INSIGHT: Multinationals Face Formidable Challenges in Valuing Intangibles: Part II – Customs

In light of the recent elevation of protectionism that created uncertainties and tension to international trade, we review the latest gap-bridging efforts between transfer pricing and customs valuation regimes in Part II of this article.

In the first part of this two-part article, we explored the similarities and differences of the intangibles valuation between transfer pricing and financial statement purposes, focusing on purchase price allocation.

Valuation of Intangibles in Transfer Pricing and Customs

The Customs Valuation Framework

Besides the purchase price allocation of intangibles, another contentious issue taxpayers face is customs valuation. World Trade Organization (WTO) members use the transaction value method for customs valuation, which is based on the price of goods paid or payable upon import, plus adjustments for commissions, shipping, licensing, insurance and other costs. What this implies is that the customs valuation is inclusive of the value of intangibles. Article 8 of the WTO Customs Valuation Agreement states that the transaction value should also include royalties and license fees related to the goods being valued that the buyer must pay.

When the buyer and seller are related, the Agreement states that this fact by itself does not mean the transaction value is not acceptable. If the relationship does not influence the price, the transaction value will still be respected. If the customs authority believes the relationship influences the price, it would conduct further inquiries with the importer. Thus, customs and tax authorities are similar in that they follow a risk based audit procedure.

The Issue

The inherent conflict of interest between the direct tax and customs authorities has been well-documented and acknowledged. Specifically, a lower price on import goods leads to a lower customs duty for the importing country, which translates to lower costs of goods sold in the same country, resulting in higher business profits and taxable income.

Despite the competing incentives, the customs and the direct tax authorities are actually trying to achieve similar objectives in a related party context: they both want to ensure the price of an underlying transaction is set as if the parties are independent third parties. However, the two sides do approach the issue slightly differently—customs authorities would like to confirm all appropriate elements (including intangibles) are included in the customs value and therefore the value is not understated; whereas tax authorities would like to make sure the transfer price does not include inappropriate elements and is not overstated.

The recently updated World Customs Organization (WCO) Guide to Customs Valuation and Transfer Pricing (WCO Guide) pointed out certain similarities between WTO methods for customs valuation and OECD methods for transfer pricing valuation. For example, the WTO deductive method (Article 5) is based on the resale price of the goods, close to the OECD resale price method. In addition, the WTO computed value method (Article 6) is based on a value built up from materials and manufacturing costs etc., plus profit, similar to the OECD cost plus method. The WCO Guide reflects the conclusion of OECD’s Base Erosion and Profit Shifting Project, which includes addressing the vulnerability resulting from over-emphasizing the contractual allocation of functions, assets, and risks, and stressing the importance of accurate delineation of transactions in comparability analysis, focusing on actual conduct and the real substance of the arrangements. The Guide also incorporates the three-tiered transfer pricing documentation approach that is now part of the Chapter V of the OECD Transfer Pricing Guidelines.

The Coordination

Over the last decade, there were dialogues between international organizations from both customs and direct tax sides to bridge the gap. We provide a short review of recent developments.

It has long been recognized that because the WTO Valuation Agreement would not be revised any time soon, it is unlikely there would be some formal alignment or merger of the two system of methodologies. As such, the practical solution had been to work around the constraints of the existing WTO Agreement provisions. Consistent with this understanding, recent efforts have been focusing on knowing to what extent the customs authorities would use transfer pricing information when carrying out examinations of related party transactions.

As of late 2017, WTO has issued three instruments directly on the topic of coordination with transfer pricing when it comes to related party transactions, a commentary and two case studies. The commentary recognizes the principle that a transfer pricing study may be used by customs as a basis for examining the circumstances of the sale (Commentary 23.1). The first case study (Case Study 14.1) establishes a scenario where the customs authority primarily relies on a transfer pricing study with the application of comparable profits method (or transactional net margin method) to confirm that a related party transaction has not been influenced by the relationship between the parties. The second case study (Case Study 14.2, which includes imbedded intangibles in products) reflects a situation where the importer’s transfer pricing report uses the resale price method. The application of the resale price method compares the importer’s gross margin with the gross margins of unrelated comparable companies, and shows the importer’s gross margin is higher than the interquartile range of gross margins earned by comparable companies. The customs authority concludes that the import prices are not settled in a manner consistent with the normal pricing practices of the industry. Hence, the import prices have been influenced by the relationship between the buyer and seller.

Although these publications emphasize the review would be on a case-by-case basis, it is important that they recognize the value of transfer pricing studies. Even in the case study where the customs authority concluded the import prices have been influenced by the related party relationship, it relied on the functions and risks sections of the transfer pricing study to examine the circumstances surrounding the sales.

From the transfer pricing side, two important organizations, the United Nations and the OECD, expressed similar views, although less specific than the WTO’s case studies. First, the United Nations transfer pricing manual recognizes that there are some similarities between customs valuation and transfer pricing methods, although the former may not always be aligned with the latter. Examining customs values may provide relevant information and a useful starting point for transfer pricing purposes and may also help taxpayers reduce the compliance burden. It also states that “in appropriate circumstances the verified customs value may be useful to tax administrations in evaluating the arm’s length character of the transfer prices of imported goods in international transactions between associated enterprises.”

The OECD’s discussion is brief, but takes a comparable view and states that the arm’s length principle is applied by many customs administrations. However, valuation methods for customs purposes may not be aligned with transfer pricing methods. The OECD’s recommendation is that customs valuations may be helpful for tax administrations in evaluating the arm’s length nature of the transactions and vice versa.

The Differences

Despite the recognition of the similarities, the WCO pointed out the following areas that could make leveraging transfer pricing studies challenging: first, transfer pricing data may cover a range of products as opposed to the single imported product. This is the primary reason for customs officials to reject the reference to a transfer pricing study. Because the customs authorities follow the principle of “goods of the same class or same kind,” which could apply a narrower definition than the typical Standard Industrial Classification (SIC) code selection in transfer pricing. The issue gets more complicated once we consider imbedded intangibles in products.

In addition, the selection of certain comparable companies under the comparable profits method for transfer pricing purposes focuses on the comparable functions and risks, which may not even be in the same four digit SIC code; therefore, they may not be in the same industry or product group as the taxpayer/importer. This is reasonable for transfer pricing studies but may not be acceptable under customs requirements.

Second, both customs and direct tax authorities may conduct audits several years after the importation of goods and the taxable year end, respectively. What the customs authorities would like to ensure is that the transfer pricing data contained in the studies relates to the specific periods under review. Transfer pricing studies generally apply the most recently available data, which may not cover the same taxable years as the transactions happened.

Additionally, although all three international organizations (OECD, WTO, and UN) recognize the improved cooperation between direct tax and customs administrations, and encourage all countries to continue enhancing such coordination, they still caution the careful use of the other side’s information because potential differences do exist. This might seem disappointing from a glass half-empty point of view; however, a glass half-full perspective would see the improved information sharing and coordination, as evidenced by the differences between the two versions (2013, 2017) of the United Nations’ transfer pricing manuals. The 2017 version of the United Nations’ transfer pricing manual painted a more promising picture in terms of coordination between direct tax and customs administrations.

A recent development that was perceived as a drawback to the convergence effort between transfer pricing and customs valuation involve the Court of Justice of the European Union’s (CJEU) decision on the Hamamatsu case (C-529/16) in December 2017. The CJEU ruled that a transfer price that is subject to retroactive adjustments after the year-end could not form the basis for the transaction value method for customs valuation purposes. Because the transaction value reflects the economic value of the goods at the time of importation and all elements that influence value should have already been taken into account, there is no basis for allowing retroactive adjustments.

The fact pattern involving the Hamamatsu case is disconcerting because the underlying intercompany transactions, Hamamatsu Germany imports goods from its parent Hamamatsu Japan, are covered by a bilateral Advanced Pricing Agreement (APA) with the German and Japanese tax authorities. At year-end 2010, Hamamatsu Germany’s profitability was below the range prescribed in the APA, the group therefore made year-end adjustments to lower the transfer prices for goods purchased by Hamamatsu Germany to increase the subsidiary’s profit. Because Hamamatsu Germany used the initial transfer prices determined by the APA as the customs value of the goods, it filed for a customs duty refunds application after the transfer pricing adjustment. Both the German customs authority and the court denied the refunds application, and CJEU concurred with this conclusion.

This decision potentially would affect many multinational enterprises that import products into the EU in an intercompany setting, and would have the largest impact on the entities that routinely use transfer prices at import as the transaction value and retroactively adjust the prices later. Considering the recent tariff and trade dispute, some practitioners caution that, although the WTO concurs it is reasonable to adjust prices of imported goods to reflect changes of the duty costs, companies need to monitor and evaluate the target profit levels closer and more frequently. The implication from the ruling, which intensifies the disjoint between transfer pricing and customs valuation, would certainly make the monitor and adjustment process more challenging in the current economic environment. On the other hand, there may still be reason to believe some customs authorities will subscribe to a more harmonized view between transfer pricing and customs valuation. Because CJEU’s ruling is based on the Community Customs Code that was in effect until April 30, 2016, the customs authorities in the EU may take a different view with the updated Union Customs Code. The WCO Guide does not specifically mention the Hamamatsu case; however, it is generally believed that the EU is striving for streamlined and simplified customs legislations and procedures.

Conclusion

Looking across the three different valuation disciplines, the PPA looks at transactions from a market participant’s perspective in an orderly market, and the market participants’ individual specifics do not necessarily have to be identified. For transfer pricing valuations, it looks at the value chain and emphasizes the facts, functions and risks to determine the specific entity or transaction’s position within the value creation process. Finally, the customs engages in a more detailed valuation approach and focuses on the features of the goods when they pass the border, inclusive of any imbedded intangibles.
What is the best practice for maneuvering between the three sets of requirements? Relying on a study prepared for another discipline is certainly not the ideal policy. In a transfer pricing audit, the agents may not appreciate a copy of the PPA analysis in response to their request for a transfer pricing study. Similarly, as a recent customs’ case study illustrated, taxpayers that only use transfer pricing studies to support the prices reported on customs invoices might be inviting more inquires.

However, this is not to say that there is nothing to leverage between the three disciplines. For example, when deciding the useful life of an intangible, both PPA and transfer pricing studies presumably obtain this information through the same process—by talking to engineers, marketing professionals, or reviewing financial or technical specs. As such, there should be a great level of coordination on this matter. Every time taxpayers use a certain study for another purpose, they either need to pay attention to more granular details, or raised the study to a higher-level perspective, focusing on the stylized characteristics.

Author Information

Joyce Beebe is a research fellow at the Center for Public Finance at Rice University’s Baker Institute for Public Policy. Bill Spiller is a lecturer in the Department of Accounting at the University of Texas at Austin’s McCombs School of Business and an independent economic consultant. The comments, views, and opinions in this article are those of the authors, and do not necessarily represent the views of Baker Institute for Public Policy or University of Texas at Austin.