On 29 April 2016 the World Customs Organization (WCO) published the full text of a case study where Customs takes into account a company's transfer pricing study based on the transactional net margin method (TNMM) in concluding that the price of imported goods had not been influenced by the relationship between the buyer and the seller (as per Article 1.2(a) of the WTO Valuation Agreement)
The case study, approved by the WCO’s Technical Committee on Customs Valuation (“TCCV”) during a meeting held April 18--22, was not expected to be published until July. Its availability is subject to the disclaimer that the text is subject to WCO Council approval.
While the facts of the case study are very specific, it does provide very useful guidance for customs and taxpayers as to the application of Commentary 23.1, which, to date, has been largely ignored, or narrowly interpreted by many customs officials.
Summary of the case study
According to the case study, XCO, a manufacturer in country X sells relays to its wholly owned subsidiary, ICO, a distributor of country I. ICO does not purchase products from unrelated sellers and XCO does not sell relays or goods of the same class or kind to unrelated buyers.
ICO has declared customs values based on transaction value, being the values on the commercial invoices. There is no indication of special circumstances per Article 1 subparagraphs (a)-(c) of the WTO Valuation Agreement.
Country I customs decides to review the circumstances surrounding the sale pursuant to Article 1.2 on the basis that it has doubts about the acceptability of the price. ICO has not provided test values as a means of demonstrating that the relationship did not influence the price.
ICO submitted a transfer pricing study prepared consistently with the OECD guidelines to customs in Country I. The study identifies ICO as the tested party and compares ICO's operating margin with the operating margins of eight comparable distributors of goods of the same class or kind located in Country I. The study concludes that the operating margin of 2.5% achieved by ICO for the relevant period is within the arm's length range of 0.64% to 2.79%.
The transfer pricing study has been reviewed by the tax authorities of Country I and Country X in the context of a bilateral advance pricing agreement (APA). The tax authorities agreed that this was an arm's length range for transactions comparable to ICOs.
After examination of the circumstances surrounding the sales between ICO and XCO, customs in Country I concludes, including by analysis of the transfer pricing study (and additional information concerning the operating expenses of ICO, as deemed necessary), that under Article 1.2(a) of the WCO Valuation Agreement, the relationship between the parties did not influence the price.
The case study provides a good example of how a transfer pricing study may be used by customs authorities when examining related party transactions. The fact pattern described in the case study is however very specific, reflecting what are assumed to be the various concerns, experiences, and positions of the TCCV delegates.
For example, the case study involves an application of the TNMM based on comparables that are located in the same country as the distributor and that deal in the same types of products. Whilst this raises doubts about the acceptance of so-called "foreign comparables" by customs authorities, it is expected that over time customs authorities will adopt a similar approach to tax authorities. That is, in the absence of local comparables and with proper economic analysis (and adjustments where necessary) comparables from other countries are accepted in most jurisdictions. . Differences in product and industry that are often acceptable for transfer pricing analysis may however prove to be more problematic in a customs context.
It should be noted also that in the case study the transactions are covered by a bilateral advance pricing agreement. The addition of this fact should not lead to the conclusion that there must be a bilateral APA agreement in place for customs to consider transfer pricing documentation, but rather that a thorough, 2-sided, transfer pricing analysis must have been undertaken for customs to give weight to the transfer pricing study.
The case study also assumes that the importer does not buy products from unrelated parties and the seller does not sell to unrelated parties. In practice there may be sales to, or purchases from, independent parties; however, due to the operating model of the business, these purchases or sales may not be comparable. For example, there may be differences in the level in the market, the geographic market, contractual arrangements, and volumes.
The case study further specifies that ICO’s operating expenses are paid to unrelated parties. This fact ensures that the purchase price of the goods is the only variable in the determination of the operating margin that may be influenced by the relationship between the parties. This allows, customs to work back from the arm's length operating margin to determine that the transfer prices are not influenced by the relationship. This implies that, in practice, to the extent there are operating expenses resulting from transactions with related parties, demonstrating in the transfer pricing study that those expenses are consistent with the arm's length principle will be critical in order for customs to give weight to the study.
Conclusion and key take-aways
Although the case study clearly states that it does not "indicate, imply or establish any obligation on Customs authorities to utilize the OECD Guidelines and the documentation resulting from the application of the OECD Guidelines in interpreting and applying the WTO Valuation Agreement," approval by the TCCV of this case study is a strong indicator of how views on transfer pricing have developed within the customs community.
In practice, the case study will serve as an influential publication for companies seeking to support customs values based on the transactional value method using a transfer pricing study, particularly in cases where the taxpayer has, or is seeking, and APA.
In this regard, taxpayers updating their transfer pricing documentation and/or reviewing their transfer pricing policy should consider that appropriately prepared transfer pricing studies can be used to help demonstrate to customs that the relationship between the parties has not influenced the price, and therefore that the transaction value should not be rejected, provided that:
- operating expenses are with unrelated parties, or are clearly demonstrated to be consistent with the arm's length principle, and
- the comparables selected and presented are carefully considered, taking into account the possible impact of geographic location, products and industry, from a transfer pricing and a customs perspective.
Having in place a bilateral APA should help provide customs authorities with additional comfort when considering the conclusions reached in a transfer pricing study.