Earlier this year, the US Government announced that related party imports (i.e., import transactions between affiliates) had for the first time exceeded $1 trillion and have almost doubled in just the last 10 years. With related party imports considered higher risk by US Customs and Border Protection (CBP) due to the potential of price manipulation, a dramatic increase in such imports places many more importers as potential targets for customs audit and enforcement actions. This is the case even for those importers with seemingly low-risk import operations by virtue of limited product diversity, absence of special duty arrangements, low or even zero duty rates, or relatively simple supply chains.
Many companies perceive the risk of related party transactions to be limited to the tax area and paying the correct amount of corporate income tax. To the extent companies are aware that related party transactions raise customs valuation issues as well, such companies may reflexively point to transfer pricing studies prepared by their tax advisors in asserting the correctness of their customs valuations. In this article, we discuss several aspects of a typical transfer pricing study that could undermine the ability of companies to rely on such studies to support customs valuation. Proactively addressing these issues can save a company from protracted and expensive disputes concerning the valuation of related party imports.
Differences Between Tax and Customs Requirements
A common misperception is that a transfer price meeting IRS requirements is also appropriate for customs valuation purposes. The assumption is not unreasonable, considering that the IRS and CBP are charged with revenue collection and, historically, both had served as part of the same federal agency. But each agency administers a different set of laws and regulations, including those provisions dealing with related party transactions.
The IRS is concerned that a company report an appropriate amount of income on an annual basis, regardless of whether certain transactions during the year did not meet targeted profit margins. For multinational companies with related party import transactions, this means apportioning income between the US company (buyer) and its foreign counterpart (seller) such that an acceptable level of profit is apportioned between the two. The relative overall profitability is the key determinant, without necessarily considering the impact of specific transactions. Thus, a year-end adjustment could remedy transactions that miss profit targets earlier in the year. By contrast, the customs law requires that valuation be accurate for each transaction. For example, transactions that are undervalued in September and October cannot be “offset” by overvaluing imports in November and December. CBP would consider this scenario to result in valuation errors in all four months.
Further, the customs valuation rules establish a hierarchy of valuation methodologies. CBP requires importers to value merchandise according to “transaction value” whenever possible. If the information is not available to utilize this methodology, then valuation must be based on an alternative series of methodologies given preference in an articulated statutory hierarchy. Thus, if transaction value is not viable, CBP looks to transaction value of identical or similar merchandise, deductive value, computed value, or adjusted value based on these alternatives (i.e., “fallback” method), in that order. On the other hand, while many US taxpayers use the comparable profits method (CPM) to validate transfer prices, US tax rules give no priority to any particular method of testing transfer prices, requiring instead that taxpayers determine the validity of transfer prices using the “best method” available. In this regard, customs valuation rules can be viewed as more rigid than those administered by the IRS.
Failing to meet appropriate profit benchmarks can also lead to different results depending on whether the IRS or CBP is your audience. If CBP considers transfer prices not meeting customs requirements, then the valuation will be considered erroneous, leaving the importer vulnerable to penalties. By contrast, if transfer prices yield an insufficient profit/income amount for IRS purposes, the taxpayer will be expected to make a year-end adjusting payment or credit so that the corporate taxes ultimately paid will be consistent with IRS requirements.
The clear differences between the customs and tax regimes governing transfer pricing indicate that a transfer price study done for IRS purposes often cannot be relied on to validate transfer prices used to value imports from related parties.
Potential Gaps in Transfer Pricing Studies
A transfer price study undertaken for tax purposes can contain information that is important in supporting customs valuation, though the importer (and not CBP) bears the burden of identifying such information and filling the gaps as they exist. But CBP will not consider a transfer pricing study prepared for IRS purposes as dispositive evidence in validating transfer prices for customs valuation purposes. The elements of a transfer pricing study discussed below should guide trade compliance personnel in their evaluation of the utility of a transfer pricing study as support for the company’s customs valuation.
- Is There an Advance Pricing Agreement? Most transfer pricing studies are not reviewed by the IRS. However, when such information is reviewed and accepted by the IRS in the form of an Advance Pricing Agreement (APA), CBP places greater trust in the study/APA and will more likely accept transfer prices established pursuant to the APA as appropriate for customs valuation. To the extent that the importer does not have an APA, addressing the potential issues below becomes more critical.
- Which Entity Does the Study Cover? CBP regulations focus on the costs and profits of the foreign seller – that is, did the foreign seller receive a price that enabled recovery of all costs plus a reasonable profit? A transfer pricing study focusing on the profitability of the US taxpayer is thus not preferred for US customs purposes.
- Do The Comparison Companies Sell the Same Merchandise That Is Imported? Transfer pricing studies using the comparable profits method often identify comparable companies as those that are functionally equivalent to the company that is the subject of the study. That is, the studies will treat retailers as comparable to retailers, manufacturers to manufacturers, distributors to distributors, etc. However, CBP regulations focus on the particular merchandise being imported, requiring that profit be evaluated on the sale of the same “class or kind” of merchandise as the imported merchandise. A study that includes profit analysis of companies that sell different products than the imported products will have less value in support of customs valuation than a study that compares companies in a similar line of business.
- How Does the Study Measure Profits? Often depending on the industry, some transfer pricing studies evaluate margins on the basis of gross profits. However, CBP considers operating profit to be the more appropriate basis to evaluate the profits of a company. An importer seeking to use a transfer pricing study using gross profits or some other measure should expect to have to explain why operating profits are not an appropriate basis of comparison.
- What Costs Are Included in the Profit Calculations? Related to the above point, the customs statute provides that transfer prices may be sufficient if they enable the seller to recover “all costs,” though this concept is not further defined. It is not uncommon for certain finance or overhead costs to be excluded in deriving operating profit. In such cases, the importer should be prepared to explain why any excluded costs do not pertain to the imported merchandise.
- When Did the Transactions Covered By the Study Take Place? An importer cannot expect a study establishing the validity of transfer prices in one year to be useful in supporting customs valuation for related party imports in another year, unless compelling evidence to the contrary can be provided. To the extent an importer seeks to use a transfer pricing study as evidence to support customs valuation, such importer should expect to commission these studies on a routine basis.
- Does the Study’s Conclusion Support Customs Valuation? As noted above, a study’s conclusion that transfer prices are appropriate for tax purposes does not necessarily support customs valuation. When applying the comparable profits method, a study typically considers whether the profit of the subject company falls within the interquartile range of the comparable companies. If the subject’s profit is higher than this range, it indicates that transfer prices were not greater than arms length and that income is not understated, resulting in appropriate taxes being paid. However, in the customs context, profit margins that exceed those of comparable companies suggest that transfer prices may be too low, resulting in undervalued imports. It is incumbent on the importer to demonstrate why its profit margins may fall outside the range of comparable companies.
Enhancing the Value of a Transfer Pricing Study for Customs Purposes
The issues and risks discussed above provide a roadmap to importers on how to enhance the value of a transfer pricing study for customs valuation purposes. While we discussed clear differences between tax and customs requirements relating to transfer pricing, there are enough similarities and related concepts that would allow for a customs-specific analysis to be incorporated into a tax-based study without great difficulty. Thus, perhaps the most significant step that an importer could take is to define the scope of the study to include an evaluation of whether transfer prices meet CBP requirements. In this regard, the importer would basically be including in the study the same information that it would likely be required to present to CBP in demonstrating how the tax study is useful for customs purposes.
Beyond expanding the scope of the study, which may not be feasible for many companies, there are several less comprehensive steps that an importer can take. First, the study should focus on the prices set and profits earned by the foreign, selling party rather than the US importing entity. Second, the importer commissioning the study should direct its advisers to include in the study profit data from companies that manufacture the same or similar merchandise as the importer. Even if the study is based on a broader range of companies that are functionally the same, including data from companies producing the same “class or kind” of merchandise will permit an analysis that is more aligned with CBP requirements. Third, the study should include financial data and profit calculations that are sufficiently detailed to confirm that the transfer prices cover “all costs” incurred by the seller and an appropriate profit margin.
With related party imports at an all time high, the potential for customs penalties for valuation errors is great. Companies should not be comforted simply by having a transfer pricing study in the files of the tax department. A thorough analysis of such a study and development of additional information that fills any gaps is critical in fulfilling the importer’s reasonable care obligations and supporting a company’s transfer prices for customs valuation purposes.
For further information on transfer pricing issues in the customs context, please see the first two Alerts in our recent series on transfer pricing and customs valuation rules.