Customs valuation and intercompany royalties: the Curtis Balkan case

By Dr. Harold McClure, New York City

The Court of Justice of the European Union (CJEU) on July 9 ruled in a Bulgarian case (C-76/19) which involved intercompany royalties paid by Curtis Balkan to its US parent, Curtis Instruments.

The question of whether intercompany royalties are dutiable for customs valuation purposes has been addressed by customs authorities around the world, including US authorities.

The general rule is that they are.

Discussions of this issue often envision a local distribution affiliate purchasing finished products from a foreign parent. Imagine a situation where the local distribution affiliate sells a product for $100 per unit and would be expected to earn gross profits of $20 per unit.

If this affiliate paid its parent $80 per unit with no royalty payments, then the customs base would be $80. Some customs planners might unbundle the intellectual property rights from the production of the good by having the intercompany goods price be only $70 per unit but also have the parent charge the distribution affiliate intercompany royalties equal to 10 percent of sales.

If the intent of this planning were to exclude the royalties from the dutiable charges, US customs law has long held that such product royalties are dutiable.

Curtis Balkan and Curtis Instruments

Curtis Balkan is the Bulgarian affiliate of Curtis Instruments. The affiliate uses US technology to assemble and sell fuel supply indicators and high-frequency speed regulators.

Curtis Balkan purchases components from manufacturers outside the European Union. The price of these components are dutiable. Curtis Balkan also pays its US parent royalties equal to 10 percent of sales for the use of the technology. The customs valuation issue was whether the royalties were also dutiable.

This case differs from our first example in three important ways. First, the case involves EU rather than US customs law. Second, the imported goods were components rather than finished products. Finally, the manufacturers were third parties and not manufacturing affiliates.

Let’s modify our original example to assume that Curtis Balkan not only distributed the products but was also responsible for the final assembly.

Let’s continue to assume that the product sells for $100 per unit and that the third-party foreign component manufacturers charge an arm’s length price, which we shall assume is $60 per unit.

Let’s also assume that Curtis Balkan incurs $20 per unit in costs for final assembly and distribution.

Consolidated profits represent $20 per unit. Any intercompany royalty rate that equals 10 percent of sales allocates half of these profits to the parent, with Curtis Balkan retaining $10 in profits per unit.

Curtis Balkan asserts that the customs value should be based on the price paid to the manufacturers for components, excluding the intercompany royalties. The Bulgarian Customs Authorities argue that the royalties should be added to the customs value of the products.

The Supreme Administrative Court of Bulgaria issued a request for a preliminary ruling before the CJEU about the customs valuation treatment of the royalty payments.

The CJEU pointed out that royalties and license fees should only be added to the customs value of the imported components if four cumulative conditions are satisfied: the royalties or license fees have not been included in the customs value of the respective goods; the royalties or license fees are related to the goods being valued, which presupposes that there is a sufficiently close link between the royalties and those goods; the buyer is required to pay those royalties or license fees as a condition of sale of the goods being valued; and it is possible to make an appropriate apportionment of the royalties based on objective and quantifiable data.

Applying a transfer pricing analysis to the facts

While this ruling does not address the transfer pricing issues, let’s contrast the transfer pricing issues in this case with the first scenario we noted.

While an issue in our first scenario is whether the intercompany price for components was arm’s length, in Curtis Balkan, the price paid to the third party component manufacturers was arm’s length.

Another difference between our first example and the facts in Curtis Balkan involves the functions of the importing affiliate.

In our first example, the only function of the importing affiliate was distribution, with the key transfer pricing question being whether a 20 percent gross margin was appropriate compensation for this function.

In our illustration using the Curtis Balkan facts, we assumed a 30 percent gross margin under the intercompany pricing policies because this Bulgarian affiliate’s functions include both final assembly and distribution functions.

Our illustration of the Curtis Balkan case assumes that this affiliate’s expenses related to these two functions represent 20 percent of sales and consolidated profits represent 20 percent of sales.

A 10 percent intercompany royalty rate leaves this affiliate with a 10 percent operating margin, which must be compared to the routine return for assembly plus the routine return for distribution.

If these intercompany royalties are deemed dutiable, then the Bulgarian Customs Authorities would have the same vested interest in transfer pricing as the IRS and an opposing interest from the Bulgarian income tax authorities.

If the appropriate returns for assembly and distribution exceed 10 percent of sales, then the 10 percent royalty rate is above the arm’s length standard.

A lower royalty rate would allocate more taxable income to Bulgaria but would also imply a lower customs base.

 Conversely, the IRS might argue that these routine returns collectively are less than 10 percent, so that the arm’s length royalty rate should be higher than 10 percent.

While such an assertion would imply less taxable income for Bulgaria, it would imply a higher customs base.