With the rapid development of the international intellectual property trade, the taxability of royalty payment becomes even more important. Recently, plenty of enterprises have divergent opinions on whether royalties should be included in dutiable value of imported goods when they are investigated by the Customs. The Customs may require enterprises to include royalties in dutiable value of imported goods and additionally pay corresponding duties.
On 24th March 2016, General Admissions of Customs (hereinafter referred to as "GAC") announced "Specifications on Completion of the PRC Customs Declaration Form for Imports and Exports" (hereinafter referred to as "GAC Announcement No.20"). It is worth noting that declaration specifications on "special relationship confirmation", "price implication confirmation" and "royalty payment confirmation" are newly added, among which "special relationship confirmation" and "royalty payment confirmation" have greater implications on royalty payment arrangement from domestic enterprises to overseas related parties.
Special relationship confirmation
Declaration of whether special relationship between the buyer and the seller exists in imports and exports activities should refer to Article16 of "Measures of the People's Republic of China ("PRC") Customs on Determination of Dutiable Value for Imported and Exported Goods" (General Administration of Customs Order No. 213, hereinafter referred to as "Measures of Dutiable Value"). It shall be regarded as a special relationship between the buyer and the seller under any of the following circumstances, and this column should be filled as "yes" or "no" otherwise.
- Both the seller and the buyer are members of the same family;
- One of the seller and the buyer is senior management personnel or board director of the other;
- One party is directly or indirectly controlled by the other;
- Both the seller and the buyer are directly or indirectly controlled by a third party;
- The seller and the buyer have joint control over a third party directly or indirectly;
- Either party owns, controls or holds 5% (inclusive) or more of the voting shares of the other party directly or indirectly;
- One party is an employee, senior management personnel or board director of the other; or
- Both the buyer and the seller are members of a partnership.
In addition, where the buyer and the seller are interconnected in business, and one party is the exclusive agent, distributor or assignee of the other, it shall be deemed as a special relationship between them provided that the provisions of the preceding paragraphs are met.
Confirmation of the royalty payment
According to "GAC Announcement No.20", if the buyer pays the royalties to the seller or the relevant party directly or indirectly, the answer "yes" or otherwise "no" shall be declared.
The release of aforementioned provisions implies that the Customs can strengthen the supervision by referring to this information. All transactions involving royalty payment will attract special attention from the Customs.
Therefore, it is imperative for import and export enterprises to understand customs issues in relation to the outbound royalty payment. This tax alert will identify the common risks of the royalties from China Customs perspective and propose suggestions so as to assist enterprises better understand and comply with the relevant provisions, and make effective customs planning beforehand.
What kind of Royalties should be included in Dutiable Value of the Imported Goods?
According to "Measures of Dutiable Value", royalties refers to "fees paid by the buyer of imports to an intellectual property rights holder or persons duly authorized thereof for licensing or transfer of patent rights, trademark rights, proprietary technologies, copyrights, distribution rights, or selling rights".
According to "Measures of Dutiable Value", if the royalties to be paid by the buyer directly or indirectly to the seller or the relevant party have not been included in the actual or payable price of the goods, they shall be accounted into the dutiable value, except for those paid under either of the following circumstances:
- The royalties are irrelevant to the imported goods; or
- The payment of royalties does not constitute a prerequisite for the sale of the imported goods within the territory of PRC.
1. The royalties are irrelevant to the imported goods
The Article 13 of "Measures of Dutiable Value" makes the following provisions for royalties "relevant" to the imported goods:
Royalties which comply with any of the following criteria shall be deemed to be relevant to the imported goods:
- Royalties are paid for the right to use patent or proprietary technologies and the imported goods fall under any of the following categories: The imported goods are inclusive of a patent or proprietary technology;
- The imported goods are manufactured using a patented method or proprietary technology; or
- The imported goods are specially designed or manufactured for the implementation of a patent or proprietary technology.
- Royalties are paid for trademark rights and the imported goods fall under any of the following categories: The imported goods are attached with a trademark;
- The imported goods attached with a trademark could be sold directly after import; or
- The imported goods are attached with trademark rights when imported and could be sold with the trademark attached after light processing.
- Royalties are paid for copyright and the imported goods fall under any of the following categories: The imported goods contain software, text, music, pictures, images, or other similar contents, including the form of tape, disc, compact disc, or other similar carriers; or
- The imported goods contain other contents with copyright.
- Royalties are paid for distribution rights, selling rights, or other similar rights and the imported goods fall under any of the following categories: The imported goods can be sold directly after import; or
- The imported goods can be sold after light processing.
2. The payment of royalties does not constitute a prerequisite for the sale of the imported goods within the territory of PRC.
The so-called "prerequisite" means the payment of royalties is the premise for the seller to sell the goods to the buyer. In other words, if the buyer does not pay the royalties, it cannot purchase the imported goods, or the goods cannot be transacted under the contractually agreed conditions.
From the above two conditions, with regards to whether royalties should be included in the dutiable value of goods, "Measures of Dutiable Value" adopts the principle of shifting burden of proof. This means if the buyer additionally pays royalties on top of the actual or payable price, but cannot prove the fact that the royalties are irrelevant to imported goods, or the payment does not constitute a prerequisite for the sale of the imported goods within the territory of PRC, the corresponding royalties shall be considered as part of dutiable value when assessing duties.
Next, we will analyze the potential customs implication that enterprises may have when making royalty payment, and provide our recommendations accordingly.
Customs Implications and Our Recommendations with respect to the Outbound Royalty Payment
1. The importance of transaction substance
When we determine whether the royalties are related to the imported goods, the substance of the transaction must be clarified.
Taking trademark royalty as an example, at which stage the trademark is attached to the goods cannot be constituted as the standard to determine whether royalties are relevant to the imported goods. Specifically, no matter the trademark of the imported goods is made explicit (e.g. the trademark has been attached to the goods before import), or the trademark is presented implicitly (e.g. the imported goods are attached by the trademark after light processing), as long as the substance of "the goods contain trademark right when imported" is provided in relevant agreement or substantially met, the royalties are deemed to be relevant to the imported goods.
Case: The food importer signed two agreements with the brand owner respectively: goods agreement and trademark royalty agreement. After the goods are transported into the territory of China, they could be sold after simple packing with trademark attached. The food importer should pay trademark royalties accordingly. We can segment the price into two parts: price of the product itself and trademark royalty. Although it appears to be two transactions, essentially the combination of the two transactions should be considered as a complete transaction. In this case, if the buyer does not pay trademark royalties, it cannot sell goods attached with trademark and goods transactions cannot be realized under the agreed terms. Therefore, the payment of royalty constitutes a prerequisite for domestic sales of imported goods.
In the above case, the Customs has reason to request the food importer to include trademark royalties in the dutiable value of the imported goods and pay the corresponding duties.
2. Determination of dutiable royalty base
Enterprises may import various types of goods including raw materials, semi-finished goods and finished goods at the same time. Some goods can be directly sold after simple packing; while some imported goods themselves are subject to complex post-processing before sale. Therefore, even if the royalties should be included in the dutiable value of imported goods, enterprises can segment them depending on different circumstances and only pay customs duties for the part which is necessarily to be included in the calculation of dutiable value.
Case: An electrical machinery company A imports the whole equipment and spare parts from overseas and pays technology royalties according to the end sales revenue.
- Whole equipment: After importation, the whole equipment will be directly sold in the market after packing and labeling. The technology royalties in relation to the sales revenue realized by these products shall be included in dutiable value of imported goods when assessing duties.
- Spare parts: Company A imports spare parts for further manufacturing and sells the finished goods to the end customers. During the processing, Company A uses the technology provided by overseas related party. The technology royalties in relation to the sales revenue realized by these products is not essentially to be included in dutiable value of imported goods when assessing duties.
If only part of the royalties paid by importer satisfies the condition of which the royalties should be included in the dutiable value of imported goods, or only some of the imported goods are related to the royalties that should be included in the dutiable value of imported goods, the royalties should be allocated reasonably based on objective and quantifiable criteria, and only account the part which should be included, as adjustment base to pay additional duties.
3. Wise arrangement of related party transactions to improve tax efficiency
Typically, when enterprises remit the outbound payment of royalties, they have paid value added tax ("VAT") and withholding tax. If the royalty payment is defined to be included in the dutiable value of the imported goods by Customs afterwards, the enterprises shall pay the duties accordingly.
Case: Company M is an agent of an international apparel brand. It imports garment from overseas third party Company J with trademark owned by Company J, and resells the garment within Chinese market. In addition to goods price, Company M shall pay trademark royalties to Company J. Company M has paid the royalties as well as relevant VAT and withholding tax. After the payment is remitted, the Customs determines that the trademark royalties should be included in the dutiable value of the imported goods and Company M should pay the relevant duty.
In the above case, Company M not only paid VAT and withholding tax for the trademark royalty payment but also paid the relevant duties. We highly recommend the enterprises to fully consider the transaction substance as well as its possible impact on the overall tax burden of the group when making the group planning for the related party transaction arrangement.
If the related party transaction arrangement and transfer pricing policy of the group only allow the trademark royalties to be charged separately on top of the goods, the domestic enterprise
is very likely to include the trademark royalties in dutiable value of imported goods and pay corresponding duties in addition to VAT and withholding tax. The specific circumstances depend on provision of "Measures of Dutiable Value" and ultimate judgment of the Customs. However, if the transaction substance is able to support the overseas related party to be fully compensated merely through purchase price rather than the separate trademark royalties, there will be only customs duties to be concerned in the transaction, while VAT and withholding tax aroused in outbound royalty payment can be waived.
As described above, in order to properly avoid the customs risks associated with the outbound royalty payment, companies should take precautions and pay attention to the following issues.
1. What should enterprises focus on?
- Recognize the substance of a transaction;
- The criteria of royalties subject to customs duties;
- Whether the royalties should be included in the goods price; and
- The contribution to the goods brought by processing activities.
2. How should enterprises properly plan ahead?
- Clarify the functions undertaken by respective transaction parties in the process of development, improvement, maintenance and protection of intangible assets; properly allocate revenues, and determine the tax base;
- Evaluate the impact of indirect taxes brought by price component elements and corresponding royalty payment model, avoid double taxation; and
- Ensure all import and export documents, agreements and other relevant information are kept properly, in response to Customs investigation.
How can GT help you?
With more than 15 years of experience and profound insights into relevant regulations, GT's Customs and Transfer Pricing team will provide practical comprehensive solutions for all different types of enterprises. Our services include but are not limited to, the following:
- Assist in enhancing communications and mutual understanding between enterprises and the Customs;
- Evaluate whether the current royalty transactions are in line with the arm's length principle, and prepare supporting documents;
- Determine the criteria that are subject to customs duties and the royalty payment ratio;
- Review the related party or third party transaction agreements; and
- Analyze the substantial relevance between the imported goods and intangible assets as well as taxable issues involved from a professional point of view.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.