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How to prepare for upcoming combined royalty changes

EY
EY Global

Ernst & Young Global Ltd.

2 minute read 13 Apr 2023
Related topics
Tax
Tax accounting
Tax compliance
Global trade
CFOs and tax functions may be inclined to treat customs issues as peripheral to their critical workload, but they must pay attention.

In brief

  • Combined (or bundled) royalties regularly create customs difficulties for companies and authorities.
  • Many CFOs need to be fully aware of the risks on dutiable royalties. They should prepare by first getting a holistic overview of their royalty exposure.
  • Tax functions must build capability by employing the right tools and third-party support to interpret the rules.

In recent years, governments worldwide have increased scrutiny of the products, components, and intangibles that are moving across their borders. Imports are now firmly under the microscope due to environmental, social and governance (ESG) pressures, including environmental targets, concerns over forced labor, and geopolitical factors like trade disputes and Brexit. 

Government authorities are demanding information on how these goods are produced, what they contain, and — as part of the drive to bolster revenue collection in the wake of a costly pandemic — their ultimate value.

The European Commission, for example, has been auditing the EU's member states to check that they're compliant with its standards on customs values, and penalizing any that allow importers to report totals that are too low.

This has put a greater focus on the need to ascertain and capture the true economic value of products when they cross the border. Here, one aspect under increasingly close examination is the application of royalties to customs value.

The World Customs Organization's Technical Committee on Customs Valuation (TCCV) recently approved a new Advisory Opinion (4.19) on a combined royalty. Payments for goods that are physically shipped across borders are also closely related to payments for intangible intellectual property. That includes royalties and license fees for the use of a patent, or of design rights, processes, trademarks, copyrights and expertise.

For example, a shoe that costs $5 for a manufacturer in Asia to produce may be worth $15 as it crosses the border to its eventual market, once embedded IP elements such as branding and trademarks are taken into account.

The Advisory Opinion shows how a single royalty paid for the right to use or incorporate a patented imported input in the production of a finished product in the destination country, as well as the use of a trademark on the finished product, should be treated for customs valuation purposes.

Royalties are a complex field. This latest Advisory Opinion adds to 19 existing instruments from the World Customs Organisation that already deal with royalties and license fees. While TCCV decisions are not binding, many courts view them as instructive. Some countries, in South America for example, regularly adopt them as regulation, and the EU typically publishes them in its Compendium of Customs Valuations.

"It's clearly not just regions like the EU that are now placing royalties under greater scrutiny," says Jeroen Scholten, EY Global Trade Leader, Indirect Tax. "The TCCV Advisory Opinion suggests that companies bringing goods across borders can also expect greater attention from customs authorities that used to be more relaxed."

While CFOs and tax functions may be inclined to treat customs issues as peripheral to their key workload, not least because they may lack expertise in customs law, they need to be paying attention. Because if customs values are higher than expected, that brings risk when it comes to duty.

"If there are royalties being paid, and there are goods being imported, that should immediately raise a red flag," says Scholten. "Teams really need to assess whether that is a dutiable element from a customs valuation perspective. Fail to get on top of the changing regulatory picture and you may unintentionally import goods without adding a royalty, simply because you're not aware it needed to be paid."

A Luxembourg perspective

Should royalties be included in the customs value of your imported goods?

Topics deemed to be slightly removed from core tax functions – e.g., indirect taxes like VAT, GST, customs and excise duties – have come more into focus in recent years. Customs duties especially, in the wake of the pandemic and supply chain crisis, are in the spotlight.

Just 18 months ago, Advisory Opinion 4.19 was adopted by the World Customs Organization. The Opinion has yet to be published, and it should be noted that it will not be treated as EU Law. However, it is expected to act as a guide for firms in determining whether, and if so, how, a single royalty should be included in the customs value for imported goods. Not doing this correctly could lead to firms incorrectly assessing which parts of their payment are dutiable or non-dutiable, leading to overpayment in some cases, or underpayment in others, which could trigger penalties. As such, knowing the value drivers behind imports, how these imports will be used (production/distribution), and whether the price already captures some intangible value (etc.) is essential for firms to stay on top of developing global frameworks. 

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Fernando Longares
EY Luxembourg Partner, TMT Leader
A photographic portrait of Olivier Lambert
Olivier Lambert
EY Luxembourg Partner, Indirect Tax Leader

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Such under-reporting may lead to a reassessment of duties and the imposition of penalties. Overpayment of royalties and duties is another potentially costly consequence to this lack of awareness.  

 

For example, from a duty perspective, teams should only consider the relevant portion of any intangible payments that belong to the economic value at the moment the goods cross the border, and not other intangibles the company may also be paying for. In the previous shoe example, these may include the look of the shoe stores in the market and the marketing and advertising material being used.

 

"Many royalty payments contain both dutiable and non-dutiable elements from a customs perspective," says Martijn Schippers, Senior Manager of Indirect Tax at Ernst & Young Belastingadviseurs LLP. "If you are not fully aware of all the royalty rules, you may add the entire royalty payment instead of assessing which parts are dutiable, and which aren't. And you can end up overstating your import duties and pay too much."

 

A thorough approach starts in the drafting of royalty agreements. Customs compliance requires specialists from tax and finance to work with transfer pricing experts and others with a deep understanding of economic value chains at this early point, to assess whether prospective agreements will spark a customs duty impact.

 

At this stage, if the agreement is set up correctly they may still have the opportunity to not include the royalty as part of the customs value. A royalty agreement can embed different value drivers, from the right to import a product, to the right to produce products in country, or to use a trademark or incur costs for marketing and sales in that territory under a product name. By conducting a thorough value driver analysis, they can see what is being paid for and determine whether it would be beneficial to apportion those payments differently.

 

Beyond this, the specialists need to build a holistic approach that can accommodate longer-term shifts in global royalties frameworks.

Taken together, this work comes at a cost, as it requires already stretched teams to engage in the challenging and time-consuming task of data gathering and analysis. Organizations must decide how much they can afford their tax and finance talent to deviate from core value-adding activities.

 

Tools such as the EY Global Trade Analytics solution can provide a single point of truth regarding a company's customs activities, a dashboard overview of the products being imported or exported, pertinent duty rate calculations, and what needs to be reported to the authorities.

 

It can also be prudent to hand over some or all of the work to external experts, who can conduct a qualitative review of your intangible payments and ensure the approach to royalties and related duties remain fit for purpose.

 

Here are five steps you can take to remain in step with royalties as the global frameworks develop:

  1. Understand the business through a customs lens. There's a difference between knowing what products you import and export, and having a full grasp of your global duty profile and bill.
  2. Know the value drivers behind the goods that are being shipped. Is it more related to production, or the distribution of finished goods? Know whether a product's price already captures compensation for intangibles, or whether there are separate payments required for things like services, royalties, and distribution rights. Is there a structure in place for paying for such intangibles? And how is transfer pricing affected?
  3. Assess what's expected by the customs authorities. Remember, while customs frameworks may apply internationally, businesses still need to ensure their approach is appropriate for every territory in which they operate.
  4. Examine royalty payments critically to ensure there's no overpayment. 
  5. Review royalties regularly. Like many aspects of global taxation, royalties are moving fast – in terms of both value chains, and the external backdrop of regulations and scrutiny. It's critical to ensure systems and processes are flexible and remain fit for purpose.

Summary

Customs royalties and duties are a complex field. The latest TCCV Advisory Opinion is merely another addition to a complicated global framework. Many CFOs and tax functions remain unaware of their exposure when it comes to the risk around dutiable royalties. This should be dealt with even as agreements are being drafted, feeding this into a holistic overview of their royalty exposure, and what they're meant to be paying duty on. The next step is choosing the right tools and third-party support to help interpret the rules and validate the chosen approach, both locally and internationally. 
 

About this article

EY
EY Global
Ernst & Young Global Ltd.
Related topics
Tax
Tax accounting
Tax compliance
Global trade

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