October, 2017
Customs Valuation Status of Exclusivity and Franchise Fees
Mark K. Neville, Jr.
We have established the primary features of the customs valuation process in a recent discussion in this space1 and so we can proceed from the basic frame of that process as we turn our attention to one of the more emergent issues. I refer to the trend for customs authorities to examine separate payments by the importer for services or for other property rights of value.
For the most part, these payments are made on a post-importation basis, but there is no reasons why the payments may not precede the entry of the merchandise.
We have already written about payments made for advertising, marketing and promotion assistance2 and we turn our attention to two other species of such extraneous payments: those for exclusivity and for franchise rights.
The view of some customs authorities on exclusivity payments is similar to the team on the field seeking the “out” call at second base. After all, we have an entity that purchases and imports goods. That importer is also making payments for exclusivity rights and, as is the case with the baseball play, such payments are “in the neighborhood” precisely because they are made by the importer. I would argue that they are in the neighborhood only because they are being made by the importer. More to the point, the mere fact that they are being made by the importer—or even if they are being paid to the seller—is not sufficient to make the payments dutiable. The customs authorities conflate the fact that there are two separate payments for two separate items of value.
As is always the case on matters of interpretation or administration of a statute, the terms of the statute control. Here the Customs Valuation Agreement (CVA) must control any analysis.3 The actual definition of the Price Actually Paid or Payable (PAPP) for the Goods, which is the foundation for all Transaction Value appraisals, is Art. 1.1, and it states in relevant part that it is the PAPP “for the goods when sold for export to the country of importation.” This should be plain enough but it bears restating—if the payment is not for the goods it is not dutiable. Even in the US where we are forced to apply the Generra4 rule—all payments to the seller are presumed dutiable—the importer is given the opportunity to rebut that presumption. 5Another way to view the matter is to note that we are not simply talking about a payment that is related to the imported good. After all, if taken to a certain level of abstraction, any and all payments by an importer would be deemed related to the imported good. We should be looking at whether payments are “for the good.” That is a step beyond a showing or even an inference that the payments are related to the good.6
To return to our analogy, customs valuation is like baseball. The mere fact that the payment is related to the imported good, without more, is no more reason for finding dutiablity than it would be the basis for a force out at a base where the fielder is close to or “in the neighborhood of” the base but never actually steps on the base.
If the importer can show that the payment is for exclusivity, for something entirely separate from the PAPP, then US Customs and Border Protection (CBP) will regard the payment as nondutiable.7 We can hope, but cannot expect, that other customs administrations would follow suit—not because it is a US position—most readers will know that I call out the US where there is a perceived error8--but simply because the logic of the US position here is firmly based on the CVA. Notwithstanding that logic, efforts to come to a consensus on this issue at the World Customs Organization (WCO) have proved unavailing.
Just as there are instances where a distributor will pay for exclusivity rights so, too, are there entities who will pay for the right to operate a franchise. Consider the many companies that run fast food restaurants on a franchised basis, to take perhaps the most visible example.
But we should be clear that in the typical franchise agreement the franchisor will be making available its full panoply of rights associated with the branded business. This will ordinarily include tradename and trademark rights, knowhow and access to proprietary software and other business processes, as well as assistance of a more general nature such as being placed in connection with vendors and service providers across all manner of sectors. The franchisee will pay fees to the franchisor for these rights and for this support. It is where the franchisee needs to buy various inputs that we may be entering into the customs valuation field.
That is because the franchisee may need to be importing some of those inputs (e.g., buns or meat for hamburgers) and, further, the franchisee may need to purchase some of those imported inputs from the franchisor or from a party related to the franchisor. If that is the case, then we may start to meet the same issues that arise when the distributor pays for exclusivity. Specifically, the question becomes, do the franchise fees become part of the customs value of any imported product, such as the imported buns or meat?
Unlike the case of exclusivity fees, with franchise fees we have a recently promulgated9 Advisory Opinion from the WCO’s Technical Committee on Customs Valuation (TCCV). With Advisory Opinion 4.17 the TCCV concluded an instrument that concluded that royalties paid by a franchisee were not dutiable. The franchisee purchased a number of ingredients for use in making baked goods and selling them from a franchised location, with the typical presentation, i.e., licensed tradename and trademarks, trade dress, associated with the franchise.
The TCCV determined that the payments were not an integral part of the PAPP, a point not developed in the Opinion, nor were they dutiable as royalties or license fees. This latter point was the focus of the discussion and this conclusion was sustained for several reasons: First and foremost, the payments were not related to the imported ingredients in any direct way but, instead, were for use of the brands and the systems that were central to the operation of the stores displaying the brands of the franchisor.
Second, many of the ingredients (e.g., flour, milk, butter, eggs) were commodity products that would be purchased in the country of importation and would not be imported by the franchisee. Third, none of the ingredients bore any of the franchisor’s trademarks or were produced with patents or any other form of intellectual property for which a payment by franchisee is made. Even though all of the ingredients were required to be sourced from the franchisor or from a third party authorized by the franchisor, that was not enough to overcome the first and third points. As an aside, this restriction on sourcing is quite typical as a brand protection requirement in franchise agreements or in those instance where a license to manufacture a product bearing a licensed trademark has been conferred. The franchisor or the trademark licensor wants to ensure uniformity in the “look and feel” of products that are associated with the business and the last development that will be tolerated is a franchisee or a licensee resorting to shoddy ingredients or materials that will deviate from quality standards. As another example of this attention to quality, contract manufacturers of garments are typically required to purchase all inputs, from fabrics, fittings and accessories, hang tags, hangers all the way to plastic bags and cardboard boxes, only from approved vendors.
While this new instrument is welcome, we must point out a worrisome ruling issued by CBP, dating to 2004. This is ruling no. W548464 (5/25/04), which dealt with the valuation law status of a payment in the nature of a 2% Technical Consulting and Retail Services Fee. CBP concluded that
Moreover, this 2004 ruling suggests a possibly flawed argument put forward by the importer’s counsel. Apparently the importer argued that there was no profit element represented by the 2% fee (“the fee is adequate to cover the costs of the services provided and nothing more”). Even if the recipient of the services were the seller and even if the payment included an element of profit, those facts would still not convert the payment into a payment for the goods.
More tax accounting support could have been adduced to demonstrate that any profits generated from the services would remain in that separate category and would not automatically be transferred over to—or altered to become--an enhanced seller’s profit on the sales of goods. Since these were related parties, one can surmise that if the issue were to arise today—some 16 years after the issue addressed in that 2004 ruling first surfaced—then it might be the case that there would be more robust transfer pricing documentation and accounting support, justifying not only the sale price (the ruling stated that there was no sales agreement available for review) but also the level of the fees paid by the importer.
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For the most part, these payments are made on a post-importation basis, but there is no reasons why the payments may not precede the entry of the merchandise.
We have already written about payments made for advertising, marketing and promotion assistance2 and we turn our attention to two other species of such extraneous payments: those for exclusivity and for franchise rights.
Distributor’s Exclusivity Payments
Consider the payment by a company for exclusivity, i.e., for the exclusive right to act as distributor in a given territory. The payment for such a right would typically be made at the outset of the relationship, before any sales have been made or any importations into the customs territory have occurred. In some instances the amount of the fee is estimated as a percentage of the expected resales in the territory or the estimated purchases by the distributor/importer. But note that, typically, the fees will be due even if there are no resales or no purchases at all, and that the payment is for a separate property right—the exclusive franchise in the subject goods in the relevant territory—and not for the imported goods, assuming there are any such purchases and imports into the customs territory. Sometimes the grant of the distribution rights is the seller of the goods, but often enough the seller of the goods and the company granting the distribution rights are not the same party. In some cases, the seller of the goods is not even related to either party to the distribution agreement.SAFE!
But the payment for such rights has given rise to what is called in baseball a “neighborhood play.” For those who are not familiar with the term, or with baseball generally, one example of this is a fielder’s (usually the shortstop or second baseman) failure to step on second base and thereby make a “force out” on the runner advancing from first base before throwing to first base in an attempt to make a double play. The fielder hopes that the umpire did not get a good view of the play, and that the umpire will rule that there was a good force out at second. Sometimes the ump misses it—and that is one reason why they have now have “replay” in Major League Baseball. And that replay review has resulted in some of those erroneous calls being reversed.The view of some customs authorities on exclusivity payments is similar to the team on the field seeking the “out” call at second base. After all, we have an entity that purchases and imports goods. That importer is also making payments for exclusivity rights and, as is the case with the baseball play, such payments are “in the neighborhood” precisely because they are made by the importer. I would argue that they are in the neighborhood only because they are being made by the importer. More to the point, the mere fact that they are being made by the importer—or even if they are being paid to the seller—is not sufficient to make the payments dutiable. The customs authorities conflate the fact that there are two separate payments for two separate items of value.
As is always the case on matters of interpretation or administration of a statute, the terms of the statute control. Here the Customs Valuation Agreement (CVA) must control any analysis.3 The actual definition of the Price Actually Paid or Payable (PAPP) for the Goods, which is the foundation for all Transaction Value appraisals, is Art. 1.1, and it states in relevant part that it is the PAPP “for the goods when sold for export to the country of importation.” This should be plain enough but it bears restating—if the payment is not for the goods it is not dutiable. Even in the US where we are forced to apply the Generra4 rule—all payments to the seller are presumed dutiable—the importer is given the opportunity to rebut that presumption. 5Another way to view the matter is to note that we are not simply talking about a payment that is related to the imported good. After all, if taken to a certain level of abstraction, any and all payments by an importer would be deemed related to the imported good. We should be looking at whether payments are “for the good.” That is a step beyond a showing or even an inference that the payments are related to the good.6
To return to our analogy, customs valuation is like baseball. The mere fact that the payment is related to the imported good, without more, is no more reason for finding dutiablity than it would be the basis for a force out at a base where the fielder is close to or “in the neighborhood of” the base but never actually steps on the base.
If the importer can show that the payment is for exclusivity, for something entirely separate from the PAPP, then US Customs and Border Protection (CBP) will regard the payment as nondutiable.7 We can hope, but cannot expect, that other customs administrations would follow suit—not because it is a US position—most readers will know that I call out the US where there is a perceived error8--but simply because the logic of the US position here is firmly based on the CVA. Notwithstanding that logic, efforts to come to a consensus on this issue at the World Customs Organization (WCO) have proved unavailing.
Just as there are instances where a distributor will pay for exclusivity rights so, too, are there entities who will pay for the right to operate a franchise. Consider the many companies that run fast food restaurants on a franchised basis, to take perhaps the most visible example.
Franchise Fees
The first point that we must make here is that franchise fees are similar to a distributor’s exclusivity fee. In fact, the term often applied to the ongoing business of a distributor of product in a given territory is that it is its “franchise.” Also, both the distributor and the franchisee would be the parties making the payments for rights associated with, indeed arising from, their operative agreements.But we should be clear that in the typical franchise agreement the franchisor will be making available its full panoply of rights associated with the branded business. This will ordinarily include tradename and trademark rights, knowhow and access to proprietary software and other business processes, as well as assistance of a more general nature such as being placed in connection with vendors and service providers across all manner of sectors. The franchisee will pay fees to the franchisor for these rights and for this support. It is where the franchisee needs to buy various inputs that we may be entering into the customs valuation field.
That is because the franchisee may need to be importing some of those inputs (e.g., buns or meat for hamburgers) and, further, the franchisee may need to purchase some of those imported inputs from the franchisor or from a party related to the franchisor. If that is the case, then we may start to meet the same issues that arise when the distributor pays for exclusivity. Specifically, the question becomes, do the franchise fees become part of the customs value of any imported product, such as the imported buns or meat?
Unlike the case of exclusivity fees, with franchise fees we have a recently promulgated9 Advisory Opinion from the WCO’s Technical Committee on Customs Valuation (TCCV). With Advisory Opinion 4.17 the TCCV concluded an instrument that concluded that royalties paid by a franchisee were not dutiable. The franchisee purchased a number of ingredients for use in making baked goods and selling them from a franchised location, with the typical presentation, i.e., licensed tradename and trademarks, trade dress, associated with the franchise.
The TCCV determined that the payments were not an integral part of the PAPP, a point not developed in the Opinion, nor were they dutiable as royalties or license fees. This latter point was the focus of the discussion and this conclusion was sustained for several reasons: First and foremost, the payments were not related to the imported ingredients in any direct way but, instead, were for use of the brands and the systems that were central to the operation of the stores displaying the brands of the franchisor.
Second, many of the ingredients (e.g., flour, milk, butter, eggs) were commodity products that would be purchased in the country of importation and would not be imported by the franchisee. Third, none of the ingredients bore any of the franchisor’s trademarks or were produced with patents or any other form of intellectual property for which a payment by franchisee is made. Even though all of the ingredients were required to be sourced from the franchisor or from a third party authorized by the franchisor, that was not enough to overcome the first and third points. As an aside, this restriction on sourcing is quite typical as a brand protection requirement in franchise agreements or in those instance where a license to manufacture a product bearing a licensed trademark has been conferred. The franchisor or the trademark licensor wants to ensure uniformity in the “look and feel” of products that are associated with the business and the last development that will be tolerated is a franchisee or a licensee resorting to shoddy ingredients or materials that will deviate from quality standards. As another example of this attention to quality, contract manufacturers of garments are typically required to purchase all inputs, from fabrics, fittings and accessories, hang tags, hangers all the way to plastic bags and cardboard boxes, only from approved vendors.
While this new instrument is welcome, we must point out a worrisome ruling issued by CBP, dating to 2004. This is ruling no. W548464 (5/25/04), which dealt with the valuation law status of a payment in the nature of a 2% Technical Consulting and Retail Services Fee. CBP concluded that
One of the significant facts for the Office of Regulations and Rulings in rendering this decision is the fact that no information has been brought forward nor has any been identified that would have enabled this office to conclusively establish that the sums paid by Zegna in the U.S. only inure to the benefit of Zenga Group sales in the United States. If the technical services and consulting fees even partially inure to the benefit of other Zegna Group entities or franchisees, the fees must be considered as being for imported merchandise.
This suggests that if any portion of the fee gets to the seller it is deemed “for the imported merchandise” and is thus, irrevocably, dutiable. But this is exactly wrong. The Generra decision does not reach this far. Instead, Generra and Chrysler, taken together, stand for the proposition that payments to seller are subject to review. If the importer can show that the payments are for something quite separate from the goods then—despite the fact that they are being made even directly to the seller-- they are not dutiable. This 2004 ruling simply shuts down that further inquiry. Its implied but inescapable prescription that payments to the seller are invariably deemed for the imported goods is inconsistent with the Generra and Chrysler jurisprudence and with the CBP position expressed in its ruling no. H242894 on exclusive distributorship fees. In short, the same close and further analysis that we saw in ruling no. H242894 and in the Advisory Opinion should always be applied.Moreover, this 2004 ruling suggests a possibly flawed argument put forward by the importer’s counsel. Apparently the importer argued that there was no profit element represented by the 2% fee (“the fee is adequate to cover the costs of the services provided and nothing more”). Even if the recipient of the services were the seller and even if the payment included an element of profit, those facts would still not convert the payment into a payment for the goods.
More tax accounting support could have been adduced to demonstrate that any profits generated from the services would remain in that separate category and would not automatically be transferred over to—or altered to become--an enhanced seller’s profit on the sales of goods. Since these were related parties, one can surmise that if the issue were to arise today—some 16 years after the issue addressed in that 2004 ruling first surfaced—then it might be the case that there would be more robust transfer pricing documentation and accounting support, justifying not only the sale price (the ruling stated that there was no sales agreement available for review) but also the level of the fees paid by the importer.
Summary
The trend is readily apparent. Customs authorities across the globe will be playing ever closer attention to importers’ off-invoice payments to sellers of imported merchandise and to parties related to those sellers. In anticipation of any such unwelcome scrutiny, this brief treatment, along with the earlier discussion on AMP payments, should be kept ready to hand....................................................................................................................
1. Neville,“Customs Valuation Precepts,” 28 JOIT April 2017 at 19.
2. Neville, “Some Observations on Customs Valuation Law: Status of Payments for AMP Payments,” 27 JOIT April 2016 at 24. See also the longer discussion in Neville (ed.), International Trade Laws of the United States: Statutes and Strategies at ¶6.05[2][b] (Canadian Memo D13-4-13 emphasis on importer needing to justify fees paid for management advice and other services).
3. I refer to the multilateral Customs Valuation Agreement (CVA) here so that readers outside the US may follow the discussion. Since the internal customs valuation laws of WTO Members track the CVA these remarks apply with equal effect across all boundaries to the US and to all Members.
4. Applying the decision in Generra Sportswear Co. v. United States, 905 F.2d 377 (Fed.Cir. 1990).
5. See Chrysler Inc. v. United States, 20 CIT 1169 (1996).
6. A regrettable example of the application of this faulty standard is offered up by ruling no.548199 (3/19/03) wherein a Service Fee paid by an importer was deemed dutiable because it was related to the imported goods. There was no discussion of, let alone a showing, that the payment was a disguised payment for the goods. It appears that counsel for the importer erred in framing its argument which impliedly conceded that a relationship of the payment to the goods was tantamount to dutiability. This was unfortunate and ill-advised in equal measures.
7. See ruling no. H242894 (12/4/13) (exclusivity payment not dutiable as an element of PAPP nor dutiable as an addition to the price as a royalty or subsequent proceeds). This 2013 ruling is notable as it effectively moves past, indeed signals a departure from, Tikal Distribution Corp. v. United States, 93 F. Supp. 2d 1269 (CIT 2000).
8. See n. 6 above and discussion below on franchise fees.
9. Consensus was reached at the 44th Session of the TCCV in May, 2017 and the Advisory Opinion was formally adopted in July, 2017.
2. Neville, “Some Observations on Customs Valuation Law: Status of Payments for AMP Payments,” 27 JOIT April 2016 at 24. See also the longer discussion in Neville (ed.), International Trade Laws of the United States: Statutes and Strategies at ¶6.05[2][b] (Canadian Memo D13-4-13 emphasis on importer needing to justify fees paid for management advice and other services).
3. I refer to the multilateral Customs Valuation Agreement (CVA) here so that readers outside the US may follow the discussion. Since the internal customs valuation laws of WTO Members track the CVA these remarks apply with equal effect across all boundaries to the US and to all Members.
4. Applying the decision in Generra Sportswear Co. v. United States, 905 F.2d 377 (Fed.Cir. 1990).
5. See Chrysler Inc. v. United States, 20 CIT 1169 (1996).
6. A regrettable example of the application of this faulty standard is offered up by ruling no.548199 (3/19/03) wherein a Service Fee paid by an importer was deemed dutiable because it was related to the imported goods. There was no discussion of, let alone a showing, that the payment was a disguised payment for the goods. It appears that counsel for the importer erred in framing its argument which impliedly conceded that a relationship of the payment to the goods was tantamount to dutiability. This was unfortunate and ill-advised in equal measures.
7. See ruling no. H242894 (12/4/13) (exclusivity payment not dutiable as an element of PAPP nor dutiable as an addition to the price as a royalty or subsequent proceeds). This 2013 ruling is notable as it effectively moves past, indeed signals a departure from, Tikal Distribution Corp. v. United States, 93 F. Supp. 2d 1269 (CIT 2000).
8. See n. 6 above and discussion below on franchise fees.
9. Consensus was reached at the 44th Session of the TCCV in May, 2017 and the Advisory Opinion was formally adopted in July, 2017.
Mark K. Neville, Jr., LL.M. (International Legal Studies), NYU, is a long-time member of the Board of Advisors. He is Principal of International Trade Counsellors and may be reached at mkneville@itctradelaw.com. He has served as an adjunct professor at The University of California, Berkeley’s Haas School of Business and NYU’s Stern School. He is The Journal’s Customs & Trade correspondent.