CESTAT holds royalty paid by OEM to overseas entities is includible in the assessable value of goods imported by contract manufacturer

 This Tax Alert summarizes the recent ruling ^[1] of the Customs, Excise and Service Tax Appellate Tribunal, Chennai (CESTAT) on whether the royalties paid by original equipment manufacturer (OEM) to overseas entities should be added to the assessable value of the goods imported by Contract Manufacturers (CMs).

The assessee and its group entities entered into an agreement with CMs to manufacture mobile phones to be sold to the assessee. CMs imported parts and components from overseas group entities for this purpose. Assessee paid royalty and license fees to overseas entities on further sale of such manufactured mobile phones.

The key observations of the CESTAT are:

• CMs did not enjoy unfettered rights of possession of the imported goods. Given the agreement’s conditions, restrictions, and reimbursement terms, the assessee is effectively the real buyer. The agreement’s core purpose is not the sale of parts but provision of work and labor.
• Since the CMs do not obtain effective possession or control over the goods, the assessee is the beneficial owner of the goods.
• Ownership of goods is not an essential condition to be an importer. Section 2(26) of the Customs Act, 1962 defines an “importer” to include the owner, beneficial owner, or any person presenting himself as the importer. On purposive reading of the above definition along with Section 28(4), duty can be demanded from the beneficial owner i.e., the assessee in the present case.
• The agreement shows that royalty is paid for bundled software and hardware technologies embedded in the imported components, and commercial structuring does not change the fact that the royalty directly relates to those imported parts.

Accordingly, the CESTAT held that the royalty/license fee paid by assessee should be added to the assessable value of the goods imported by CMs as per Section 14 of the Customs Act. Consequently, it upheld the demand on the assessee even for the extended period of limitation along with interest and penalty.

Comments:

• CESTAT ruling may significantly impact various sectors operating under the similar commercial arrangement involving contract manufacturing and technology transfer.
• Applicability of this ruling regarding “condition of sale” may have to be analysed in cases where businesses can segregate royalty payments related to imported components from the one associated with post-import manufacturing or distribution activities.

The order passed by CESTAT is likely to be appealed before the Supreme Court