INSIGHT: New U.S. Tariffs and BEAT Stir Interest in Tax Code Limitation on Related Party Costs

Where U.S.-dutiable goods are imported by a U.S. company from a related foreign seller, and the U.S. importer’s reported cost for tax purposes exceeds the U.S. importer’s reported customs value, tax code Section 1059A can apply.

Section 1059A is applicable, for example, where the U.S. importer has improperly, although inadvertently, understated, to the Customs and Border Patrol (CBP), the dutiable customs value of inventory bought from the related party, and has reported to the Internal Revenue Service a higher purchase price of those goods than the value declared to CBP, in determining the U.S. importer’s cost of goods sold. In such a case, Section 1059A generally directs the IRS to reduce the U.S. importer’s cost of goods sold to reflect the costs improperly omitted for CBP duty valuations. This is in addition to possible liability to the CBP itself for duties and penalties under 19 U.S.C. Section 1592, which can apply where the reported customs value of dutiable or even non-dutiable goods has been understated.

Treasury Regulation Section 1.1059A-1(c)(1) provides that non-dutiable goods are not subject to Section 1059A. Thus, for example, goods that are non-dutiable pursuant to U.S. Free Trade Agreements and other international agreements, such as goods imported from Mexico that are exempt under NAFTA, are not subject to Section 1059A. Similarly, goods that are non-dutiable under the U.S. statutory Generalized System of Preferences (GSP) for designated less-developed countries, such as India and Turkey before May 2019, have not been subject to Section 1059A.

In 1986, when Section 1059A was enacted and entered into force, 67% of the value of the goods entering the U.S. was dutiable, and 33% of the value of goods entering the U.S. was non-dutiable. By contrast, due to the 1994 NAFTA Agreement and other post-1986 U.S. tariff eliminations and reductions, the situation had reversed by 2018. In 2018, 67% of the value of the goods entering the U.S. was non-dutiable, and 33% of the value of goods entering the U.S. was dutiable. In 2018, goods entering into the U.S. from Mexico, generally non-dutiable under NAFTA, constituted about 14% of all U.S. imports.

2019 Developments

In early June 2019, President Trump announced an indefinite postponement of previously proposed tariffs on all Mexican-originating goods, even those previously non-dutiable under NAFTA. However, President Trump also announced the possible future imposition of such tariffs if Mexico does not cooperate with the U.S. on certain immigration matters. There are many unknowns relating to the possible Mexican tariffs at this point, including whether they will indeed enter into force, if so, what implementing regulations will be associated with them, and whether they may ultimately be invalidated at a later date through a legal challenge. If such tariffs do apply, then, with respect to imports of Mexican products by U.S. companies related to the exporter, such imports could be covered by Section 1059A. This would represent a very large expansion of the percentage of import transactions subject to review under Section 1059A.

Similarly, in June 2019, the U.S. is proceeding with plans to impose tariffs on many Chinese goods. Although many Chinese-originating goods have been dutiable since before 2019, any Chinese goods which first become dutiable in 2019, and are imported by a related U.S. importer, may first become subject to Section 1059A in 2019.

Conversely, in early June 2019, President Trump also promoted the possibility of a new, post-Brexit, Free Trade Agreement with the U.K. Any future elimination of tariffs on U.K.-originating goods would correspondingly reduce the scope of Section 1059A.

In late May 2019, President Trump announced the termination of eligibility for GSP of imports originating from Turkey (the fifth largest GSP beneficiary, with estimated annual non-dutiable imports of $2 billion). In late May 2019, President Trump also announced the termination in June 2019 of eligibility for GSP of imports from India (the largest GSP beneficiary with estimated annual non-dutiable imports of $6 billion).

Many of the large U.S. multinationals who imported Indian and Turkish products, which were exempted from duty before May 2019, also imported from affiliates dutiable products from other countries, and are familiar with Section 1059A. However, smaller U.S. importers of formerly non-dutiable Indian and Turkish products from related parties, may now be, for the first time, subject to Section 1059A. For example, U.S. importers from related Indian and Turkish suppliers, and who had no other related party dutiable imports before June 2019, may be facing Section 1059A exposure for the first time.

BEAT

Even before, and unrelated to, the dramatic 2019 U.S. tariff developments, many larger U.S. groups (at least $500 million in average gross receipts, and thus possibly subject to the Section 59A Base Erosion and Anti-Abuse Tax (BEAT)), who both import products from foreign related parties, and pay significant fees to foreign related parties, were in the process of reviewing their payment structure. Their goal has often been to seek to include the fees in inventory costs, which are generally treated as non-base-eroding payments, rather than having such fees treated as ordinary deductible business expenses, which are generally treated as base-erosion payments. In 2018, the IRS issued proposed regulations concerning BEAT. The preamble to those proposed regulations states: “the proposed regulations do not explicitly address whether a royalty payment is classified as deductible under section 162 or as a cost includible in inventory under sections 471 and 263A resulting in a reduction in gross income under section 61.”

Based on the preamble, some commentators have suggested, for example, that franchise fees, based on the sale of inventory, paid by a U.S. distributor potentially subject to BEAT, to a related foreign franchisor, could be accounted for as non-base-eroding capital expenditures, even if the franchise fees are immediately deductible as allocable to current year sales under Treas. Reg. Section 1.263A-1(e)(3)(ii)(U).

However, any U.S. buyer considering such an approach must consider Section 1059A. An April 11, 1996 IRS field service advice involved a U.S. subsidiary which acted as U.S. distributor for its U.S.-dutiable products bought from its German parent. The U.S. subsidiary paid the German parent, in addition to the invoiced price of the goods, a percentage of the U.S. subsidiary’s sales, for the privilege of reselling the German parent’s products. The U.S. subsidiary apparently included this fee in its cost of goods sold for income tax purposes, but incorrectly, in violation of the CBP valuation rules, omitted this fee from the U.S.-dutiable value timely declared to the predecessor of the CBP. The IRS National Office approved a downward adjustment by IRS to cost of goods sold of the U.S. distributor under Section 1059A, by reason of the U.S. distributor’s erroneous failure to timely include the fee in the dutiable value.

Timing

In that 1996 field service advice, the IRS National Office further held that a voluntary payment by the U.S. importer to the predecessor of the CBP—made after the U.S. distributor learned that the fees may be dutiable additions—did not prevent the IRS Section 1059A adjustment where such payment was made following the period that the CBP determination of value became final, as specified in Treas. Reg. Section 1.1059A-1(d).

Similar timing problems have been raised by commentators when the related U.S. importer determines that it is entitled to increase its cost of goods sold above the invoiced import price, on a timely filed income tax return, under the arm’s-length test of Treas. Reg. Section 1.482-1(a)(3), but does not contact the CBP before the CPB determination date.

Conclusion

Given this Administration’s interest in the imposition and removal of U.S. tariffs as a commercial and political tool, income tax directors of U.S. importers from foreign related parties, in order to avoid disallowances under Section 1059A, must keep abreast of tariff developments. For example, U.S. importers of Indian and Turkish goods from related parties will, for the first time, if they have not yet imported dutiable goods from related parties, face possible Section 1059A tax issues, as well as new CBP issues. Even large U.S. corporate importers that are accustomed to coordinating reporting to CPB and IRS under Section 1059A will, as they consider revising their payment structure to reduce their BEAT connected to dutiable imports, need to consider Section 1059A issues, as well as the BEAT and CBP issues.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.