Customs Value, Licensing And Royalties—
The Russian Perspective
Gorodissky & Partners
This article originally appeared in the September 2014 issue of les Nouvelles.
Cross-border trade is a driver of the global economy and the world's better financial condition. According to the World Trade Report 2013, the rise of a world economy, the spread of investment and technology, the growth of international specialization, the ascent of new economic powers, and the dramatic surge in growth and population would not have been possible without a massive expansion of global trade over the past 200 years.1 Being a constantly developing BRICS region, Russia persistently fights to conquer first place by vying with its competitors and improving its commercial status.
In fact, Russia has always been an attractive platform for doing business, especially from the supply and distribution standpoint. Different foreign companies and brand owners have gotten used to bringing their brands, technologies and products to Russia every day in order to have them reach the hands and minds of Russian consumers. Before that happens though, these companies and brand owners have to tackle certain customs and border clearance procedures established for imports by Russian laws. And, that is where different issues, including on the point of determination of the exact customs value of products being declared, can arise during or after the process of release of the same onto the market place.
Background and Issue
When involved in the business of trade and participating in various import campaigns, foreign companies and brand owners will normally undertake the international customs planning matters to consider the calculation of relevant fees and duties in advance. However, as the Russian customs practice shows, many contracted business partners (buyers, distributors, agents, licensees, etc.) may sometimes ignore the aspect of royalties or license fees in the context of determination of the correct customs value by trying to turn the saved funds into another transaction benefit. Although it is not clear, whether such actions depend on the mere lack of knowledge of the Russian intellectual property and customs laws, or on the intention to pay less money to the Russian government, or on improper communications (negotiations) and documentation (e.g. supply and license agreements) involved in the course of the customs clearance proceedings, or on some other factors, it is obvious that such negligence can lead to severe legal consequences, including customs fines and other charges. Therefore, before implementing any specific customs planning for the Russian market, it is important to understand in each particular case, whether royalties or license fees, if they do exist under the executed license agreement(s) underlying the signed supply agreement(s), will be included or excluded from the customs value of the imported goods, since proper calculation and settlement of the same will help the businesses to avoid any potential problems and monetary sanctions in the future.
Laws and Regulations
In accordance with paragraph 1 of Article 1235 of the Russian Civil Code (Part IV) (the "RCC"), under a license agreement one party—an intellectual property owner (licensor)—grants or is obliged to grant to the other party (licensee) a right to use the intellectual property subject matter within terms as set out by the subject agreement. Pursuant to paragraph 5 of Article 1235 of the RCC, a licensee is obliged to pay an agreed compensation to the benefit of the licensor under the license agreement, unless such agreement provides otherwise. Practically, an agreed compensation will take the form of royalties in most licensing transactions, where royalties will be repeated instalments paid on a monthly, quarterly or annually basis. Normally, these instalments will be computed as a percentage of proceeds of sales of the licensed products imported in the contractual territory (e.g. Russia).
According to Article 64(1) of Customs Code of the Customs Union,2 adopted on November 27, 2009 (the "Customs Code"), the customs value of the goods imported into the customs territory of the customs union shall be determined in accordance with the international treaty3 of member-states of the customs union that regulates the issues of determination of the customs value of the goods moved through the customs borders. According to Article 64 (2) of the Customs Code, the customs value of the goods imported into the customs territory of the customs union shall be determined if the goods actually cross the customs borders and such goods are moved to the customs proceedings for the first time right after traversing the customs borders, except for the customs proceedings related to customs transit. According to Article 64(3) of the Customs Code, the customs value of the goods shall be determined by the customs declarant or customs representative acting on behalf of the customs declarant, and in cases set forth by the Customs Code—by the customs agency.
Pursuant to Article 65(3) of the Customs Code, the customs value shall be the integral part of the declaration of goods. Pursuant to Article 65(4) of the Customs Code, the declared customs value of the goods and evidence submitted related to its determination shall be based on the information that is true and can be determined and supported by documentation. Pursuant to Article 66 of the Customs Code, the inspection of the customs value of the goods shall be done by the customs agency before or after the release of the goods, including through the use of the risk management system.
According to Article 5 of the Agreement between the Government of the Russian Federation, the Government of the Republic of Belarus and the Government of the Republic of Kazakhstan, dated January 25, 2008, "On Determination of the Customs Value of Goods Transported Across the Customs Borders of the Customs Union" (the "Agreement on Determination of the Customs Value"), royalties must be generally included into the customs value of goods. Specifically, in the sense of paragraph 1(7) of Article 5 of the Agreement on Determination of the Customs Value, license and other similar fees, set for the use of intellectual property (including royalty payments for patents, trademarks, copyrights), related to the valued (imported) goods, and which are directly or indirectly paid, or will be paid, by the buyer as a condition for the sale of valued (imported) goods in the amount not included into the price which has been de facto paid or is subject to payment for such goods,—shall be considered during the determination of the customs value of the imported goods under the transaction cost in addition to the price which has been de facto paid or is subject to payment for such goods.
In other words, there are two (2) basic requirements in Russia under which royalties or license fees will be included into the customs value of the imported goods: (a) royalty payments must relate to the imported goods; and (b) royalty payments must be made as a condition for the sale of the imported goods. Importantly, these conditions must both be met at the same time, meaning that if one of them is omitted, or not duly complied with, royalties will be excluded from the customs value of the imported goods. Hence, royalties shall be included into the customs value in the case when they are related with the imported goods and payment of the same stands as a condition precedent for the sale of such goods. This shall obviously mean that the documentation (i.e. supply agreement) submitted by the importer in the course of customs clearance proceedings (or afterwards) must provide for the contractual obligation of the importer to acquire the right of use of certain intellectual property under a license agreement in exchange for a purchase of the goods; otherwise, the goods will not be sold to the importer.
Further, pursuant to paragraph 1(7) of Article 5 of the Agreement on Determination of the Customs Value, there are certain royalty payments, which shall not be added to the customs value of the imported goods. In particular, the following royalties or license fees shall be excluded from the customs value of the imported goods: (a) royalty payments related to the right of reproduction (copying) of the imported goods in the customs territory of the customs union; and (b) royalty payments related to the right of distribution or re-sale of the imported goods, if such payments do not attend to the condition for sale of the imported goods for the purpose of exportation to the customs territory of the customs union. There are no other exceptions provided by the law when royalties can be excluded from the customs value. Hence, if the documents (i.e. supply and license agreements) submitted by the importer in the course of customs clearance proceedings (or afterwards) clearly state that royalties or license fees, subject to payment for distribution or re-sale of the imported goods, do not stand as the condition precedent for sale of such goods in the territory of the customs union (e.g. Russia), then such royalties or license fees will be excluded from the customs value as per the above "statutory exception rule." In addition, it should be noted that the right of reproduction, as referenced above, does not mean copying of the imported goods only. It can also relate to manufacture of the patented product (or process) or reproduction of know-how.
Court Practice and Case Law
In the opinion of many local customs officials, the dutiable customs value produce more than 30 percent of all income of the Russian government. Hence, it is not a surprise that the Russian Customs Authorities will try to increase the customs value of the imported goods in order to bring more income to the country. Sometimes, they may do it correctly and the calculations they make (or add to the declared customs value) will match with the records of the importers, who then remit the required outstanding amounts in favor of the state budget. At the same time, some Russian Customs Authorities make mistakes by correcting the customs value in an incorrect or ungrounded manner leaving the bona fide companies a chance to challenge the customs calculations in court. In fact, many locally-based entities representing foreign businesses and brands in Russia, including Beiersdorf, Procter & Gamble, ABB, Oriflame Cosmetics, Colgate Palmolive, Quelle, Rockwool, ZARA and others, have already had to struggle with the decisions of the Russian Customs Authorities on the judicial basis. These actions eventually helped to establish specific precedents on the issue.
Although Russia is a civil-law jurisdiction, and the national case law does not necessarily have any binding legal effect for future analogous situations, as opposed to the U.S., UK or other common law countries, certain court decisions and opinions, especially those issued by the highest local tribunals, may be taken into account in similar cases. In view of the fact that the issue of inclusion of royalties into the customs value has not been finalized to date at the highest judicial level, and no judicial recommendations or suggestions have been announced by the supreme court so far, the court practice with respect to this area is rather diverse in Russia, meaning that there are judgments issued in favor of the Russian Customs Authorities4 as well as judgments issued in favor of the businesses (importers, licensees).5 Of course, such court decisions will vary depending on the specific circumstances surrounding the referenced cases and material evidence submitted in the course of the civil proceedings. Interestingly, the very recent court practice tends to be more reasonable and positive for the businesses.
The review of the "unfavorable case law," where the judgments have been issued in favor of the Russian Customs Authorities, shows that many courts are of the opinion that royalties or license fees must be included in the customs value every time the license agreement is made in support of the supply agreement, since royalties or license fees would relate to the imported goods and be paid by licensees as a condition for further distribution of the same in Russia. According to the cited court decisions and additional customs guidance, the existence of a license agreement may be treated as a valid condition for the sale of the goods, notwithstanding the fact of whether such agreement is connected with (and referenced in) a supply contract or not, or the fact whether such agreement is made with a supplier or third party (i.e. intellectual property owner). Moreover, many Russian Customs Authorities believe that the connection between royalties and imported goods may be traced by the form of payment of contracted compensation (e.g. license fees dependent on net sales). It is curious, that some local courts would agree that the above can actually be applied not only to licenses, but to franchise agreements, which provide for the grant of right to trademark usage as a part of the franchised system conveyed to franchisees.
The review of the "favorable case law," where the judgments have been issued in favor of the importers/licensees, shows that there are courts in Russia that started to apply the "statutory exception rule," under which royalties or license fees shall not be included in the customs value in the event when such royalties or license fees relate to the right of distribution or re-sale of the imported goods and do not attend to the condition for sale of the imported goods for the purpose of exportation to the customs territory of the customs union (see paragraph 1(7)(b) of Article 5 of the Agreement on Determination of the Customs Value). Specifically, according to the one recent court decision,6 in a situation when: (a) supply and license agreements are not linked together, (b) such agreements do not have any cross-references, including with regard to payment of royalties, and (c) payment of royalties under the license agreement is not a condition precedent to the execution of the supply agreement,—such royalties must be excluded from the customs value of the imported goods. This case is especially a good judgment to rely on in the event where three (non-inter-connected) parties are involved, where the importer has a supply agreement with one company (supplier/seller) and has a license agreement with another company (intellectual property owner/licensor), and where both agreements are not linked. However, when the licensor and the buyer are different but inter-connected entities (see paragraph 1 of Article 3 of the Agreement on Determination of the Customs Value), the payment of royalties may be a condition for sale of goods, consequently— they will be included into the customs value.
Another "favorable" recent court decision7 is a perfect example of how businesses need to distinguish royalties paid for the use of the franchised trademark from royalties paid for the use of the other franchised intellectual property objects (i.e. trade name, knowhow and software) which are usually included in the franchised system. The court held that while a trademark might have a direct relation to the product since it was a source identifier, the relation of the franchised trade name, know-how and software to the product had to be proved, but that was not done in that case by the plaintiff (customs office). The court also referred to some additional documents (deeds of conveyance) accompanying the franchise agreement where it was expressly mentioned that neither these intellectual property subject matters (i.e. trade name, know-how, software), nor the payments for the use of the same were related to the imported products. Hence, the franchisee was not supposed to be paying royalties for the use of the franchised trade name, know-how and software as a condition for sale of the imported products in Russia. The court summarized that when different royalty payments were set for various contracted intellectual property subject matters in the franchise agreement, it was possible to include certain royalties into the customs value (i.e. trademark-related royalties) by excluding the other (trade name, know-how and software related royalties). By analogy, this court ruling may have a precedential effect for regular licensing transactions.
In light of the existence of the conflicting case law, it will be very useful to know the judicial advice or position of the supreme tribunal on the issue. It is hoped that the highest Russian judiciary will provide certain guidance in the near future, as some of the cited court decisions are being appealed at this time and may finally reach the supervisory court.
Discussion and Analysis
Generally, royalties will relate to the imported goods in the event when such goods contain any particular form of intellectual property, such as copyrights, patents, trademarks, know-how, etc. For instance, if the imported product, or its packaging, has been trademarked, and the use of the trademark provides for the payment of royalties, they will most probably be related to the imported product. At the same time, the affixation of the trademark on the product, or its packaging, does not necessarily mean that the corresponding royalties or license fees will always relate to the imported products. For example, royalties may not simply be related to the imported products in case when the trademarked packaging is being imported into Russia for further packaging of the products in Russia, and the trademark use is supposed to be made in connection with such products, while the payment of royalties is not a condition for sale of the packaging in Russia.
Further, if the imported goods are used as components in the product manufacture process in Russia, where a licensee will be using the licensed know-how in exchange for the payment of royalties, such royalties will be excluded from the customs value, as they will relate to the licensee's activities committed after the importation of the products into Russia. And, in the case where in exchange for the payment of royalties a buyer acquires the right to use the owner's know-how in order to manufacture a specific product in Russia, and it separately buys some machinery from the manufacturer for the purpose of making the use of the licensed know-how in Russia, royalties will also be excluded from the customs value, since the payment of the same does not clearly attend to the condition for sale of the machinery in Russia, even though royalty payments are linked with the whole manufacture process.
In any event, all circumstances, contracts and documents of the subject transaction(s) must be subject to due diligence each time before reaching a final conclusion as to the inclusion of royalties into the customs value of the imported goods, products, components and/or ingredients (as applicable). According to the recommendation of the European Commission, in determining whether a particular royalty relates to the goods to be valued, the key issue is not how the royalty is calculated, but why it is paid (i.e. what in fact the licensee receives in return for the payment). Thus, in the case of an imported component or ingredient of the licensed product, or in the case of imported production machinery or plant, a royalty payment based on the realization on sale of the licensed product may relate wholly, partially or not at all to the imported goods.8
As to the second requirement, more specifically, whether royalties are paid as a condition for sale of the goods to be imported, the European Commission states that the question to be answered in this context is whether the seller would be prepared to sell the goods without the payment of a royalty or license fee. The condition may be explicit or implicit. In the majority of cases it will be specified in the license agreement whether the sale of the imported goods is conditional upon payment of a royalty or license fee. However, it is not essential that it should be so stipulated.9 Hence, the direct provision in the licensing contract that the trademark usage, and, therefore, payment of royalties, shall not be regarded as a valid condition for the sale of the trademarked goods can mitigate the whole situation, essentially when different contracts (e.g. supply and license agreements) governing the supply of goods and the exploitation of intellectual property will be made with different noninter-connected companies (e.g. supplier and intellectual property holder). For example, if the importer makes royalty payments to a third party owner for the right to use certain intellectual property subject matters in Russia, such intellectual property subject matters relating to the goods imported under a supply agreement which is made with a different supplier may not be a condition for exporting these goods for sale into Russia, and as a result—such royalty payments will be excluded from the customs value.
At the same time, pursuant to the opinion of the European Commission, when goods are purchased from one person and a royalty or license fee is paid to another person, the payment may nevertheless be regarded as a condition of sale of the goods under certain conditions. The seller, or a person related to him, may be regarded as requiring the buyer to make that payment when, for example, in a multinational group goods are bought from one member of the group and the royalty is required to be paid to another member of the same group. Likewise, the same would apply when the seller is a licensee of the recipient of the royalty and the latter controls the conditions of the sale.10 The following elements should be analyzed to determine if there is control: (a) the licensor selects the manufacturer and specifies it for the buyer; (b) there is a direct contract of manufacture between the licensor and the seller; (c) the licensor exercises actual control either directly or indirectly over the manufacture (as regards centers of production and / or methods of production); (d) the licensor exercises actual direct or indirect control over the logistics and the dispatch of the goods to the buyer; (e) the licensor nominates/restricts who the producer can sell their goods to; (f) the licensor sets conditions relating to the price at which the manufacturer/seller should sell their goods or the price at which the importer/ buyer should resell the goods; (g) the licensor has the right to examine the manufacturer's or the buyer's accounting records; (h) the licensor designates the methods of production to be used/provides designs etc.; (i) the licensor designates/restricts the sourcing of materials/components; (j) the licensor restricts the quantities that the manufacturer may produce; (k) the licensor does not allow the buyer to buy directly from the manufacturer, but, through the trademark owner (licensor) who could as well act as the importer's buying agent; (l) the manufacturer is not allowed to produce competitive products (nonlicensed) without the consent of the licensor; (m) the goods produced are specific to the licensor (i.e., in their conceptualization/design and with regard to the trademark); (n) the characteristics of the goods and the technology employed are laid down by the licensor. It should be noted that, in individual cases, other kinds of indicators may also exist.11
Basically, in the absence of any local clarifications or guidance from the Russian Customs Authorities as well as the Russian highest judiciaries, these recommendations of the European Commission may play a persuasive role and be tested in Russia. However, if the Eurasian Economic Commission (EEC) approves the draft of Rules for Inclusion of License and Other Similar Fees for Use of Intellectual Property in Customs Value,12 which have been prepared and submitted by the Russian non-commercial organizations, including by the Chamber of Commerce and Industry of the Russian Federation, the nationally oriented recommendations may enter into force to be applied in intellectual property/customs practice of Russia, Belarus and Kazakhstan.
Conclusion and Comment
When considering whether to include or exclude royalties in the customs value, it is important to carefully analyze all facts, circumstances and documents involved in the particular importation of the goods into Russia. Different facts, circumstances and documents may produce different advice and strategies. Therefore, before taking any steps forward, assistance of local counsel should be obtained.
Generally, there are a few practical recommendations that might help to deal with or mitigate the issue of customs value vs. royalty:
- Form the contractual relationship of the parties on the basis of a single agreement (e.g. supply, distributorship) by simply permitting the contractor to use the associated intellectual property (e.g. patent, trademark) in connection with the sale of products without royalty payments—applicable for a situation when: (i) the seller and the intellectual property owner are one and the same business entity, and (ii) manufacture of products stays beyond the scope of the transaction at issue;
- Form the contractual relationship of the parties on the basis of a single agreement (e.g. supply, distributorship) and grant a separate letter of authorization by permitting the contractor to use the associated intellectual property (e.g. patent, trademark) in connection with the sale of products without royalty payment—applicable for a situation when: (i) the seller and the intellectual property owner are different business entities, and (ii) manufacture of products stays beyond the scope of the transaction at issue;
- Omit cross-referencing or citation of the subject transaction documentation (e.g. supply and license agreements)—applicable for a situation when inter-connected business entities (e.g. supplier and licensor) are involved in the transaction at issue;
- Clearly indicate in the subject transaction documentation (e.g. supply and license agreements) that the use of the associated intellectual property subject matter is not a condition for sale of the imported goods—applicable for a situation when: (i) product components or product packaging are involved in the transaction, and (ii) manufacture of products stays within the scope of the transaction at issue;
- Split royalty payments for the use of various contracted intellectual property subject matters—applicable for a situation when the license/ franchise agreement set out different intellectual property subject matters.
As to the appropriate method of calculation of the exact amount of the customs value, this aspect is beyond the scope of the present article. The Agreement on Determination of the Customs Value as well as different customs resolutions provide for a diversity of options in this regard. In one of the above-referenced "unfavorable" cases, the Supreme Commercial Court of the Russian Federation, when refusing to hear the appeal of the importer, upheld the lower courts' holding. In its ruling, delivered on November 8, 2012,13 the Russian Supreme Commercial Court stated that considering the principle of freedom of contract, the variety of intellectual property forms, the individual characteristics and terms of license agreements, it is not possible to develop unified methods of calculation of license fees subject to inclusion into the customs value. Basically, the supreme court confirmed that a particular method of calculation of customs value of the imported goods should be followed in terms of the factual matters and relevant provisions of the subject license agreement depending on the documents submitted by the importer in the course of the customs clearance proceedings. In any event, the choice of the optimum method of determination of the customs value can always be made in the framework of negotiations and consultations between the customs office and the importer.14
- On July 6, 2010 Russia, Belarus and Kazakhstan established a new and regional Customs Union within the framework of the Eurasian Economic Community (EAEC).
- The Agreement between the Government of the Russian Federation, the Government of the Republic of Belarus and the Government of the Republic of Kazakhstan, dated January 25, 2008, "On Determination of the Customs Value of Goods Transported Across the Customs Borders of the Customs Union."
- Decision of the Federal Commercial Court of the Moscow District dated 5 May 2009 No. KA-A40/3422-09, Decision of the Federal Commercial Court of the Moscow District dated 26 March 2010 No. KA-A41/2366-10, Decision of the Ninth Commercial Appellate Court dated 18 May 2010 No. 09AP- 6825/201-AK, Decision of the Federal Commercial Court of the Moscow District dated 8 September 2011 No. A40-133761/10- 147-845, Decision of the Federal Commercial Court of the Moscow District dated 10 July 2012 No. A40-60752/11-149- 331, Decision of the Federal Commercial Court of the Moscow District dated 10 October 2013 No. A40-152783/12-92-1453, Decision of the Federal Commercial Court of the Moscow District dated 10 October 2013 No. A40-154132/12-120-1592, Decision of the Federal Commercial Court of the Moscow District dated 10 October 2013 No. A40-154144/12-21-1491.
- Decision of the Federal Commercial Court of the NorthWestern District dated 6 June 2011 No. A44-3558/2010, Decision of the Federal Commercial Court of the Central District dated 12 March 2012 No. A23-1556/10A-18-68, Decision of the Federal Commercial Court of the North-Western District dated 16 April 2014 No. A56-31657/2013, Decision of the Thirteenth Commercial Appellate Court dated 28 February 2014 No. A56-7925/2013, Decision of the Seventeenth Commercial Appellate Court dated 5 May 2014 No. 17AP-3327/2014-AK.
- Decision of the Federal Commercial Court of the NorthWestern District dated 16 April 2014 No. A56-31657/2013.
- Decision of the Seventeenth Commercial Appellate Court dated 5 May 2014 No. 17AP-3327/2014-AK.
- Paragraph 11 of the Commentary No. 3 of the Customs Code Committee (customs valuation section) on the incidence of royalties and license fees in customs value (EC Compendium of Customs Valuation).
- Paragraph 12 of the Commentary No. 3 of the Customs Code Committee (customs valuation section) on the incidence of royalties and license fees in customs value (EC Compendium of Customs Valuation).
- Paragraph 13 of the Commentary No. 3 of the Customs Code Committee (customs valuation section) on the incidence of royalties and license fees in customs value (EC Compendium of Customs Valuation).
- Paragraph 1 of the Commentary No. 11 of the Customs Code Committee (customs valuation section) on the application of Article 32 (1) (c) CC in relation to royalties and licensee fees paid to a third party according to Article 160 of Reg. (EEC) No. 2454/93.
- Ruling of the Supreme Commercial Court of the Russian Federation dated 8 November 2012 No. VAS-13933/12.
- Letter of the Federal Customs Service of Russia dated 22 September 2008 No. 05-33/39045.