Chinese customs authorities have recently stepped up price investigations focusing on cross-border payments of intellectual property (“IP”) royalties or license fees. More and more multinational companies (“MNC”) have been chosen by the customs as principal audit/investigation targets for their royalty arrangements between Chinese subsidiaries and foreign parent companies or other associated parties. HaoLiWen customs practice lawyers have been approached by some of MNCs to advise on dutiability of such royalty payments and any risk exposure to customs law violation or even smuggling.

Based on the relevant customs valuation rules, if imported goods are connected to royalty payments which are not factored into the relevant import prices, the relevant importer must declare to the customs such royalty payments, which then should be included in the dutiable price of the goods concerned for the purpose of paying import duties and value added taxes (“Import Taxes”).

An importer bears burden of proof that the given import shipments are not connected to the royalty payments. If an importer fails to discharge this burden, the customs has the power to impose and collect the Import Taxes on the amount of royalties corresponding to the given shipments at the import duty rates applicable to the same imports. Besides, even where an importer has somehow proved that the royalties paid or payable are not connected to imported goods, the customs may still levy the Import Taxes on the amount of royalties as long as the customs can prove the existence of so-called “Deemed Connection” between the imported goods and the royalty payments as prescribed by the relevant customs valuation rules. The specific circumstances of such Deemed Connection may vary depending on the types of intellectual property rights involved, i.e., patents, trademarks, copyrights, know-how, distribution or resale rights.

In practice, it is crucial in a customs investigation or audit case that the importer is able to prove non-existence of Deemed Connection. However, in entering into an IP licensing agreement, the importer normally has been inclined to put all the seemingly relevant IP rights under the umbrella of the licensing agreement so as to justify the amount of royalties or license fees, regardless whether specific IP rights have been actually licensed to the importer. This practice in effect has seriously impaired the importer’s ability to disprove the Deemed Connection and will lead to increased import duty risks.

Where the importer is not able to disprove the Deemed Connection between a given import shipment and royalty payment, the previous failure to declare such royalty payments resulting in underpayment of the relevant Import Taxes may constitute violation of customs regulations. Moreover, if any evidence of intent is found, the smuggling liabilities may even ensue. Besides the issue of Deemed Connection, the royalty coverage of import shipments is also important. The legal test and customs practices on these issues are far from the empirical understanding in the business world. Different customs authorities may deal with these issues differently. For all these reasons, the customs duty risks associated with royalty payments have grown into complex legal and highly technical issues that deserve great prudence and attention.

Some MNCs tend to argue that since royalty payments are normally calculated on a pro rata basis by percentages to domestic sales value, only those goods for domestic sales on which royalties are calculated can be deemed connected to royalty payments. In the legal sense, however, the calculation of royalties is nothing but a formula of calculation, and cannot further imply the existence or non-existence of connection between imported goods and royalty payments. Rather, the importer has still to prove the absence of Deemed Connection, which is also crucial in determining dutiability of royalties paid to a foreign company.

The customs duty risks associated with royalty payments have become an acute legal and compliance issue. When concluding any IP license agreement, the importer must make sure whether it can prove the royalties paid or payable are irrelevant to the imported goods. If yes, no customs duty issue would probably arise; otherwise, such royalty payments must be duly declared to the customs. The Deemed Connection, the scope of connected imported goods, the dutiable amount of royalties must all be taken care of in advance through legal agreements and arrangements, depending on the nature of businesses of different companies.