First Published in Taxation Today, Issue 37, February 2011.
This article considers the Customs duty valuation rules in the context of payments made for the use of intellectual property rights relating to imported product. It would seem that many importers are not aware of these rules and the requirement to take royalties or similar fees into account when calculating Custom duty liabilities.
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.
Various duties are charged on the import of goods into New Zealand, of which the most significant are:
- Excise equivalent duty; and
- Import duty (often referred to as a "tariff").
GST is imposed on imports by s 12 of the Goods and Services Tax Act 1985 but is administered by Customs under the Customs and Excise Act 19961.
Excise equivalent duty is only payable on limited types of product – mainly tobacco, fuel products and alcohol. Excise equivalent duty is usually charged as a fixed amount per unit of product (usually expressed through volume or weight) rather than by reference to the value of the product. Accordingly, the valuation rules discussed in this article do not generally apply to excise equivalent duty.
Import duty is generally imposed as a protectionist measure and usually applies to goods that could otherwise be sourced within New Zealand. Import duties are usually calculated on an "ad valorem" basis – ie they are imposed as a percentage of the "dutiable value" of the goods in question. The amount of import duty charged on products may be reduced or removed entirely if the country of origin is subject to a free trade agreement with New Zealand or is classified as a country afforded preferential treatment.
Importantly, the value of imported goods for the purposes of calculating import duty and GST is based on the valuation rules in the Second Schedule to the Customs and Excise Act 1996, which are in turn derived from the Agreement on Implementation of Article VII of the General Agreement on Tariffs and Trade 1994 ("GATT").
VALUATION AND ROYALTIES
Importers are required to specify the value of their imported goods in an import entry2 and the Second Schedule to the Customs and Excise Act 1996 provides rules for determining the value of an import for Customs purposes.
The primary valuation method provided by the Second Schedule is the "transaction value" method. For transactions between related parties, the transaction value method is only appropriate where the importer can show that the price was not influenced by the association with the seller and if this is not the case then other methods must be used.
Under the transaction value method, the value of an imported good is the price "paid or payable" for that good, subject to certain additions or deductions. One such addition is intellectual property rights, and these are dealt with by cl 3(1)(iv) of the Second Schedule, which requires the following amounts to be added to the agreed contract price (if not already included):
Royalties and licence fees, including payments for patents, trademarks, and copyrights in respect of the imported goods that the buyer must pay, directly or indirectly, as a condition of the sale of the goods for export to New Zealand, exclusive of charges for the right to reproduce the imported goods in New Zealand.
The Second Schedule goes on to provide similar inclusions for payments such as commissions, buying fees, packing costs and transportation within the country of export.
Until the late 1990s, importers would not typically add royalties to the Customs value of their imports on the basis that the payment of these royalties was not a "condition of the sale of the goods". At that time most importers took the position that cl 3(1)(iv) would only be triggered where the contract for sale provided for an express condition that royalties must be paid. Such a condition would generally only be provided for in an agreement where the seller and intellectual property owner were the same party3.
However in the late 1990s the interpretation of cl 3(1)(iv) was considered by the courts. The main cases are briefly summarised below.
"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 New Zealand". New Zealand Customs have interpreted these words widely, and New Zealand courts have generally followed this view.
In 1998 the issue was brought before the Court of Appeal in Adidas New Zealand Ltd v Collector of Customs4. The issue was whether the Customs value of goods imported by adidas NZ should have included royalties paid by adidas NZ to its German parent company, adidas AG. Adidas NZ argued that the words "condition of the sale" meant that there had to be a contractual condition requiring the payment of royalties in the sale agreement itself. The Court of Appeal disagreed with adidas NZ and took a much broader interpretation of the words "condition of the sale".
In the Adidas judgment Blanchard J 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 (adidas Asia-Pacific) and this gave adidas AG effective control over adidas NZ's purchases.
Henry J held that the royalty payment was a condition of sale because adidas NZ was contractually restricted in its ability to import manufactured product (it could only have goods manufactured overseas by manufacturers approved by adidas AG). His Honour concluded that the effect of this was that adidas NZ could not import the product which it later sold without incurring the liability to pay a royalty. This was held to be so even though the liability would only crystallise after the goods were imported.
The reasoning behind the Adidas decision was confirmed by the Court of Appeal in Collector of Customs v Avon Cosmetics Ltd5 and later by the High Court in Nike New Zealand Ltd v Chief Executive of the New Zealand Customs Service6. In the latter case the Court noted that the phrase "a condition of the sale" should not be read as meaning "a condition of the contract of sale".
The High Court in Nike, despite being bound by Adidas acknowledged that a contrary view has been taken in Canada in relation to identical wording in the equivalent Canadian law. In Canada (Deputy Minister of National Revenue) v. Mattel Canada Inc7, the Canadian Supreme Court found in favour of an importer, holding that the payment of royalties could not be described as a condition of sale unless the seller was entitled to refuse to sell the goods or to cancel the sale contract if royalties were not paid. The Canadian Supreme Court emphasised the fact that the sale contract and the royalty contract were separate agreements between different parties and that the royalties paid could not be included in the transaction value of the goods.
Nike nevertheless followed Adidas and found that the royalty payments were a condition of sale for the purposes of the Second Schedule. The decision was appealed to the Court of Appeal8 but was dismissed by a 3-2 majority which upheld the decision in Adidas and distinguished Mattel on its facts. The Court appeared to follow Adidas in focusing on the practical implications of royalties not being paid, rather than on the terms of the sale contract itself.
In summary, there appears to have been a divergence between the test applied in New Zealand and Canada, with New Zealand adopting what might be seen as an "economic reality" test while the Canadian courts have focused on the actual legal position of the parties9.
THE CURRENT POSITION
The position that is generally adopted by most importers (and it would appear also Customs) is that all royalties paid in respect of imported product should be included the dutiable value. The only exception is the proviso in cl 3(1)(iv) which is for charges that are for the right to reproduce the imported goods in New Zealand.
One practical difficulty that importers face when calculating duty is that typically royalties are calculated by reference to "net sales" and therefore the amount of the royalty for a particular good is not known at the time of importation.
Customs' practice has been to require the importer to use the previous year's figures to estimate the amount of royalty that is expected to be payable in relation to imports for the current year. This estimate is expressed as a percentage of the import price which is added to the dutiable value of product imported for the current year. The uplift figure is then usually treated as an interim payment and at the end of each year the position is reviewed to see whether additional duty is payable (or refundable).
It should be noted that the broad wording of cl 3(1)(iv) potentially includes all types of payments that are related to intellectual property rights, not just "royalties" as that term might be used in the commercial sense. Care should therefore be taken in relation to generic "management" or "technical" fees as these could fall within the scope of cl 3(1)(iv). In some cases it may be appropriate to expressly apportion fees between any service component and any intellectual property component.
Some importers do not pay import duty, either because the product is not subject to import duty or because the product qualifies for preferential treatment under a free trade agreement. While these importers may not be familiar with Customs valuations principles, the issue of royalties and Customs valuation is still important for the purpose of calculating the correct amount of GST on each import entry. While importers may be entitled to a credit for GST charged on their imports, Customs takes the position that notwithstanding this, importers can be liable for administrative penalties for returning an incorrect amount of GST.
POSSIBLE DISTINCTIONS FROM NIKE
The absence of recent litigation on this issue might be seen as indicating that there is no longer any doubt as to whether royalties should be taken into account in determining the Customs value of goods. However, it would seem that the Court of Appeal's judgment in Nike combined with the Canadian Supreme Court decision in Mattel leaves open the possibility that some royalty arrangements fall outside the ambit of the Second Schedule to the Customs and Excise Act 1996.
The majority decision in Nike (delivered by Blanchard J) considered the requirements for royalties to be caught by the Second Schedule, in particular the importance of the relationship between the licensor and licensee:
"First, the royalty must be payable to the manufacturer or to another person as a consequence of the export of the goods to New Zealand and, secondly, the party to whom the royalty is payable must have a control of the situation going beyond the ordinary rights of a licensor of intellectual property and giving it the ability to determine whether the export to New Zealand can or cannot occur. An ordinary licensor, unrelated to the licensee, may be able to take steps to prevent future importation of licensed product, but it has no control over an importation prior to any default."
In Nike the importer and trademark owner were members of the same corporate group and it is this factor that the Court of Appeal emphasised when distinguishing Mattel:
"The factual situation in Mattel was quite different. There the royalty was payable as a consequence of the export of goods to Canada but Licensor X had no ability to exercise control through Mattel US"
While the Court of Appeal noted that the Canadian Supreme Court's decision was "inappropriately narrow in the context of the interpretation of an international agreement", it did not go so far as to reject the reasoning in Mattel, in fact noting "that is not to say that we would disagree with the result on the particular facts of the case which are readily distinguishable from the present case and from I and Avon."
Blanchard J's decision leaves scope for an importer to exclude royalties from the calculation of dutiable value where the relevant intellectual property is owned by an unrelated third party who is not the seller. In doing so the Court also acknowledged the interpretative approach taken in Integrity Cars (Wholesale) Ltd v Chief Executive of New Zealand Customs Service10, which noted that when interpreting legislation designed to give effect to international agreements, New Zealand common law should not have a decisive role.
If there was no situation when royalties paid to an unrelated third party should be excluded from cl 3(1)(iv), then it would seem that all royalties must be included in determining dutiable value and words "condition of sale" would become meaningless. The reference to an "ordinary licensor" would suggest that the Court of Appeal did not consider cl 3(1)(iv) should have such a wide application. This consequence was noted by Major J in Mattel:
"Had Parliament intended for all royalties and licence fees to be dutiable, it would not have stated it is only those that are paid "directly or indirectly, as a condition of the sale of the goods for export to Canada" in accordance with s. 48(5)(a)(iv) that are dutiable."
Even where royalties are paid to a related company it may be possible to distinguish the facts from Adidas and Nike. In Adidas, Blanchard J had some reservations as to whether cl 3(1)(iv) applied, but then noted "I have concluded that because of the particular buying practice adopted by adidas NZ it can be said that it was a condition of the sale of the goods for export to New Zealand that the royalty be paid on them to adidas AG". The "buying practice" Blanchard J refers to is the importer's delegation of its various purchasing arrangements (placing orders etc) to another adidas company. In Nike, Blanchard J emphasised 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 led Blanchard J to conclude that the importer's ultimate parent company controlled the entire transaction. Accordingly, where an importer maintains control over the buying process it might be possible to distinguish Adidas and Nike even where royalties are paid to a related party.
OBJECTIONS TO THE CURRENT POSITION
In any event it seems inappropriate for the Second Schedule to capture royalty payments which have no direct connection to the sale and importation itself. Import duty is intended to tax the import of goods based on the physical value and utility of the good itself. Intangible rights that arise in relation to the use of the goods within New Zealand should be irrelevant when determining the value of the goods imported into New Zealand. The words "condition of the sale of the goods for export to New Zealand" suggest that the condition must be one which would actually prevent the importation from occurring, rather than merely being something that affects the resale of those goods by the importer11.
A further argument in favour of a narrow interpretation to cl 3(1)(iv) is that the Second Schedule targets related expenses that would otherwise have been included in the price charged by the seller to avoid parties artificially reducing prices by simply charging separate transport charges etc. In many cases a manufacturer will be indifferent as to the importer's royalty arrangements with third parties – 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".
Finally, one might expect that Australia would have similar Customs valuation rules on the basis that it is also a party to the GATT. However, the equivalent Australian legislation specifically excludes the addition of royalties unless they are payable "to the vendor or to another person under the import sales transaction"12. Many Australian businesses that import goods into New Zealand operate on the assumption that New Zealand adopts the same valuation principles as Australia. Such an assumption may be understandable given that the Australian New Zealand Closer Economics Relations Trade Agreement (ANZCERTA) refers to the "the harmonisation of customs policies and procedures" between the two countries and is based on the premise of the countries taking a unified approach to global trade matters.
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 Second Schedule, particularly in relation to generic fees that may cover a wide range of services or rights.
Importers that pay royalties to unrelated third parties might consider relying on both Nike and Mattel 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 New Zealand and accordingly that the sale agreement would effectively be "conditional" on a related royalty agreement.