made to the seller of the goods, it is still possible that it needs to be included in dutiable value. Second, royalties may need to be included irrespective of whether the payment is made to a domestic rights holder or a foreign rights holder.
It is inevitable that royalties will continue to be a major area of contention between Customs authority and importers and even between different customs divisions. The US Customs' position is that, if the holder of the trademark (the party receiving the royalties) is not the seller of the goods or its related party and there is no other evidence that the trademark holder can control the transaction between buyer and seller, then it can concept that the payment of royalties is not a condition for the sale. Many Customs authorities in Asia (including Thailand and China) have stricter rules, where even if there is no connection between the holder of the rights and the seller of the goods, there is a strong tendency to assume some influence on the part of the patent or trademark holder, so royalty payments are viewed as a condition of sale.
Possible distinction from Nike
A recent Supreme Court case on third party royalties was won by the plaintiff i.e. Nike Thailand, as the court determined that third party royalties do not need to be added to the customs value of the imported goods. Once of the critical factors is the level of control the Intellectual Property holder has over the manufacturer. The Supreme Court decided that the transaction were similar to WCO Advisory Opinion 4.8, in that the license holder has no direct control over the seller of the goods, and the sales contract does not contain a requirement for the importer to pa the royalty. Therefore although the royalty is related to the imported goods (the trademark was affixed at the time of importation), it is not a condition of sale of the goods.
There are a number of other third party royalty cases where Thai Customs has previously determined that the royalty is dutiable, and therefore the license holder has control over the sale of the goods. There are some clear-cut cases where the license holder has a lot of influence over the manufacturer, and can prevent the manufacturer selling the license goods if the royalty is not paid.
Condition of the sale
There has been a significant amount of litigation concerning whether a royalty can be said to be payable 'as a condition of the sale of the goods for export to Thailand'.
In the Nike Thailand case, the Supreme Court Judges have interpreted these words narrowly, even though the Court of Nike NZ case noted that the phrase 'a condition of the sale' should not be read as meaning 'a condition of the contract of sale'.
In the Adidas NZ judgment decided that the royalty payment was a condition of the sale because of the particular buying practice adopted by Adidas NZ. That practice was that Adidas NZ had left all the buying arrangements in the hands of another Adidas company and this gave Adidas AG effective control over Adidas NZ's purchases.
It appears in the Supreme Court case on Nike Thailand that Thai Customs defended the royalty payment as a condition of sale because of the buying practice adopted by Nike Thailand. From that practice, Nike Thailand was restricted in its ability to import manufactured product from a third party manufacturer (it could only have goods manufactured overseas by manufacturers approve by Nike International. The effect of this was that Nike Thailand could have imported the product which it later sold without incurring the liability to pay a royalty.
It appears that the Thai Supreme Court might not see the payment of royalty as an 'economic reality' test but was confused on the actual legal position of the parties. The Buying Practice of Nike Thailand is the importer (Nike Thailand's) delegation of its various purchasing arrangements to another Nike (Nike Inc). Thai Supreme Court had overlooked the significance of the importer utilising a related company as a buying agent. This, along with restrictions placed on the importer's ability to obtain letters of credit through its group can be concluded that importer's ultimate parent company controlled the entire transaction.
A further argument against the Thai Supreme Court but Thai Customs had failed to do is that - if the manufacturer would have charged the same selling price irrespective of whether royalties were paid, then it cannot be seen to be a condition of the 'sale of the goods for export'.
Many importers may think that this recent Supreme Court Case provides greater guidance to importers and customs advisors including more confidence to challenge customs rulings in the courts.
However, the most important issue will always be the precise circumstances of each case, and no amount of guidance and precedent will ever be able to cover every situation. Duty assessments of royalties can never be automated, and importers should review any royalty transactions.
Importers should ensure that their intellectual property arrangements are carefully considered when calculating dutiable value, particularly where those goods are subject to import duty. Importers should also be conscious of the other types of additions to dutiable value which are required by the Thai Customs Act and WTO Valuation Agreement, particularly in relation to generic fees that may cover a wide range of services or rights.
The importer that pays royalties to unrelated third parties might consider relying on Nike Thailand to exclude those payments from duty calculations. Whether the courts will endorse this remains to be seen. However, despite the reservations in Nike, a Court might take a very broad, practical approach and say that any sale agreement for branded product would be of little value without an ongoing right to sell the products in Thailand and accordingly that the sale agreement would effectively be 'conditional' on a related royalty agreement.
When enterprises undertake international tax planning, they often view royalties as a tool for transferring funds and repatriating profits, neglecting the customs duty considerations. This can result in higher than expected overall tax burdens or even stiff fines. Thus companies planning to make royalty payments should make sure they consider whether those payments will have to be included in dutiable value calculations.
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