Ruling of the Week 18: Transfer Price

Customs valuation is subject to its own rules and requirements. Importers apply those rules and requirements when reporting the value of merchandise to Customs and Border Protection. As you likely know, when the buyer and the seller are related, the sales price between the parties is suspect and Customs can seek to determine whether the relationship affected the sales price. If so, the related party price might be rejected as a basis for transaction value, causing Customs to apply a different basis for valuation. That is a compliance hassle that no one wants.

Over on the income tax side of things, they have their own statutory rules and tests to determine whether transfer prices are an acceptable means of valuing products. The problem for customs compliance professionals is that the IRS tax compliance often drives transfer pricing and customs compliance must find a way to make due with the result. IRS compliance is sometimes the big dog that wags customs valuation as a small tail. When the customs compliance professionals press for changes to the transfer pricing system, the response is sometimes "We can't touch that, it is controlled by tax." That is not always the case and customs compliance people can make their lives a lot easier by educating tax professionals on customs issues.

Customs HQ Ruling H2043 (Aug. 18, 2014) illustrates some of that tension. In the ruling, the company involved was buying pharmaceutical products from its related party in Germany. The two companies were operating under a bilateral Advanced Pricing Agreement for tax purposes. This agreement required that the selling party maintain a certain level of profit to establish what the IRS and foreign tax authorities considered to be an arms-length level of profits. To accomplish this, the companies made accounting adjustments to transfer money back and forth over a period of years to get the seller to the level of profitability required by the APA.

Because the U.S. company was smart, it realized that these adjustments were made to the cost of goods sold to the U.S. company and might represent changes to the dutiable value of the imported goods. Consequently, the company filed a prior disclosure with Customs and Border Protection. The disclosure identified the adjustments and argued that they are not dutiable because the adjustments were for tax purposes and did not reflect the value of the merchandise.

In this case, Customs found that the way the APA worked, the adjustments were made to cost of goods sold with the intention that the adjustment affect the profitability of the seller. Based on this, Customs found that the adjustments had a direct impact on the price paid for the imported goods and, therefore, were part of the customs value of the merchandise.

That causes a potential problem for the importer. Between related parties, transaction value is only applicable where the relationship did not affect the price. If you think about the reason for these adjustments, you can see that the adjusted price was clearly impacted by the relationship between the parties. The parties were making the adjustments for the express purpose of managing the profitability of the seller, with the blessing of the IRS. That necessarily raises the question of whether transaction value is applicable.

Customs has established a five-part test to determine whether transaction value is applicable to related party transactions subject to a formal transfer pricing policy. Under that test, the transfer price is acceptable where:

(1) A written transfer pricing policy is in place prior to importation and the policy is prepared taking IRS code section 482 into account;
(2) The U.S. taxpayer uses its transfer pricing policy in filing its income tax return, and any adjustments resulting from the transfer pricing policy are reported or used by the taxpayer in filing its income tax return;
(3) The company’s transfer pricing policy specifies how the transfer price and any adjustments are determined with respect to all products covered by the transfer pricing policy for which the value is to be adjusted;
(4) The company maintains and provides accounting details from its books and/or financial statements to support the claimed adjustments in the United States; and,
(5) No other conditions exist that may affect the acceptance of the transfer price by CBP

 The theory is that where these factors are present, the adjustment to sales represents the application of an objective formula, which has always been acceptable for transaction value.

In this case, the importer apparently did not provide information supporting the application of transaction value on the basis of the five-part test. As a result, Customs found that the importer could not claim the benefit of an objective formula, which would have allowed for refunds in the case of adjustments that lowered the purchase price.

Instead, counsel for the importer argued that the five-part test is inapplicable. Rather, counsel argued that the circumstances of the sale indicate that the relationship did not affect the price. This is also a legally viable way to preserve the application of transaction value. As Customs and Border Protection puts it: "[T]ransaction value is an acceptable basis of appraisement only if, inter alia, the buyer and seller are not related, or if related, an examination of the circumstances of the sale indicates that the relationship did not influence the price actually paid or payable, or the transaction value of the merchandise closely approximates certain 'test values.'” 19 U.S.C. §1401a(b)(2)(B); 19 CFR §152.103(l).

Unfortunately, the company did not submit sufficient information to prove that the circumstances of the sale indicate the relationship did not affect the sale price. As a result, increases in value need to be reported and, to the extent duties are applicable, duties paid.


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