Country Road duties case – an element of moral reasoning?

The case concerns the use of intellectual property relating to a “complex retail formula” which was said to create the Country Road retail experience. There are elements of the reasoning which raise questions about whether the High Court placed too much weight on policy or floodgate considerations and not enough on the statutory language.     

The key issue was whether the price paid by Country Road NZ for imported goods should include these licensing/royalty payments when calculating customs duties.

The Tariff Act 1988 imposes customs duties on imported goods based on the “customs value” which at the relevant time was determined in accordance with the Customs and Excise Act 1996 (the Act). Schedule 2 of the Act provides that the customs value is “the price paid or payable for the goods” when sold for export to New Zealand, adjusted to include:

1. Royalties and licence fees in respect of the imported goods that the buyer must pay as a condition of the sale of the goods (cl 3(1)(a)(iv)), or
   
   
2. The value of any part of the proceeds of any subsequent resale of the goods that accrues directly or indirectly to the seller (cl 3(1)(a)(v)).

Summary of facts and positions

Country Road NZ sells clothing and homeware in its New Zealand retail stores. Country Road NZ imports goods from Country Road Australia under an informal arrangement which involves three categories of payment:

1. The sale price for the cost of goods to Country Road Australia, plus a 10-15% loading to compensate for the design, sourcing, distribution costs, and the use of intellectual property including the Country Road trademarks (the loading sale price),
   
   
2. Licensing/royalty payments relating to the use of “know how” for the successful retailing of the Country Road and Trenery brands and the exclusive right to distribute these brands in New Zealand. The evidence suggested that the “know how” involves strategic direction, brand development and positioning, product development, store layout and merchandising which all contribute to the specific Country Road in-store retail experience, and
   
   
3. Payments for routine retail management and administrative services.

The contentious category was the second of those payments.

Country Road NZ’s position

Country Road NZ did not include licensing/royalty payments of NZ$20m made to Country Road Australia in its calculation of customs duties between January 2014 and June 2018. 

Country Road NZ argued that the payments were made in respect of the comprehensive retail formula which related to the process of selling the goods, rather than the imported goods themselves.

The argument went that the payments were a profit-sharing arrangement to enable Country Road NZ to share with Country Road Australia the profit it helped create. The payments were calculated using a profit split method, being 75% of Country Road NZ’s net profit above a “routine return”.  

Customs’ position

New Zealand Customs Service (Customs) took the view that the “true cost” of the goods should include the licensing/royalty payments as those payments relate to intellectual property rights that are in effect “incorporated” within the goods. Customs calculated the resulting underpayment of customs duties and GST to be NZ$2.5m.

The Authority’s decision

The case at first instance was heard by the Customs Appeal Authority (the Authority). The Authority found that the licensing/royalty payments had “no quantifiable nexus with the cost or the value of the imported goods.” The payments were held to be a form of post-importation profit sharing, unconnected to the “true value” of the goods. 

In reaching that decision, the Authority relied on the proposition that the price paid for the goods was set by a transfer pricing regime, and accordingly, Country Road NZ satisfied its customs duties obligations as there was no evidence of an underpayment for the goods themselves. In other words, if the price paid for the goods was “right” for income tax purposes applying the arm’s length principle in the transfer pricing rules, the price should also be right for duties purposes.   

Custom’s appeal to the High Court

Customs appealed the Authority’s decision on the following grounds: 

1. The Authority failed to correctly apply three New Zealand Court of Appeal cases that considered materially similar issues (Adidas New Zealand Ltd v Collector of Customs (Northern Region) (1999) 1 NZCC 55,001; Collector of Customs v Avon Cosmetics Ltd (2000) 1 NZCC 55,014; and Chief Executive of the New Zealand Customs Service v Nike New Zealand Limited (2004) 1 NZCC 55,028 (the ‘trilogy of cases’). Customs considered that the Authority misinterpreted the judgments in Adidas and Avon as standing for the principle that the purpose and effect of the wording in the duties regime was to determine the true “market value” of the goods at the border, as opposed to the “true cost of the goods to the importer”.  Customs argued that a consequence of that misinterpretation was that the Authority failed to consider the key issue of whether the goods could have been imported for the purpose of resale without incurring a liability for the licensing/royalty payments.
   
   
2. The transfer pricing analysis was irrelevant in determining the customs value of the goods.
   
   
3. The alternative test under cl 3(1)(a)(v) captures the licensing/royalty payments even if they are a form of profit-sharing.

Customs’ arguments rested on the following key propositions:

1. The intellectual property represented by the complex retail formula was too connected to the goods to treat it as separate for the purposes of calculating the customs value, and
   
   
2. The intellectual property could not be confined as relating only to the sales process as without the goods being imported and subsequently sold by Country Road NZ, there was no reason for Country Road Australia to provide Country Road NZ with post-importation support. The associated control over the goods and how they are sold meant that the payments must have constituted a condition of the sale of the goods for export to New Zealand.

Country Road NZ argued that the trilogy of cases was distinguishable because of the royalty payments in those cases were made in relation to the right to sell goods which were imprinted with the brand rather than in the form of post-importation support.

The High Court’s decision

The High Court (Becroft J) quashed the Authority’s decision and ruled in favour of Customs.  

The Court gave the following reasons for its decision: 

a. The arrangement did not provide for a separation between the licensing/royalty payments and the goods

The Court considered that the commercial reality of the informal arrangement between Country Road NZ and Country Road Australia did not support a separation between the licensing/royalty payments and the goods themselves. The Court found it difficult to discern which forms of intellectual property were covered under the loading sale price and the intellectual property included in the payments; for example, it was unclear whether the Country Road branding on the outside of the goods was included in the loading sale price or the licensing/royalty payments.

More importantly, the Court reasoned that if the retail formula was solely focused on the sale of the goods, it would be artificial to say that the retail formula was not in respect of the imported goods themselves, as goods cannot be separated from the way in which they are sold.

An expert in the field of intellectual property provided evidence (led by Country Road NZ) that most of a brand’s values and characteristics are expressed through retail services, and marketing promotes the services of Country Road NZ and “not just the products”. The Court had difficulty accepting that evidence and instead found that marketing relates to the products and are inseparable from the products (at least to a sufficient extent for customs duty purposes).  

b. Licensing/royalty payments are caught by cl 3(1)(a)(iv)

The Court considered that adopting the wide approach taken in the trilogy of cases to the interpretation of cl 3(1)(a)(iv) led to the conclusion that the payments were a condition of the sale of the imported goods.

The Court considered that two phrases were of most importance in interpreting cl 3(1)(a)(iv). Firstly, “in respect of imported goods” and secondly, “as a condition of the sale of the goods for export to New Zealand”.

The first was given the widest possible interpretation. The question was whether the goods could have been purchased for the purpose of resale without purchasing the intellectual property. The Court found that the licensing/royalty payments were entirely related to the goods as Country Road NZ had no purpose, other than selling the goods.

The second presented more difficulty. The commercial reality of the transaction is that Country Road NZ has no ability to import the goods from Country Road Australia without making the licensing/royalty payments. Country Road NZ could not sell the goods in a way that departed from the retail formula, nor could it sell generic goods in its retail stores. Therefore, if Country Road NZ refused to import the goods from Country Road Australia, its stores would be empty of merchandise.

c. A sound policy reason for applying cl 3(1)(a)(iv) 

The Court also considered there were strong policy reasons to conclude that the case fell within cl 3(1)(a)(iv). The Court commented that if it was held that customs duties were not payable here “it would also allow agreements of this type to become a playground for lawyers. It would invite ingenious drafting to circumvent customs duties for payments expressed to relate to intellectual property in the sales and marketing processes for the goods” (at [131]). 

Observations and comments

The High Court’s reasoning that the outcome was in part necessary to discourage other duty payers from structuring and drafting agreements in a manner to explicitly separate licensing/royalty to minimise the customs value of goods merits closer examination.

If a court’s role is to interpret the provisions of the Act, whether one interpretation, or another, may create “a playground for lawyers” or invite “ingenious drafting” of contractual arrangements is of questionable relevance. On one view, it is only for Parliament’s language to encourage or discourage practices, activities and behaviours.   

It is, of course, open to a court to test whether the payment is for what the contractual arrangement says it is for (a sham-type inquiry), and whether the licensing/royalty payments so commercially viewed fell within the statutory wording that determines the customs value, but the scope for more moral-based judgment in legal reasoning is appropriately limited. The policy-based concern expressed by the High Court as a reason for the decision here is presumably by way of buttress at best.     

Informal arrangements

It is strongly inferred in the judgment that the difficulty in determining whether there was an arrangement in place between Country Road NZ and Country Road Australia and then reaching a view on how that arrangement operated in practice muddied the waters. There is little doubt that this put Country Road NZ at a disadvantage in advancing its interpretation of the relationship between the complex retail formula and the goods themselves. A clearer formal arrangement could have assisted the positions for all parties and ultimately influenced the Court’s reasoning.

There is a cautionary tale here in investing in clear and properly constructed documentation governing commercial arrangements even if the parties are related by ownership.   

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