China Customs duties on royalties – unexpected risks for multinational groups operating in China

We are delighted to feature this article, which has been kindly contributed by Harvey Lee, Senior Partner at Shanghai Kingfaith Consulting Co. Harvey’s contact details can be found at the end of the article.

The payment of royalty and license fees by a Chinese subsidiary to its foreign parent company is a common feature of transfer pricing (TP) arrangement structures used by multinationals investing in China. However, unless those multinationals take customs issues into consideration at an early stage and put in place appropriate documentation and procedures, such royalties and fees can create unexpected compliance risks, including potential administrative penalties imposed by China Customs.

In the TP compliance strategies adopted by multinational groups, tax implications are always one major concern. There is a common misconception that royalty and license fees are only liable for taxes collected by the State Administration of Taxation, and they have nothing to do with Customs authorities, which are believed to only supervise “tangible” goods and articles. However, the payment of royalty and license fees is also subject to Customs regulation in China, as China Customs has the taxing power over royalties and license fees under certain conditions.

Over the years, we have represented clients before Customs officers to sort out various “royalty and license fees” issues. Recently we have been working on a case of this kind with the hope that our client would be exempt from administrative punishment. As this case is representative of prevalent practice in terms of cross-border trading and licensing structures, we’d like to share it with multinationals to kindly draw their attention to Customs compliance issues. For the sake of our client, we have simplified the case with the concrete information omitted.

Case study - facts

Importer A in China and Manufacturer B in country X are both subsidiaries of parent company C in country Y. A imports goods from B, and C owns the rights in trademarks which are attached to the goods. In the sales contract between A and B, there is no concrete requirement for the payment of royalty. Meanwhile, in accordance with a separate agreement with C, A is obliged to pay a royalty to C in order to be permitted to use the trademark on the goods.

Importer A has been importing the same goods for a number of years without declaring the payment of royalties to China Customs. Several months ago, it received a notice from its local Customs office inquiring about its royalty arrangements and alleging that a substantial amount of unpaid duties and taxes may be due, together with potential administrative penalties.

Customs laws in China

China Customs enforces a specialized legal system that features an intricate web of international agreements, laws, government regulations, decrees and orders and which is very different from the fields that enterprise management or general legal practitioners are familiar with.

As regards the case in question, pursuant to the relevant laws and regulations, royalties and license fees (relating to patents, knowhow, trademarks, copyright, the right to distribute, etc) are to be added to the transaction value of imported goods, if they are related to the imported goods and have to be paid as a condition for the sale of such goods. Once they are added to the transaction value, they become part of Customs value based on which Customs duty, VAT and excise (for some categories of commodities) are levied by China Customs. In addition, the importer is under an obligation to declare at time of entry whether it has paid any royalties and license fees relating to the imports. If the importer fails to make truthful declaration, it may expose itself to the risk of administrative penalties.

Analysis of the issues

How to determine whether or not royalties and license fees are (1) related to the imported goods and (2) paid as a condition of sale is a complicated legal question. The provisions are abstract and obscure even though there are some rules specified. On the other hand, the facts of each case are often complex and business models vary from one group to another, and from one type of products to another. In some cases, the royalty payments are made for a bundle of different types of rights, which may be partly related to the imported goods. To differentiate between those royalties which are related to imported goods, and those which are not – and accordingly apportion the value of payments among them – is an onerous task for many groups. In addition, variations in business arrangements can make the issues even more complex, as a payment item that must be added to the transaction price for one business scenario may not be dutiable if the business arrangement varies.

In order to be compliant in China Customs issues and manage the relevant risks, a thorough legal analysis needs to be conducted in each individual case in combination with comprehensive examination of the trading facts surrounding both the goods and licensing transactions, supported by appropriate documentation including intercompany agreements.

Recent developments in enforcement practice in China

In recent years, China Customs has intensified its efforts in verifying and auditing enterprises on their licensing fees, royalties and Transfer Pricing. Besides routine inspections, a number of industry-wide Customs auditing campaigns on licensing fees & royalties have been initiated across the country targeting various industries. Many MNEs have been audited and often quite substantial amount of tariffs and taxes were pursued subsequently. In some cases, administrative penalties have been imposed, which may in turn impact on their Customs ratings.

As China Customs is shifting its focus from supervision of consignments of goods to regulation of enterprises as a whole, Customs compliance risks will further increase. Notably, China Customs has established information exchange mechanism with the State Administration of Foreign Exchange, and enterprises’ foreign currency payments are under close watch by China Customs.

Recommendation

China Customs administers an extensive range of responsibilities. Besides licensing fees & royalties and Transfer Pricing, there are also other issues that may fall into the “sphere” of China Customs. It is strongly suggested that the enterprise attach much importance to customs compliance issues as risks of this kind would most likely materialize with damaging effects on enterprises’ business.

Harvey can be contacted by cellphone on ++86 17622958270 and by email at harvey.lee@kingfaith.com.cn.