W545114
VAL CO:R:C:V W545114 DPS
District Director
U.S. Customs Service
San Juan, Puerto Rico
RE: I.A. 55/92; dutiability of royalty payments made by importer to manufacturer for rights to patented process used in manufacture of finished product in U.S.; where amount of payment is determined as percentage of finished pharmaceutical product sold in U.S.
Dear Sir:
This is in response to your memorandum (APP-6-8:DD:CO:IAB CT452) dated August 21, 1992, forwarding a request for internal advice from Pfizer Pharmaceutical, Inc. (Pfizer), the importer. The I.A. request seeks Customs interpretation regarding the dutiability of royalty payments made by Pfizer to Bayer AG (“Bayer”) pursuant to a License Agreement between Pfizer and Bayer, the German manufacturer of the imported active ingredient and licensor of the synthesis process used to transform the imported active ingredient into a useful pharmaceutical product, which is then marketed in the U.S. You forwarded the I.A. request to Headquarters for a legal interpretation regarding the dutiable status of the subject royalty payments in light of Headquarters Ruling Letter (HRL) 544436, dated February 4, 1991, and Customs’ General Notice regarding royalty payments of February 10, 1993 (“Hasbro II”).
FACTS:
Bayer manufacture s Ortho-Nitrobenzaldehyde (“ONB”) and Ortho-Nitrobenzaldeh yde Dimethylacetal (“ONBA”) (jointly referred to hereafter as “ONB/A”). Pfizer imports ONB/A into the U.S. from Bayer in connection with its production of a pharmaceutical product known by its generic name as nifedipine, and by the trade names of Procardia® and Procardia XL® (together, the “Royalty Products”). Pfizer obtained the right to manufacture and sell the Royalty Products in the U.S. pursuant to a License Agreement with Bayer. The information presented indicates that Pfizer and Bayer are not related.
In May, 1978, Pfizer entered into an Option Agreement with Bayer that granted Pfizer an option to obtain a license from Bayer to make, use and sell the Royalty Products in the U .S. Pfizer’s right to this license was contingent on its ability to obtain the Food and Drug Administration's (“FDA”) approval of the Royalty Products’ New Drug Application. Pfizer subsequently obtained the necessary FDA approval and exercised its option to obtain a license to make, use and sell the Royalty Products. Thus, as of December 31, 1981, the date on which the FDA approved the New Drug Application, Pfizer had exclusive legal right for a period to make, use and sell the Royalty Products in the U.S.
Subsequently, Pfizer entered into a supply agreement with Bayer which had an initial term of five years. Pfizer was, for the first three years, obligated to purchase all of its ONB requirements from Bayer. Thereafter, Pfizer had the contractual right to buy ONB from a manufacturer other than Bayer if Bayer failed to match any lower purchase price offered to Pfizer by a third party. The initial supply agreement remained in effect until April 20, 1992.
In exchange for the right to use Bayer’s patent rights and know-how, including the right to use Bayer’s patented synthesis process to make the finished Royalty Products in the U.S., Pfizer pays Bayer a royalty. These royalties began to accrue on the date of the first commercial sale of the Royalty Products in the U.S. Royalty payments due from Pfizer to Bayer are calculated as a percentage of Pfizer’s net sales of Royalty Products in the U.S.
In early 1991, Pfizer began to use ONBA instead of ONB in the production of the Royalty Products. ONBA is an intermediate material that is less advanced than ONBA. Pfizer negotiated the terms of an ONBA Supply Agreement with Bayer which it signed on April 20, 1992. This agreement requires Pfizer to purchase all of its requirements of ONBA for a period of ten years, in return for a specific price. Until the ONBA supply agreement was signed, Pfizer had both the technical ability and the legal right to make ONBA itself, or purchase it from other suppliers. Nevertheless, Pfizer chose to continue buying its ONBA requirements from Bayer for a number of important business reasons, the most important being Bayer's reliability as a source.
The subject royalties become due, pursuant to agreements between the parties, only upon commercial sale of the Royalty Products. Similarly, no royalties are due if ONBA is used, resold or disposed of in such a way that sales of Royalty Products do not occur. Thus, Pfizer is free to resell ONBA to third parties without incurring any royalty obligation.
In January, 1992, Pfizer was informed by Customs, San Juan District, of its intent to apply HRL 544436, dated February 4, 1991 (C.S.D. 91-6; 25 Cus. Bull. 18), commonly referred to as the Hasbro ruling, to Pfizer’s importations of ONB/A. Relying on that ruling, the District advised the importer of its intent to assess duties upon the subject royalty payments. The importer subsequently filed this request for internal advice.
Action on the matter was delayed pending the release of Customs review of HRL 544436, and an analysis of public comments on the modification of Customs position on royalties and proceeds of subsequent resale, disposal or use (sections 402(b)(1)(D) and 402(b)(1)(E) of the TAA) resulting from HRL 544436. On February 10, 1993, Customs published a General Notice in the Customs Bulletin (referred to hereafter as Hasbro II), which incorporates customs analysis of public comments concerning the change in position and our decision both modifying and affirming the holding in the Hasbro ruling.
Pfizer takes the position that the subject royalty payments are not dutiable either as royalties or proceeds of subsequent resale, disposal or use. Pfizer pays Bayer a royalty for the right to use Bayer’s patented synthesis process to make the finished Royalty Products, not for the right to purchase or resell the imported ONBA. The agreements between the parties indicate that no royalty would become due if Pfizer were simply to resell the imported ONBA. The chemical “intermediate” from Bayer that is synthesized together with many other starting materials of U.S. origin to create the final Royalty Products contain none of the imported material. Because the imported product is modified to the extent it loses its identity, Pfizer asserts that no resale of the imported merchandise occurs in the U.S. such that finding the payments dutiable under §402(b)(1)(e) is precluded.
ISSUE:
Whether the payments by Pfizer to Bayer in exchange for the right to use a patented process and know how in the manufacture of finished product in the U.S., which amount is calculated on sales of finished product that is materially different from the imported merchandise, are to be included in the transaction value of the imported merchandise as a royalty under §402(b)(1)(D) or as a proceed of subsequent resale, disposal or use under § 402(b)(1)(E) of the Tariff Act of 1930 as amended by the Trade Agreements Act of 1979 (19 U.S.C. 140la(b) ; TAA ).
LAW & ANALYSIS:
For the purpose of this response, we assume that transaction value is the proper basis of appraisement. Transaction value, the preferred method of appraisement is defined in section 402 (b)(1) of the TAA as the “price actually paid or payable for the merchandise” plus five enumerated statutory additions. Here, two of the five statutory additions are at issue. Sections 402(b)(1)(D) and (E) of the TAA provide for additions to the price actually paid or payable for:
(D) 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; and
(E) the proceeds of any subsequent resale, disposal, or use of the imported merchandise that accrue, directly or indirectly, to the seller.
The importer in HRL 544436 was required to pay 7% of the “resale price” to the seller, in addition to the price originally paid to the seller for the imported merchandise. The importer had been paying duties on the additional 7% payments as “royalties” under section 402(b)(1)(D) of the Tariff Act of 1930, as amended by the TAA. In HRL 544436, Customs held that the payments were not dutiable under the royalty provision, section 402(b)(1)(D) of the TAA. Rather, Customs determined that the payments were proceeds of subsequent resale of the merchandise that accrued to the seller. Accordingly, the payments were dutiable under section 402(b)(1)(E) of the TAA.
The determination in HRL 544436 was upheld in Hasbro II and modified to the extent the subject payments were found to be dutiable as either royalties under 402(b)(1)(D) or proceeds under 402(b)(1)(E). The analysis first addressed the question of whether the payment qualified as a dutiable royalty. In addressing this issue, Customs took an historical approach that incorporates the Statement of Administrative Action (SAA), legislative history and case law under the prior statute. The analysis adopted in Hasbro II sets forth three questions derived from decisions by the Customs Court construing prior law to determine the dutiability of payments for royalties under export value. Applying these questions to particular import transactions under the current law provides importers and Customs with a uniform approach to determining whether certain payments constitute dutiable royalties, one of the statutory additions to the price actually paid or payable under transaction value.
The three questions considered by Customs to be determinative with regard to finding a dutiable royalty in Hasbro II are:
(1) Is the imported merchandise imported under patent?
(2) Is the royalty involved in the production or sale of the imported merchandise?
(3) Can the importer buy the product without paying the fee?
Consistent with Hasbro II, responses to the above questions help determine the dutiability of royalty payments.
Pfizer’s answers to the three questions were provided in a supplement to its request for internal advice. With regard to the first question: Is the imported merchandise manufactured
under patent; the importer’s response was no. The company stated that ONB/A is available from several potential sources, none of whom needs to be licensed by a patent holder to manufacture the component. Notably, the U.S. manufacturing process presently employed by Pfizer, which is patented by Bayer, does not require use of the particular ONB/A manufactured by Bayer. Rather, any reliable version will suffice.
In response to the second question: Is the royalty involved in the production or sale of the imported merchandise; the importer’s answer was no. The only royalty involved in this case is paid for the license to use the patented manufacturing process in the U.S. to make nifedipine from ONB/A. Counsel further states that Pfizer’s royalty payment is not “inextricably intertwined” with the imported ONB/A. The importation of ONB/A does not involve the payment of any royalty, unless the manufacturing process employed by Pfizer, in the U.S., is the patented one licensed by Bayer.
According to our analysis in Hasbro II, “no” answers to the first two questions point to the nondutiability of Pfizer’s royalty payment to Bayer. The third question, could the importer buy the product without paying the fee, goes to the heart of whether a payment is considered a condition of sale. Pfizer answers this question in the affirmative. Pfizer may source ONB/A from Bayer without paying the royalty, just as long as Pfizer does not use the patented process to manufacture nifedipine. Furthermore, based on the information provided, the sale of ONB/A is not conditioned in any way upon the payment of the fee; nor is Pfizer’s obligation to pay the fee relieved by Pfizer's purchasing ONB/A from a supplier other than Bayer.
The foregoing answers to the three questions posed in Hasbro II demonstrate that Pfizer’s royalty payments, made in connection with its use in the U.S. of the patented process to manufacture nifedipine, do not constitute dutiable royalties under section 402(b)(1)(D) of the TAA.
The next issue is whether the payments constitute proceeds of subsequent resale, disposal or use, pursuant to section 402(b)(1)(E) of the TAA. The Statement of Administrative Action addresses the dutiability of proceeds of subsequent resale as follows:
Additions for the value of any part of the proceeds of any subsequent resale, disposal, or use of the imported merchandise that accrue directly or indirectly to the seller, do not extend to the flow of dividends or other payments from the buyer to the seller that do not directly relate to the imported merchandise. Whether an addition will be made must be determined on a caseby-case basis depending on the facts of each individual transaction.
The information provided by counsel regarding the subject transactions shows that substantial processing is undertaken in the U.S. to turn the imported ONB/A into royalty products (Procardia® and Procardia XL®, known generically as nifedipine).
In its original request for internal advice, an explanation of how the imported ONB/A is processed and changed during the production cycle was provided. ONBA is a liquid chemical starting material used in the production of nifedipine. It is one of six other starting materials and solvents that are synthesized together using a patented four-step synthesis process to create nifedipine. As discussed above, it is Pfizer’s use of the four-step patented process that requires it to pay royalties to Bayer once the royalty products are sold. The synthesis process causes a chemical reaction which changes the starting materials and solvents into nifedipine. Nifedipine’s chemical structure is significantly different from that of ONB/A. Counsel emphasizes that once the synthesis of nifedipine is complete, there is no ONB/A left in the nifedipine because the ONB/A molecules are chemically transformed during the synthesis process. The nifedipine powder that results from the synthesis process is then put into dosage form, by a process involving grinding, blending with other powdered ingredients and compressing the blended ingredients into tablet form. Various coating and stamping operations are then undertaken to finish the pharmaceutical product. A different finishing process is undertaken to place nifedipine into liquid-filled soft gelatin capsule form.
With regard to proceeds of subsequent resale, the statutory language and SAA state that additions are to be made for proceeds of any subsequent resale of the imported merchandise that accrue to the seller. Here, imported ONBA is synthesized into nifedipine. This process involves much more than simple mixing and finishing. The product that is marketed in the U.S. is not the imported product, but rather one that incorporates the imported product at an early stage of production in the U.S. Once the nifedipine powder is produced, it is physically impossible to change it back into ONBA, or isolate the ONBA. The finished products, Procardia® and Procardia XL® are sold in the U.S. and a royalty/license fee is calculated on those sales.
The importer argues that unlike the royalties presented in HRL 544436, which were paid upon resales of the very same merchandise that was imported, the royalties it pays to Bayer accrue upon sales in the U.S. of finished Royalty Products which are entirely different from the imported ONBA. The amount of the royalty is based not only on the value of the imported ONBA, but also on the significant value of domestic materials and solvents, U.S. labor and substantial overhead. The information presented indicates that the value of U.S. materials, labor and overhead approximates 89% (less royalties) of total standard cost.
In support of the position that the payments are not dutiable under §402(b)(1)(E) of the TAA, counsel cites a recent ruling from this office interpreting the proceeds provision. In HRL 544656, dated June 19, 1991 (published as C.S.D. 92-12, 26 Cus. Bull. 23, June 3, 1992), Customs analyzed the dutiability of certain royalties paid by the importer to Swiss Reiter under both provisions, 402(b)(1)(D) and (E). The analysis concerning the proceeds provision focused on the resale in the U.S. of the imported product. Customs held:
In the present case, unlike HRL 544436, the payments are not based on the resale of the imported product. Rather, the payments are based on the resale of a finished product that includes U.S. components. Thus, a substantial portion of the payments is based on components that were not imported. As a result, we hold that the payments made by the importer to Swiss Reiter are not dutiable under section 402(b)(1)(E) of the TAA.
The foregoing situation is similar to that presented by Pfizer. Applying that analysis here, the imported product that is “resold” in the U.S. has, for all practical purposes, lost its identity as ONBA, and cannot be considered the same product as imported.
Here, the royalty/license fee payments are made for the right to use a patented process and know how necessary to manufacture, compound and formulate the finished royalty products. The royalty/license fee payments are based on the resale of a finished product that includes a substantial percentage of U.S. ingredients. Accordingly, the payments made by Pfizer to Bayer are not dutiable under section 402(b)(1)(E) of the TAA.
HOLDING:
The subject royalty/license fee payments made by the importer for the right to use the patented process and know how necessary to produce the finished Royalty Products do not qualify as statutory additions to the price actually paid or payable under either section 402(b)(1)(D) or 402(b)(1)(E) of the TAA, and are not to be included in determining the transaction value of the subject imported merchandise. In so holding, we point out that these determinations are to be made on a case-by-case basis, taking all relevant circumstances into consideration.
Sincerely,
John Durant, Director
Commercial Rulings Division