Customs Treatment of Related Fees: Tax Planning Under WTO

Goods and equipment other than computer software and information technology have become the main source of potential revenues for Customs and also the main source of potential surprises for PRC importers and their foreign suppliers.

Double Taxation Risk

The most onerous potential surprise can be a type of double taxation. Before being permitted to remit fees abroad for intellectual property such as patents, proprietary technology, trademarks or copyrights, a PRC licensee must deduct and pay business tax and withholding tax, normally to local tax authorities in the locality where the PRC licensee has its place of business and typically at an aggregate rate of 14.5%. But these same fees would also be subject to import duty and VAT levied by PRC Customs at the place of importation if they constitute part of the customs value of imported goods as detailed by the Royalty Procedures.

Prevention vs Cure

An appeal against a PRC Customs levy may in general only be filed after payment has been made.⁶ The existence of the above double taxation has not been recognized as a basis to appeal either type of taxation. There is also no mechanism available to credit one type of taxation against the other. Each is determined in isolation from the other, by different collection authorities implementing different regulations.

Risk Reduction More Important

Avoiding the risk of separate payments being included in customs value should now be the main goal of tax planning for cross-border supply chains. Reducing the purchase price of imported goods is less important, especially in view of declining duty rates. Import duty makes up a falling portion of levies on most goods (at an average rate below 12%, heading towards zero for information technology,⁷ and already zero for most software⁸), while import VAT makes up a rising portion (at a typical rate of 17%).⁹ When the duty rate on an imported good is zero, import VAT does not affect the cost of goods of the supply chain as a whole, because an importer that pays VAT enjoys an offsetting credit when collecting and paying VAT on its resale of the imported goods.

Condition of Sale

The question of when a payment is a "condition of sale" of imported goods can be complex. The Royalty Procedures state that the payment constitutes a condition of sale "if payment of a Royalty constitutes a precondition for the seller of the imported goods to sell the goods towards the interior of the PRC Customs frontiers, i.e., if the buyer does not [agree to] pay the above fee, then the sale of such goods under the agreed contract conditions could not possibly be agreed".¹⁰ (In other words, if the buyer refused to accept an obligation to make the separate payment, the seller would not have agreed to sell the goods under the same terms of sale.) International commentaries make clear that the royalty payment should not be deemed a condition of sale of the goods if the buyer had the alternative of purchasing the goods under the same price and terms of sale without agreeing to pay the royalty and without receiving the rights for which the royalty was charged.¹¹

Everything is Related

The Royalty Procedures specify a long list of examples of when a royalty right will be deemed "related" to an imported good.

A patent or proprietary technology, even if delivered over the Internet or via satellite, is deemed related to a good if the good "contains the patent or proprietary technology", the good is produced using the patent or proprietary technology, or the good is a machine that is "specially designed or manufactured to implement" the patent or proprietary technology.¹² (The phrase "specially designed or manufactured to implement" the patent or proprietary technology appears to have a relatively narrow intended meaning. But this phrase also appears to permit relatively subjective interpretation so, until there is further clarification, special care on this point is advisable for all foreign companies that supply both machines and technology to the same PRC customer.)

A trademark is deemed related to a good if the trademark has been applied to the good at the time of import, is "directly permitted to be resold" after application of the trademark after import, or if the good "already contains the trademark right" at the time of import, is permitted to be sold after a light degree of processing and application of the trademark.¹³ (A good that "already contains the trademark right" appears to mean any good to which the importer is permitted to apply the trademark, if the permission has already been granted at the time of importation).

A copyright is deemed related to a good if the good contains software, literature, music, pictures or other "copyright contents" in which the copyright exists.¹⁴ (Interestingly, copyright contents appear to be related only if they are "contained in" the imported good, unlike patents and proprietary technology, which are stated to be related even if delivered over the Internet or via satellite).

Distribution rights, resale rights or similar rights within the customs frontiers of the PRC, possessed by the seller of the imported good, are deemed related to a good if the good is permitted to be directly sold after import, or is permitted to be resold after a light degree of processing.¹⁵ (The requirement that such rights be "possessed by the seller" might raise some interesting questions where the seller is a middleman that would not itself be entitled to engage in distribution or similar activities within the PRC.)

More Data to be Required

PRC Customs now needs broader and deeper information from importers. To determine whether separate payments should be included in the customs value of goods, PRC Customs needs information and evidence indicating whether the payments are related to the goods and especially whether they are a condition of sale.

More broadly, PRC Customs now needs information in order to determine whether a particular transaction is covered (under the Value Procedures) by an exception to the general requirement that customs value be based on the actual transaction value agreed between the buyer and seller. Transaction value may be disregarded only under specified conditions, e.g., if there are certain types of restrictions on the buyer's disposition or use of the goods, if the sale or price is subject to some condition or consideration for which a value cannot be determined, or if the buyer and seller are related and their relationship influenced the price.¹⁶

Finally, PRC Customs will need more information in order to apply the calculation methods that are permitted (under the Value Procedures) after actual transaction value has been disregarded. Listed in the order they must be applied,¹⁷ these methods are: (i) transaction value of identical goods; (ii) transaction value of similar goods; (iii) "deducted" value; (iv) computed value; and (v) other reasonable means.¹⁸

Retrospective Influence

Although formally effective only from July 1 2003, the Royalty Procedures are also useful for understanding the perspective of PRC Customs on standards applicable during several previous periods. This is not of merely historical interest, because many investigations remain pending on importation conducted during these periods, and new investigations may examine inaccurate or incomplete customs declarations filed during prior years.¹⁹

WTO standards have applied to PRC imports since the January 1 2002 effective date of the Value Procedures, or arguably since WTO entry on December 11 2001. Even the PRC regulations in effect before WTO entry²⁰ included provisions²¹ roughly consistent with the WTO Customs Valuation Agreement, which itself took effect in 1994.²²

Transitional Bumps & USTR Criticism

The PRC formally adopted WTO standards on customs value with effect from January 1 2002, only 20 days after the PRC 's WTO entry. But implementation has been slower, and has drawn criticism from the United States Trade Representative (the USTR). In early 2003 the USTR reported: "...importers report that many Customs officials continue to use minimum and reference price lists rather than the actual transaction price for valuation purposes".²³ The USTR also commented on the precise issue covered by the Royalty Procedures, stating: "Many Customs officials are still inappropriately applying royalty and software fees to the dutiable value even if these fees are not a condition of the particular sale in question."²⁴ The Royalty Procedures facilitate the use of transaction value in place of reference prices, but do not remove all areas of potential disagreement, notably on the question of how to determine when royalties are a condition of sale.

Precautions & Internationalized Interpretation

Careful documentation of all related transactions is now needed in order to minimize customs value and avoid the risk of double taxation. Documentation should be prepared with one eye on changing PRC regulations and policies, and the other on interpretations developed over a number of years by the WTO itself and by other member countries.

Endnotes

1 The key WTO-related requirements are set out in the 1994 Agreement on Implementation of Article VII of the General Agreement on Tariffs and Trade, commonly referred to as the "WTO Customs Valuation Agreement".

2 The Royalty Procedures, Article 2.

3 Ibid, Article 3.

4 Ibid, Article 13.

5 The Value Procedures, Article 4.

6 Article 36 of the PRC Import and Export Customs Duty Regulations, last amended in February 1992 (the 1992 Duty Regulations).

7 The Information Technology Agreement requires duties to be completely eliminated by January 1 2005 on "information technology". This includes semiconductors and semiconductor manufacturing equipment, computers and computer parts, software, telecommunications equipment and computer-based analytical instruments.

8 Computer software is now subject to a duty rate of zero, although it remains subject to import VAT.

9 Duty rates are trending down, especially for information technology goods. According to the United States Trade Representative's 2003 National Trade Estimate Report on Foreign Trade Barriers, the overall average tariff rate fell from over 15% to 12% in 2002.

10 The Royalty Procedures, Article 9.

11 See, e.g., Saul L. Sherman and Hinrich Glashoff, Customs Valuation: Commentary on the GATT Customs Valuation Code (ICC Publishing S.A., 1988, p. 125), where the authors state: "The question which is critical ... is whether the seller would have sold the tangible at the price in question if the buyer had preferred to omit the intangible, and the royalty."

12 The Royalty Procedures, Article 5.

13 Ibid, Article 6.

14 Ibid, Article 7.

15 Ibid, Article 8.

16 The Value Procedures, Article 3.

17 Each method must be attempted before the subsequent method may be used. The only exception is that, at the request of the importer, (iii) deducted value may be attempted before (iv) computed value.

18 The Value Procedures, Article 7.

19 Article 2 of the PRC Customs Inspection Regulations, issued by the State Council on January 3 1997.

20 Prior to China's WTO entry, the key regulations were the 1992 Duty Regulations, the PRC Customs Assessment of the Dutiable Value of Import and Export Goods Procedures, effective September 1 1992, and the PRC Customs Imported Goods Duty Collection and Exemption on Software Fees Tentative Procedures, effective February 1 1993 (1993 Software Fee Tentative Procedures).

21 Article 11 of the 1992 Duty Regulations adopted the calculation methods of: (i) transaction value of the identical goods; (ii) transaction value of the similar goods; (iii) deducted value; and (iv) reasonable means. Article 15 of the 1992 Duty Regulations required inclusion of "fees for patents, trademarks, copyright, proprietary technology, computer software, information, etc., which are incurred in relation to the said imports and paid to foreign parties in order that the goods may be manufactured, used, published or distributed domestically". The 1993 Software Fee Tentative Procedures provided additional detail on inclusion of such fees.

22 The "software fees" in the title of the 1993 Software Fee Tentative Procedures were defined in the text to include virtually any intellectual property-related fees. Article 2 of the those rules defined "software fees" as "patent fees, trademark fees, copyright fees, and other fees for proprietary technology, computer software, materials and other items".

23 USTR, 2003 National Trade Estimate Report on Foreign Trade Barriers, p. 49.

24 Idem.