Case law development: inclusion of royalties for the use of know-how in manufacturing and related withholding VAT in the customs value of imported goods

On 19 September 2022, the Ninth Arbitration Appeal Court upheld the trial court ruling on case No. A40−82 219/2022, in which the decisions of a customs authority were found to be lawful.

The matter considered in the case was the lawfulness of the customs authority’s decisions in requiring royalties for the right to use know-how and technical documentation in manufacturing products in Russia and amounts of VAT paid on those royalties by the importer as a tax agent to be included in the customs value of imported components.

Facts of the case

A Russian importer ("the Company") imported various kinds of parts and components ("Components") for use in manufacturing motor cars ("Vehicles") into Russia under foreign trade contracts with related suppliers.

The right to use know-how and technical documentation in manufacturing Vehicles in Russia was granted to the Company under a licence agreement with a foreign licensor which is also a supplier of Components under a foreign trade contract.

The provisions of the licence agreement require the payment of royalties for know-how and technical documentation in the form of a percentage of the net value added by the Company to the Components ("Royalties"), i.e., as the difference between the net selling price of the Vehicles and the net selling price of the imported Components.

The case file also indicates that the processes of ordering Components and manufacturing Vehicles in Russia are carried out not by the Company itself but by related group companies. The Company’s arrangements are summarised in the diagram below.

The customs authority carried out an in-house customs audit of the Company, as a result of which it concluded that amounts of Royalties and amounts of VAT paid on those Royalties by the Company as a tax agent must be included in the customs value of the Components.

The customs authority’s position is based on two key factors:

• The licensing agreement and the agreement on the supply of Components contain a number of interrelated provisions indicating that the Components cannot be acquired and imported without the payment of Royalties;
• The Components are imported exclusively for use in manufacturing the Vehicles. The value of the know-how determines the value of the Components.

Taking the view that the customs authority’s decisions were unlawful, the Company appealed to the arbitration court.

The court’s position

The appellate court upheld the trial court’s ruling, giving the following reasoning for its decision:

Inclusion of royalties in the customs value of the Components

Condition 1 (the royalties relate to the imported goods) is met by reason of the following:

• The licensing agreement establishes requirements relating to the acquisition and use of the Components in the manufacture of Vehicles;
• The licensing agreement contains provisions requiring the Company to conclude a supply agreement with the licensor;
• The sole purpose of importing the Components is to use them in manufacturing Vehicles in accordance with the know-how and technical documentation provided under the licensing agreement.

Condition 2 (the payment of royalties is a condition of sale of the goods) is met by reason of the following:

• The licensing agreement contains provisions requiring the supply agreement to be terminated if the Company fails to pay Royalties;
• The licensor, which is also the supplier of the Components, monitors the importation and use of the Components;
• The quantity and make-up of Components to be supplied are determined by a related company which is both the supplier and the licensor.

Methodology for the inclusion of royalties in the customs value of Components

The court also evaluated the methodology used for the inclusion of royalties in the customs value of Components based on the customs authority’s explanations:

• The Company did not, during the audit, provide information on the allocation or matching of Royalty amounts to particular items of Components used in manufacturing Vehicles;
• The Company’s accounting policies do not allow for specific Components to be matched to specific Vehicles based on Royalty invoices and/or goods declarations;
• The Company used only imported Components for the assembly of Vehicles in the audited period;
• It therefore follows that the full amount of Royalties should be included in the customs value of imported Components.

However, it is not possible to determine from the case file what position the Company takes on this matter.

Inclusion of amounts of VAT on Royalties paid by the Company as a tax agent

The court did not evaluate the validity of the position that amounts of VAT on Royalties paid by the Company to the Russian budget as a tax agent must be included in the customs value of the Components.

Current trends and outlook

This case further adds to the negative trend for companies involved in international trade in the contesting of customs authorities' decisions requiring royalties for the right to use know-how in the manufacture of finished products in Russia to be included in the customs value of imported raw materials and components.

It is interesting to note in this instance that, despite the detailed examination of the structure of supplies and the conduct of manufacturing operations, the court did not address the fact that the importer/licensee, while being a party to the licensing agreement, was not the direct purchaser of the components or the manufacturer of the finished products.

The court pays greater attention to analysing the formal provisions of agreements than the actual circumstances of the transactions, which highlights the importance of making a thorough review of the provisions of licensing and foreign trade agreements to identify provisions that might affect the assessment of whether the conditions for the inclusion of royalties in the customs value of imported goods are met.

Another interesting feature of the case is the court’s approach to the question of whether withholding VAT payable by the importer (licensee) on royalties should be included in the customs value.

The question of whether amounts of withholding VAT should be included in the customs value of imported goods as part of royalties remains open. Case law on this issue is continuing to evolve and a definitive approach has yet to be established.

In view of this fact, we advise companies to act pre-emptively and make a thorough review of customs risks associated with the inclusion of royalties and taxes thereon in the customs value of imported goods.