U.S. Customs and Border Protection Versus the
APRIL 2008 - The
U.S. Customs and Border Protection (CBP) issued a new Informed
Compliance Publication, What Every Member of the Trade Community
Should Know About: Determining the Acceptability of Transaction
Value for Related Party Transactions, in April 2007. While
this publication breaks no new ground, it is a signal that in
the near future the CBP may scrutinize related-party valuation
issues more closely.
transactions typically arise whenever either an overseas exporter
or a U.S. importer directly or indirectly owns or controls 5%
or more of the voting stock of the other party, or if both directly
or indirectly control, are controlled by, or are under common
control of, a third party. The prices in such related-party transactions
are regulated in the United States by both CBP and the IRS, and
may be regulated overseas as well by the exporting country’s
counterpart of the IRS.
imposed by CBP and the IRS are similar in theory because both
seek to establish that the related-party prices are determined
in an arm’s-length transaction. However, these requirements
are sometimes drastically different in the details of their application.
the valuation statute (19 USC section 1401a) administered by CBP,
the value declared for imported merchandise is almost always determined
under the transaction value standard, because the statute requires
that the secondary methods of appraisement (transaction value
of identical or similar merchandise, deductive value, or computed
value) be used only after the primary transaction value method
is rejected. The U.S. Customs Service defines transaction value
as “the price actually paid or payable for the merchandise
when sold for exportation to the United States” plus certain
additions. If such prices are between unrelated parties, the inquiry
ends. If related parties are involved, however, CBP may inquire
as to whether such prices are acceptable for determining transaction
If the exporter
and importer are related, one way to avoid a CBP inquiry into
the acceptability of the related-party prices is first-sale appraisement.
First-sale appraisement is possible if the related exporter purchases
the merchandise from an unrelated factory and the transactions
otherwise qualify as sales for exportation to the United States.
The basic requirements are that the factory knows the goods are
destined for the United States and that the transactions should
be established as sales. Once these requirements are met, CBP
is faced with a transaction value based on prices in sales between
unrelated parties, and the inquiry ends. The advantages to this
method are that the exporter’s mark-up is not included in
the values declared to CBP, resulting in lower duties, and that
the sometimes onerous documentation requirements discussed below
for supporting related-party prices can be avoided. [On January
24, 2008, CBP published a notice in the Federal Register proposing
to eliminate first-sale appraisement. See Proposed Interpretation
of the Expression “Sold for Exportation to the United States”
for Purposes of Applying the Transaction Value Method of Valuation
in a Series of Sales, 73 Fed. Reg. 4254 (Jan. 24, 2008).
This proposal raises some doubt as to the continuing viability
of the first-sale appraisement method in the near future. For
commentary on the potential impact of this proposal, see the Sidebar.]
Related-Party Pricing Tests
availability of first-sale appraisement, under the customs laws,
related-party prices are acceptable for transaction value purposes
if they meet either the circumstances-of-sales test or a test
value. While evidence sufficient to meet only one test is required,
reliance on only one test is not recommended.
test. The circumstances of sales test is met if
the analysis reveals that the relationship between the buyer and
the seller did not influence the prices paid, which can be demonstrated
in three ways. Under variation 1, the circumstances-of-sales test
is met if the related-party prices are settled in a manner consistent
with the normal pricing practices in the industry, such as when
the related-party prices are tied to quoted public market prices,
such as for traded commodities.
2 is met if the related-party prices are settled in a manner consistent
with the way the seller settles prices in sales to unrelated buyers.
For example, if the exporter sells the same merchandise to unrelated
buyers in the U.S. or in other countries and uses the same pricing
formulas, or if the prices are comparable at the same level of
trade, then the related-party prices are acceptable for CBP purposes.
The documentation necessary to satisfy CBP here would include
a comparative analysis of the related and unrelated prices converted
into a common currency, along with sales invoices from the exporter
demonstrating such prices. CBP prefers a comparison using prices
in sales to unrelated parties in the United States, but will accept
comparisons to prices in sales to unrelated parties outside the
United States, if such sales do not exist in the United States
and the exporter provides an adequate explanation of such sales.
3 is met if the related-party price is adequate to ensure recovery
of all the exporter’s costs plus a profit equal to its overall
profit realized over a representative period of time, such as
a year in sales of merchandise of the same class or kind. Anytime
an analysis of the cost of production is undertaken, the amount
of documentation necessary to satisfy CBP as to the accuracy of
such costs is enormous; therefore, variation 3 is recommended
only as a back-up method or if variations 1 and 2 do not apply.
necessary to satisfy CBP that the circumstances-of-sales test
is met deserve mention. CBP will often reject circumstances of
sales analyses because they contain statements that are not supported
by evidence. Thorough documentation is a must for any circumstances-of-sales
values. The second method of establishing the acceptability
of related-party prices is to determine whether such prices closely
approximate the appraised value of the merchandise if one of the
secondary methods of appraisement were used. Three variations
exist. The first test value is the transaction value of identical
or similar merchandise in sales to unrelated buyers in the United
States. This variation requires the exporter to sell to unrelated
buyers in the United States, or to have access to and documentation
of its competitors’ prices in sales to unrelated U.S. buyers.
value is the second possible test value and starts with the U.S.
importer’s resale prices to unrelated buyers in the United
States, and then subtracts the duties and freight, the importer’s
selling, general, and administrative costs, and the profits in
the United States.
possible test value is computed value, which looks at the exporter’s
cost of production, general overhead, and profits.
CBP has a policy of not accepting any test values unless one of
the secondary appraisement methods was actually used in a previous
importation and was accepted by CBP. This policy effectively rewrites
the statute and eliminates test values. If the valuation statute
requires an importer to use transaction value unless such method
is rejected, then an importer would not have had the opportunity
to use a secondary method of appraisement until after CBP questioned
the acceptability of the related-party prices. According to CBP,
by then it is too late.
Only a few
court cases have addressed related-party pricing under the customs
laws. Although the CBP’s standing policy has been raised
in those cases, the court decisions have not discussed it. Therefore,
test values should be used only as a backup method.
Transfer Pricing Tests
whose only options are accepting or rejecting related-party prices
for transaction value appraisement purposes, the IRS can adjust
transfer prices for tax purposes if such prices do not meet the
IRS’s tests. The IRS has several profit-based methods and
three transaction-based methods for reviewing transfer prices.
In addition to using one of these methods, the IRS requires a
taxpayer to demonstrate that the method used provides the best
and most reliable measure of the arm’s-length nature of
the transfer prices.
methods. The profit-based methods include the comparable
profits, comparable profit split, and residual profit split methods,
all of which focus on overall profits and not on specific transactions.
Profit comparisons are made either between the related parties
or between the related parties and competitors. Because a customs
value must be ascertained for each imported article, these IRS
methods will generally not establish the acceptability of such
related-party prices for CBP purposes.
methods. The IRS’s transaction-based methods
include the comparable uncontrolled price (CUP) method, the resale
price method, and the cost-plus method. The CUP test compares
the related-party transfer prices to the prices in sales to unrelated
parties. Therefore, this method is very similar to variation 2
of CBP’s circumstances of sales test and could possibly
be met by the same type of documentation: an analysis comparing
such related and unrelated prices and the sales invoices demonstrating
resale price method compares the gross margin earned in related-party
sales to the gross margin earned in sales to unrelated parties.
This method is typically used for a reseller. The IRS’s
cost-plus method is ordinarily used for a manufacturer, and again
compares the gross margins earned in related- and unrelated-party
sales. Therefore, the resale price method is somewhat similar
to CBP’s deductive test value, and the cost-plus method
is somewhat similar to variation 3 of CBP’s circumstances
of sales test or the computed test value; but both of these IRS
methods would have to undergo significant adjustments before they
were acceptable to CBP.
Versus the IRS
U.S. taxpayers can obtain an advanced pricing agreement (APA)
either with the IRS or with the IRS and the overseas taxing authorities.
If they do not have an APA, many multinational companies prepare
their own transfer pricing studies based on the IRS methods. In
the aforementioned Informed Compliance Publication, CBP serves
notice that the existence of an APA or a transfer pricing study
will not by itself satisfy its inquiries into the acceptability
of related-party prices for transaction value appraisement purposes.
Instead, the importer must demonstrate how the IRS transfer pricing
method used also satisfies one of the CBP tests. Similar in effect
to an APA, a proactive importer can apply for a CBP ruling approving
its related-party pricing. The CUP test is the only IRS method
that appears to readily satisfy a CBP test as well. Information
found in the other IRS transaction-based methods may help support
one or more CBP tests, but significant adjustments would be required.
aspect of the interplay between the IRS and CBP with regard to
related parties deserves mention. Under IRC section 1059A, the
inventory costs of imported merchandise taken into account by
a related-party importer for IRS purposes shall not exceed the
value declared to CBP. This statute does not apply to first-sale
appraisements, but applies a double penalty when, for example,
a related-party importer does not declare an assist, one of the
required additions to the price paid or payable. (Common assists
include materials, components, tools, and dies or molds supplied
free of charge or at a reduced cost by the buyer of imported merchandise
to the overseas parties.) Not only is the importer subject to
CBP penalties for undervaluing its imported merchandise, but the
IRS can disallow the tax deduction for the cost of that assist.
Answers for Questions
devote significant time and resources preparing for when the IRS
questions their transfer prices. Companies typically do not, however,
devote comparable time and resources preparing for the day CBP
questions the acceptability of the related-party prices for purposes
of transaction value appraisement. The recent Informed Compliance
Publication serves notice that the CBP will probably raise these
questions sooner rather than later.
Alan Goggins, Esq., CPA, a partner of
the law firm Barnes, Richnardson & Colburn, is a member of the
NYSSCPA and its Relations with the Legal Community, Apparel and
Textile, and Chief Financial Officers committees.