I came across an interesting statistic the other day published by the U.S. Census Bureau: in 2014, related-party imports accounted for about 50.9 percent (($1,178.7 billion) of all imports for consumption. With 50 percent of imports being made between related parties, we can begin to see why related-party valuation is such an important topic for U.S. Customs and Border Protection (CBP), and why this is such a frequent focus of customs valuation audits.
When we report the value of goods at the time of importation, the general rule is to use the “transaction value,” which is defined by statute as the total price “paid or payable” for the imported merchandise, regardless of how that price is derived. See 19 USC § 1401a(b). It is the “preferred method” of valuation. A critical limitation on the application of transaction value, however, is when the parties are “related.” For purposes of the statute, a “related party” is defined to include “any person directly or indirectly owning, controlling, or holding, 5 percent or more of the outstanding voting stock or shares of any organization and such organization.” See § 1401a(g)(1).
If the parties are related within the meaning of § 1401a(g)(1), then the use of transaction value will be precluded as the basis of the customs value, unless the importer can establish that the relationship between the related buyer and seller has not influenced the price actually paid, or payable. If transaction value is precluded, then the basis of the customs value falls to one of the other methods of customs valuation, such as the transaction value of identical or similar merchandise, or more frequently, computed or deduction value. See § 1401a(c-f). These alternate methods of valuation are often complex and time consuming in their application, and frequently they require importers to use special customs invoices and/or participate in special programs, such as CBP’s “entry reconciliation” to report their customs value.
If you are importing from a related-party, how do you establish with CBP that your related party transfer price is an acceptable transaction value?
The statute provides that a related-party transfer price is an acceptable transaction value if it: (a) closely approximates certain “test values,” or (b) satisfies the “circumstances of the sale test.” A “test value” is a customs value based on a prior legal appraisement of the entry of merchandise under one of the alternative methods of value, such as the transaction value of identical or similar merchandise, computed or deduction value. This almost never happens. In fact, there is not a single published customs ruling that has found the existence of a “test value” to support a related party transfer price as an acceptable transaction value. This inevitably leaves the importer with the only option to support its related party transfer price by using the “circumstances of the sale test.”
Transaction Value and the Circumstances-of-sales Test
Under the circumstances-of-sales test, a transfer price will be considered an acceptable transaction value if:
- The price is determined in a manner consistent with normal industry pricing practice;
- The price is determined in a manner consistent with the way the seller deals with unrelated buyers in the United States; or
- The price is adequate to ensure recovery of all costs, plus a profit that is equivalent to the exporter’s overall profit realized over a representative period of time in sales of merchandise of the “same class or kind.”
These methods are presented as examples to illustrate that the relationship has not influenced the price, but other factors may be considered relevant as well. See 19 C.F.R. § 152.103(I); see also HQ H037375, dated December 11, 2009; HQ H029658, dated December 8, 2009; HQ H032883, dated March 31, 2010, and H008101, dated October 9, 2012. In fact, an importer is free to present evidence that any one or more of these methods establish the validity of its transfer price.
Very often, the foreign related party seller does not sell to unrelated buyers in the United States, so method (b) is used infrequently. This leaves only methods (a) “the price is determined in a manner consistent with normal industry pricing practice,” and/or (c) “the price is adequate to ensure recovery of all costs, plus a profit…”
According to CBP, the “all costs plus a profit” test is the most objective method of meeting the circumstances-of-sale test when there are no sales to unrelated buyers in the United States; however, it is often the case that the importer does not have sufficient information from the foreign related party seller to substantiate its transfer price under this methodology. In such situations, the importer is left only with the option to establish that its related party transfer price is determined in a manner that is consistent with the normal pricing practice of the industry.
The balance of this article examines how CBP looks at a transfer pricing studies when considering whether an importer’s transfer price is an acceptable transaction value under the “normal industry pricing practice” methodology.
Transfer Price Studies and Transaction Value under the “Normal Industry Pricing Practice” Methodology
The “normal industry pricing practice method” (Method one) relies on the presentation of evidence of publicly available industry information on the price of the product being imported; such as quoted commodity prices, standard product price lists, or evidence that the price is consistent with the practices of other companies in the same or a similar industry. Very often, however, the imported products are not traded on the commodities market, and are not listed on industry standard product price lists. This leaves only evidence that the related party price of the imported product is consistent with the practices of other companies in the same or a similar industry.
CBP has uniformly held that an importer must have (a) objective evidence on how prices are set by the relevant industry in order to establish the “normal pricing practices of the industry” in question, and (b) present evidence that its transfer price was settled in accordance with these industry pricing practices.
To do so, CBP has said that an importer may use information compiled from various transfer pricing studies, which establish that other producers and suppliers utilize the same or similar methodologies to establish a selling price, and that the profit earned is within a range of profits earned by producers or suppliers within the same industry. For CBP, however, not all transfer pricing studies are created equally, and very often, the transfer pricing study relied on by the importer to establish an arms-length transaction under IRS Code § 482 fails to provide adequate support for customs valuation purposes.
In various administrative rulings, CBP has determined that a transfer pricing study or even an Advance Pricing Agreement (“APA”) with the IRS is not by itself sufficient to show that a related party transaction value is an acceptable transaction value. CBP has noted that although the broad goal of both the Customs and the tax law is the same, i.e., to ensure that related party transactions are at arm’s length, there are substantial differences in the legal requirements in the two laws. In fact, CBP has stated that an importer that relies solely on an APA or transfer pricing study to conclude that transaction value is acceptable would not be exercising reasonable care.
So how does an importer establish that its transfer price method results in a transfer price that is an acceptable transaction value? On this subject, CBP has provided lots of advice, but as we will see, it is seldom followed.
Since the adoption of the new customs value law in 1980 (19 USC 1401a), there have been approximately 88 headquarter rulings that refer to the use of “normal industry pricing practice method” as a means of establishing the viability of the transfer price under the “circumstances of the sale test.” Of these rulings, only 22 address the use of a transfer price study or APA agreement as a means of establishing the acceptability of the transfer price under the “normal industry pricing practice method.” Of these 22 headquarters rulings, 15 find that the transfer price study fails to establish the acceptability of the transfer price under the “normal industry pricing practice method,” and 5 conclude that transfer price study, either alone or together with other information, establish the acceptability of the transfer price under the “circumstances of sale” test. So why does CBP accept some transfer price studies but reject others? A review of these rulings quickly tells the story. Here are some of the key takeaways:
- The “comparable companies” are not in the same industry as the exporter or party under review. In the majority of instances where CBP rejects the TPS as a means of establishing the acceptability of the transfer price under the “normal industry pricing practice method,” CBP found that the study did not compare companies engaged in the manufacture, production, or distribution of products in the same industry. When selecting “comparable companies” for the study, financial consultants will often select companies according to similarities of function and risk, rather than on companies that are within the same industry as the exporter or other party under review.
- Following on the first reason for rejection is the lack of product particularity. In this case, the study may select a company for comparison, but that company has multiple businesses and produces a wide range of products, some that are of the same “class or kind” of product as being imported, and some that are not. CBP’s focus is on the comparison of companies that are in the same industry and producing the same “class or kind” of product as being imported. If the data on the comparison companies cannot be broken out to reflect only the data on a business unit producing the same “class or kind” of product as being imported, then CBP will reject the data because it does not reflect the “normal industry pricing practice” related to the products being imported.
- Lack of information on competitor companies. In many of the transfer pricing studies accepted by CBP, the importer has used financial information from direct competitors. CBP considers this information extremely relevant in determining the “normal industry pricing practice” related to the products being imported.
- Reliance on old data. If the importer is going to present a transfer price study as a basis to support the “normal industry pricing practice” related to the products being imported, then the study needs to include current information. A transfer price study that is not current or more than two years old will likely be rejected as not reflecting the current “normal pricing practice” of the industry in question.
- The transfer price study or APA agreement is based on the “comparable profits method (CPM), which CBP has said has the least relevance for Customs valuation purposes. While CBP has accepted transfer price studies based on CPM, it is done so when there is the presence of additional circumstances. CBP has said that it prefers the CUP method, as being most reflective of customs valuation rules.
Other important considerations for CBP accepting a transfer pricing study as evidence of the “normal industry pricing practice” include:
- Consideration and acceptance of the transfer pricing study by the IRS.
- The existence of a unilateral Advanced Pricing Agreement (APA) with the IRS.
- The existence of a bilateral Advanced Pricing Agreement (APA) with the IRS and foreign tax jurisdiction.
CBP has said that its participation in the unilateral or bilateral APA negotiations is also helpful for it in understanding and accepting the terms of the transfer pricing methodology in the APA agreement as an acceptable customs value.
It is important to keep in mind that this reflects the opinions and findings of CBP rulings. It is often the case that during a customs audit, or a review with the local import specialist, or Industry Center, the transfer pricing methodology or study will be accepted even if it does not reflect all of the elements discussed in these CBP rulings. However, if importers have the ability to influence how their transfer pricing studies will be conducted, then they should advise their company tax department, or CFO, on the conditions under which CBP will accept the transfer pricing study as evidence of the “normal industry pricing practice” related to the products being imported, and accept the transfer price as a viable transaction value under section 1401a(b).
George Tuttle, III is an attorney with the law offices of George Tuttle in the San Francisco Bay Area. The Tuttle Law firm is a part of a strategic alliance with the BLG, and assists BLG on specific projects.