Multinational companies face compliance challenges and spend substantial time and money on transfer pricing issues. Transfer pricing arises as an issue when affiliated entities within a business enterprise buy or sell goods or services between them. Major car makers, for example, have many subsidiaries and affiliates throughout the world. They ship parts from one affiliate to another through a supply chain that produces an assembled vehicle. To use a hypothetical, when a Chinese subsidiary ships a gear box to its parent company’s US assembly plant, this is a purchase/sale transaction between affiliates. Two major governmental issues arise when this happens – taxes and Customs duties.
Tax authorities in both China and the US want the pricing of the gear box to be properly established, so that each government can collect its fair share of taxes. If there were no transfer pricing rules, the auto maker would be inclined to set pricing in a manner that minimizes its overall taxes. If it cost less in tax to price the gear box in a manner that minimizes the mark-up (or margin) between the Chinese cost of production and the sale price to the US affiliate, then pricing would be set in this way to achieve tax savings. China and the US (like all countries) insist, however, that the US auto company set pricing as though it were buying from an unaffiliated company in China. There are various ways to establish that a pricing policy used between affiliates will satisfy Chinese and US tax authorities, including use of recognized transfer pricing methods (based on studies) or advance pricing agreements between tax authorities and the company.
Even if a transfer pricing formula or agreement achieves tax compliance, Customs authorities in the two countries may have different standards and will use difference procedures for applying duty rates to imports. The country to which the gear box is imported will insist on pricing in the documentation of each shipment that will allow proper determination of duties to be paid on the imported products.
US Customs valuation of imported items is generally based on transaction value. In other words, if an importer pays US$100 for an item, that is the transaction value, which should be stated on the Customs form at the time of importation and used to calculate the amount of duty owed. With affiliated companies acting as exporter and importer, however, transaction value is obviously subject to being set on a basis that would minimize the value of the imports, in order to lower the duty that will be paid. US Customs does not take the same approach to affiliate valuation as the US IRS prescribes. And US Customs, like all Customs authorities, is based on an entry by entry procedure. Every single shipment of goods imported into the US must be accompanied by a specific stated value for the imported goods, which is then used to compute applicable duties. The importer has some time after entry to adjust the value up or down (and so alter the amount of ultimate duties owed) from the figure declared on the import documentation, before an entry is deemed to be “liquidated” and so final (though subject to challenge if incorrect).
If in our example of an imported gear box, the US parent and Chinese subsidiary agree that the pricing of the gear box can be lowered for a given past period of time (based on changes in raw material cost or other valid reasons), the US importer would want to apply for a reduction in duties paid at the time of importation and so receive a refund. US Customs has, however, refused to recognize such post-importation factors and so routinely denies refund requests of this type. This was clarified in a November 2001 ruling stating that transaction value could not be used in an affiliated party case, on the ground that a price set by related parties cannot be seen as “fixed and determinable under an objective formula.” See Customs & Border Protection (CBP) Headquarters Ruling Letter 547654.
About a year ago, CBP issued a notice and sought public comment about this discrepancy between how to value related party transactions for IRS purposes and Customs methods. On December 28, 2011, CBP put a formal notice on its website (www.cbp.gov), that it intends to issue a policy change – to be HRL 548314. This will make it possible for global business to use a transfer pricing policy for Customs purposes if it embraces five factors:
- The enterprise had a documented “intercompany transfer pricing determination policy” that sets a method for pricing prior to importation;
- The US importer uses the same transfer pricing method for IRS purposes;
- The enterprise’s policy specifically covers the products where the importer wants to adjust the value after importation;
- The policy says what adjustments will occur to the transfer price, with solid explanation; and
- There are no conditions that indicate ultimate pricing cannot be justified as one that reflects what an arm’s-length price would have been.
Assuming the policy becomes final, as is expected, US companies that buy from their affiliates can achieve compliance with lesser cost and uncertainty than before. The policy will create the potential for using the same basis for pricing to achieve both IRS and Customs compliance in related party commerce. This will be so for US purposes. There is, however, no global consensus on harmonizing Customs and tax authority transfer pricing. The ideal solution would be a global agreement, at least among OECD and other major trading economies, that would provide a consistent and level playing field for global commerce.
This imminent change will affect a growing percentage of US trade in goods. CBP statistics show that over 40% of US imports are from related parties, for a total declared value of US$1.3 trillion in 2010 (up 23.6% from 2009). Companies purchasing from foreign affiliates should consider meshing their IRS and Customs transfer pricing policies to achieve greater certainty, increased duty refund potential and lesser administrative cost.