R&D Costs Included in Calculation of Value for Duty for Footwear

On March 2^nd, 2015 the Federal Court of Appeal released its decision in Skechers USA Canada Inc. v. Canada (Border Services Agency), 2015 FCA 58 upholding seven decisions of the Canadian International Trade Tribunal which upheld the decisions of the Canada Border Services Agency ruling that research, design & development expenses paid by a Canadian subsidiary to its U.S. parent must be included in the price “paid or payable” for shoes imported into Canada.

When goods are imported into Canada, their value for duty is determined by the “transaction value” of the goods coming into Canada. The transaction value of goods is determined by ascertaining the price paid or payable for the goods when the goods are sold for export to Canada and adjusting the price paid. The legislation provides that adjustment shall include engineering, development work, art work, design work, plans and sketches undertaken elsewhere than in Canada and necessary for the production of the imported goods.

The core business of the Skechers Canada and of its sole shareholder Skechers USA is the sale of Skechers-brand footwear. Skechers USA designs the various styles of footwear, which are manufactured offshore by third parties. Skechers Canada purchases footwear from Skechers USA for re-sale in Canada.

When Skechers Canada purchases the goods from Skechers USA, the transfer price includes: the factory price paid by Skechers USA to the manufacturers; the cost of shipping the goods to the United States and warehousing them in Skechers USA’s distribution centre; and an arm’s-length profit.

Skechers Canada also makes payments to Skechers USA pursuant to a Cost-Sharing Agreement (“CSA”). Under the CSA, Skechers Canada provides compensation for costs that Skechers USA incurs for activities necessary to the development and maintenance of the Skechers brand and to the sale of footwear. Such activities include research, development, design, advertising, and marketing.

The amount that Skechers Canada pays under the CSA is a percentage of Skechers USA’s total costs for these activities. Each year, this percentage is determined according to a formula based on the ratio of the appellant’s anticipated operating profit to the total anticipated operating profits of all participants to the CSA.

The payments at issue in the appeal before the Federal Court – the R&D payments – consist of a portion of the payments made by Skechers Canada under the CSA; only costs relating to research, design, and development are included.

Skechers USA undertakes significant research, design, and development activities to create its footwear. Each season, the process involves researching trends to develop themes and concepts, which are translated into designs for its various product lines. These designs are eventually developed into prototype samples. Of the 40,000 to 50,000 prototype samples that are produced each year, approximately 5,000 become “successful” footwear styles available for sale. The appellant usually markets approximately 1,700 of these styles.

The price that Skechers USA pays to the manufacturers of the successful styles includes compensation for the prototypes, moulds, samples, etc. leading to the production of these styles. However, this price does not include compensation for costs incurred by the manufacturer relating to the unsuccessful styles; such compensation is provided through a separate payment.

As a result, the transfer price Skechers Canada pays to Skechers USA for the goods includes the costs of the moulds and samples leading to the production of the styles which are being imported. However, this price does not include the costs of the moulds and samples of unsuccessful styles and styles not imported into Canada. It also does not include general research and design costs (such as the salaries of Skechers USA’s research and design staff).

In 2006, the Canada Border Services Agency (“CBSA”) initiated an audit of the value for duty of the goods in issue based on the value that Skechers Canada had declared for these goods in 2005. On March 25, 2008, the CBSA issued a decision stating that for the 2005 calendar year, a portion of the R&D payments should be included in the “price paid or payable”. Skechers Canada asked the Canadian International Trade Tribunal for a re-determination of the CBSA decision for the years 2005 to 2011. Skechers Canada argued that the R&D costs (for unsuccessful footwear, for example) are not necessary for the production of the goods in issue or for the basic use of the goods in issue as footwear. However, the Tribunal found this argument to be untenable based on the evidence, which demonstrated that the purpose of the research, design, and development process was the development of footwear. In the Tribunal’s view, the goods in issue could not have been produced without this process. Furthermore, the brand is intimately related to the imported goods, and so the R&D payments are “inseparable from the footwear products themselves.” The Tribunal also concluded that the entire research and development process is required to produce the successful styles of footwear. It found that “the different steps of the research and development process are all interrelated into a common effort towards producing a shoe that customers wish to buy.”

Skechers had relied upon a previous decision of the Tribunal, Simms Sigal & Co. Ltd v. The Commissioner of the Canada Customs and Revenue Agency (27 May 2003), AP-2001-016 (CITT) [“Simms Sigal”] in support of its argument. However, the Tribunal distinguished that case on the basis that the payment at issue in Simms Sigal – a distribution fee – was tied to the marketing and sale of the goods after their importation and not to their production.

The Federal Court of Appeal found that the Tribunal’s conclusion that the entire research, design, and development process was required to produce the goods in issue was one that was reasonably open to it based on the evidence. It accordingly dismissed the appeal.