July, 2018
A Quick Look at Patent Royalties
Mark K. Neville, Jr.
We have often returned to the question of the customs valuation law status of royalty or license fee payments. As we turn back to this familiar ground our intent is not to embark on a general overview of the topic but to focus upon a few take away points. This review is warranted because some traders still consider an unbundling of intellectual property rights otherwise subsumed within sales price of merchandise to be imported as an appropriate planning strategy. But the “instead my paying you $100 for this widget, I’ll pay you $95 for the widget and then separately pay you a $5 royalty” gambit will usually result in the customs value being pegged at the same $100 that it would have been if the IP right had been embedded within the sales price. In other words, most separate royalty or license fee payments will not be treated as nondutiable charges (NDCs) but rather as dutiable amounts that must be captured so as to adjust the invoice price for the underlying goods.
It is also important to note that royalties and license fees have not been defined in the statute or the accompanying regulations. In this connection, the Customs Valuation Agreement does note that “royalties or license fees may include, among other things, payments in respect to patents, trade marks and copyrights.”2 Thus, we may generally accept that royalties or license fees are ordinarily for intellectual property rights being conveyed, and that they may refer to patents or trademarks or tradenames.
This distinction was made in Customs and Border Protection’s3 famous 1993 Hasbro II ruling which set forth a three-part test for determining dutiable status for royalty payments.4 In the General Notice, CBP referred to earlier precedents and to legislative history and formulated a test consisting of three questions: (1) was the imported merchandise manufactured under patent? (2) was the royalty involved in the production or sale of the imported merchandise? and (3) could the importer buy the product without paying the fee? You may recognize that the second point invokes the statutory phrase “royalties and license fees related to the goods being valued” and the last point restates the statutory “condition of sale” criterion.
Under the three-part test, affirmative responses to factors one and two and a negative response to factor three would indicate that the payments were a condition of sale and, therefore, dutiable as royalty payments. CBP has noted that the language included in the legislative history to the 1979 customs valuation statute provides that royalties and license fees for patents covering processes to manufacture imported merchandise generally will be dutiable.5 It is not a stretch to state that patent royalties are presumptively dutiable,6 and the importer is obliged to establish a non-dutiable status.
Confronted with this challenge, the obvious strategy for the importer is to establish that the imported article was not produced under patent or the royalty was not related to the imported merchandise. CBP has previously held that royalties that are paid solely in furtherance of domestic manufacturing and marketing operations are not dutiable royalties under section 402(b)(1)(D) because they were not involved in the production or sale of the imported merchandise and because they were not a condition of sale of the imported merchandise.7
The relevant portion of the statute, which refers to royalties required to be paid as a condition of sale, does not state to whom, or for whose benefit, in particular, the payment is made. Although a reference to the seller is included in the definition of the PAPP, it is conspicuously absent from the instant provision. Thus, royalties paid to unrelated third parties could constitute a condition of the sale and, hence, be dutiable. So, in considering royalties paid for the use of a patent covering manufacturing processes, it is of little to no relevance to whom the payments are made; what is relevant is whether the royalty is involved in the production or sale of the imported merchandise.8
This third-party royalty issue was raised by an importer as recently as ruling no. H233376 (9/19/16) even though it might have been regarded as well-settled by that time.
In at least one ruling, no. H233376, CBP has rejected the notion that condition of sale is grounded in legally enforceable contract rights. There, CBP rejected this out of hand
I would raise the following hypothetical—if a licensee/prospective buyer did not pay the required royalty to the Licensor, would the manufacturer/seller be able to raise that non-payment as a defense to its refusal to manufacture and sell the subject goods to the licensee/prospective buyer? Conversely, if the licensee/prospective buyer did not pay the royalty, would that party be able to assert that non-payment as a defense in an enforcement action brought by the manufacturer/seller in response to the licensee/prospective buyer’s non-performance? Only if the answers are in the affirmative are the royalty payments a condition of sale.
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Applicable Statute
Merchandise imported into the United States is appraised in accordance with section 402 of the Tariff Act of 1930, codified at 19 USC § 1401a. The preferred method of appraisement under the US customs valuation scheme is transaction value, which is defined as "the price actually paid or payable for the merchandise when sold for exportation to the United States," (the PAPP) plus certain enumerated additions if the elements they cover have not been included in the PAPP.1 These additions include "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...” 19 USC § 1401a(b)(1)(D). You will have noticed the twin requirements of the payment relating to the imported goods and being a condition of sale. It is especially important not to overlook the second criterion.It is also important to note that royalties and license fees have not been defined in the statute or the accompanying regulations. In this connection, the Customs Valuation Agreement does note that “royalties or license fees may include, among other things, payments in respect to patents, trade marks and copyrights.”2 Thus, we may generally accept that royalties or license fees are ordinarily for intellectual property rights being conveyed, and that they may refer to patents or trademarks or tradenames.
Patent vs. Trademark Rights
As an initial point it is worthwhile to comment on the fact that in the US there is a real difference in the dutiable status of payments for patents vs. those for trademarks. In fact, almost all patent royalties will be held to be dutiable. It will be well-nigh impossible to escape dutiable status if the payment in question is for the right to manufacture the imported merchandise. These will generally be dutiable.This distinction was made in Customs and Border Protection’s3 famous 1993 Hasbro II ruling which set forth a three-part test for determining dutiable status for royalty payments.4 In the General Notice, CBP referred to earlier precedents and to legislative history and formulated a test consisting of three questions: (1) was the imported merchandise manufactured under patent? (2) was the royalty involved in the production or sale of the imported merchandise? and (3) could the importer buy the product without paying the fee? You may recognize that the second point invokes the statutory phrase “royalties and license fees related to the goods being valued” and the last point restates the statutory “condition of sale” criterion.
Under the three-part test, affirmative responses to factors one and two and a negative response to factor three would indicate that the payments were a condition of sale and, therefore, dutiable as royalty payments. CBP has noted that the language included in the legislative history to the 1979 customs valuation statute provides that royalties and license fees for patents covering processes to manufacture imported merchandise generally will be dutiable.5 It is not a stretch to state that patent royalties are presumptively dutiable,6 and the importer is obliged to establish a non-dutiable status.
Confronted with this challenge, the obvious strategy for the importer is to establish that the imported article was not produced under patent or the royalty was not related to the imported merchandise. CBP has previously held that royalties that are paid solely in furtherance of domestic manufacturing and marketing operations are not dutiable royalties under section 402(b)(1)(D) because they were not involved in the production or sale of the imported merchandise and because they were not a condition of sale of the imported merchandise.7
Third Party Licensor
One argument that will not sustain an assertion of nondutiable status is that the payment of the royalty or license fee was not made to the seller, or to a party related to the seller, but to a third party, one with no relationship to the seller.The relevant portion of the statute, which refers to royalties required to be paid as a condition of sale, does not state to whom, or for whose benefit, in particular, the payment is made. Although a reference to the seller is included in the definition of the PAPP, it is conspicuously absent from the instant provision. Thus, royalties paid to unrelated third parties could constitute a condition of the sale and, hence, be dutiable. So, in considering royalties paid for the use of a patent covering manufacturing processes, it is of little to no relevance to whom the payments are made; what is relevant is whether the royalty is involved in the production or sale of the imported merchandise.8
This third-party royalty issue was raised by an importer as recently as ruling no. H233376 (9/19/16) even though it might have been regarded as well-settled by that time.
Condition of Sale
CBP has often acknowledged that this third criterion is the most important of the three-factor Hasbro II test. CBP has stated that, “Question 3 goes to the heart of whether the payment is considered to be a condition of sale.”9 CBP views utility patents as having an inbuilt conditionality to the manufacture of the imported merchandise, as summarized by the followingWith regard to utility patents, such as those at issue herein, we have numerous rulings… that support a finding that royalties paid to a U.S. licensee for the right to use such patents in the production of the imported merchandise are dutiable additions to the price actually paid or payable….[I]n such cases the patent goes to the production of the imported merchandise and such merchandise would not exist, but for, the patented process or invention involved in the manufacture of the merchandise. In addition, without obtaining the license to produce the merchandise under patent and import it into the U.S., the importer would not be able to legally import the merchandise into the U.S. In other words, without the license, importation of the merchandise into the U.S. would infringe the patent holder’s rights under the patent.
In the event, CBP will concentrate on the contractual terms, both in respect to contracts for the manufacture or sale of the imported goods and in respect of the license agreement. CBP will look for a nexus between the two, such that non-payment of the royalty or license fee will lead to a termination of the right to purchase or import the merchandise. A review from a 2012 ruling, no. H168397 (2/14/12), is typical of this close CBP scrutiny. I would submit, however, that while the point is often made, and well-made, that the agreements are “inextricably intertwined,” there is still no showing of an enforceable contract right such that failure to pay the patent royalty will not only breach the license agreement but will perforce terminate the manufacture or sales agreement.In at least one ruling, no. H233376, CBP has rejected the notion that condition of sale is grounded in legally enforceable contract rights. There, CBP rejected this out of hand
Although counsel refers to the interpretation of the statutory language based on its common meaning, counsel’s argument that “condition” be construed “in accordance with U.S. laws and practices regarding contracts between parties for the sale of goods” is an interpretation based upon a legalistic understanding of the term “condition” and not one based on a “common meaning” understanding of the term.
Instead, CBP posited a “practical, common sense” standard, that runs along the following logical track:- Non-payment of the royalty will breach the license agreement
- Without the license agreement, the goods cannot be lawfully (or “legally” if you will) manufactured
- If the goods cannot be lawfully/legally manufactured, they will not exist
- If the goods do not exist, they cannot be sold
- Therefore, the payment of the royalty is a condition of sale.
I would raise the following hypothetical—if a licensee/prospective buyer did not pay the required royalty to the Licensor, would the manufacturer/seller be able to raise that non-payment as a defense to its refusal to manufacture and sell the subject goods to the licensee/prospective buyer? Conversely, if the licensee/prospective buyer did not pay the royalty, would that party be able to assert that non-payment as a defense in an enforcement action brought by the manufacturer/seller in response to the licensee/prospective buyer’s non-performance? Only if the answers are in the affirmative are the royalty payments a condition of sale.
License to Use Patented Technology in US manufacture
One way around the general trend to impose dutiable status on these royalty payments is to change the focus and application of the patent, if at all possible. Instead of a utility patent to make the imported articles, if the patent is used to make products in the US then the royalty payment may be seen as nondutiable.10 This would especially be the case if the finished products were made with at least some inputs from third parties. The same rationale led to the Technical Committee on Customs Valuation of the World Customs Organization promulgating its Advisory Opinion 4.17 last year. There, the franchise fee was related not to the imported goods but to the brands and systems of the franchisor which would apply to the franchise operation and the manufacture and sale of the finished products bearing the IP of the franchisor.11...................................................................................................................
1. Note that the US statutory scheme is consistent with the Customs Valuation Agreement, formally the AGREEMENT ON IMPLEMENTATION OF ARTICLE VII OF THE GENERAL AGREEMENT ON TARIFFS AND TRADE 1994.
2. The Customs Valuation Agreement, at Interpretative Note to Art. 8.1 (c), para. 1.
3. Of course, CBP was not established until 2003 but we often use the term CBP when referring to actions taken under its predecessor agency name, the US Customs Service, for ease of reference.
4. General Notice, Dutiability of Royalty Payments, Vol. 27, No. 6 Cust. B. & Dec. at 1 (February 10, 1993) ("Hasbro II ruling")
5. See, e.g., ruling no. W548692 (3/2/07).
6. See ruling no. H233376 (9/19/16).
7. See ruling nos. 545307 (2/3/95), 545951 (2/12/98) and 546660 (6/23/99).
8. See ruling no. H024980 (7/22/08).
9. See, e.g., ruling no. W548649 (9/05/06).
10. See ruling no. 547761 (3/14/02) (“…the license fee is not a condition of the sale for exportation to the United States of the imported merchandise. These payments pertain to the technical assistance and know-how that clearly relate to the finished product, not the imported product. The purchase of the products and the payment of the license fees are not related to one another, and the payment of the license fees does not exist as a condition of sale of the imported merchandise.”)
11. This was discussed in Neville, “Customs Valuation Status of Exclusivity and Franchise Fees,” 28 JOIT Oct. 2017 at 29.
2. The Customs Valuation Agreement, at Interpretative Note to Art. 8.1 (c), para. 1.
3. Of course, CBP was not established until 2003 but we often use the term CBP when referring to actions taken under its predecessor agency name, the US Customs Service, for ease of reference.
4. General Notice, Dutiability of Royalty Payments, Vol. 27, No. 6 Cust. B. & Dec. at 1 (February 10, 1993) ("Hasbro II ruling")
5. See, e.g., ruling no. W548692 (3/2/07).
6. See ruling no. H233376 (9/19/16).
7. See ruling nos. 545307 (2/3/95), 545951 (2/12/98) and 546660 (6/23/99).
8. See ruling no. H024980 (7/22/08).
9. See, e.g., ruling no. W548649 (9/05/06).
10. See ruling no. 547761 (3/14/02) (“…the license fee is not a condition of the sale for exportation to the United States of the imported merchandise. These payments pertain to the technical assistance and know-how that clearly relate to the finished product, not the imported product. The purchase of the products and the payment of the license fees are not related to one another, and the payment of the license fees does not exist as a condition of sale of the imported merchandise.”)
11. This was discussed in Neville, “Customs Valuation Status of Exclusivity and Franchise Fees,” 28 JOIT Oct. 2017 at 29.
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.