Royalty payments remain among the most closely scrutinized items in customs audits, frequently giving rise to substantial duty and tax assessments. Not all royalties, however, are dutiable. Under customs valuation rules, a royalty should be added to the customs value only when it relates to the imported goods and constitutes a condition of their sale for export to the importing country. The treatment matters well beyond the royalty line itself: customs duties and value-added tax on importation are both computed from that value, so amounts added to it enlarge the base on which those charges are assessed.

The central question in these disputes is whether the royalty payment is connected to the importation of the goods. The Post Clearance and Audit Group (PCAG) of the Bureau of Customs (BoC) routinely requires importers to submit their trademark, technology, and intercompany royalty arrangements, and often proceeds from the assumption that all royalties paid by an importer should be added to the transaction value of imported goods. The review reaches a broad population of businesses: related-party importing — in which a local subsidiary brings in goods from a foreign parent or affiliate while paying royalties for the trademarks, patents, and technology behind those products — is a common feature of multinational operations.

A recent Supreme Court (SC) decision in a dispute between a multinational consumer products company and the Commissioner of Customs illustrates both the risk and the opportunity: while royalties tied to imported goods remain dutiable, the importer in the case succeeded in substantially reducing the assessment by showing that only part of its royalty payments was connected to importation.

When royalties become a condition of sale

The case involved a multinational consumer products company that imported products from related foreign entities and paid royalties to its parent company under patent and trademark agreements. These agreements allowed the company to use the parent company's intellectual property in the Philippines in exchange for royalties equivalent to 5% of the net sales of licensed products.

Following a post-entry audit, the BoC issued an assessment covering several matters, with the royalty treatment as the principal issue. The BoC maintained that the company should have included the royalty payments in the transaction value of its imported goods.

The company argued that the royalties were paid for the use of patents, trademarks, and know-how in the Philippines, rather than as a condition for importing or purchasing the goods. It submitted a letter from its parent company stating that royalty payment was not a condition of sale, but the courts gave the statement little weight and looked instead to the parties' licensing agreements. Under those agreements, non-payment of royalties could result in termination. The courts also noted the absence of evidence that the company could have obtained or sold the imported goods under another brand without paying royalties. On this basis, they concluded that the royalty payments were a condition of the sale of the imported goods and were therefore dutiable.

Separating dutiable from non-dutiable royalties

At first glance, the ruling appears unfavorable to importers because the SC affirmed that royalties are dutiable when they relate to imported goods and constitute a condition of sale. A closer look, however, shows how the importer established that only part of the royalties related to imported goods, substantially reducing the original assessment.

The company showed that the BoC's royalty base was overstated because the royalties had been computed on the net sales of both imported and locally manufactured licensed products. An independent CPA analysis demonstrated that a substantial portion of the payments related to products manufactured in the Philippines, which could not form part of the customs value of imported goods.

The courts agreed that only the royalties attributable to imported products sourced from the parent should be included in the transaction value for customs purposes, while royalties attributable to locally manufactured products should be excluded.

The key issue in the case, therefore, is not the existence of royalty payments but the extent to which those payments are connected to imported goods. The independent CPA's analysis proved valuable not because it established that the royalties were entirely non-dutiable, but because it provided a reasonable basis for allocating the royalties between imported and locally manufactured products. That allocation ultimately led to a substantial reduction in the assessment, as the courts declined to fully adopt the BoC's blanket assumption and instead relied on the allocation supported by the independent CPA.

Building a stronger defense against royalty assessments

Perhaps the most important lesson from the case is that, although royalties may be dutiable in principle, importers can successfully challenge customs assessments that broadly assume all royalty payments are dutiable. Importers may do so by demonstrating which portions of the royalties are connected to importation and which are attributable to other activities. This can be achieved through:

• clearly drafted royalty and license agreements;
• evidence showing that the royalties relate to activities other than imported goods, such as local manufacturing know-how, technical assistance, or marketing intangibles;
• documentation establishing that the purchase of imported goods is not contingent upon the payment of royalties; and
• analyses that segregate dutiable and non-dutiable royalty components.

The decision also addressed the treatment of wharfage and arrastre charges, holding that these fees are necessary expenses incurred in moving imported goods from the vessel to the consignee prior to their release from customs custody. Accordingly, the court ruled that such charges form part of the "other charges" that should be included in computing VAT on importation.

Key takeaways for importers

The recent SC decision in the multinational consumer products company's case against the Commissioner of Customs marks a significant development in Philippine customs jurisprudence on royalties. More importantly, it serves as a reminder that the best defense against royalty-related customs assessments begins long before a customs audit. Through clearly drafted royalty and license agreements, together with documentation that properly segregates dutiable and non-dutiable royalty components, importers can strengthen compliance and reduce the risk of unwarranted or excessive assessments. How the BoC applies that allocation approach in future post-entry audits — and whether importers' records already separate royalties tied to imported goods from those attributable to local manufacturing — will be the practical measure of the ruling's reach.

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This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinions expressed are those of the author and do not necessarily represent the views of SGV & Co. Stephanie Vicente Nava is a tax principal of SGV & Co.

This article was originally published by BusinessWorld.