What Are the Impacts of Impending Tariffs on Transfer Pricing?

International trade is facing the possibility of rising tariffs that will severely impact global supply chains and the cost of doing business, including transfer pricing. This article explains and outlines the mechanics and interaction of the impending tariffs and transfer pricing.

Transfer pricing within multinational enterprises as well as unrelated global trading activities must consider the impact on their cost and pricing structures when doing business across borders between the “big trading blocks” of the US, China, and the European Union. There is still a great deal of uncertainty on the exact measures and potential counter-measures to be adopted by many countries in bilateral trade deals.

1. Tariff Basics

From an economic perspective, tariffs charged on imports or exports qualify as a tax cost. Whether an import is subject to a tariff, and the amount due, is based on several factors, including:

Country of origin. Either: (1) the country where the goods were produced in entirety, or (2) if more than one country was involved in the production, the country where the last substantial transformation took place.
Tariff classification and duty rates. The customs tariff number should be double-checked to determine the correct customs value.
Customs valuation. Valuation principles require imported goods to be priced in line with the usual market price for similar goods.
Free Trade Agreement (FTA) and Rules of Origin (ROO). A company must check whether (1) it can benefit from FTAs and to what extent the preference process can establish customs licensing and prevent unnecessary paid duties; and (2) if the company may benefit from customs simplifications to potentially save import duties.

The parameters listed above need to be reviewed based on the facts and circumstances of an MNE’s supply chain and associated intercompany transactions. The appropriate path forward may not be clear as an MNE must consider pending measures that may imply new tariffs or modifications of existing tariffs. Because of the lack of clarity, we will focus on the mechanics below.

2. Interrelatedness of Tariff Value and Transfer Price

The customs value and the transfer price should be closely aligned from an economic perspective, as the objective of both standards is to produce a “market” or “arm’s length” price. The methods used for determining customs value and transfer pricing, however, are similar but not always the same.

According to, the World Customs Organization (WCO) Guide to Customs Valuation and Transfer Pricing (released June 2015; updated September 2018), a global system aligning the transfer pricing and customs valuation system is needed.

Customs Valuation. The system of methods determining the customs valuation has a binding sequence of methods—meaning that the methods must be applied in a strict heirarchical order. There are six valuation methods, but the most commonly used one (for approximately 95% of imports) is the transaction value method where the the price paid (or payable) for goods determines the customs value. Import transactions between two distinct and legally separate entities of the same MNE group are treated as “related party transactions”. To determine whether this method works, importers must review whether (i) there is an actual sale between related parties; and (ii) if the first sale is allowed in the specific region of import due to the local applicable rules of customs valuation.

Transfer Pricing. The transfer pricing regulations found in US Treasury Reg. §1.482 and in the OECD’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations outline various transfer pricing methodologies that can be chosen (by selecting the most appropriate method) to determine the transfer price. The methodologies include using data from identical transactions with third parties (Comparable Uncontrolled Price method) or identifying functionally comparable third parties and utilizing their financial information to create a range of profitability guidance (most transfer pricing methodologies). The transfer price is often part of the analysis of creating a customs value.

3. Impact of Tariffs on Transfer Pricing

Once additional costs stemming from higher tariffs have been determined, the impact on the transfer pricing may be assessed. The impact may vary depending on the transfer pricing method applied, as outlined below.

A. Comparable (Uncontrolled) Price Method
The often preferable, but most difficult to apply, transfer pricing method, is the comparable price method. Where such a comparable price is reliably available, tariffs would be applied on that price. Depending on INCOTERMS either the supplier or the distributor could economically bear the tariffs. A comparable uncontrolled price (CUP) could be derived from historical transfer prices (i.e., arguing that a price that was arm’s length in the past should remain arm’s length unless relevant parameters change) or from pricing to unrelated customers in the same, or other, jurisdictions (internal CUP). The reliability of historical transfer prices of course decreases over time and the reliability of any CUP is very sensitive to comparability parameters, such as the timing of the transaction (i.e., before or after a significant change in economic circumstances), individual market characteristics, volumes, quality, etc.

B. Cost Plus Method for Manufacturing
In the case of contract manufacturing or similar low value-added production activities, the cost plus method appears to be widely used. This one-sided approach focuses on the cost of the manufacturer, disregarding the cost of the other counter-party (principal) receiving the residual result from the business operations. Transfer price and tariff value should be very much the same (i.e., cost plus mark-up). Consequently, any tariff related to the import of the finished product is paid by the principal and any export tariff would be added to the cost of the manufacturer and finally be borne by the principal. Therefore, the principal in a contract manufacturing arrangement bears any tariff imposed.

C. Resale Minus Method / TNMM for Distribution
In circumstances where you have a distributor with limited functions / risks (i.e., not an entrepreneurial trading business) the transfer pricing is generally based on a retrospective analysis / bottom line analysis of the distributor to determine an appropriate gross margin (resale minus method) or net margin (transactional net margin method—TNMM) based on what an unrelated distributor is paid in a comparable situation. With the availability of (third-party) sales prices and the known distribution cost, an appropriate transfer price can be determined. As explained above, tariffs are additional costs from an economic point of view and if these costs cannot be fully shifted to the customer, the group’s total profitability will be negatively affected. Straight application of the resale minus method results in a decreasing profitability on the intercompany transaction by the amount that is not able to be shifted to customers. (Applying the resale minus method and depending on INCOTERMS, the supplier might bear tariffs or the parties need to consider the tariffs when (re-) determining the distributors gross margin. In both cases, finally, the supplier bears the tariff.) The profitability of the limited risk distributor would remain stable within the range of comparable unrelated distributors’ profitability, and therefore the manufacturer/supplier (i.e., the foreign entrepreneur) would bear excess tariff costs as the distributor has limited risks.

For routine distributors, the total group’s profitability is diminished by whatever cost (i.e., tariff) increases that are not passed along to the third-party customer. In addition, the routine distributor should bear more or all the tariff costs because its risks are not limited by a related party.

A reduction of the transfer price to a lower arm’s-length price—if also used for the customs valuation—would decrease the amount of tariffs paid. From a global perspective, this option reduces the total tariff burden of the MNE. Compared to the application of the comparable uncontrolled price method and the cost-plus method, this reduces the impact of tariffs at group level.

D. Profit Split Considerations
Although an application of the profit split method is unlikely a suitable method for routine distribution activities, a more balanced result could be achieved by assessing the impact of tariffs utilizing a profit split methodology to allocate tariffs to both foreign entrepreneur/manufacturers and distributors in countries implementing prohibitive tariffs. According to the resale minus method and the TNMM, it would not be appropriate to fully burden the distributor with the additional cost of tariffs. On the other side, if additional costs are incurred in the country of the distributor, arguably the distributor should participate in such an impact. Although there is no exact calculation at hand, and considering the global picture, it might be appropriate to limit the profitability of the distributor to the lower range of comparable distribution profits or even to a “break even” zero-EBIT.

Similar arrangements have been seen in the past during times of global economic crisis when entire industries suffered losses. In this situation it may be inappropriate if distributors still earn a “guaranteed” profit. Moreover, even limited risk distributors do bear some risk and should participate in global losses at least by limited profits (or only breaking even). After all, limited risk does not mean no risk. Based on such analysis and thorough documentation, the impact of tariffs on profit allocation within an MNE could be balanced out at least to some extent.

3. Relocation of Function and Exit Taxation

One main goal of any tariff regime is to strengthen the local economy and attract domestic investment. Any shifting of existing production and/or distribution functions including related risks and intellectual property (IP) from one jurisdiction to another jurisdiction potentially implies a relocation of functions (RoF) in terms of Chapter IX of the OECD TP Guidelines and potentially triggers (exit) tax implications.

The arm’s length principle underlying any transfer pricing considerations provides that a RoF might coincide with a transfer of “something of value” (as the OECD TP Guidelines say) that needs to be remunerated appropriately. Basically, the value of such function needs to be determined from the transferring and the receiving parties’ perspective (two-sided valuation). The value or purchase price (typically the mid-value of the two-sided valuation) of the function is then subject to taxation at the level of the transferring enterprise while the receiving enterprise activates and depreciates assets or goodwill.

The existence of a RoF and valuation parameters are frequently subject to lengthy and difficult discussions with tax authorities around the globe. Tax authorities of the jurisdictions of transferring enterprises request high values of a RoF, while tax authorities of jurisdictions of receiving enterprises often have a very different understanding of an appropriate price to accept for such a RoF. Amounts at stake are often high and positions are contrary by definition. This requires thorough consideration of the underlying facts and valuation parameters, as well as proper documentation of the specific case. Legal certainty might be fostered by advance pricing agreements.

4. Takeaways

Although there are major interplays between transfer pricing and customs valuation, one needs to bear in mind the methodologies are ultimately different, including how the appropriate method is selected and how it is used. Transfer pricing and custom valuation methodologies were not written with the other in mind. An important difference is that the customs valuation of products imported is done so at the time of import on the basket of goods being imported, whereas the transfer pricing is used for the entire year, generally analyzed on an aggregate basis. Another important difference is that transfer pricing might permit retroactive year-end adjustments. When importing products into a specific region, the applicable customs laws might not permit the amendments of customs declarations including changes to the customs value, or only allow such amendments under very limited circumstances. Per the World Customs Journal, Tthe WCO “does not provide a definitive approach to this issue but it ‘provides technical background and offers possible solutions regarding the way forward, and shares ideas and national practices.’” The WCO also acknowledges there is a need for a global set of rules aligning the systems, and that such is not to be expected at short notice in all global regions. Therefore, there is still a major need for a workable solution.

Transfer pricing has multiple considerations on how tariffs are accounted for, partly dependent on transfer pricing methodology being used. INCOTERMS should be considered, when in the past they may have been overlooked. Accounting for tariffs are different if the arrangement is based on a cost plus, (e.g., contract manufacturing transaction) versus a resale minus transfer price. Ultimately the overall profitability of a distributor should be examined as a tax authority would expect it to be at least covering its costs, (i.e., “break even”). Lastly, if a company is considering a change to its supply chain to potentially mitigate any tariffs assessed, then exit taxes need to be taken into consideration. A modeling exercise may be beneficial to understand the effect of altering the customs valuation through altering the transfer price has on the total tariff and tax burdens.

Given that a solution is not to be expected in the near future, it may be advisable to seek advanced customs valuation rulings.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Friederike von Borries is a customs senior manager at Forvis Mazars Germany. Elizabeth Hazzard-Herzingis a transfer pricing director at Forvis Mazars US. Roland Pfeiffer is a transfer pricing partner at Forvis Mazars Germany. Eline Polak is a global indirect tax partner at Forvis Mazars Netherlands.